Too Big to Fail

by Andrew Ross Sorkin

  “We’ve got an emergency,” Ken Wilson said, coming into Paulson’s office and ticking off a list of panicked CEOs who had begun phoning him that morning at 6:30: Larry Fink of BlackRock, Bob Kelly of Bank of New York Mellon, Rick Waddell of Northern Trust, and Jim Cracchiolo at Ameriprise.

  “They’re telling me people are clamoring for redemptions. Hundreds of billions of dollars where people want out!” Wilson said. “People are concerned about anyone who has any exposure to Lehman paper.”

  Paulson fidgeted nervously. The Lehman-induced panic was spreading like a plague, the black death of Wall Street. The money market industry needed to be shored up. Wilson also told him that he was hearing that Morgan Stanley was coming under pressure from hedge funds seeking redemptions as well. And if Morgan Stanley were to go, Goldman, the firm where both had spent their entire careers, would likely be next in line.

  “Another day, another crisis,” Paulson said with a nervous laugh that betrayed an uneasy sense that he was truly beginning to panic himself.

  Paulson’s instinctive response had been serial deal making—the private sector’s solution to systemic problems. Firms consolidated, covered one another’s weaknesses.

  But this situation didn’t feel normal, in that respect; behind every problem lurked another problem. He may have been praised for not bailing out Lehman, but he could see now that the unintended consequences had been devastating. The confidence that had supported the financial system had been upended. No one knew the rules of engagement anymore. “They pretended they were drawing a line in the sand with Lehman Brothers, but now two days later they’re doing another bailout,” Nouriel Roubini, a professor at New York University’s Stern School of Business, complained that morning.

  And now he could understand it: commercial paper and money markets—that was his bread and butter, Goldman’s specialty. The crisis was hitting close to home.

  Across town, Kevin Warsh, a thirty-eight-year-old governor at the Federal Reserve, whose office was a few doors down from Bernanke’s, was having his own worries.

  He was just finishing up a conference call with Bernanke and central bankers in Europe and Asia in which they explained what they had just done with AIG. Jean-Claude Trichet, the president of the European Central Bank, had been furious with them for their decision to “let Lehman fail” and was lobbying Bernanke to go to Congress to implement a large government bailout for the entire industry, to restore confidence.

  But Warsh was nervous about a different issue: Morgan Stanley, where he had worked as an M&A banker before leaving seven years earlier to become special assistant to the president for economic policy. He could tell that his former firm was quickly losing confidence in the marketplace. To him, there was an obvious solution to its problems: Morgan Stanley needed to buy a large bank with deposits. His top choice? Wachovia, a commercial bank with a large deposit base that itself was struggling. Wachovia’s 2006 acquisition of Golden West, the California-based mortgage originator, was turning into a catastrophe, saddling the bank with a giant pile of bad debt that was beginning to reveal itself.

  Given that no one at Treasury was allowed to talk to Bob Steel now that he had become CEO of Wachovia, worrying about that firm had become Warsh’s responsibility. And he increasingly had more to worry about: as a former deal maker himself, he knew that Wachovia, too, needed a partner desperately and he just might to have play the role of matchmaker. There was no way the bank would make it on its own, he thought.

  But like Paulson with Goldman, Warsh had his own conflict-of-interest problem with Morgan Stanley, so he sought out Scott Alvarez, the Fed’s general counsel, and requested a letter clearing him to make contact with his former employer, based on an “overwhelming public interest.”

  Warsh contacted Steel and instructed him to call Mack in twenty minutes, which left him enough time to give Mack a heads-up.

  Warsh then called Geithner and asked, “Do you want me to call John? Or do you want to call John?”

  They decided to call him together.

  Despite its terminal illness, Lehman Brothers was bustling with activity. Legions of sleep-deprived, depressed traders, lawyers, and other employees were still working the phones and doing what they had to do before closing up the shop. Fresh on their minds was the memo that Dick Fuld had sent out the previous night: “The past several months have been extraordinarily challenging, culminating in our bankruptcy filing,” he wrote. “This has been very painful on all of you, both personally and financially. For this, I feel horrible.” To some angry employees, it was an extraordinary understatement that called to mind Emperor Hirohito’s famous surrender broadcast on August 15, 1945, when he told a stunned nation that “the war situation has developed not necessarily to Japan’s advantage.”

  But later that day, Bart McDade, Skip McGee, and Mark Shafir, working off of four hours’ sleep in three days, were able to announce a welcome bit of good news: Though it was far too late to save the entire firm, Lehman had an agreement to sell its U.S. operations for $1.75 billion. The buyer was Barclays, Lehman’s onetime would-be savior, which ended up getting the part it wanted without having to acquire the whole firm. The deal would allow at least some of Lehman’s ten thousand employees in the United States to keep their jobs.

  As McDade, McGee, and Shafir walked the floors, some employees stood up to applaud.

  Mack knew what Bob Steel was calling about, and he was happy to speak with him. Both men were graduates of Duke and members of the university board, and not long after Steel had taken over at Wachovia, Mack had gone down to see him in Charlotte, to pitch Morgan Stanley as an adviser. No business had come out of the meeting—the bank had Goldman to help them sort through the Golden West quagmire—but the men realized they spoke the same language and agreed to stay in touch.

  “Very interesting times,” Steel now said. “I imagine you’ve already heard from Kevin. He told me he thought we should connect.”

  Steel went on, intentionally keeping the discussion vague until he gauged Mack’s intentions. “There might be an opportunity for us. We’re thinking about a lot of things. I think this could be the right time to talk. But we’d need to move fast.”

  “I could see something,” Mack replied, intrigued but noncommittal. “What’s your timing?”

  “We’re moving in real time,” Steel said.

  Considering the meltdown in the markets, Mack thought it was at least worth talking. For Steel, a Morgan Stanley deal happened to be both commercially and personally attractive. All the tumult within the firm had left Mack without a clear successor. While he may not have wanted Mack’s job immediately, their mutual friend Roy Bostock, a Morgan Stanley board member, had privately hinted to Steel that a deal between Morgan Stanley and Wachovia could present an elegant solution to Morgan’s succession problems down the road. This could be Steel’s big opportunity to finally run a top Wall Street firm.

  After speaking with Steel, Mack called Robert Scully, his top deal maker, and told him about the conversation. Scully had his doubts; he didn’t know much about Wachovia’s books, but what he did know alarmed him. He agreed, however, that at this point, no options could be automatically ruled out. Besides, Wachovia had one of the biggest, most solid deposit bases in the country, an extremely attractive feature as Morgan Stanley was watching its cash fly out the door.

  Scully in turn called Rob Kindler, a vice chairman, to tell him that Dave Carroll, Wachovia’s head of business development, was coming to meet them on Thursday and get things started.

  In the relatively straitlaced banker culture of Morgan Stanley, Kindler was an outlier—loud, indiscreetly blunt, and predisposed to threadbare old suits. In the 1990s, he had been a star lawyer at Cravath, Swaine & Moore, but he always preferred banking. He left law and originally joined JP Morgan. (A constant prankster, he soon had hats made with the slogan, “One Firm, One Team, Bribe a Leader,” mocking JP Morgan’s slogan of “One Firm. One Team. Be a Leader.”) Despite his idiosyncrasies, wh
en it came to deal making, his advice was highly valued. Kindler didn’t initially like the notion of a Wachovia merger either, he told Scully, and took a reflexively cynical view: “Let’s put this in context for a moment: Bob Steel comes from Goldman; Wachovia’s investment bankers are Goldman; Paulson is obviously from Goldman. The only reason we’re having this meeting with Wachovia is because Goldman won’t do the deal!”

  Scully had been thinking much the same thing but hadn’t been willing to say so. “I don’t know,” he said. “Seems like a bad idea.”

  But Kindler couldn’t help himself and soon began to wrap his brain around the possibilities of the deal. “It could be good for us,” he told Scully. “It brings us a deposit base; a regional banking franchise. Let’s see how it plays out.”

  Scully and Kindler got Jonathan Pruzan, co-head of Morgan Stanley’s financial institutions practice, to start running the numbers on Wachovia. The obvious concern was its gargantuan subprime exposure, some $120 billion worth. As the Wachovia due diligence got under way, Mack got a call back from Vikram Pandit, delivering what amounted to a soft no on the merger talks. “The answer is no. The timing isn’t right, but at some point we’d like to do something.”

  Mack clicked off, exasperated. Wachovia was nobody’s idea of a dream date, but at the moment, it was the only girl at the dance.

  “This is an economic 9/11.”

  There was chilling silence in Hank Paulson’s office as he spoke. Nearly two dozen Treasury staffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge of Paulson’s desk, scribbling on legal pads. Looming over them was a portrait of Alexander Hamilton, a copy of a portrait painted in 1792, when the young nation endured its first financial panic. A Treasury associate, William Duer, who also happened to be a personal friend of Hamilton’s, had used inside information to build up a huge position in government securities. When bond prices slid, Duer could not cover his debts, setting off a panic. Hamilton decided against bailing out his friend but did direct the Treasury to buy government securities, steadying the market—a long-forgotten but potentially instructive model of government intervention.

  Paulson was seated in a chair in the corner, slouching, nervously tapping his stomach. He had a pained look on his face as he explained to his inner circle at Treasury that in the past four hours, the crisis had reached a new height, one he could only compare with the calamity seven years earlier, almost to the week. While no lives may have been at stake, companies with century-long histories and hundreds of thousands of jobs lay in the balance.

  The entire economy, he said, was on the verge of collapsing. He had been on the phone that morning with Jamie Dimon, who had expressed his own anxiety. Paulson was no longer worried just about investment banks; he was worried about General Electric, the world’s largest company and an icon of American innovation. Jeffrey Immelt, GE’s CEO, had told him directly that the conglomerate’s commercial paper, which it used to fund its day-to-day operations, could stop rolling. He had heard murmurs that JP Morgan had stopped lending to Citigroup; that Bank of America had stopped making loans to McDonald’s franchisees; that Treasury bills were trading for under 1 percent interest, as if government-backed bonds were the only thing that investors could still trust.

  Paulson knew this was his financial panic and perhaps was the most important moment of his tenure at Treasury, and possibly of his entire career. The night before, Bernanke and Paulson had agreed that the time had come for a systemic solution; deciding the fate of each financial firm one at a time wasn’t working. It had been six months between Bear and Lehman, but if Morgan Stanley went down, probably no more than six hours would pass before Goldman did, too. The big banks would follow, and God only knew what might happen after that.

  And so, Paulson stood in front of his staff in search of a holistic solution, a solution that would require intervention. He still hated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment.

  “The only way to stop this thing may be to come up with a fiscal response,” he said. They needed to start thinking about what kind of program they could put together, and while he wasn’t sure that that approach would even be politically feasible, it had to be explored.

  He told the staff that he knew and accepted that he would be subjected to an enormous amount of political flak; he had already been criticized for the bailout of AIG, with Barney Frank mockingly declaring that he was going to propose a resolution to call September 15—the day Lehman filed for bankruptcy—as “Free Market Day.” “The national commitment to the free market lasted one day,” Frank said. “It was Monday.”

  Senator Jim Bunning, Republican from Kentucky, was decrying that “once again the Fed has put the taxpayers on the hook for billions of dollars to bail out an institution that put greed ahead of responsibility.” Richard Shelby, Republican from Alabama, added that he “profoundly disagrees with the decision to use taxpayer dollars to bail out a private company.”

  The first order of business, Paulson said, was addressing the money market crisis. Steve Shafran, a former Goldman banker, suggested that the Treasury could simply step in and guarantee the funds. “We have the authority,” he said, citing the Gold Reserve Act of 1934, which set aside a fund, now totaling $50 billion, to stabilize essential markets. The key, Shafran said, was that all they needed to access it was presidential approval, bypassing Congress.

  “Do it!” Paulson said, and Shafran slipped out of the room to put the process in motion.

  There was, however, no such easy solution to begin stabilizing the banks. Phil Swagel, the wonky assistant secretary for economic policy, emphasized the necessity of being bold and not avoiding addressing the problems for fear of political fallout. “You don’t want to be running Japan,” he said.

  Swagel and Neel Kashkari dusted off the ten-page “Break the Glass” paper they had prepared the previous spring: In the event of a liquidity crisis, the plan called for the government to step in and buy toxic assets directly from the lenders, thereby putting right their balance sheets and enabling them to keep extending credit. The authors knew that executing their plan would be complicated—the banks would fight furiously over the pricing of the assets—but it would keep the government’s involvement in the day-to-day businesses as minimal as possible, something conservatives strongly desired.

  “This is what we should do,” Kashkari told Paulson. He had been involved in HOPE NOW, one of the government’s early efforts at helping distressed homeowners, and had learned firsthand how difficult it would be to get the banks making new loans as long as they were carrying bad loans on their balance sheets. On the speakerphone from New York, where he still was embroiled in the AIG situation, Paulson’s adviser Dan Jester argued that the purchasing of assets was too cumbersome and recommended instead that capital be injected directly into the institutions. “The more bang for your buck is to put capital in,” he said, explaining that even if the market continued to fall, it would help the banks manage the downturn.

  The difficulty with that approach, countered Assistant Secretary David Nason, was the specter of nationalization. If the government put money into firms, it became a de facto owner, which is precisely what most of the people in the room wanted to avoid. “Are people going to think we’re going to AIG them?” he asked, already using the government’s investment less than twenty-four hours earlier as a verb. Paulson had liked the “Break the Glass” idea when it had first been presented to him and was now leaning to move in that direction. AIG was a disaster they couldn’t afford to repeat, and buying the assets maintained a clear border between government and the private sector. The job now was to begin preparing the outlines of legislation for Congress. They were going to need a ton of money, and they were going to need it immediately.

  He assigned Kashkari and a team of staffers the task of fleshing out the idea; “Break the Glass” might have been an interesting document in theory, but it lacked details and
was far from executable. He gave them twenty-four hours to fill them in.

  Before ending the meeting, Paulson asked, “How much is this going to cost?”

  Kashkari, who had originally estimated the expense at $500 billion back in the spring, said gravely, “It’s going to be more. I don’t know, maybe even double.”

  Dismissing everyone with a warning that their conversation had been confidential, Paulson then called Geithner to compare notes. “You cannot go out and talk about big numbers with regard to capital needs for banks without inviting a run,” Geithner told him. “If you don’t get the authority, I’m certain you’ll spark a freaking panic. You have to be careful about not going public until you know you’re going to get it.”

  By midafternoon Wednesday, Morgan Stanley’s stock had fallen 42 percent. The rumors were flying: The latest gossip had the company as a trading partner with AIG, with more than $200 billion at risk. The gossip was inaccurate, but it didn’t matter; hedge funds continued to seek nearly $50 billion in redemptions. Hoping to poach Morgan Stanley’s hedge fund clients, Deutsche Bank was sending out fliers with the headline: “DB: A Solid Counterparty.”

  John Mack was meeting with his brain trust, already anticipating what had become a grim end-of-day ritual. At 2:45 p.m., hedge funds would start pulling money out of their prime brokerage accounts, asking for all the credit and margin balances. At 3:00, the Fed window would close, leaving the firm without access to additional capital until the following morning. Then, at 3:02, the spread on Morgan Stanley’s credit default swaps—the cost of buying insurance against the firm’s defaulting—would soar. Finally, its clearing bank, JP Morgan, would call and ask for more collateral to protect it.

  “It’s outrageous what’s going on here,” Mack almost shouted, arguing that a raid on Morgan Stanley’s stock was “immoral if not illegal.” Intellectually he understood the benefit that shorts provide in the market—after all, many were his own clients—but at risk now was his own survival.