All the Devils Are Here

by Bethany McLean; Joe Nocera

  And by Monday morning, March 17, Bear Stearns had been sold to J.P. Morgan for $2 a share. Paulson, who had urged J.P. Morgan to make the deal so that Bear wouldn’t go bankrupt—and wreak havoc on the financial system—had insisted on that punitive price. Later, facing a revolt by Bear shareholders, J.P. Morgan raised the price to $10 a share. In his book, Paulson describes the new price as “an unseemly precedent to reward the shareholders of a firm that had been bailed out by the government.” And it had, because J.P. Morgan would not have done the deal if the Fed hadn’t agreed to provide a $30 billion loan to a stand-alone entity that would buy a pool of Bear’s mortgages that J.P. Morgan didn’t want.

  The banks’ dirty little secret was now out in the open. It wasn’t just Fannie and Freddie that had been creating moral hazard all these years. So had the nation’s big banks. They had taken on terrible risks, built up immense leverage, and created such tight interconnections with their derivatives books that the failure of any one of them could bring down all the others. When things got bad, they assumed they had an “implicit government guarantee,” just like Fannie and Freddie. In On the Brink, Paulson recalls a phone call he received from his former number two at Goldman, Lloyd Blankfein. It was the Saturday that Treasury and the Fed were negotiating with J.P. Morgan to take over Bear. “I could hear the fear in his voice,” writes Paulson. The Goldman CEO told him that “the market expected a Bear rescue. If there wasn’t one, all hell would break loose.

  At Fannie Mae and Freddie Mac, the losses continued to grow. Fannie was about to slide under OFHEO’s capital requirements, which executives referred to as “the line of death.” Even though they were convinced they could survive the losses, they worried that if they slid below even by a dollar, OFHEO would punish them in some way.

  Some in the government were starting to freak out about the GSEs. In an e-mail on March 16 to others at Treasury, Bob Steel, the undersecretary for domestic finance and Paulson’s point man on Fannie and Freddie, wrote, “I was leaned on very hard by Bill Dudley”—an executive vice president at the New York Fed—“to harden substantially the gty.” That meant that the New York Fed wanted the U.S. government to explicitly stand behind the GSE’s debt. It was an expression of the fear officials were starting to feel about the GSEs. And yet, on March 19, four days after Bear was rescued, OFHEO, backed by Treasury, issued a press release announcing that it had agreed to reduce Fannie and Freddie’s capital cushion, which, claimed OFHEO, was “expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market.” A month earlier, OFHEO had loosened the portfolio caps the GSEs had agreed to after the accounting scandals. The two changes together “should allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year,” OFHEO reported. “These companies are safe and sound, and … they continue to be safe and sound,” said Lockhart.

  Lockhart should have known better. What OFHEO had really done was reduce Fannie and Freddie’s protection against insolvency—even though the companies were edging closer to it every day. Because if it didn’t, no one in America would be able to buy a house.

  Later that day, Josh Rosner released a report entitled “OFHEO Got Rolled.” “We view any reduction as a comment not on the current safety and soundness of the GSEs but on the burgeoning panic in Washington,” he wrote. “While many are viewing these actions as a positive sign, we continue to believe that they highlight that the building is shaking from the top to bottom.”

  “From March to September,” says a former Treasury official, “the big question was, how would we attempt to deal with the next shoe dropping?” Nobody doubted another shoe was coming.

  With his antennae so attuned to Wall Street, Paulson had long thought the next shoe could be Lehman Brothers, the second smallest of the big five. When Bear Stearns started its downward spiral, Paulson had called Lehman CEO Dick Fuld, who was on a business trip in India. “You better get back here,” Paulson told him, according to Too Big to Fail, Andrew Ross Sorkin’s book about Wall Street during the financial crisis.

  Fuld was an aloof, stubborn executive who had run Lehman since 1994 and had seen his firm through crises before. He felt certain he could do it again. But he was playing a dangerous game. Instead of getting “closer to home,” like Goldman Sachs, Lehman had decided to double down, in large part by financing and investing in big commercial real estate deals at the very height of the real estate bubble. Between the fourth quarter of 2006 and the first quarter of 2008, Lehman’s assets had increased by almost 50 percent, to some $400 billion. Its leverage ratio was 30 to 1. “Pedal to the metal,” is how David Goldfarb, Lehman’s chief strategy officer, described the firm’s growth, according to Lehman’s bankruptcy examiner.

  All that risk on its books was taking a toll, however. The market was starting to ask questions, just as it had with Bear. The stock was declining. And starting in 2007, according to one well-placed observer, Lehman had begun to lose access to unsecured funding, so it was increasingly dependent on the repo market. But repo lenders had begun to steadily increase the “haircut” they demanded from Lehman. On March 26, Eric Felder, Lehman’s U.S. head of global credit products, sent an e-mail to Bart McDade, the head of Lehman’s equity capital markets group. “I’m scared that our repo is going to pull away … We need to be set up for [commercial paper] going to zero and a meaningful portion of our secured repo fading (not because it makes sense but just because)…. The reality of our problem lies in our dependence on repo and the scale of the real estate related positions… .”24

  Ian Lowitt, who was then Lehman’s co-chief administrative officer, wrote back, “People are on it. Agree there will be another run, but believe it will be industry wide not Lehman specific. You are not Cassandra, cursed by Apollo to be able to see the future but have no one believe you!!!”

  That the government knew Lehman Brothers was playing with fire—and did nothing about it—would become clear in the aftermath of the crisis. The SEC, for instance, would later tell the Lehman bankruptcy examiner that it was well aware that the bank had repeatedly violated its own internal risk limits. But, the agency added, it “did not second-guess Lehman’s business decisions so long as the limit excesses were properly escalated within Lehman’s management.”

  The Federal Reserve developed rigorous stress tests for Lehman that were supposed to determine its ability to withstand a run on the bank. The Fed devised two scenarios, which they called Bear and Bear Stearns Lite. Lehman Brothers failed both. The Fed came up with an additional round of tests; Lehman failed those, too. Lehman did pass stress tests of its own devising. “It does not appear that any agency required any action of Lehman in response to the results of stress testing,” the examiner later wrote.

  And there was strong suspicion that Lehman’s marks were inflated. Indeed, Tim Geithner would later tell the Lehman bankruptcy examiner that a fire sale of assets might have revealed that Lehman “had a lot of air in [its] marks.”

  What bothered Hank Paulson, though, was that Fuld just didn’t seem to share his urgency. Although Fuld did raise $4 billion in additional capital in March, for which Paulson congratulated him, he was deeply resistant to Paulson’s constant suggestion that Lehman Brothers was vulnerable and that Fuld needed to find a buyer. Fuld, Paulson would later tell the bankruptcy examiner, was “a person who heard only what he wanted to hear.” What he wanted to hear, clearly, was that the government wouldn’t let Lehman go under—a view that had become widespread inside the company, even though Paulson says he consistently told Fuld that help would not be forthcoming. “Hank was consistent in emphasizing to Dick, ‘You’ve got to have a plan B and C. Hope isn’t a strategy,’” Bob Steel told Vicky Ward, the author of The Devil’s Casino, a book about the fall of Lehman.

  Then again, maybe hope was a strategy. Ward also reports that around this time a former Lehman bond trader named Peregrine Moncreiffe bumped into a friend who was working for John Paulson. Fuld had recently visited Paulson’s
offices. “Fuld told us he’s deliberately going to keep the balance sheet big,” the friend told Moncreiffe. “He thinks that this way, the government will have no choice but to save him.”

  On June 9, Lehman preannounced its second-quarter earnings, saying it would lose $2.8 billion. That day, Skip McGee, Lehman’s head of investment banking, forwarded a message to Fuld from another banker. “Fyi—representative email,” McGee wrote. The message read, “Many, many bankers have been calling me in the last few days. The mood has become truly awfull [sic] and for the first time I am really worried that all of the hard work we have put in over the last 6/7 years could unravel very quickly…. Senior managers have to be much less arrogant and internally admit that some major mistakes have been made. Can’t continue to say ‘we are great and the market doesn’t understand.’” Lehman’s stock price fell below $30 a share, a 60 percent decline over the past year.

  Three days later, Lehman announced that it was firing Erin Callan, its chief financial officer—who had become the face of the firm as she attempted to fight the rumors that it was in trouble—and its president, Joe Gregory. Somebody had to be sacrificed to the market gods, and they were chosen. The next day, Citigroup, which cleared trades for Lehman, asked the company to provide it with a “comfort deposit” of between $3 billion and $5 billion to help cover Citi’s exposure to the firm. (The amount was later negotiated down to $2 billion.)

  “Market is saying Lehman cannot make it alone,” wrote Citigroup risk management officer Thomas Fontana to his colleagues. “Loss of confidence here is huge at the moment.”

  On July 10, 2008, a story appeared on the front page of the Wall Street Journal that began, “The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter.” The next morning, the New York Times chimed in. “[S] enior Bush administration officials are considering a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems worsen,” the paper said. Fannie’s stock, which had slowly fallen to under $20 over the previous year, dropped 50 percent in two days. It was barely in double figures.

  Mudd picked up the phone and called Paulson. “Jesus, Hank,” he said. Paulson, says one person familiar with the conversation, told Mudd that he had “raised hell,” telling the White House staff—who Mudd assumed were the source of the leaks—that they needed to keep out. (Paulson insists, “I can guarantee with 100 percent certainty that the White House knew nothing about a conservatorship strategy,” because at that point, that wasn’t part of Treasury’s plan.)

  Two days later, IndyMac, the Countrywide spinoff, was taken over by the FDIC. IndyMac’s distinction had always been that it specialized in Alt-A loans, as opposed to subprime mortgages. The government takeover was a rude awakening for investors who believed that Alt-As were somehow safer than subprime loans. They weren’t. And who had more Alt-A exposure—way more Alt-A exposure—than anybody else? Fannie and Freddie.

  Debt investors around the world owned a staggering $1.7 trillion in either mortgage-backed securities guaranteed by the GSEs or GSE debt, according to the study by Jason Thomas. Suddenly, for the first time in memory, they were net sellers of that debt, unloading some $66 billion in Fannie and Freddie debt securities in July and August. Fannie and Freddie had literally billions of dollars in debt that they would need to roll over in the coming months.

  Now Paulson was obsessively focused on Fannie and Freddie. He still didn’t know the extent of the credit risk on their books. Indeed, their regulator was still saying they were in good shape, and Paulson had no way of judging for himself whether that assessment was right or wrong. And Fannie and Freddie were every bit as vulnerable to a run on the bank as Bear Stearns—maybe even more vulnerable, because their capital cushion was so small. It really wouldn’t take much to put them over the edge.

  If panicked investors around the globe started dumping Fannie and Freddie debt, the government would be helpless to do anything about it. That’s the only thing Paulson really knew. “I had no power, and the regulator had no power, no responsibility, and no authority,” Paulson later said. The would-be reformers had long clamored for a way to wind down a failing GSE. But Paulson had already failed to push through legislation that might accomplish that.

  Paulson’s instinct—as it always was when faced with a problem—was to take control and do something. “Hank wanted to fire anyone who said the GSEs were OFHEO’s problem,” recalls a Treasury official. “He said, ‘We own this problem. It’s ours to solve.’” But how? The staff worked all weekend to come up with a plan: get Congress to give Treasury “emergency powers,” to use Paulson’s phrase, that would allow the government to put money into Fannie and Freddie. At the same time, the logjam surrounding the creation of a new regulator had finally broken. And so the bill that finally, at this desperate late date, passed Congress did a few things all at once. It created a new regulator for the GSEs (though it was really the old regulator with a new name). It gave the Federal Reserve power to look at the GSEs, so the Treasury staff didn’t have to rely on OFHEO’s judgment of their health. It made it easier for the government to take over the companies through conservatorship should they fail—it included, among other things, a provision that if their boards consented to a takeover, shareholders couldn’t sue. And it gave Treasury the unlimited ability to use and increase those long-standing $2.25 billion lines of credit that Fannie and Freddie had. At that point, Paulson never intended to use it.

  “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out,” as Paulson explained it to Congress.

  Less than two weeks later, Tim Geithner had a dinner party at the New York Fed, as he often did so the Treasury secretary could talk with Wall Street’s chiefs. Paulson explained to the assembled CEOs why his actions on the GSEs should be reassuring to the market. Lloyd Blankfein raised his hand. “Hank, I don’t mean to be disrespectful,” he said. “But this is a strange market, one that’s driven by fear. Stop and think.” Blankfein paused before delivering his punch line. “Fannie and Freddie are the U.S. government’s SIVs.” He finished, “Hank, how long did it take before Citigroup had to step up to its SIVs and put them on its balance sheet?”

  “I had to change the subject because the moment he said it, I knew he was right,” Paulson later said.

  The news of the bazooka did not turn the tide. The irony was powerful. For decades investors had bought Fannie’s and Freddie’s stocks, happy in the knowledge that the GSEs were backed by an implicit government guarantee. It had always been one of the most attractive things about owning the stock. But now that the government was saying, quite explicitly, that it would back Fannie and Freddie, investors didn’t like it at all. Why would they? The government might put in equity and become a preferred shareholder, putting itself ahead of the common shareholders. Or it might take over Fannie and Freddie and wipe the shareholders out entirely. Everyone saw that the animosity toward the GSEs that had existed for so long in Washington would make it practically impossible for the government to put money into them without punishing their shareholders.

  But even if that hadn’t been the case, the government’s priority wasn’t the shareholders. It was preventing the housing market from collapsing. For decades, Fannie and Freddie had worked to maximize profits at the expense of its government mission. Now that mission was paramount. The shareholders would have to fend for themselves. Fannie and Freddie’s stocks continued to plummet.

  Even after everything that had happened, getting the bill passed required Fannie and Freddie’s support. Fannie got language inserted saying that the government could use its bazooka and inject equity only if Fannie approved. But Fannie executives didn’t bother to fight the provision about consenting to conservatorship, because they thought that “consent” would require a negotiation. In which case Fannie thought it had a trump card: it could always threaten to
shrink the company’s balance sheet and stop supporting the mortgage market. And maybe there was a little hubris at work, too. “I used to say that if two accounting scandals, a Republican Congress and White House couldn’t kill us, how could you kill us ever?” says a former executive.

  The legislation was signed at the end of July. Immediately Paulson brought in bank examiners to comb through the GSEs’ books. Just before heading off to Beijing for the summer Olympics—and just before Fannie and Freddie announced that they had lost a combined $3 billion in the first half of 2008—Paulson also hired Morgan Stanley to analyze the companies. He wanted to get an idea of how much money the GSEs could lose on mortgages they owned or guaranteed. He also wanted to get a feel for their ongoing liquidity—whether they would be able to continue to finance their operations. “Hank was very concerned with the overhang of this unraveling, and with $5 trillion, you don’t wait for the razor’s edge,” says one person who was involved.

  Three weeks later, on August 19, the Morgan Stanley team told Paulson it thought Fannie and Freddie could lose as much as $50 billion. It was a staggering number, far worse than Fannie’s worst estimates. The examiners from the Fed were similarly horrified when they looked closely at the loans that made up the GSEs’ Alt-A books. Fannie and Freddie may not have called them subprime, but they sure looked that way to the examiners.