Confidence Men: Wall Street, Washington, and the Education of a President

by Ron Suskind

  With his nomination secure by early June, Barack Obama—now the putative leader of the Democratic Party—was faced with the most important decision since the declaration of his candidacy: choosing a running mate.

  The guiding principle for the selection of a “number two” has long been a hard-eyed assessment of need—finding a person who will fill some perceived deficits in the politician topping the ticket. Geography, of course, usually carries the day. The denizen of a part of the country that looks with suspicion on the nominee: He’s not from here, he’s not one of us, but he’s chosen someone who is. It was decided, not surprisingly, that Obama’s greatest vulnerability was his lack of experience, especially in facing John McCain, who’d spent three decades on the national political stage. Obama, until so recently a midwestern state legislator, needed a partner who could claim long affinity with a part of America that was still largely foreign to him: the tiny nation-state of Washington, D.C.

  To head up the search committee, Obama announced on June 4 that he had turned to someone who had long, intimate relations with Washington’s most experienced players: Jim Johnson, the former head of Fannie Mae.

  Johnson’s gravity and profile were testimony to a host of hard truths—ones not found in high school civics texts—about the way the nation’s capital has actually operated, at least for the past few decades.

  Back in 1977, Johnson was executive assistant to Vice President Walter Mondale and went on to be Mondale’s campaign chairman in his failed run against Reagan in 1984. Reagan’s landslide was fueled in no small measure by the enthusiastic support he received from American business. Johnson—having to raise money for Mondale against Reagan’s overwhelming advantage—acutely felt the change Reagan had brought to Washington: an official end to the adversarial relationship between government and business engendered by FDR during the Depression. That stance—of government acting as the no-nonsense traffic cop, enforcing the “rules of the road” for the great pursuit of economic advancement and profit—had been slowly buckling since 1971. That year, Richard Nixon imposed a 10 percent tariff on all imported goods as a response to the way economics had increasingly become a kind of “war by other means,” as Clausewitz would put it, in the burgeoning, increasingly borderless global economy. It was a war that every American soon felt buffeted by with the oil embargo, gas rationing, and resultant “stagflation” of the 1970s, as Ford and then, more dramatically, Carter, increasingly saw government’s role as nourishing the profits and protecting the franchise of America’s signature industries. It wasn’t until Reagan, though, that the laws guiding the conduct of business were themselves seen as the problem, and that government needed to “get out of the way,” in Reagan’s parlance, in every way possible, to unleash America’s native, “can-do” spirit. Profits and patriotism were starting to become gently enmeshed.

  Jim Johnson followed Mondale’s crushing defeat with a trip north, to a managing director’s post at Lehman Brothers. In 1991, suffused with exciting insights about risk management from Wall Street’s first modern era of “financial engineering,” he returned to Washington with some innovative ideas about how to breathe life into that slow-footed half-man/half-beast called Fannie Mae.

  The Federal National Mortgage Association, known colloquially as Fannie Mae, was established by Roosevelt in 1938 to spread home ownership and more affordable housing to a still-beleaguered nation. The idea was for Fannie Mae to act as the builder and guarantor of a liquid, second-mortgage market that would disencumber the balance sheets of banks so they could make more housing loans. The government had been holding bids and creating short-lived specialty markets since the days of Alexander Hamilton, but creating a permanent entity that, in essence, held a monopoly over an industry—in this case second mortgages—was a new, somewhat uncomfortable role. So, in 1954, a federal statute turned Fannie Mae into something novel, a “mixed-ownership corporation,” in which the federal government held controlling preferred stock while private investors could purchase common stock. In 1968 it officially became a publicly held corporation, to remove its debt and related activities from the federal balance sheet. But the federal guarantor’s role remained. Fannie, and, in 1970, a sister entity called Freddie Mac—built to compete with Fannie in the second-mortgage market in order to create some marketplace discipline—both carried the “full faith and credit” backing of the United States, a security blanket that merited continued government oversight of their activities while allowing them to borrow money more cheaply than any potential competitor could.

  Which is what they both did through the 1970s and 1980s, as the two government-sponsored enterprises, or GSEs, bought and sold mortgages, and then mortgage-backed securities. By “backstopping” loans that conformed to certain standards of sound underwriting, they lowered the cost of those loans as a way to, in essence, reward prudence.

  It wasn’t until the early 1990s, under Johnson, that Fannie Mae began to rethink the earnings potential of this arrangement. Wall Street was working furiously, as it had been for a decade, to free its net income from the consequences of risk. It was, after all, the core of their business model to package, parcel, and sell off debt, getting transactional fees and a taste of the debt service, while transferring burden of “default risk”—that cold shower of propitious clarity for lenders since ancient times—to any locale other than their own balance sheets.

  But someone had to “hold the risk” and, through the 1990s, Jim Johnson volunteered. Year by year, Fannie’s and Freddie’s balance sheets became engorged with underpriced risk as the guarantor of nearly 80 percent of the U.S. mortgage market. Along the way, though, the GSEs—and by association the U.S. government—were the guarantors of Wall Street’s business model and its vast profits.

  There were, of course, a few people who noticed the perils of this financial arrangement and waved their arms in distress, but they were washed downstream on a fresh and frothy river of cash that was soon surging though Washington. Johnson, who helped dig the canal, made sure that water flowed wherever it was needed. Political action committees and campaign coffers of both parties, and all manner of causes, some quite worthy, were recipients of Fannie’s largess. Johnson became chairman of both the Kennedy Center for the Arts and the Brookings Institution, while Fannie and Freddie became the destination of choice for former elected officials, assorted senior regulators, and anyone of consequence in D.C. with that patriotic can-do spirit and bills to pay. Meanwhile, Johnson and his deputy, Franklin Raines, were among a handful of people in Washington who were graced with Wall Street–level compensation. And they did it the Wall Street way: justifying handsome compensation by moving expenses off Fannie’s balance sheet, an action that a government oversight agency later deemed improper, and underreporting Johnson’s pay at $6.2 million. In fact, it was $21 million. Ultimately, Johnson’s haul from seven years running Fannie—he handed it off to Raines in 1998—was over $100 million.

  The issue of compensation, though, was even more broadly applicable. Elected officials of both parties, watching the two-decade rise of the professional, managerial, and financial classes in America while most Americans saw their incomes freeze or decline, could compensate for those shifts by directing Fannie’s might. From the mid-1990s forward, Fannie, by widening the types of mortgages it would guarantee, was the agent of the “American dream of home ownership”—a dream trumpeted by both Clinton and Bush—by extending mortgages to those who were, increasingly, on the wrong side of economic tides Washington felt it could do so little to reverse.

  The price for those best intentions was to “bid out” the government’s precious role as guarantor. While Wall Street created the models to separate risk from reward, the government’s role as backstop—final recipient of the risk being passed to and fro between investors in debt—was crucial to the equation. By 2003, concern that the GSEs, at that point carrying $1.5 trillion in debts, could be capsized by a shift in the markets prompted the Bush administration to propose they be
overseen by a division of Treasury that could set capital requirements for the giants based on market conditions. The subtext, of course—to curb the GSEs’ lending standards—soon became a political struggle with populist overtones. Fannie’s supporters rose up: policing Fannie in this way would mean less affordable homes for middle- and low-income Americans.

  As is often the case, the debate was shaped by the distinctive voice of Representative Barney Frank, the Massachusetts Democrat and a member of the powerful House Financial Services Committee.

  “Fannie Mae and Freddie Mac are not in crisis,” he said at a hearing. “The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious losses to the Treasury, which I do not see, I think we see entities that are fundamentally sound financially, and withstand disaster scenarios, and even if there were a problem the Federal government doesn’t bail them out, but the more pressure there is there, then the less I think we see in terms of affordable housing.” Did it matter that Barney’s partner, Herb Moses, had worked at Fannie, a job Barney helped him get, or that his mother, the sainted Mrs. Frank, had received a $75,000 grant from Fannie for a foundation she ran that helped the elderly?

  Probably not, but appearances notwithstanding, nothing was done as Fannie and Freddie took on more of Wall Street’s risk. To be sure, the GSEs never pressed for the underwriting of subprime loans—which were defined by the fact that they didn’t conform to Fannie’s and Freddie’s underwriting standards. But mixing of conforming and nonconforming loans into CDOs and other mortgage-backed securities brought the contagion directly into the Roosevelt-era’s edifice to affordable housing for a battered nation.

  What was clear by the fall of 2007 was that those best intentions worked only in a landscape where government and business were separate and distinct in their definition of core interests—one of public purpose, the other private endeavor. Once the government business partnership was stuck, with profits as a shared goal, it was just a matter of when the “mixed ownership corporation” would explode and how costly it would be.

  When Jim Johnson was first asked to join up with Caroline Kennedy and Eric Holder to start some preliminary inquiries for a VP search in April, the former Fannie Mae CEO was already displaying signs of toxicity. Some smart analysts on Wall Street and a few at Treasury had begun running the numbers on Fannie and Freddie: their liabilities in the current environment were daunting and taxpayers could be on the hook if the federal government were forced to make good on the GSEs’ precious guarantee. But as soon as Johnson was officially introduced on June 4 to head the VP search committee, McCain’s campaign went on the offensive. It took just five days for reporters to discover that Johnson had gotten loans for some of his properties directly from Angelo Mozilo—the CEO of Countrywide, the huge mortgage underwriter at the center of the subprime mess.

  “I think it suggests a bit of a contradiction,” McCain chided Obama on Fox News, “talking about how his campaign is not going to be associated with people like that.”

  Two days later Johnson resigned his post, stressing it was unpaid and thereby voluntary—a statement showing his continued appreciation of the power of illusion. Tapping Johnson was a misstep for Obama, spurred on by his desire to pick a running mate who would ease his flight to a perch atop the nation’s imperious and insular capital. McCain, of course, had spent many years in Washington as a boy—the son and grandson of famous admirals—and saw it change from the time he arrived as a freshman congressman from Arizona in 1983. In fact, he lived it, getting caught up in the signature scandal of the early 1990s savings-and-loan mess as one of the five senators accused of trading favors with failed S&L operator Charles Keating.

  McCain could remember the post–World War II period in Washington, when the town was filled with plenty of lifelong public servants who didn’t pine for private sector rewards or think about the perfect time to leave for lobbying work. It was to that era—and that ethic—that he spoke about passionately and publicly, expressing genuine shame and contrition about his dealing with Keating. It saved his political career, and he went on to be a crusader, certainly among Republicans, for campaign finance reforms. Obama and a campaign team heavy with Washington outsiders were showing a lack of acuity about the town they soon hoped to command, while McCain understood the ugly ways in which Washington had, from year to year, been debased. Yes, Jim Johnson knew everybody in Washington—and across decades he had helped fund the town’s glorious, can-do lifestyle—but suddenly, no one could afford to know him.

  The driver of the car pulled up to 32 Maple Hill Drive on June 9 and peered into the modest Tudor home for signs of life. The clock showed 7:00 a.m., and the air was already warm in anticipation of a hot summer day.

  These early-morning pickups more often involved gated estates, where the crunch of tires on gravel announced the car service’s arrival. In the world of high finance, rare was the curbside pickup. But then, Tim Geithner had never been party to the affluence that typically came with a career in the industry. He was often mistaken for an investment banker. Something about the quick smile, withdrawn just as quickly. After being put in charge of the New York Fed, he and his wife bought this relatively modest house in Larchmont, New York, in front of which a car engine now softly idled.

  Inside the house, Geithner was getting ready for a wildly busy day. The driver might make the Fed building in thirty minutes if FDR Drive was clear, but even so, he would be cutting things close. Geithner’s first morning call, with Goldman CEO Lloyd Blankfein, was scheduled for 7:45. John Mack from Morgan Stanley was set for 8:15, and Jamie Dimon of JPMorgan for 9:30, and by then Geithner would probably be running late for his speech at the Economic Club of New York. It was an insane schedule. It had been since Bear’s collapse.

  As the subprime crisis began to unfold, Geithner had joined with Hank Paulson and Ben Bernanke to decide, in a sense, the fate of the economy. He was the least high profile of the three but had become, all the same, increasingly central to the group’s decision-making process. Just three months earlier it had been Geithner in the lead, setting up the Bear Stearns deal with JPMorgan.

  While Paulson was still holding the line that Wall Street would have to take care of itself without the help of taxpayer money, Geithner was tending to his downside risk: having to answer the “what did you know and when did you know it” question.

  The New York Fed chair had first become aware of the gathering economic storm in an August 2007 phone call. To Geithner’s disbelief, the mortgage giant Countrywide, and leader of the subprime bonanza, was not going to be able to refinance its repo book.

  “Repo” was industry-speak for “repurchase agreement,” a growing practice in the financial sector by which firms borrowed and lent each other huge sums of money on short-term bases—a few weeks, a few days, sometimes just overnight. Like any other loan, collateral has to be put up to secure the loan. Like lots of firms of all types—banks, financial firms, industrial companies—Countrywide was using mortgage derivatives, such as CDOs, as collateral. At this point, Geithner, like virtually every other regulator, had only a passing familiarity with how repos were being used and how they’d grown since 2005. They were viewed as another kind of cheap, short-term lending, somewhere between commercial paper and a swap. And as with the credit default swaps, the participants in this arrangement were called counterparties. No one, in 2007 or even 2008, knew how big the repo market was.

  “That was really interesting,” Geithner later reflected, “because Countrywide had no idea what its exposure was, no understanding of what it had gotten into. And the fact that the market was unwilling to fund Treasuries if Countrywide was a counterparty was the best example of how fragile confidence was and how quickly it turned.”

  Translation: the market would not even lend Countrywide cash to buy Treasury bonds, the safest investment in the firmament. CDOs, MBSs, or similar types of mortgage-based collateral that Countrywide was using to ro
ll over its repo loans were suddenly seen as impossible to value or sell in August 2007, meaning it was illiquid. The whole point of collateral is that it can be taken—the way the repo man repossesses your car after too many missed payments—and sold in liquid markets for cash. Collateral that is illiquid is no collateral at all. Countrywide’s intended use for the borrowed funds—to go out, like Sal Naro, and buy Treasuries and shore up its balance sheet or to use them as collateral for emergency bank loans—was irrelevant. Its collateral was no good.

  Geithner, at the time and looking back, saw this strictly in terms of confidence.

  Confidence, in fact, was Geithner’s currency. He viewed his role, then and later, as assuring confidence in the financial markets, by any means necessary, at whatever cost. His view was that the financial markets would engage in myriad transactions, all but matching the diversity of flora and fauna in the natural world. Knowing how all those transactions worked was daunting and unnecessary. His job, and that of the Fed, was to preserve widespread faith in the system’s overall soundness.

  “People on Wall Street watch each other,” he explained. “It’s like watching people leave a theater. As soon as a few people leave, the tone of the theater shifts. All these huge institutions start to pull back, and they watch each other pulling back and wonder, ‘What’s going on?’ ”

  Whether there is actually a fire in this crowded theater, or just someone yelling “Fire!,” the job of the regulator is to rush in with the hoses. Spray first; ask questions later. Over the weekend of March 14–16, as Bear Stearns imploded, Geithner had taken extraordinary measures to prevent a mass exodus from the Wall Street theater. Bear Stearns died because it could not roll over its repo book. Why? It was using mortgage-backed securities and related derivatives, still sporting their triple-A ratings from Moody’s, as collateral. In its final weeks, other firms, getting jittery about Bear, were shorting the repo durations, from months to weeks to days. In its last week, Bear had to raise $50 billion a night in repos to replace the expiration of its day-to-day obligations and to fund operations. This is called “rolling your book” of debts. This is how financial firms die in this era. It’s not from losses, or declining revenues. It happens when they can’t roll their debts—essentially replacing old credit cards with new ones, every day.