Too Big to Fail

by Andrew Ross Sorkin

  Paulson knew he couldn’t do much for Lehman himself. Treasury itself did not have any powers to regulate Lehman, so it would be left to the other agencies to help manage a failure. But that made him anxious.

  Earlier in the summer, David Nason had held a meeting with the SEC and told Paulson they were not on top of the situation. With streams of spreadsheets of Lehman’s derivative positions splayed before them in the Grant conference room, he had questioned Michael A. Macchiaroli, an associate director at the SEC, about what they would do if Lehman failed.

  “There are a lot of positions,” Macchiaroli said. “I’m not sure what we’d do with the positions, but we’d try to net them out, and we’d go in there, and SIPC would come in,” he added, referring to Securities Investor Protection Corporation, which acts in a quasi-FDIC capacity but on a much smaller scale.

  “That can’t be the answer,” Nason replied. “That would be a mess.”

  “The problem is that half their book is the U.K.,” Macchiaroli said, explaining that many of Lehman’s trades went through its unit in London.

  “And their counterparties are outside the United States, and we don’t have jurisdiction over them.” In the event of a disaster, all the SEC could do was try to maintain Lehman’s U.S. broker-dealer unit, but the holding company and all of its international subsidiaries would have to file for bankruptcy.

  There were no good answers. Nason had raised the possibility that they might have no choice in an emergency but to go to Congress and seek permission to guarantee all of Lehman’s trades.

  But as quickly as he raised the idea, he shot himself down.

  “To guarantee all the obligations of the holding company, we would have to ask Congress to use taxpayer money to guarantee obligations that are outside the U.S.,” he announced to the room. “How the hell would we ask for that?”

  Across a sweeping meadow from the Jackson Lake Lodge, the towering white peaks of the Tetons offered a majestic view, but one that no longer took Ben Bernanke’s breath away the way it once had. As he walked its trails on August 22 he recalled that it was here, at the Federal Reserve Bank of Kansas City’s summer symposium in the Grand Teton National Park, that he had first made his name nearly a decade ago. For the next three days, however, he could expect little more than criticism, questioning of his actions over the past year and questions about what role the government should play with respect to Fannie and Freddie. In the summer of 1999, when the mania for Internet stocks was in full bloom, Bernanke and Mark Gertler, an economist at New York University, had presented a paper at Jackson Hole that contended that bubbles of that sort need not be a huge concern of the central bank. Pointing to steps taken by the Federal Reserve in the 1920s to pop a stocks bubble that only created problems when an economic downturn took hold, Bernanke and Gertler argued that the central bank should restrict itself to its primary responsibility: trying to keep inflation stabilized. Rising asset prices should only be a concern for the Fed when they fed inflation. “A bubble, once ‘pricked,’ can easily degenerate into a panic,” they argued in a presentation that had been the talk of the conference and had attracted the favorable notice of Alan Greenspan.

  A year ago Jackson Hole had been a more trying experience for Bernanke. As the credit crisis escalated that summer, Bernanke and a core group of advisers—Geithner; Warsh; Donald Kohn, the Fed vice chairman; Bill Dudley, the New York Fed’s markets desk chief; and Brian Madigan, director of the division of monetary affairs—huddled inside the Jackson Lake Lodge, trying to figure out how the Fed should respond to the credit crisis.

  The group roughed out a two-pronged approach that some would later call “the Bernanke Doctrine.” The first part involved using the best-known weapon in the Fed’s arsenal: cutting interest rates. To address the crisis of confidence in the markets, the policy makers wanted to offer support, but not at the expense of encouraging recklessness in the future. In his address at the 2007 conference, Bernanke had said, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” Yet his very next sentence—“But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy”—bolstered what had been perceived as the central bank’s policy since the hasty, Fed-organized, Wall Street–financed bailout of the hedge fund Long-Term Capital Management in 1998: If those consequences were serious enough to impact the entire financial system, the Fed might indeed have broader obligations that might require intervention. It was precisely this view that influenced his thinking in protecting Bear Stearns.

  By this year’s conference the Bernanke Doctrine had come under attack. As Bernanke, looking exhausted, sat slumped at a long table in the lodge’s wood-paneled conference room, speaker after speaker stood up to criticize the Fed’s approach to the financial crisis as essentially ad hoc and ineffective, and as promoting moral hazard. Only Alan Blinder, once a Fed vice chairman and a former Princeton colleague of Bernanke’s, defended the Fed. Blinder told this tale:

  One day a little Dutch boy was walking home when he noticed a small leak in the dike that protected the people in the surrounding town. He started to stick his finger in the hole. But then he remembered the moral hazard lesson he had learned in school…. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout, and doing so would just encourage more shoddy construction. Besides, the foolish people who live here should never have built their homes on a floodplain.” So the boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned—including the little Dutch boy.

  Perhaps you’ve heard the Fed’s alternative version of this story. In this kinder, gentler version, the little Dutch boy, somewhat desperate and worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. It was painful and not guaranteed to work—and the little boy would rather have been doing other things. But he did it anyway. And all the people who lived behind the dike were saved from the error of their ways.

  The previous day, Bernanke, in his address to the symposium, had made a plea to move beyond a finger-in-the-dike strategy, by urging Congress to create a “statutory resolution regime for nonbanks.”

  “A stronger infrastructure would help to reduce systemic risk,” Bernanke noted.

  It would also mitigate moral hazard and the problem of “too big to fail” by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention.

  A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.

  Bernanke did not mention Fannie or Freddie, but their fate was on the minds of many at Jackson Hole. That Friday Moody’s cut its ratings on the preferred shares of both companies to just below the level of non-investment grade, or junk. Expectations increased that Treasury would have to pull the trigger and put capital in Fannie and Freddie.

  Jackson Hole also had, of course, long been a popular destination for the very wealthy. James Wolfensohn, the former Schroder’s and Salomon Brothers banker who became president of the World Bank, was one of Jackson Hole’s celebrity residents, and during the 2008 symposium he held a dinner at his home. In addition to Bernanke the guest list included two former Treasury officials, Larry Summers and Roger Altman, as well as Austan Goolsbee, an economic adviser to Barack Obama, who was about to be officially nominated as the Democratic candidate for president.

  That night Wolfensohn posed two questions to his guests: Would the credit crisis be a chapter or a footnote in the history books? As he went around the table and surveyed opinions, everyo
ne agreed that it would probably be a footnote.

  Then, Wolfensohn asked: “Is it more likely that we’ll have another Great Depression? Or will it be more of a lost decade, like Japan’s?” The consensus answer among the dinner guests to that question was that the U.S. economy would probably have a prolonged, Japan-like slump. Bernanke, however, surprising the table, said that neither scenario was a real possibility. “We’ve learned so much from the Great Depression and Japan, that we won’t have either,” he said assuredly.

  “We’ve made a decision,” Paulson announced to his team and advisers in a conference room at Treasury the last week of August about the fate of Fannie and Freddie. “They can’t survive. We have to fix this if we are going to fix the mortgage market.”

  Upon his return to Washington from Beijing, Paulson had spent a day listening to presentations from Morgan Stanley and others and had decided that they had no choice but to take action, especially as he watched the shares of both companies continue to slide. To Paulson, unless he solved Fannie and Freddie, the entire economy would be in jeopardy.

  Morgan Stanley had spent the past three weeks working on what was internally called, “Project Foundation.” Some forty employees had been assigned to the task, working nights and weekends. “It’s easier in jail,” complained Jimmy Page, an associate. “At least you get three meals a day and conjugal visits.”

  The firm had undertaken a loan-by-loan analysis of the portfolios of the two mortgage giants, shipping reams of mortgage data from Fannie and Freddie off to India, where some thirteen hundred employees in Morgan’s analytic center went through the numbers on every single loan—nearly half the mortgages in the entire United States.

  The Morgan Stanley bankers had also conducted a series of phone calls with investors to get a better sense of the market’s expectations. The outcome was, as Dan Simkowitz described it to the Treasury team: “The market cares what the Paulsons think. John Paulson and Hank Paulson. They want to know what John Paulson thinks is enough and they want to know what Hank Paulson is going to do.” (John Paulson was the most successful hedge fund investor of the past two years, having shorted subprime before anyone else, making some $15 billion for his investors and personally taking home more than $3.7 billion.)

  The Morgan Stanley bankers estimated that the two mortgage companies would need some $50 billion in a cash infusion, just to meet their capital requirement, which should be equal to 2.5 percent of their assets; banks, at a minimum, had to have at least 4 percent. With the housing market deteriorating it was clear that the GSEs’ thin capital cushion was in danger.

  Worse, Paulson could see signs that China and Russia could soon stop buying, and perhaps begin selling, Fannie and Freddie debt. Jamie Dimon had separately called him and encouraged him to take decisive action.

  Paulson led a discussion around the table at Treasury about whether it made sense to put Fannie and Freddie in Chapter 11 bankruptcy protection or whether conservatorship—in which the companies would still be publicly traded with the government as a trustee exercising control—was the better option.

  Ken Wilson was a bit anxious about pursuing what Paulson was describing as a “hostile takeover” without more professional guidance. “Hank, there is no fucking way we can pursue these kinds of alternatives without getting a first-rate law firm,” Wilson told him.

  “Okay,” Paulson agreed. “So what do you think?”

  “Let me call Ed Herlihy at Wachtell and see if he’ll do it,” Wilson said. “The idea of putting these guys in Chapter 11 is a joke. These are still privately owned entities with obligations to shareholders and bondholders. It’s going to get ugly.”

  Wilson had a compelling reason for having recommended Herlihy: He had been involved in some of the biggest takeover battles in corporate America. Earlier in the year he had helped advise JP Morgan Chase in its acquisition of Bear Stearns. His firm—Wachtell, Lipton, Rosen & Katz—was synonymous with corporate warfare. One of its founding partners, Martin Lipton, had devised among the most famous of antitakeover defenses, the “poison pill.” If Treasury was planning a government-led hostile takeover—the first in history—then Herlihy was certainly the lawyer they wanted.

  They began their battle plans on the weekend of Auguest 23. Herlihy and a team of Wachtell, Lipton lawyers came to Washington on a half-dozen different Delta and US Airways shuttles in order not to arouse suspicion. Paulson walked them through the game plan, assisted by Dan Jester, the lanky Texan who had joined Treasury less than a month earlier. The hope was that like megamergers that are often completed over the course of a single three-day weekend to protect against a leak impacting the stock market, they could take Fannie and Freddie over during the Labor Day holiday, which was the following weekend.

  The lawyers and the Treasury officials spent several hours debating possible tactics, relevant statutes, and the structures of each of the companies. Jester and Jeremiah Norton, another staffer at Treasury, outlined a plan to put capital into Fannie and Freddie, and an actual mechanism to take control of them, via the purchase of preferred stock and warrants.

  But Paulson soon realized that the Labor Day target was going to be impossible. One of the lawyers had noticed that Fannie’s and Freddie’s regulator from the Federal Housing Finance Agency, James Lockhart, had written letters to both companies over the summer saying that they were considered adequately capitalized. “You’ve got to be kidding me,” Paulson replied, when he heard about the letters. Treasury could face resistance from the GSEs’ supporters in Congress and from the companies themselves if the government were to reverse itself apparently arbitrarily. The companies’ claims that they were well capitalized and the regulator’s endorsement would both have to be challenged.

  “That’s intangibles and all the stuff that I would call bullshit capital,” Paulson complained.

  “We need to reconstruct the record,” Jester announced about the Federal Housing Finance Agency letters.

  “Right, right,” Herlihy chimed in. “We need new letters that are pretty bad—or at least accurate.”

  The Federal Reserve was then asked to provide examiners, and they would spend the next two weeks going through the books, desperately trying to document the capital inadequacies at Fannie and Freddie.

  As the Treasury team went around the table, one issue kept getting raised about pushing forward with a takeover: What if the boards of the two companies resisted?

  “Look, trust me,” Paulson said. “You don’t believe me, but I know boards, and they’re going to acquiesce. When we get done talking with them, they’ll acquiesce.”

  On the morning of Tuesday, August 26, Paulson walked over to the White House and was escorted downstairs to the basement of the West Wing, where he was given a seat in the five-thousand-square-foot Situation Room. At 9:30 President Bush was beamed onto one of the large screens from his ranch in Crawford, Texas, for a secured videoconference with Paulson. After some brief pleasantries, Paulson laid out his plan to mount the equivalent of a financial invasion on Fannie and Freddie. Bush told him he could proceed with the preparations.

  As Labor Day weekend approached, the Treasury team and its advisers started to plot the actual details of the dual takeover. They knew they would have to move quickly, with military precision, and in secrecy before the GSEs could start rallying their supporters in Congress. They wrote scripts specifying exactly what they would tell the companies and their boards. They wanted to make certain that there could be no compromises, no delays. Internally, Treasury officials talked about offering Fannie and Freddie two doors: “Door 1, you cooperate; Door 2, we’re doing it anyway.”

  On Thursday morning, August 28, Bob Willumstad and AIG’s head of strategy, Brian Schreiber, walked into JP Morgan’s headquarters at 270 Park Avenue and, escorted by a security guard, were taken by private elevator to the firm’s executive floor, where they had an appointment with Jamie Dimon.

  Passing through the main glass doors into a wood-paneled reception area, Wi
llumstad and Schreiber took in the newly renovated offices on the forty-eighth floor. As the two men sat waiting, Willumstad knew his associate was silently irate. Schreiber had been working throughout August on various plans to raise capital and extend the company’s credit lines to avoid facing a cash crunch if the market were to worsen. As part of his efforts he had held a bakeoff among a number of banks and had been unimpressed with JP Morgan’s pitch—and he was still smarting from the firm’s aggressive attitude when they raised capital for AIG in the spring. He had hoped to use Citigroup and Deutsche Bank, but Willumstad had insisted that they consider JP Morgan. The way things were playing out, if things really did get much worse, Willumstad figured he’d rather be dealing with an ally in Dimon, even if his colleague felt otherwise.

  The AIG executives were escorted to Dimon’s office, which actually consists of an office with a desk, a sitting room, and a conference room. In the conference area Dimon, Steve Black, co-head of the investment bank, Ann Kronenberg, and Tim Main took their places around a wood table with a whiteboard behind them.

  After some small talk, Dimon thanked them for coming, and Main, who headed the bank’s financial institutions group, launched into his pitch for why AIG should use JP Morgan. Main pointed out his group’s number one ranking in the latest league underwriting tables and noted its work in helping CIT Group issue two equity offerings worth $1 billion.

  “That’s a dubious achievement to cite,” Willumstad later commented to Schreiber, “given that shares of CIT were trading below $10 [in August 2008] when they were more than four times that a year ago.” All in all, however, it was a fairly standard pitch from a Wall Street banker, the kind everyone in the room had heard dozens, if not hundreds, of times before: We’re the best suited to help you, we have the most talent, the most resources; we understand your needs better than anyone else.