Too Big to Fail

by Andrew Ross Sorkin

  Colm Kelleher, Morgan Stanley’s CFO, was more fatalistic—the short-sellers couldn’t be stopped, he believed, or even necessarily blamed. They were market creatures, doing what they had to do to survive. “They are cold-blooded reptiles,” he told Mack. “They eat what’s in front of them.”

  Mack had just gotten off the phone with one of his closest friends, Arthur J. Samberg, the founder of Pequot Capital Management, who had called about withdrawing some money.

  “Look, if you want to take some money out, take money out,” Mack told him, frustrated.

  “John, I really don’t want to do it, but my fund-to-funds accounts are saying I have too much exposure to Morgan Stanley,” he said, citing the rumors about its health.

  “Take your money,” Mack told him, “and you can tell all your peers to take their credit balances out.”

  Mack believed negative speculation was purposely being spread by his rivals and repeated uncritically on CNBC. He was so furious with the “bullshit coverage” that he called to complain to Jeff Immelt, the CEO of GE, which owned CNBC as part of its NBC Universal unit.

  “There’s not a lot we can do about it,” Immelt could only say apologetically.

  Tom Nides, Mack’s chief administrative officer, thought they needed to go on the offensive. Nides, a former CEO of Burson-Marsteller, the public relations giant, had been one of Mack’s closest advisers for several years, his influence so great that he had persuaded the lifelong Republican to support Hillary Clinton. He now encouraged Mack to start working the phones in Washington and impress upon them the need to instate a ban against short selling. “We’ve got to shut down these assholes!” he told Mack.

  Gary Lynch, Morgan Stanley’s chief legal officer and a former enforcement chief at the SEC, volunteered to call Richard Ketchum, the head of regulation of the New York Stock Exchange, and put a bug in his ear about suspicious trading. “I’m in favor of free markets—and I’m in favor of free streets too, but when you have people walking down the streets with bats, maybe it’s time for a curfew,” he said.

  Nides set up a series of phone calls for Mack, who also contacted Chuck Schumer and Hillary Clinton, pleading with them to call the SEC to press the case on his behalf. “This is about jobs, real people,” he told them.

  After speaking with Christopher Cox, the head of the SEC, however, he was in an even fouler mood. Cox, a free-market zealot, seemed to Mack to be almost intentionally ineffectual, as if that were the proper role of government regulators. There was nothing he was going to do about the shorts, or about anything at all, for that matter.

  Paulson, who was next on his call list, was clearly sympathetic to Mack’s cause to ban the short-sellers, but it was unclear whether he could do anything to help him. “I know it, John. I know it,” he said, trying to pacify him. “But this is for Cox to decide. I’ll see what I can do.”

  Mack then contacted his most serious rival, Lloyd Blankfein of Goldman, desperate for an ally. “These guys are taking a run at my stock, they’re driving my CDS out,” Mack said frantically. “Lloyd, you guys are in the same boat as I am.” He then made a request of Blankfein: to appear on CNBC with him, as a show of force.

  While Blankfein kept a television in his office, he was so disgusted with what he called Charlie Gasparino’s “rumormongering” that he turned it off in protest. “That’s not my thing,” he told Mack. “I don’t do TV.”

  As Goldman wasn’t in total crisis mode, Blankfein explained, he was disinclined to join Mack in a war on the shorts until he absolutely needed to.

  Making little progress, Nides had another, perhaps shrewder, angle to play. He could call Andrew Cuomo, the New York State attorney general, who badly needed a cause to resurrect his political fortunes. Nides had a hunch that he might be willing to put a scare into the shorts. It was an easy populist message to get behind: Rich hedge fund managers were betting against teetering banks amid a financial crisis. Everybody remembered what Eliot Spitzer had managed to do to Wall Street from the same platform.

  When Nides reached Cuomo, he pitched on announcing an investigation of the shorts. Cuomo had voiced concerns about short-selling before, but this would be a shot across the bow. “If you do this,” Nides said, “we’ll come out and praise you.” Nides knew Mack would be reluctant—he’d be assailing his own clients—but this was a matter of survival.

  Before the market closed, Mack sent the following e-mail to the entire staff.

  To: All Employees

  From: John Mack

  I know all of you are watching our stock price today, and so am I. After the strong earnings and $179 billion in liquidity we announced yesterday—which virtually every equity analyst highlighted in their notes this morning—there is no rational basis for the movements in our stock or credit default spreads.

  What’s happening out there? It’s very clear to me—we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down. You should know that the Management Committee and I are taking every step possible to stop this irresponsible action in the market. We have talked to Secretary Paulson and the Treasury. We have talked to Chairman Cox and the SEC. We also are communicating aggressively with our long-term shareholders, our counterparties and our clients. I would encourage all of you to communicate with your clients as well—and make sure they know about our strong performance and strong capital position.

  “It’s ridiculous that I can’t deal with Goldman at a time like this!” Paulson complained to his general counsel, Bob Hoyt. He was supposed to take part in a 3:00 p.m. call with Bernanke, Geithner, and Cox to discuss Goldman Sachs and Morgan Stanley, but unless he could get a waiver, he would be unable to participate.

  With Morgan Stanley on the ropes, Paulson had been growing increasingly worried about Goldman, and if Goldman were to topple, it would, he believed, represent a complete destruction of the system. He’d had enough of recusing himself. Part of him regretted signing the original ethics letter agreeing not to get involved in any matter related to Goldman for his entire tenure. At the time it seemed a good-faith gesture to go above and beyond the typical one-year moratorium on dealing with former employers, but now, he thought, it had come back to bite him.

  Geithner had raised this very issue back in March after the Bear Stearns deal. “You know, Hank, if another one of these banks goes,” he said, “I don’t know who would have the ability to take them over other than Goldman, and we have to do something about your waiver-recusal situation because I don’t know how we can do one of these without you.”

  Given the extreme situation in the market, Hoyt told Paulson he thought it was only fair that he try to seek a waiver; Hoyt had, in fact, already even drafted the material needed to request one. As Paulson had sold all of his Goldman stock before he took office, Hoyt thought he could easily tell the Office of Government Ethics that Paulson had no conflict, apart from his remaining stake in Goldman’s pension plan, but that constituted only a small part of his overall wealth. After he turned sixty-five years old, Goldman would pay him $10,533 a year.

  Paulson appreciated that the “optics” of receiving a waiver to engage with his former employer would only feed the continuing conspiracy theories about his efforts to help Goldman, but he felt he had no other choice. And he hoped it would remain a secret: He and Hoyt discussed keeping the existence of a waiver confidential.

  Hoyt reached out to Fred F. Fielding, counsel to the White House and a longtime Washington hand who knew his way around the system, and to Bernard J. Knight Jr., the DAEO, or designated agency ethics official, at Treasury, who was attending a conference in Florida with another colleague from the White House ethics office. With virtually no pushback, given the gravity of the situation, they quickly accepted Hoyt’s recommendation.

  “I have determined that the magnitude of the government’s interest in your participation in matters that might affect or involve Goldman Sachs clearly outweighs the concern that your participation may cause a
reasonable person to question the integrity of the government’s programs and operations,” Knight wrote in an e-mail.

  Fielding’s office made it official by having a copy of the formal waiver walked over to the Treasury Building. On White House letterhead, it began, “This memorandum provides a waiver….

  In your position as Secretary of the United States Department of the Treasury, you are responsible for serving the American people and strengthening national security by managing the U.S. Government’s finances effectively, promoting economic growth and stability, and ensuring the safety, soundness, and security of the United States and international financial systems.

  You currently have an interest in a defined benefit pension plan through your former employers, the Goldman Sachs Group, Inc. Your total investment in this plan represents only a small fraction of your overall investment portfolio. For this reason, your financial interest in the plan is not so substantial as to be likely to affect the integrity of your services to the Government. With this waiver, you may participate personally and substantially in the particular matters affecting this defined benefit pension plan, including the ability or willingness of the Goldman Sachs Group, Inc. to honor its obligations to you under this plan.

  Unknown to the public, Paulson was now officially free to help Goldman Sachs.

  “Stop the insanity—we need a time out” was the subject line of Glenn Schorr’s e-mail. An analyst at UBS who covered the banking industry, Schorr had sent the missive to accompany his latest report to his clients on Wednesday afternoon. But by the time the market closed—with Morgan Stanley’s shares plummeting 24 percent, to $21.75, after dropping to $16.08 earlier in the day, and Goldman plunging 14 percent, to $114.50, after hitting a low of $97.78—Schorr’s e-mail was being forwarded all around town.

  “We think investors should be focused on risk management and performance and not just whether you have retail deposits (banks go out of business, too, last we checked—and at this rate, following money fund redemptions, deposits could be around the corner). In our view, a lack of confidence and forced consolidation into firms that are ‘too big to fail’ can’t be the final solution,” he wrote. “The world should really be concerned about this because if we continue to squeeze the financial system’s balance sheet and see fewer players in the business, the available credit to corporations and hedge funds will shrivel up and the cost of capital will continue to skyrocket across the board.”

  The e-mail eventually found its way to the Treasury Building, where Paulson was returning phone calls from a long list, trying to get a realistic view of what was taking place on Wall Street. Among the people he spoke with was Steve Schwarzman, the chairman of Blackstone Group, the private-equity giant.

  “Hank, how’s your day going?” Schwarzman jibed when the call was connected.

  “Not well. What do you see out there?” Paulson asked.

  The conversation quickly turned serious. “I have to tell you, the system’s going to collapse in the next few days. I doubt you’re going to be able to open the banks on Monday,” Schwarzman said, deeply spooked by what he was seeing.

  “People are shorting financial institutions, they’re withdrawing money from brokerage firms because they don’t want to be the last people in—like in Lehman—which is going to lead to the collapse of Goldman and Morgan Stanley. Everybody is just pursuing his self-interest,” Schwarzman told him. “You have to do something.”

  “We’re working on some things,” Paulson said. “What do you think we should do?”

  “You have to approach what you’re doing from the perspective of being a sheriff in a western town where things are out of control,” Schwarzman replied, “and you have to do the equivalent of just walking onto Main Street and shooting your gun up in the air a few times to establish that you’re in charge because right now no one is in charge!”

  Paulson just listened, trying to picture himself in that role. “What do you recommend?”

  “Well, the first thing you could do is stop short-selling of financial institutions—forget whether it’s effective in removing the pressure, although it might be. What will be accomplished is that you will scare the participants in the market, and they will recognize that things are going to change and they can’t continue to invest in the exact same way, and that will force people to pause,” Schwarzman said.

  “Okay. That’s not a bad idea,” Paulson agreed. “We’ve been talking about that. I could do that. What else do you got?”

  “I would stop the ability of people to withdraw, you know, transfer their brokerage accounts,” Schwarzman continued. “Nobody really wants to transfer their account out of Goldman or Morgan. They just feel they have to do it so they’re not the last person on a sinking ship.”

  “I don’t have the powers to do that,” Paulson replied.

  “You could get rid of the ability for people to write credit default swaps on financial institutions,” Schwarzman offered as alternative, “which is putting enormous pressure on financial institutions.”

  “I don’t have the powers to do that either,” Paulson protested.

  Schwarzman, concerned that he wasn’t getting through to Paulson, replied, “Look, you’re going to have to announce something very big to rescue the system, some huge amount of money that gets utilized to address the problems of the system.”

  “Well, we’re not ready to do that yet,” Paulson told him. “We’ve got some ideas,” he said.

  “I don’t think that it’s relevant if you haven’t fully baked everything,” Schwarzman said, “You need an announcement tomorrow to stop the collapse and you’ve got to figure something out that will grab people’s attention.”

  “What’s wrong?” John Mack asked in alarm as his CFO, Colm Kelleher, walked into his office late Wednesday, his face ashen.

  “John,” Kelleher said in his staccato British inflections, “we’re going to be out of money on Friday.” He had been nervously watching the firm’s tank—its liquid assets—shrink, the way an airline pilot might stare at the fuel gauge while circling an airport, waiting for landing clearance.

  “That can’t be,” Mack said anxiously. “Do me a favor, go back to the financing desk, go through it again.”

  Every hour was bringing a new problem. The internal memo he had sent out earlier decrying short-sellers had started leaking out, and now several prominent hedge fund clients that used shorting strategies—some simply to hedge their exposures to other securities—were closing their Morgan Stanley accounts in protest.

  “It’s one thing to complain, but another to put out a memo blaming your clients,” railed Jim Chanos, the short-seller who famously unearthed the problems at Enron. He had been a Morgan Stanley client for twenty years, but now he was making his displeasure known by pulling $1 billion from his account at the firm. Julian H. Robertson Jr., the founder of Tiger Management, one of the first and most successful hedge funds, called the firm apoplectically, though he stopped short of redeeming the money he kept with Morgan Stanley.

  As annoyed as they might have been by the attack on shorts, the firm’s clients were about to become a good deal angrier. Mack was reviewing draft language for the statement he would publish the following day in support of Cuomo’s investigation into short selling. Though he knew full well that his language would infuriate his clients and send even more of them packing, Mack didn’t believe he had a choice but to lend his support:

  Morgan Stanley applauds Attorney General Cuomo for taking strong action to root out improper short selling of financial stocks. By initiating a wide-ranging investigation of this manipulative and fraudulent conduct, Attorney General Cuomo is showing decisive leadership in trying to help stabilize the financial markets. We also support his call for the SEC to impose a temporary freeze on short selling of financial stocks, given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks.

  Kelleher returned to Mack’s office thirty minutes af
ter having been sent to review the firm’s balances again, slightly less shaken, but only slightly. After finding some additional money trapped in the system between trades that hadn’t yet settled, he revised his prognosis: “Maybe we’ll make it through early next week.”

  Paulson was hunched over his telephone, straining to hear Bernanke and Geithner on the speakerphone. It was late Wednesday, and the Treasury staff was already girding for another all-nighter.

  Bernanke was making his frustration clear; he didn’t believe the crisis could be solved by individual deals or some one-off solution. “We can’t keep doing this,” he insisted to Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”

  Paulson agreed in theory but was concerned that Bernanke was underestimating the political calculus. “I understand that you guys don’t want to be fighting this fire alone, but the worst outcome would be if I go ask, and they tell me to screw off,” Paulson said. “We will then show that we’re vulnerable and we don’t have the armaments we need.”

  “There are no atheists in foxholes and no ideologues in financial crises,” Bernanke, trotting out a phrase he had tried out on some Fed colleagues a day earlier, told Paulson, trying to persuade him that intervention was necessary.

  Paulson agreed but said if they were going to proceed, he wanted to promote his plan to have the government buy toxic assets, a solution that he thought would be the most politically palatable, because it would be comparable to the Resolution Trust Corporation of the late 1980s. Congress created the RTC in 1989 to handle the more than $400 billion in loans and other assets held by 747 failed savings and loans as part of the S&L crisis. The RTC had been the recipient of a wide range of loans, properties, and bonds from the failed thrifts. Like the predicament Paulson currently faced, some of the assets were good but most were bad, and some, including construction and development loans, had no discernible market. The task was daunting: L. William Seidman, the RTC chairman, initially estimated that even if the agency sold $1 million of assets a day, it would take three hundred years to dispose of everything. By the time the RTC completed its job in 1995, a year ahead of its deadline, the cost to the taxpayers was nearly $200 billion (in 2008 dollars)—a much lower tab than what many had feared at the time the agency had been created.