Too Big to Fail

by Andrew Ross Sorkin

  As Paulson and Bernanke both knew, AIG had effectively become a linchpin of the global financial system. Under European banking regulations, financial institutions had been allowed to meet capital requirements by entering into credit default swap agreements with AIG’s financial products unit. Using the swaps, the banks had essentially wrapped AIG’s triple-A credit rating around riskier assets, such as corporate loans and residential mortgages, allowing the banks to take on more leverage.

  If AIG were to fail, however, those protective wrappers would vanish, forcing the banks to mark down assets and raise billions of dollars—a frightening prospect in the current markets. And the numbers were staggering: Halfway though 2008, AIG had reported more than $300 billion in credit default swaps involved in this wrapping procedure, which it politely called “regulatory capital relief.”

  Then, of course, there was the matter of AIG’s vast insurance empire, which included about 81 million life insurance policies around the world with a face value of $1.9 trillion. While that part of the business was highly regulated and the policies generally protected, there was a risk that panicky customers would cash in their policies in droves and create instability at other major insurers.

  Bernanke listened patiently as Geithner made his case, but Warsh made his reluctance known, as he had been promoting a “buying time” plan. His view was that the Fed should open its checkbook, but only for thirty days—enough time to really examine AIG seriously.

  “I know it could leave us with open-ended exposure,” Warsh admitted, “but let’s actually figure what the hell is going on here.”

  Although Bernanke bluntly acknowledged, “I don’t know the insurance business,” Geithner continued to urge them to commit. The systemic risk was just too great, he insisted.

  After hearing his arguments, Bernanke told him to develop a plan. Once he came back to them with more details, they’d formally vote on how to proceed.

  “Let me just make sure I’m characterizing the support of you and the board on this accurately….” Geithner then repeated what had just been said.

  Michael Wiseman and Jamie Gamble passed through security at the Fed and went in search of Braunstein. They needed to understand what was happening with AIG, and if nothing was happening, they needed his team to help them plan for the bankruptcy.

  Wiseman finally tracked him down in the confidential meeting that was still going on about how the Fed could backstop AIG. “Listen, we don’t have a lot of time and we could use your help with some of the numbers,” he told him angrily after pulling him out of the room. “But we need to know which hat you’re wearing. Are you working for us, the Fed, or JP Morgan?”

  “I don’t think I can answer that question without talking to my lawyer,” Braunstein said after a pause. Signaling that he needed a second, he dashed back into the conference room.

  When he emerged a few moments later, he said stiffly to Wiseman: “I can’t talk. You should contact Treasury directly.”

  “Okay. Thanks,” Wiseman said, putting out his hand to shake it, but Braunstein only turned around and returned to his meeting.

  Within seconds, an aide from the Federal Reserve appeared and informed Wiseman and Gamble that they had to leave the building.

  “Did you just see that?” Wiseman asked Gamble as they were escorted to the door. “Doug wouldn’t even shake my hand. What the fuck is going on in there?”

  However resistant Hank Paulson had been to the idea of a bailout, after getting off the phone at 10:30 a.m. with Geithner, who had walked him through the latest plan, he could see where the markets were headed, and it scared him. During his time at Goldman, he had educated himself about the insurance industry, and with that background he understood how an AIG bankruptcy could very well trigger a global panic. As a regular visitor to Asia, he also knew how much business AIG did there and how many foreign governments owned its debt. Foreign governments had already been calling Treasury to express their anxiety about AIG’s failing.

  Jim Wilkinson asked incredulously, “Are we really going to rescue this insurance company?”

  Paulson just stared at him as if to say that only a madman would just stand by and do nothing.

  Ken Wilson, his special adviser, raised an issue they had yet to consider: “Hank, how the hell can we put $85 billion into this entity without new management?”—a euphemism for asking how the government could fund this amount of money without firing the current CEO and installing its own. Without a new CEO, it would seem as if the government was backing the same inept management that had created this mess.

  “You’re right. You’ve got to find me a CEO. Drop every other thing you’re doing,” Paulson told him. “Get me a CEO.”

  Wilson got back to his office and started scrolling though his computer’s address book. After years as a financial institutions banker at Goldman Sachs, he knew the top people in the industry. Before even getting to the B’s, a name popped into his brain: Ed Liddy, the former CEO of Allstate and a Goldman board member. He was a perfect candidate, currently “on the beach” without a job and someone who would welcome the challenge. Liddy also knew AIG: He was the Goldman board member to whom everyone turned for advice whenever they discussed whether the firm should acquire it.

  But Wilson didn’t have his phone number. So he called Chris Cole at Goldman Sachs, who had been at AIG all weekend and had attended the meeting at the Fed on Monday, who gladly retrieved the number for him.

  There was no time for small talk when Wilson reached Liddy, and he immediately explained why he was calling.

  “Do you have time to take a call from Hank?” Wilson asked, and Liddy assented enthusiastically.

  “You have to hang up,” Wilson told Paulson, who was on the phone when he appeared in his boss’s office door. “I’ve got your CEO.”

  AIG’s stock had fallen below $2 a share when Willumstad’s assistant stepped into his office and handed him a fax from Hank Greenberg. Willumstad had heard earlier that Greenberg was out telling the press that he planned to mount a proxy contest or a takeover of the company.

  “Do I have to read it?” he asked warily, and was not surprised at what he saw:

  Dear Bob,

  We have been discussing for several weeks my offer to assist the company, in any way that you and the Board desired. Throughout those discussions, you have told me and David Boies that you believed my assistance was important to the company. The only concern that you have expressed to me is the fear that if I were to become an advisor to the company that I would overshadow you. I respectfully suggest to you, and to the Board, that the continuing refusal to work together to save this great company is far more important than any concern over personal positions or perceptions.

  I do not know whether or not it is now too late to save AIG. However, we owe it to AIG’s shareholders, creditors and our country to try.

  Since you became Chairman of AIG, you and the Board have presided over the virtual destruction of shareholder value built up over 35 years. It is not my intention to try to point fingers or be critical. My only point is that under the circumstance, I am truly bewildered at the unwillingness of you and the Board to accept my help.

  Geithner began to prepare in his office for a conference call with Bernanke. They were going to do this, he thought. They were really going to do this.

  Jester and Norton were poring over all the terms. They had just learned that Ed Liddy had tentatively accepted the job of AIG’s CEO and was planning to fly to New York from Chicago that night.

  To draft a rescue deal on such short notice, the government needed help, preferably from someone who already understood AIG and its extraordinary circumstances. Jester knew just the man: Marshall Huebner, the co-head of insolvency and restructuring at Davis Polk & Wardwell, who was already working on AIG for JP Morgan and who happened to be just downstairs.

  Meanwhile, Bob Scully of Morgan Stanley, whom Geithner had hired to advise the Fed, wanted to make sure he was aware of all the risks ahead
of the call. As Scully continued to study the rapid deterioration in the markets, he became increasingly anxious about whether AIG would be able to maintain its payments on a government loan. What had looked like a steal before might still be a tough sell.

  “I want to be clear that there’s a real risk you may not be made whole on this loan,” he warned as Geithner dialed into the conference call.

  While Bernanke said that he had decided to back the deal, he nevertheless wanted to take a straw poll among the participants in the call. He was clearly anxious, asking, “Are you sure we’re doing the right thing?”

  But with his implicit support—and Geithner’s insistence that this was the only way to avert a financial Armageddon—the vote was 5–0. There was no longer any discussion of moral hazard, and no talk of Lehman Brothers.

  Before Wiseman and Gamble had gotten far after being escorted by security guards from the NY Fed, they were surprised to suddenly find themselves being invited back in. There had been a mix-up, they were told, and they were taken to a table in the dining room.

  “This isn’t the cool kids’ table,” Gamble remarked, looking over at another table at the other end of the enormous space, where JP Morgan and Goldman bankers were waiting.

  “One thing is for certain,” Wiseman said, “they are not doing a private deal. They’d never look this relaxed.”

  While they waited, Gamble took a call about two new issues: Insurance regulators in Texas, where AIG had a major life insurance business, were starting to panic. Even worse, JP Morgan had just pulled a line of collateral in Japan, which was AIG’s largest market outside the United States. Gamble couldn’t believe it: JP Morgan, AIG’s adviser just twenty-four hours earlier, was now only exacerbating the problem, however prudent it might have been to do so.

  Twenty minutes later, Eric Dinallo, superintendent of the New York State Insurance Department, came over to a relieved Wiseman and Gamble’s table. “I can’t tell you much,” Dinallo said, “but don’t do anything precipitous.”

  “Eric,” a frustrated Gamble replied, “we’re happy to hold tight, but our securities lending business is in trouble.” Then he pointed at the JP Morgan and Goldman Sachs contingent. “The guys over there are creating this problem. Go talk to those guys.”

  “I think we’re about to be out of cash!” John Studzinski announced at the teetering insurance giant’s headquarters. It was nearly 1:00 p.m., and if Studzinski’s math was correct, AIG was minutes away from bankruptcy.

  Just then, Willumstad walked out of his office with something that hadn’t been seen in some time in the building: a smile.

  “They blinked,” he said.

  He had just gotten off the phone with Geithner, who told him about the bailout plan: The Fed would extend to AIG a $14 billion loan to keep the firm in business through the rest of the trading day. But Geithner added that AIG would have to immediately post collateral before it could receive the loan. Officially, it was called a “demand note.”

  While clearly relieved, Willumstad understandably wondered how they were supposed to come up with $14 billion in the next several minutes. Then it dawned on one of them: the unofficial vaults. The bankers ran downstairs and found a room with a lock and a cluster of cabinets containing stock certificates for AIG’s insurance units—tens of billions of dollars’ worth, dating mostly from the Greenberg era. They began rifling through the drawers, picking through fistfuls of securities that they guessed had gone untouched for years. In an electronic age, the idea of keeping physical certificates on hand was a disconcerting but welcome throwback.

  AIG’s senior vice president and secretary, Kathleen Shannon, stacked the bonds up on the table and put them in a briefcase.

  “I don’t think it’s worth you getting mugged carrying $14 billion of certificates,” Michael Wiseman from Sullivan & Cromwell advised her over the phone. “We’ll get Fed security to escort you over.”

  Ten minutes later, Shannon was carrying an inestimably valuable briefcase across Pine Street, flanked by two armed guards.

  Hank Paulson hustled down the stairs and out the side exit of the Treasury building, briskly heading for the White House. He and Ben Bernanke had scheduled a meeting with President Bush to brief him on the extraordinary steps they were about to take.

  After passing through security and a brief stay in a waiting room, they were escorted to the Oval Office, where Paulson delicately walked the president through the terms.

  As Paulson explained the deal, however, detailing its points in Wall Street jargon, Bush clearly looked perplexed.

  Bernanke jumped in and said, “Mr. President, let’s step back for a minute.” Donning his professorial hat, he explained how deeply entwined AIG had become in the banking system. More important, he tried to appeal to the Everyman in Bush, emphasizing how many citizens and small businesses depended on the firm. People used AIG’s life insurance policies to protect their families. They used AIG’s annuities to fund their retirements. AIG also provided surety bonds, a kind of guarantee for construction projects and public works.

  The president then posed a question that, in its own way, went directly to the heart of the problem: “An insurance company does all this?”

  This one did.

  At around 4:00 p.m. that afternoon, the Fed’s offer clattered through an AIG fax machine (which should have been replaced and shipped to the Smithsonian a decade earlier). An army of lawyers on AIG’s eighteenth floor were anxiously awaiting it. After the three-page document finally appeared, a lawyer grabbed it and quickly made copies.

  “Well, you finally get your chance to work for the federal government,” Richard Beattie, the lead lawyer for the outside directors on the AIG board, told Willumstad as he scanned the terms.

  “What do you mean?” asked Willumstad.

  “They own you now,” Beattie replied with a grin.

  And they did. The Federal Reserve was providing AIG a credit line of $85 billion—which it hoped would be enough to avert catastrophe and keep it afloat. But in exchange for the loan, the government was taking a large ownership stake—79.9 percent in the form of warrants called “equity participation notes.” It was similar to the proposal that JP Morgan and Goldman had been working on.

  If Washington was going to take Wall Street off the hook, the government wanted to make certain that at least the old stakeholders didn’t profit in any untoward fashion. “Paulson is handling this the same way he did Fannie, Freddie, and Bear Stearns—if the government steps in, the shareholders will pay for it,” Cohen observed.

  The Fed loan also came with a significant debt burden. AIG would have to pay at a rate based on a complex formula—the London interbank offered rate, a benchmark for short-term loans between banks, which then came to about 3 percent—plus an extra 8.5 percentage points. Based on that day’s rate, the interest the company would have to pay soared to more than 11 percent, which at the time was considered usurious. The loan would be secured by all AIG’s assets, and the government would have the right to veto payments of dividends to both common and preferred shareholders.

  In order to pay back the government, AIG would have to sell off assets—and under the circumstances, that meant a fire sale. To AIG loyalists, the loan was proving to be less a bridge to solvency than a plank to an organized breakup.

  “This is unbelievable,” Willumstad said, setting aside the document.

  The board of AIG was prepared to meet soon for an emergency session. As Willumstad stood and reread the terms in a virtual state of shock, his assistant called out to say that Tim Geithner was on the phone. It was 4:40 p.m.

  Willumstad followed Beattie and Cohen into his office and hit the speakerphone button.

  “Can you hang on a minute?” Geithner said after greeting him. “Secretary Paulson is going to pick up.”

  “Okay,” Willumstad said, adding, “I’ve got Dick Beattie and Rodgin Cohen sitting here with me.”

  “So, you’ve seen the new agreement, right?” Geithner aske
d after Paulson joined in. “We want to know that you are going to accept the terms. We need an answer back from you soon, because trading is going to start in Asia.”

  In the back of his own mind, Geithner had a nagging worry: Were the terms too harsh? But he was at least as concerned about potential blowback from the other direction—that Treasury would be criticized for giving AIG a sweetheart deal.

  It was no coincidence, though, that the government’s terms had so much in common with what the private sector had been considering. For one thing, they had used many of the same advisers. And in the current political environment, there was safety in being able to say that AIG was only getting what the market had been willing—or almost willing—to offer.

  “Obviously, we have a board meeting in fifteen minutes, and I’m prepared to present it there,” Willumstad said. “Tim, it’s Dick,” Beattie said, jumping in. “I just want to be clear that you know that you shouldn’t assume just because you stepped in that the board will approve this. We’ve got a fiduciary duty to our shareholders, so it is going to be complicated.”

  Beattie, playing hardball, had effectively implied a threat that AIG might be better off filing for Chapter 11 bankruptcy than taking the government’s deal.

  Geithner didn’t flinch. “This is the only proposal you’re going to get,” he tersely replied, and then added, “There’s one other condition….”

  Paulson, interrupting, said, “The condition is that we’re going to replace you, Bob.”

  Beattie and Cohen looked at Willumstad in embarrassed silence.

  “O…kay,” Willumstad said. “If that’s what you want.”