by Adam Tooze
II
In 2007 the best hope of the authorities was still that the private sector might rescue itself. J.P. Morgan’s consortium of 1907 was the stuff of Wall Street legend. In late October 2007, with the help of the US Treasury, the three largest banks—Citigroup, Bank of America and JPMorgan Chase—agreed to collaborate in creating a so-called Master Liquidity Enhancement Conduit that would help to stabilize the market for mortgage-backed securities and revive the ABCP market.9 Not surprisingly, Treasury Secretary Paulson loved the idea. But any private sector arrangement was vulnerable to problems of collective action. Though bankers detested government intervention, they also wanted to avoid the stigma of joining a cartel of ailing firms, especially one including Citigroup, whose balance sheet was particularly toxic.10 When major global competitor HSBC announced that it would absorb the full amount of $45 billion in losses suffered by its SIVs onto its balance sheets, its largest American rivals could not be seen to be settling for a second-best option.11 By December 2007 the private bad bank plan had collapsed.
When collective action failed, the state could step in, acting as a matchmaker in chief, brokering takeover deals between individual banks. In Britain in 2008, the Scottish conglomerate HBOS would be sold off to Lloyds Bank with encouragement from Downing Street.12 Germany’s number two bank, Dresdner, would be amalgamated with Commerzbank, the number three.13 As both deals would reveal, the risk was that the bank that was in trouble would pull its rescuer down with it. In the United States the amalgamations began in earnest with Bear Stearns, which came to the point of failure on the night of March 13–14, 2008.14 If it had unloaded its portfolio of $200 billion in asset-backed securities and CDO at fire sale prices, the effect would have been catastrophic. It would have forced all the other banks to recognize crippling losses, spreading the panic. To the relief of the Treasury and the Fed, J.P. Morgan was interested in buying out Bear. Its hard-charging CEO, Jamie Dimon, was confident that his robust balance sheet put him in a position to safely pick over the carcass. But to finalize the deal, Dimon needed the right inducement. Under the emergency powers provided by section 13(3) of the Fed’s statutes, $30 billion in the most toxic assets were taken off Bear’s books by a SIV funded by the New York Fed.15 Then, at five a.m. on the morning of March 14, with the repo markets closed to Bear, the New York Fed lent $12.9 billion to J.P. Morgan, which J.P. Morgan then lent to Bear. After that, the die was cast. J.P. Morgan initially agreed to pay the laughable price of $2 per share for what was left of Bear. This compared with a valuation of $159 per share only one year earlier. When Bear’s shareholders protested, the price was raised to $10 per share. Whether at $2 or $10, J.P. Morgan was confident it would make a profit.
The Fed’s actions forestalled what might have been a disruptive and chaotic bankruptcy. But the inducements that J.P. Morgan had extracted were debatable, to say the least. Paul Volcker, the legendary ex-chairman of the Fed, would characterize them as extending “to the very edge of its lawful and implied powers.”16 Strict advocates of moral hazard logic would forever after argue that it was the Bear rescue that set up the Lehman disaster.17 With one investment bank having been rescued, Lehman’s management felt safe. A solution for their problems would be found too. They could afford to take their time finding the best possible deal, an attitude that would cost them dearly.
Whether it was legal or wise, rescuing investment banks by means of obscure balance sheet transactions was a technical business that could be kept out of the political headlines. That changed with Fannie Mae and Freddie Mac. As the indispensable government-sponsored backdrop to the American housing market, they were at the center of one of the most formidable political networks in Washington. By the summer of 2008, with private securitization stalled, they were also responsible for backstopping 75 percent of new mortgages in the United States. The vast bulk of the Fannie Mae and Freddie Mac balance sheet consisted of top-quality conforming mortgages. If they had had conventional balance sheets, they ought to have been able to ride out the storm. The problem was they did not. In June 2008 Fannie Mae and Freddie Mac held MBS valued at $1.8 trillion and guaranteed another $3.7 trillion on the basis of shareholder equity, which in the case of Fannie Mae came to only $41.2 billion, and in the case of Freddie Mac, to $12.9 billion.18 It was a leverage ratio that would have made even the boldest investment banker blush. It was conceivable only because Fannie Mae and Freddie Mac were government-sponsored enterprises. In the summer of 2008 the meaning of that term was going to be put to the test. Allowing for only minimal losses, the capital of both Fannie Mae and Freddie Mac would be completely wiped out. If they folded they would take down the last remaining lenders in the mortgage market and put in doubt the credit of the United States. They would put in jeopardy a huge portfolio of securities widely held by foreign investors. In the summer of 2008 foreign investors held $800 billion in debt issued by the GSEs. Fannie Mae and Freddie Mac were, as the influential blogger Brad Setser quipped, “too Chinese to fail.”19
Desperate to gain a grip on the situation, in the spring of 2008 Hank Paulson’s Treasury began to broker a deal between congressional Democrats and Republicans that would give the federal government the powers necessary to overhaul the mortgage giants.20 But over the summer Congress dragged its heels. The Republicans were uncooperative and the Democrats insisted that if they were to carry the bill, it must include support for struggling home owners and the transfer of block grants to hard-hit states to buy up foreclosed properties. By mid-July the situation was becoming critical. Given the scale of the crisis and the opacity of the GSEs’ financial situation, the capital injection might need to be huge.21 The Treasury favored an authorization limited only by the federal government’s borrowing ceiling, putting the full financial clout of the American state behind the GSE. As Paulson famously put it to the Senate Banking Committee, “[I]f you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”22 Paulson’s request was meant to sound impressive, and his bazooka comment echoed around the world. The US Treasury secretary was desperate to reassure foreign bondholders. Beijing was increasingly alarmed.23 In his memoirs, Paulson recorded: “I was talking to them [Chinese ministers and officials] regularly because I didn’t want them to dump the securities on the market and precipitate a bigger crisis. . . . And so when I went to Congress and asked for these emergency powers [to stabilize Fannie and Freddie], and I was getting the living daylights beaten out of me by our Congress publicly, I needed to call the Chinese regularly to explain to the People’s Bank of China, ‘listen this is our political system, this is political theatre, we will get this done.’ And I didn’t have quite that much certainty myself but I sure did everything I could to reassure them.”24
The Chinese might be excused their confusion. The political theater being played in Washington, DC, was new and strange. A conservative, free-market administration led by businessmen was proposing unlimited state spending to nationalize a large part of the housing finance system. The Republican electorate was outraged by the thought of assisting undeserving mortgage borrowers and the New Deal machinery that had aided and abetted their fecklessness. But to Paulson the systemic imperative was obvious. And President Bush stood behind him. “It was a tremendous act of political courage,” Paulson gushed, “It was as if, in the last days of his administration, the president were suddenly switching sides, supporting Democrats and opposing Republicans on matters that went against the basic principles of his administration. But he was determined to do what was best for the country.”25 Paulson was registering a basic rift within American conservatism. The right wing of the party could not be counted on to give support to measures that were unpopular and distasteful, but were clearly necessary to save “the system.” Paulson recognized that the authorization he was asking for was unprecedented. “I don’t know if any executive branch agency had ever before been given the authority to lend
to or invest in an enterprise in an unlimited amount. All I could do was argue that the extraordinary and unpredictable nature of the situation warranted the authority in this case.”26 He also knew that it was only the Democrats, the party with relatively less inhibition about expanding the scope of government, who were willing to go along with this logic of absolute and unlimited necessity, dictated not by a national security emergency but by a financial crisis.
Paulson’s extraordinary plenipotentiary authorization to rescue Fannie Mae and Freddie Mac passed Congress on July 26, with three quarters of House Republicans voting against. It was signed into law on July 30. The White House thought it best to forgo the usual festive Oval Office ceremony. There was no reason to goad the Republicans and no time to lose. With a team recruited from Morgan Stanley on a pro bono basis, the Treasury plunged into weeks of forensic investigation and negotiations with the GSEs’ failed regulators. The results were dispiriting. Both of the GSEs were insolvent. Liquidity support would not be enough. On Sunday, September 7, 2008, Fannie Mae and Freddie Mac were placed under conservatorship. It was nationalization in all but name. If necessary, the Treasury would replenish their capital to make up any gap between assets and liabilities up to an initial maximum of $100 billion each. The Fed provided credit lines and undertook to buy whatever MBS the ailing GSEs needed to offload. It wasn’t so much a bazooka as the nuclear option.
The crucial effect of this intervention was to reassure bondholders, especially those abroad, that Fannie Mae and Freddie Mac would not fail. Despite the machinations of Russia, the breakdown of America’s government-sponsored mortgage machine did not spill over into a global crisis. But the political fallout was dire and it had serious implications for the future course of the crisis. On the right wing of the Republican Party, fully mobilized for the hotly contested presidential election, the nationalization of Fannie Mae and Freddie Mac unleashed a firestorm.27 The Treasury did its best to ward off allegations of cronyism by imposing a punitive dividend for the capital it contributed, wiping out the GSEs’ existing shareholders. The American Bankers Association rallied to the administration, calling on Republicans to support the rescue effort. But it was immediately countered by the conservative Club for Growth, a key right-wing lobby group funded by the Koch brothers. House leader John Boehner and former speaker Newt Gingrich spoke out against Paulson’s bailout. John McCain personally was thought to favor a rescue. But on August 29 he nominated the populist Alaskan governor Sarah Palin as his vice-presidential running mate. Palin did not have coherent views on the GSEs or the financial crisis. But her bluff persona fired up the passions of the Republican base. As the crisis deepened, the Bush administration was terrified that they might find themselves facing an insurgency from within their own party led by a presidential candidate on the warpath against bailouts. What made the Republican brush fire so worrying was that by early September it was clear that the rescue of Fannie Mae and Freddie Mac was only the first round, and that the next phase of the battle would be decided not in Washington but on Wall Street.
For months the Treasury had been anxiously watching as Lehman Brothers looked for a buyer. By the second week of September options were running out. Talks with a potential Korean suitor had stalled. In frantic negotiations hosted by Geithner’s New York Federal Reserve and personally overseen by Paulson, the search for a private sector solution failed. The culminating moment came on the weekend of September 13–14. What exactly happened in those forty-eight hours will remain forever a matter of controversy. What is beyond dispute is that Bank of America, the giant commercial bank that had been expected to act as the white knight for Lehman, bought Merrill Lynch instead.
Merrill was bigger than Lehman. It too was heavily exposed to the real estate bust. Like Lehman it was an investment bank that could not function without access to the repo market. After Lehman it would certainly have been the next to fail.28 But unlike Lehman, Merrill’s management was nimble and saved its bank by pushing for direct talks with Bank of America. It was well known that Bank of America CEO Ken Lewis had long wanted to emulate Citigroup in integrating an investment bank with his commercial banking business. On the desperate weekend of September 13–14, 2008, Bank of America’s hundreds of billions of retail deposits guaranteed by the FDIC were one part of the financial system that was not running. That funding base gave Bank of America the platform to buy out Merrill Lynch. But on what terms? On the face of it Merrill was a prize. One of the biggest names on Wall Street, at the end of 2007 it was valued at $150 billion, with $1.02 trillion in assets and more than sixty thousand employees worldwide. But given the potential losses on its books and its precarious wholesale funding, what was Merrill worth in September 2008? In the event, under huge pressure from Paulson and Bernanke, Bank of America paid $50 billion, $29 per share, a third of what Merrill had recently been worth, but 40 percent more than its market valuation the previous week.
After Bank of America took Merrill, for Lehman, the last remaining hope was a transatlantic deal with the British bank Barclays, where the expat American Bob Diamond, formerly of Morgan Stanley and Credit Suisse, was calling the shots. But Prime Minister Gordon Brown and Chancellor Alistair Darling refused to loosen regulations to allow the takeover to go ahead without full shareholder approval and without commitments of support from the US Treasury. If Bank of America had chosen Merrill, what was wrong with Lehman? They told Paulson that London did not want to “import America’s cancer.”29
The basic question is why the options for Lehman were so narrow? Why were the Fed and the Treasury unwilling to sweeten the Lehman deal in the way that they had J.P. Morgan’s takeover of Bear Stearns?30 Why, following the failure of the private option, was some other kind of backstop not worked out, of the kind that they would provide so liberally in the weeks to come? Geithner, Paulson and Bernanke have all insisted that the question is otiose. The problem was not that the Treasury and the Fed lacked the will, but that they lacked the means. The Lehman collapse was not the result of a deliberate intention on the part of the authorities. “We hadn’t done it on purpose,” Geithner insisted. “We had run up against the limits of our authority and the fears of the British regulators.”31 The Fed could not lend to Lehman, Bernanke maintains, because the Fed lends only against good collateral to solvent banks.32 Lehman was insolvent and, due to the nature of its investment banking business, its lack of depositor base and alternative income streams, it lacked the collateral. But these are retrospective justifications. At the time Lehman’s failure was seen as the result of a deliberate decision, and a welcome one. On September 17, Democratic congressman Barney Frank declared in a hearing with Treasury officials that Monday, September 15, the day of Lehman’s failure, would long be celebrated as “Free Market Day.”33 Frank was joking. But others were not. As one of Paulson’s assistants remarked, September 15 felt like a “good day at the Treasury.” They had let markets do their work.34 A New York Times editorial declared that it was “oddly reassuring” that Lehman had been allowed to fail.35 The Wall Street Journal congratulated Paulson on not blinking. “[T]he government had to draw a line somewhere.”36 For Geithner at the New York Fed, this was no comfort: “We hadn’t chosen to draw a line. We had been powerless, not fearless. We had tried but failed to prevent a catastrophic default.”37
On this interpretation of the crisis, Geithner would go on to base an entire program of state building. If in 2008 what had been missing were adequate state powers of intervention, the answer was to equip the Fed and the Treasury with the right tools. What Geithner could not admit is the possibility that “Hank and Ben” had, in fact, made a mistake. That they might have underestimated the severity of the fallout that Lehman’s failure would cause. Or that Paulson, as a Republican Treasury secretary, might, in fact, have been constrained by politics. But this is what subsequent forensic reconstruction suggests. The best available contemporary evidence, rather than the self-justifications that the actors fashioned for themselves
after the catastrophic consequences of Lehman’s failure became apparent, suggests that the basic constraint on the Lehman rescue was Paulson’s refusal, from the outset, to consider another bailout.38 British chancellor Alistair Darling was in frequent contact with New York throughout the critical weekend. His perspective is telling: “What was worrying was that it was becoming more evident that the US Treasury was reluctant to provide the financial support to make the deal work. I was not entirely surprised. . . . I didn’t think he had enough political capital to persuade the Republicans to nationalize another bank.”39 It was a judgment that would be borne out two weeks later in the desperate battle to pass the Troubled Asset Relief Program (TARP). Though it was Paulson who took the lead in the Lehman talks in New York, from Washington Bernanke was fully in agreement. The Fed was notably uncooperative in the desperate efforts of Lehman’s management to buy time. Contrary to the impression created by Bernanke’s retrospective testimony, the Fed concertedly pushed Lehman toward bankruptcy. The argument made at the time was that ending uncertainty by means of bankruptcy would help to calm the markets. It is easy to say with hindsight, but it was a spectacular error of judgment.
The scale of that error became clear within hours as the shock wave from the Lehman failure impacted the American and the world economy. A day later, Paulson, Bernanke and Geithner had to face the question of what to do about the insurance giant AIG.40 Here too their first impulse was to look for a private solution, with J.P. Morgan and Goldman Sachs leading “frenetic” discussions throughout Monday, September 15. But by seven p.m. any hope of a private rescue had evaporated. When the bailout team had reached a similar conclusion about Lehman twenty-four hours earlier, they had started preparing for bankruptcy. This time, the conclusion was the opposite. The financial markets would not withstand a second shock, and AIG’s level of interconnectedness through derivatives, repo and securities lending was even greater than that of Lehman. Letting AIG fail would, in the words of one Wall Street player, have been an “extinction-level” event. Instead, the Fed stepped in. As it had done with Bear Stearns, the Fed declared a section 13(3) emergency. The New York Fed would offer a secured credit facility of up to $85 billion. On the early afternoon of Tuesday, September 16, Fed security personnel rushed to the offices of AIG at 80 Pine Street in Lower Manhattan to gather up tens of billions of dollars of share certificates to serve as collateral. With the deeds to the world’s second-largest insurance company safely stashed in the vaults of the New York Fed, the first phase of the rescue was announced at 3:30 p.m. The Fed backstopped AIG’s credit default swap portfolio and its securities lending business. In exchange it would take stock in AIG and its subsidiaries that would give the US government a 79.9 percent equity stake in AIG’s global insurance business. Following the template established with the Fannie Mae and Freddie Mac nationalization, the deal inflicted a huge loss on AIG’s existing shareholders. The securities lending business was unwound, with the New York Fed purchasing from AIG its depreciated portfolio of MBS, enabling it to pay off its securities-lending counterparties. Most generous of all was the resolution of the CDS portfolio, which was accomplished by buying out the dangerous CDO on which AIG had written insurance. In effect, together with the collateral they had already claimed from AIG, the counterparties received payment at 100 percent of par on $62.2 billion in toxic mortgage-backed securities, the market value of which was closer to $27.2 billion. How little they would have been worth if AIG had been driven into bankruptcy is anyone’s guess. In any case, the subsidy to the counterparties and their clients clearly ran into the billions. Nor was it only the American financial system that benefited. In the course of the bailout, the Fed made sure to leave in place the insurance contracts that AIG had offered to European banks to provide “regulatory relief.” If they had been voided, the Americans estimated that the European banks would have faced calls for at least $16 billion in additional capital. “For fear of shouting ‘Fire!’ in a crowded theater,” the New York Fed later told Congress, it thought it best not even to mention this potential fallout from AIG’s crisis to European regulators.