The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  At the June 8, 2008, meeting of the Governing Council, the group was divided. As Trichet put it that day, “We exchanged many opinions and views around the table, as always, with a very candid exposition of our analysis. A number of us thought that . . . we had a case for increasing rates. A number of us considered that there was a case for increasing rates, but at a later date, and some amongst us considered that there was not necessarily a case for doing so.” The compromise: This time, Trichet wouldn’t pledge “strong vigilance” and a near-certain rate hike but rather “heightened alertness,” which raised the possibility of a hike without committing to it; often, central bank communications is the art of managing such fine distinctions.

  The Governing Council met again on July 3—just when, it turned out, many commodities were at all-time highs. The price of light sweet crude oil had reached $145 per barrel. It had been $100 per barrel as recently as April, and only about $73 a year earlier. The inflation rate in the eurozone was 4 percent. Trichet that morning steered the council toward an interest rate hike, using his tools of persuasion to guide a still-divided committee.

  As the Frenchman announced a 0.25-percentage-point rise in the ECB’s target for interest rates, he delivered a stern message to anyone who might have thought that the ECB wasn’t serious about stopping inflation: “We are solemnly telling all economic agents, corporate businesses, price setters in the economy, and social partners that the worst decision they could take would be precisely to believe that what we are observing today, namely this protracted period of high inflation, will last in the medium term.”

  But as it turned out, eurozone inflation wasn’t really the problem.

  The Bank of England, meanwhile, couldn’t decide whether inflation or recession was the greater threat to the economy. So the bank elected for patience. Even after its governor’s noninterventionist approach had facilitated the first British bank failure in 141 years, the institution was biding its time, neither raising nor lowering interest rates, waiting to see what might happen next.

  Among the nine members of its Monetary Policy Committee, expat Dartmouth professor “Danny” Blanchflower was the only one convinced that the British economy was in grave peril and immediate action was necessary.

  Blanchflower envisioned the rapidly spreading financial crisis driving up joblessness and crushing consumer spending. He wasn’t the most persuasive spokesman for that argument internally; even some MPC members who were sympathetic to Blanchflower’s views thought that he’d offered more vague warnings rather than hard evidence—and in the King of Threadneedle Street’s domain, hard evidence was everything. It was common knowledge among bank staff that the surest path to career advancement was working on what mattered most to Mervyn: the Monetary Analysis and Statistics Division, which he’d created. The “MA Way,” full of theoretical rigor, ruled the land. Blanchflower, by contrast, practiced what he called “the economics of walking about,” making decisions based on the messy realities of the world as he found it.

  By late August, Blanchflower was fed up with trying to persuade his fellow committee members that he was right. So he called a reporter at Reuters and told him what he really thought. “We are going to see much more dramatic drops in output,” he told the news service, predicting that two million Britons would be unemployed by Christmas. “I feel that things I have been fearful about have come to pass, and I have actually been pretty accurate in what’s coming and I have failed to convince the others of what is appropriate.”

  “Sitting by doing nothing is not going to get us out of this,” Blanchflower warned. At the MPC’s monthly meeting the next week, he said, he would be pushing for a rate cut of more than 25 basis points.

  Furious, King called Blanchflower into his office.

  “How dare you do that?!” Blanchflower recalled him raging.

  “What’s it got to do with you?” asked Blanchflower.

  King complained that Blanchflower had violated central banking’s unwritten rules, which call for secrecy, tact, and, above all, collegiality.

  “I don’t care what you think,” said Blanchflower, who’d grown steadily angrier at what he saw as King’s controlling style. “How dare you speak to me like that. It has nothing to do with you. Piss off. Just piss off. I’m an independent member of the committee, and I think you’re all completely mad. I represent the British people. I don’t represent you, and I think you’re wrong.”

  With that, Blanchflower walked out, his already poor relationship with King now fully off the rails.

  Two weeks later, on September 11, 2008, Blanchflower and King sat with a row of colleagues in Portcullis House, a striking modern building on the bank of the Thames that contains offices of members of Parliament. They were addressing the House of Commons’ Treasury Committee, and although Blanchflower was more diplomatic than he’d been in King’s office, he left little doubt of what he really thought.

  “I do have a somewhat more doom-laden view,” he began in response to a question from MP John McFall. “I think we are going to see a deeper decline than others think.”

  What did the chairman of the MPC make of that prediction? “I do not think we really know what will happen to unemployment,” King said during the hearing. “At least, the Almighty has not vouchsafed to me the path of unemployment data over the next year. He may have done to Danny, but he has not done to me.”

  Blanchflower was visibly upset just recalling the episode three years later. “Well, I just read the data, shithead!” he said. “Literally, I could’ve punched him. He was only sitting two seats down from me.”

  • • •

  The world’s central bankers admired the ingenuity and even the elegance with which Bernanke and Geithner engineered the rescue of Bear Stearns—a “masterful” rescue, as one European central banker said later. They assumed that the Americans would be up to the task the next time a major financial institution teetered on the brink. In fact, in that outwardly calm summer of 2008, Bernanke and Geithner were coming to grips with just how limited their power might be.

  Bernanke pushed his staff to think broadly about the Fed’s options to try to bolster the financial system; he famously sent e-mails with the subject line “Blue Sky,” instructing staff to brainstorm ideas. But as the same forces that brought down Bear Stearns started to endanger Lehman Brothers, they found there was little under the clear blue sky that they could do.

  Like Bear Stearns and many other Wall Street firms, Lehman was heavily involved in the creation of mortgage-backed securities. It also relied to a great extent on borrowed money, with $700 billion in total assets against only $25 billion in capital. In July, Lehman came to the New York Fed with a proposal: that it convert itself into a bank holding company, the sort of institution that would come under explicit oversight by the Fed, and in exchange gain access to the full range of central-bank programs that insure steady funding. To Geithner, the proposal seemed “gimmicky.” This securities firm didn’t look like a bank or smell like a bank. Why should the Fed pretend it was a bank?

  At the same time, Fed officials in New York and Washington were game-planning what to do if Lehman encountered trouble similar to Bear’s. On the evening of July 14, in a conference call with Geithner, Donald Kohn, and others, New York Fed markets desk chief Bill Dudley laid out a proposal for how the central bank might deal with a Lehman failure. His idea, described in detail in an e-mail exchange the next day, was to divide Lehman in two: a “bad bank,” consisting of $60 billion of complex mortgage and other securities that were hard to value in a time of crisis, of which $55 billion would be funded by the Fed, and a “clean Lehman” consisting of everything else, which would be a more liquid, less leveraged investment bank stripped of ugly assets. In exchange for providing billions for the bad bank, the Fed would be given stock in the good bank.

  The concept had theoretical elegance, but Fed lawyers in Washington were appalled. The emergency
lending authority they’d used with Bear allowed them to lend against safe collateral, not to invest in the stock of an investment bank. There was, in this plan, no other buyer that could come in and take over like J.P. Morgan had done with Bear. Kohn hadn’t pushed back much against the proposal in the evening conference call, according to an e-mail, but a Fed lawyer, Kieran Fallon, told general counsel Scott Alvarez that he would “raise significant concerns” over the proposal. Nothing similar to what Dudley had outlined ever materialized.

  Less than a week later, Bernanke sent an e-mail to his closest advisers: “Our Options in the Event of a Run on LB.” Patrick Parkinson started his reply this way: “The short answer is the one that Tim [Geithner] gave to the FOMC on Wednesday: There are no good options.” He went on to give the long answer, explaining that even if the Fed were to take the dramatic step of extending $200 billion in credit to Lehman Brothers—at a time when the central bank’s total balance sheet was $930 billion, essentially putting more than 20 percent of its resources to work for a single firm—it wouldn’t necessarily fix the problem. “Absent an acquirer our action would not ensure LB’s survival,” Parkinson wrote on July 20.

  The Fed injection might be enough for Lehman to satisfy its overnight lenders, but because of the stigma effect, the firm would likely face demands of cash from other entities it did business with. Or, if investors started to question the Fed’s ability to fulfill mounting demands for cash in overnight-lending markets, it might not be enough. “That’s not to imply that it would not be worth the gamble, but it would be a gamble,” Parkinson concluded.

  As Lehman’s finances became ever more fragile in the summer of 2008, the consensus at the Fed was that there were no good options to save it unless a buyer came forward. “If we think that the run had progressed too far and that it wouldn’t be sold,” said New York Fed economist Jamie McAndrews in a July e-mail, “then any lending we did to it would be a permanent addition to the government’s balance sheet—like Northern Rock, again.”

  The reckoning for Lehman came much as it did for Bear: slowly, then all at once. After months of a low murmur of worry, the actual collapse in confidence happened over just a few days, on the heels of the U.S. government’s putting Fannie Mae and Freddie Mac into conservatorship, a form of bankruptcy. After a summer of relative calm, the crisis was back, and as the Fed had long feared, the markets were zeroing in on Lehman.

  On the morning of Thursday, September 11, New York Fed officials sent colleagues in Washington a five-page plan for the weekend titled “Liquidation Consortium.” The plan was to bring together the heads of the financial firms that had the most to lose if Lehman went down, “to provide a forum where these firms can explore possibilities of joint funding mechanisms that avert Lehman’s insolvency” as well as more widespread financial devastation. The Fed wanted to invite only institutions that would stay at the negotiating table. If one left, the document noted, “many more may follow.”

  To minimize the possibility of leaks, the Fed gave less than two hours’ notice to the invited executives, but when the executives showed up on Friday afternoon, news photographers were already arrayed around the New York Fed’s headquarters in lower Manhattan.

  The next two days were the most consequential for global capitalism in modern times. The guiding principle of the weekend was that Wall Street, not the Fed, would be the one to bail out Lehman Brothers. Geithner and Hank Paulson scurried between rooms, looking desperately for a buyer, or at least for a consortium of stronger firms that might, as Geithner phrased it, put “foam on the runway” for Lehman’s crash.

  • • •

  As officials in the United States braced for impact, the central bankers and finance ministers of Europe gathered at one of the grandest villas in the south of France, nestled between Nice and Monaco in the village of Beaulieu-sur-Mer. They clinked champagne glasses in hundred-year-old gardens overlooking the Mediterranean, in a house that was built at the start of the twentieth century for, appropriately enough, a banking heiress, Béatrice Ephrussi de Rothschild. An opera singer’s tenor carried through the late summer air. Apart from the absence of ball gowns on the women and white ties and tails on the men, one attendee observed, the scene looked as if it were taking place before World War I.

  The opulent setting wasn’t the only thing that called to mind the Great War. As Bank of England deputy governor for monetary policy Charles Bean had said in a parliamentary hearing that very morning, the same one in which Blanchflower wanted to punch King, “We thought a year ago, when this crisis first emerged, that it ‘might be over by Christmas,’ a bit like World War I, but as it has gone on we have realized that there are far deeper and more well-seated problems that will take longer to unfold.” That the global crisis would, in different forms, go on for years more and profoundly endanger European unity made the comparison only more apt.

  But the central bankers in Europe had little grasp of the peril their countries were facing. On that moonlit evening on the French Riviera, and the next day in more businesslike meetings in Nice, the mood was one of confidence that the Americans would take care of their mess. They had in the past, and Bank of America seemed poised to scoop up Lehman. The Europeans were constantly stepping outside to send e-mails or place calls to their contacts in the United States—and constantly heard very little in response. No one knew for sure how the details of the talks at the New York Fed were proceeding, in no small part because Geithner and Paulson were far too busy to loop in their counterparts overseas. Thus the discussion in Nice focused on longer-term reforms to financial regulation. Trichet even gave a speech in which he offered his thoughts on the current “financial-market correction,” carefully avoiding the word “crisis.”

  As the Europeans left Nice on the evening of Saturday, September 13, the Americans were watching everything fall apart. Bank of America had elected to acquire Merrill Lynch, not Lehman Brothers. And British bank regulators were uncomfortable with Barclays buying Lehman, which could turn the American government’s problem into the British government’s problem. On Sunday, the Americans got to the end of the line: They had no buyer for Lehman.

  The idea of a consortium had collapsed, in no small part due to the fragile finances of the very banks that it would have comprised. The Fed is allowed to lend money only against sound collateral. Whatever the arguments against the Bear Stearns bailout, the Fed had a plausible case that it would get its money back. Lehman was insolvent—a loan wouldn’t solve its problem, and there was no legal way for Bernanke or Paulson to hand money over to a private firm. It’s not clear that U.S. politicians, from President George W. Bush to congressional Democrats who were tiring of Wall Street bailouts, would have stood for it anyway.

  That’s why, Bernanke explained to Trichet in a phone call that Sunday, Lehman Brothers would have no choice but to file for bankruptcy protection first thing Monday morning.

  Bernanke, not sounding terribly persuasive, said that he was hopeful that in the six months since Bear Stearns’ failure, banks worldwide had girded themselves for the possibility of another large institution going down. Under no circumstances should you allow this firm to fail, Trichet argued, angry that the Americans would act so recklessly with a company that had deep financial interconnections with major banks all over the earth.

  “We have no other options,” Bernanke told Trichet.

  “I think,” the Frenchman replied, “that the result of this will be very grave indeed.”

  ELEVEN

  A Wall of Money

  The decision to let Lehman Brothers go bankrupt, in the end, wasn’t really a decision at all. Never were Ben Bernanke and Tim Geithner and Hank Paulson equipped with a workable plan for preventing the firm from going bankrupt. By the time Lehman was on the brink, the crisis fighters were running up against the legal and political limits of their ability to stop it from going over.

  That, however, wasn’t what they told the outsid
e world at the time. They wanted to project confidence and calm, to give the impression that the Lehman bankruptcy was a deliberate decision they’d made out of their conviction that the financial markets were sufficiently prepared for the possibility of such a failure—which had seemed imminent ever since the near collapse of Bear Stearns six months earlier. That was the message Fed officials voiced to reporters, their contacts in the markets, and even other central bankers.

  “It was a bit crazy how calm they seemed,” said one European central banker. “They were taking a big risk, and it seemed like a political choice that Paulson had made, but they framed it in terms of ‘the markets are well prepared for this.’”

  Privately, other central bankers blamed Paulson and the Bush administration more than they did Bernanke and Geithner. But even those sympathetic colleagues didn’t understand the dilemma that the Fed had faced. “For central banks with different traditions and governments with the ability to guarantee their banks, they found it inconceivable that we would be constrained the way we were,” said one American official. In any case, the result was plain: By allowing a financial institution of such great international economic reach to go bankrupt, the Fed had failed the global community of central bankers.

  There was no time for remorse, however. On Monday, September 15, 2008, after a sleepless weekend dealing with Lehman, Geithner and his colleagues at the New York Fed faced a whole new crisis: American International Group, an insurance company with a $1 trillion balance sheet and 116,000 employees, was on the brink of collapse.

  AIG had operations in almost every corner of the world economy: writing insurance policies against fire for homeowners, guaranteeing pension plans for municipalities, leasing 747s to airlines. But what had accounted for a surprising portion of its earnings in the previous few years—and the part of the company that now threatened to bring the whole thing down—was its financial products division. It had developed a wildly lucrative business of guaranteeing those seemingly high-quality mortgage bonds created by Wall Street. With AIG standing behind such securities, investors considered them virtually riskless. The insurer, meanwhile, viewed the odds of losing money on insuring these supersafe bonds as so low that it didn’t reserve any money for payouts.