Too Big to Fail

by Andrew Ross Sorkin

  Of course, what none of the congressmembers nor the public knew was that TARP was being completely rethought within Treasury, as Jester, Norton, and Nason began developing plans to use a big chunk of the $700 billion to invest directly into individual banks.

  Jester had flown back to his home in Austin for a brief respite, but he was constantly on his BlackBerry with Norton going over their various options. Norton and Nason, told by Treasury’s general counsel, Bob Hoyt, that they could not hire an outside financial adviser because of the inherent conflicts, made a series of outbound calls to Wall Street bankers on an informal basis to bounce various ideas off them about how to implement a capital injection program. Their call list included a cast of characters that had become well known to them through the recent spate of weekend deal-making: Tim Main and Steven Cutler of JP Morgan, Ruth Porat of Morgan Stanley, Merrill Lynch’s Peter Kraus, and Ned Kelly of Citigroup, among others. They intentionally did not call anyone from Goldman Sachs, concerned that the conspiracy theory rumor mill was already in overdrive.

  Norton and Nason asked them all the same questions: How would you design the program? Should the government seek to receive common or preferred shares in exchange for their investment? How big a dividend would banks be willing to pay for the investment? What other provisions would make such a program attractive, and what provisions would make it unappealing?

  But Jester, Norton, and Nason knew they had precious little time to complete their planning. Even with TARP approved, the markets did not immediately respond by stabilizing. The Dow Jones Industrial Average, which had been up as many as 300 points before the start of the voting, closed down 157.47 points, or 1.5 percent. After the Wells Fargo deal for Wachovia was revealed, shares of Citigroup fell 18 percent, their sharpest decline since 1988. For the week, the Standard & Poor’s 500 stock index was down another 9.4 percent.

  “I’m the ugliest man in America,” Dick Fuld, beside himself in a mix of sadness and anger, privately acknowledged to his team of advisers before they strode into a congressional hearing in Washington on Monday, October 6, that had been called to examine the failure of Lehman Brothers. The markets remained in turmoil, falling another 3.5 percent despite the passing of TARP, as investors continued to question whether the program would actually work.

  As he entered, spectators were waving pinks signs with handwritten scrawls proclaiming “Jail not Bail” and “Crook,” and in case Fuld didn’t fully comprehend how he was perceived, John Mica, a Republican congressman, announced, “If you haven’t discovered your role, you’re the villain today. You’ve got to act like a villain.”

  For the past several weeks Fuld had been in a depression deeper than any he’d ever experienced, pacing his home in Greenwich at all hours, taking calls from former Lehman employees who wanted either to scream at him or to cry. He continued to go to the office, but it was unclear even to him what he was doing there. He was, however, sufficiently self-aware to finally comprehend what had happened and to perceive the full extent of the vitriol that was now being directed at him. He wanted to be defiant, but he found he couldn’t. He was at times saddened and angry—angry at himself, and increasingly angry at the government, especially at Paulson, whom he saw as having saved every firm but his. His beloved Lehman Brothers had died on his watch.

  He now said as much to the congressmembers. “I want to be very clear,” Fuld told the committee. “I take full responsibility for the decisions that I made and for the actions that I took.” He added, “None of us ever gets the opportunity to turn back the clock. But, with the benefit of hindsight, would I have done things differently? Yes, I would have.”

  But his audience had little use for his contrition, peppering him instead with questions about his compensation. “Your company is now bankrupt, and our country is in a state of crisis,” Representative Henry Waxman said. “You get to keep $480 million. I have a very basic question for you: Is that fair?”

  “The majority of my stock, sir, came—excuse me, the majority of my compensation—came in stock,” Fuld replied. “The vast majority of the stock I got I still owned at the point of our filing.” In truth, while he had cashed out $260 million during that period, most of his net worth was tied up in Lehman until the end. His shares, once making him worth $1 billion, were now worth $65,486.72. He had already started working on plans to put his apartment and his wife’s cherished art collection up for sale. It was a telling paradox in the debate about executive compensation: Fuld was a CEO with most of his wealth directly tied to the firm on a long-term basis, and still he took extraordinary risks.

  As he spoke he struggled to gain any measure of empathy from his listeners, suggesting, “As incredibly painful as this is for all those connected to or affected by Lehman Brothers, this financial tsunami is much bigger than any one firm or industry.” He also expressed his great frustrations—with hedge funds for spreading baseless rumors, with the Federal Reserve for not allowing him to become a bank holding company over the summer, and ultimately with himself.

  For a moment, as his testimony was winding up, he looked as if he was about to break down, but he steadied himself, as he had done at home virtually every day prior to the hearing. The room fell silent as the congressmembers leaned forward in their chairs, waiting for him to speak.

  “Not that anybody on this committee cares about this,” Fuld said, putting his notes aside and surprising even his own lawyer by speaking so extemporaneously, “but I wake up every single night wondering, What could I have done differently?” On the verge of tears, he added, “In certain conversations, what could I have said? What should I have done? And I have searched myself every single night.”

  “This,” he said gravely, “is a pain that will stay with me for the rest of my life.” And, he continued, as he watched the government go to extraordinary steps to save the rest of the system he remained baffled why the same hadn’t been done for Lehman.

  “Until the day they put me in the ground,” he said, as everyone in the chamber hung on his words, “I will wonder.”

  That Monday afternoon Hank Paulson received a private four-page, typed letter from his friend Warren Buffett. They had spoken over the weekend about Paulson’s current predicament—namely, that even though his TARP plan had been approved by Congress, it was not passing muster on Wall Street, where investors were beginning to worry that it would be ineffectual. Paulson had confided in him that he was considering using TARP to make direct investment in banks. Buffett told him that before he went down that path, he had some ideas about how to make a program to buy up toxic assets work that he would put in a letter, which he said would spell out both the problems with the current plan and a solution.

  In the letter, Buffett, perhaps one of the clearest and most articulate speakers on finance, first explained the shortcomings of Paulson’s current plan:

  “Some critics have worried that Treasury won’t buy mortgages at prices close to the market but will instead buy at higher ‘theoretical’ prices that would please selling institutions. Critics have also questioned how Treasury would manage the mortgages purchased: Would Treasury act as a true investor or would it be overly influenced by pressures from Congress or the media? For example, would Treasury be slow to foreclose on properties or too bureaucratic in judging requests for loan forbearance.”

  To address those problems, Buffett proposed something he called the “Public-Private Partnership Fund,” or PPPF. It would act as a quasi-private investment fund backed by the U.S. government, with the sole objective of buying up whole loans and residential mortgage–backed securities, but it would avoid the most toxic CDOs. Instead of the government doing this on its own, however, he suggested that it put up $40 billion for every $10 billion provided by the private sector. That way the government would be able to leverage its own capital. All proceeds “would first go to pay off Treasury, until it had recovered its entire investment along with interest. That having been accomplished, the private shareholders would be entitle
d to recoup both the $10 billion and a rate of interest equal to that received by Treasury.” After that, he said, profits would be split three fourths to investors, one fourth to Treasury. His idea also had a unique way to protect taxpayers from losing money: Put the investors’ money first in line to be lost.

  Buffett said he was so excited about this structure that he had already spoken to Bill Gross and Mohamed El-Erian at PIMCO, who had offered to run the fund pro bono. He had also been in touch with Lloyd Blankfein, who had likewise offered to raise the investor money on a pro bono basis. Finally, Buffett added, “I would be willing to personally buy $100 million of stock in this public offering,” which, he explained, “constitutes about 20 percent of my net worth outside of my Berkshire holdings.”

  After reading the letter, Paulson was intrigued. He was still starting to lean in favor of injecting capital directly into the banks, but he thought maybe a program modeled after portions of Buffett’s proposal could be feasible as well. Paulson called Kashkari into his office; he had just named him interim assistant secretary for financial stability that morning, putting him in charge of the TARP plan. The appointment was already generating a firestorm, with accusations that Paulson was once again favoring his former Goldman Sachs employees. (At Goldman, meanwhile, none of the senior management seemed to know who Kashkari was, and some of them asked their assistants that morning to look though the computer system to find out.)

  Paulson handed Kashkari Buffett’s letter. “Call him.”

  “It is clearly a panic, and it’s a panic around the world,” John Mack, having flown to London, was telling his employees at their headquarters on Canary Wharf the morning of Wednesday, October 8. “So you think back how the regulators have done and what they have done—could they get ahead of this—you know it’s pretty hard because you really didn’t know how bad it was until it got worse….”

  The stock market was cratering yet again amid renewed panic that the banking system—and the economy as a whole—were about to suffer further setbacks. Mack, who had gone to London in part to have dinner with his newest investors from Mitsubishi, was under perhaps the most pressure. He was exhausted, having spent much of the past week living on airplanes. In the wake of China Investment Corp.’s hasty departure from Morgan Stanley’s building after Gao found out the firm was about to do a deal with the Japanese, Mack flew to Beijing to try to repair relations. It was a diplomatic mission, intended to calm frayed nerves and to avoid what seemed as if it might turn into a minor international incident, given that Paulson had quietly gotten involved in the talks with the Chinese government originally. Just as important, CIC was still a large investor in Morgan Stanley, and Mack wanted to placate his foreign partners.

  But for now, Mack wasn’t interested in anyone’s hurt feelings. He was glued to his stock price, which had fallen 17 percent the day before, as investors grew nervous that Mitsubishi might renege on its deal. After a week and a half of diligence and regulatory approvals, the investment still had not been finalized, and as Morgan Stanley’s stock price continued to drop, questions were raised about whether Mitsubishi would be better off simply walking away from the agreement. All they had on paper was a term sheet—no better than what Citigroup had signed with Wachovia. And Federal Reserve requirements wouldn’t allow the firms to complete the deal until Monday, leaving Morgan Stanley exposed to the gyrations in the stock market—and the possibility that Mitsubishi could pull out—until then.

  Earlier that day Mitsubishi had released a statement in Tokyo saying: “We have been made aware of rumors to the effect that MUFG is seeking not to close on our proposed investment in, and strategic alliance with, Morgan Stanley. Our normal policy is not to comment on rumors. Nevertheless, we wish to state that there is no basis for any such rumors.”

  That was all Mack needed to know; he trusted the Japanese and wanted to be confident that they wouldn’t withdraw. In his gut, however, he couldn’t help but be anxious.

  Hank Paulson was about to officially change his mind.

  It was Wednesday, October 8, and Ben Bernanke and Sheila Bair were on their way to meet with him in his office at 10:15 a.m.

  He had finally determined that Treasury should make direct investments in banks, sufficiently persuaded by a growing chorus both inside and outside of Treasury to do so.

  “We can buy these preferred shares, and if a company becomes more profitable, you will get a share of that as well,” Barney Frank said during a speech championing the idea of taxpayers becoming shareholders. Chuck Schumer was also in favor of the idea, stating, “When the market recovers, the federal government would profit.”

  But perhaps the greatest indication that the concept was feasible came from abroad: The United Kingdom had announced plans to invest $87 billion into Barclays, the Royal Bank of Scotland Group, and six other banks in an effort to instill confidence after a near Lehman-like meltdown confronted them. In exchange, British taxpayers would receive preferred shares in the banks (including annual interest payments) that were convertible into common shares, so that if the banks’ prospects improved—and their shares rose—taxpayers would benefit. Of course, the plan was also a huge gamble, for the reverse was also true: If the banks faltered after the investment was made, a great deal of money stood to be lost.

  Paulson and President Bush had been briefed by Gordon Brown on these plans on Tuesday morning at 7:40 by phone in the Oval Office. Now that the formal announcement had been made, Brown was being praised for his judgment to step in so decisively—often in favorable contrast to Paulson. “The Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own,” Paul Krugman, the economist and New York Times columnist, wrote days later.

  With the G7 ministers scheduled to be in Washington for the long Columbus Day weekend, Paulson began to think that he should take advantage of the occasion to once and for all make a bold move to stabilize the system. Still, he knew it could be unpopular politically. After he broached the idea with Michele Davis a week earlier, she only looked at him with a sense of bafflement and remarked, “There’s no way you’re going to say that publicly.”

  Paulson had been discussing his shifting views with Bernanke, who had been a fan of capital injections from the start, and they were now in agreement. But they had been thinking about another program to go hand in hand with such an announcement: a broad, across-the-board program to guarantee all banking institution deposits. It would essentially remove any incentive for a customer or client of a bank to ever feel nervous enough to withdraw his deposits. By Bernanke’s estimation, announcing capital injections and a broad guarantee would be an effective enough economic cocktail to finally turn things around.

  But first they needed the money to effectuate such a guarantee program, which is where Bair came in. They felt that the FDIC was the only agency with such powers, and that the guarantee would fall within the agency’s mission.

  Paulson and Bernanke, sitting in Paulson’s office, now walked Bair through the concept. The FDIC, they explained to her, would essentially be offering a form of insurance for which the banks would pay by being assessed a fee. The FDIC, Paulson argued, could even end up making money if the assessments outweighed the amount of payouts.

  Bair instantly recoiled, doing the math in her head to assess the extraordinary strain such a guarantee could put on the FDIC’s fund.

  “I can’t see us doing that,” she replied.

  Morgan Stanley’s Walid Chammah woke up Saturday morning deathly afraid that his firm was going to go out of business. Its stock price had continued to fall, closing on Friday at $9.68—its lowest level since 1996. Hedge funds and other clients were again pulling money out. Dick Bove, an influential analyst at Ladenburg Thalmann, was comparing Morgan Stanley to Lehman Brothers and Bear Stearns. “The focus on Morgan Stanley is to change the ending,�
�� Bove wrote in a note to clients. “In sum, one must hold one’s breath at the moment and hope that this is a different movie.”

  Chammah had canceled a talk he was scheduled to give at Duke’s business school so he could stay in New York to try to shore up morale at the firm. That Friday he walked every floor in Morgan Stanley’s headquarters, stopping to reassure fretful employees and giving a speech on the trading floor. “This firm has been around for seventy-five years and will be around for another seventy-five years,” he proudly told the traders. To work his way down from the fortieth floor to the second took him three and a half hours. When he got back to his office he was emotionally drained, practically in tears.

  It had been a difficult day for one other reason: Rumors were by now rampant that Mitsubishi was going to renege on its deal. No one at Morgan Stanley had received the slightest indication that they were even thinking of doing so—indeed, Mitsubishi had confirmed that they intended to honor the commitment—but the uncomfortable truth was that withdrawing might actually be the right business decision.

  “They’re going to recut. They just have to,” Robert Kindler told Paul Taubman that afternoon. “When are they going to call? It’s a nobrainer.”

  And everyone inside Morgan Stanley knew what Mitsubishi pulling out would mean: a run on the bank all over again, and, just possibly, the end of the firm.

  With Mack flying back from London that day, it had been left to Chammah to hold the firm together in the face of that anxious speculation. His wife, who had been watching the financial news on television, called him at the office. “Are you okay?” she asked.