Crashed
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III
If systemic stability was the goal, the kind of improvisations that had let Lehman fail and rescued AIG would not suffice. Having realized the scale of what they were up against, Bernanke and Paulson decided on September 17 that they must appeal to Congress for additional resources and the authority to use them.41 Paulson knew it was a serious political risk. But they were now faced with the collapse of the entire Wall Street system, and the resources at their disposal to meet it were stretched to the limit. With money hemorrhaging out of the money market funds, the Treasury made the extraordinary decision on September 19 to offer a guarantee to any fund willing to pay an insurance fee, with the coverage to be backed by $50 billion in the Exchange Stabilization Fund. It was another improvisation. The Exchange Stabilization Fund was a creation of the New Deal era. It was established in 1934 to enable FDR’s Treasury to manage the exchange rate of the dollar after the abandonment of the gold standard. The fund was tiny compared with the scale of the trillion-dollar cash pools that were running in September 2008. But using it to back an insurance fund allowed it to be leveraged, and, more important, it was the only pot of money immediately available to the Treasury.
Meanwhile, Morgan Stanley and Goldman, the two investment banks left standing, were under immense funding pressure. One week after Lehman, they were rescued by the transparent expedient of redesignating them as commercial bank holding companies so that they might benefit from the protection of FDIC deposit insurance. But that only increased the burden on the FDIC, which had problems of its own. On September 25 the FDIC closed, broke up and sold off Washington Mutual. With $244 billion in mortgages on the balance sheet, WaMu was the largest commercial bank in American history to fail. J.P. Morgan promptly snapped up WaMu’s network of 2,239 retail branches and their deposits.42 Nor was J.P. Morgan the only buyer that could see the prizes on offer in the giant fire sale. The Japanese bank Mitsubishi was poised to rescue Morgan Stanley by taking a 20 percent stake. Warren Buffett was about to prop up Goldman Sachs with a $5 billion capital injection. But both deals were contingent on the promise of a government backstop.
On September 20 the Treasury sent Congress a three-page legislative proposal asking for authority to spend up to $700 billion to stabilize securities markets. After the unlimited bailout authorization for the GSEs, the Treasury was now asking to spend the equivalent of the entire US defense budget on bad mortgage securities. But what was truly audacious about Paulson’s bill was the nature of the power he was asking for.
As the three crucial sentences of the bill read:
“The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States. . . . The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time. Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”43
Paulson was asking for legal carte blanche.
Sketchy though it was, the proposal did not come out of the blue. Already in mid-April 2008 Paulson and a Treasury team had met with Bernanke and his staff to discuss what they called a “Break the Glass” memo outlining different options for emergency action.44 They had considered large-scale guarantees for mortgages but had shied away because the liability was uncertain and potentially huge. Recapitalization was a more direct way of intervening in a bank. It was also efficient. Every dollar of bank capital was leveraged. So a dollar of government capital would support ten, twenty or thirty times as much in lending. But recapitalization was rejected on political grounds. Paulson had no desire to go down in history as the Treasury secretary who nationalized America’s banking system. And even if Paulson had been willing to pay the personal price, an open call for government recapitalization would never have passed Congress. The Republicans would have voted en bloc against nationalization, and without bipartisan cover the Democrats could not take the risk.45 Already in the spring of 2008 the Treasury team thus decided that asset purchases were the path of least resistance. Buying debts did not involve ownership of banks. It did not raise issues of control or corporate governance. It could all be done through “the market.” An auction mechanism could be used to determine the price. It was also, admittedly, slow moving and expensive: $700 billion would cover barely more than half the outstanding subprime securitization. It wasn’t the perfect solution. But after Lehman, AIG and WaMu, the Treasury and the Fed were desperate. They needed something that might pass, and pass quickly.
Legislation that would ordinarily spend months in Congress needed to be passed in a matter of days. It was “hyperdrive blitzkrieg,” one lobbyist flippantly remarked, and it ran into trouble from the start.46 As Geithner recorded in his memoirs: “Congressional leaders, who had seemed shell-shocked but willing to act after Hank and Ben warned them about a second depression . . . now just seemed angry.” “This proposal is stunning and unprecedented in its scope—and lack of detail, I might add,” said Senate Banking Committee chairman Chris Dodd. “I can only conclude that it is not just our economy that is at risk, but our Constitution as well.”47 Dodd was a Democrat and at least willing to consider the possibility of action. Republicans were less measured. Jim Bunning of Kentucky described the proposal as “un-American financial socialism.”48 Ted Poe, a Texas Republican, lambasted the plan: “New York City fat cats expect Joe Sixpack to buck up and pay for all of this nonsense. . . . Putting a financial gun to the head of every American is not the answer.”49
By 2008 the Bush administration had a credibility issue when it came to emergency powers. “This is eerily similar to the rush to war in Iraq,” declared Representative. Mike McNulty, a Democrat from upstate New York. “We have been told repeatedly by this administration that the economy is fundamentally sound, and then all of the sudden they say the economy is going to collapse. That is unacceptable.”50 Representative Pete Stark (D-CA) recalled how General Colin Powell, Bush’s secretary of state during the Iraq crisis, had “tried to scare us some years ago by saying if we didn’t vote for an ill-conceived war we’d see terrorists on the streets.”51
In the Financial Times the economist and blogger Willem Buiter remarked that Paulson’s bill read “as though it was personally written by Dick Cheney, the prince of absolute executive authority, no checks and balances, no accountability, no recourse. No administration that brought us WMD in Iraq and the torture camps of Guantanamo Bay and Abu Ghraib should expect anything but hysterical giggles in response to such a request.”52 The left-wing filmmaker Michael Moore weighed in with an incendiary e-mail to his mass following, entitled “The Rich Are Staging a Coup This Morning.” As the British journalist Paul Mason remarked, Paulson’s cack-handed proposal triggered an “accidental synergy between the right-wing populist opposition to the bailout and the left-liberal stance.”53 History would prove it to be more than accidental.
In the midst of a presidential election it was explosive stuff. The Democratic candidate Barack Obama was not the problem. Not only was Obama backed by an economics team recruited by way of Robert Rubin and the Hamilton Project but his personal entourage included top bankers from UBS and Merrill Lynch.54 The problem was John McCain. If McCain threw in his lot with the rebel Republicans, it would not only threaten the proposed legislation, it would force the Democratic presidential campaign into a devastatingly unpopular choice. House Republican leader John Boehner was not helpful. One third of the Republican congressional party was so ideologically opposed to any more bailouts that there was no hope of their support. Another third were in tight races and could not risk alienating their base. “You were being asked to choose between financial meltdown on the one hand and taxpayer bankruptcy and the road to socialism on the other and you were told do i
t in 24 hours,” Representative Jeb Hensarling of Texas, head of the conservative Republican Study Committee, indignantly told journalists.55 Rising stars from the right wing of the Republican Party, like Paul Ryan of Wisconsin and Eric Cantor of Virginia, rallied around the resistance to the Bush administration’s “sellout.”
With the Republicans deeply divided, on September 24 McCain suspended his campaign and announced he was returning to Washington to take the lead in “fixing” the crisis. In the Treasury and the White House this caused panic. The markets were in a febrile mood. No one knew what McCain had in mind. What was certain was that it would stir up the Republican base. Startled at the news, Paulson screamed into his Motorola, demanding that the White House get a grip on “their” candidate.56 Bernanke was so alarmed by the intensity of the political power play that he thought it better to withdraw to the safety of the Fed. In the end it took interventions by the White House chief of staff and major Republican donors, including Henry Kravis, the private equity billionaire, J.P. Morgan vice chair James Lee and John Thain of Merrill Lynch, to hold McCain in line.57 But this left McCain tongue-tied, torn between the demands of “the system” and the populist groundswell that Palin was rallying to his cause. In the climactic meeting of the two candidates with the Bush administration on September 25, a meeting called at McCain’s request, the Republican candidate literally had nothing to say.58
By Sunday, September 28, it seemed that Paulson and the congressional Democrats had a deal. Paulson agreed to caps on remuneration, a phased release of the TARP aid, multiple layers of oversight and a commitment that if the taxpayer made a loss, the cost would be covered by a tax on the financial industry. To speed TARP along it was tacked on to House Resolution 3997, also known as the Defenders of Freedom Tax Relief Act, providing tax breaks for members of the armed services, volunteer firefighters and peace corps members. On the morning of the vote, Monday, September 29, the president gave a press conference hailing agreement on the Paulson bill. Later that same day he was hosting embattled President Yushchenko of Ukraine. It was a moment to demonstrate that the leader of the free world was still firmly in charge. Markets needed all the help they could get. The news from Europe was terrible. On Wall Street trading was jittery. All eyes were on the screens, waiting for the news from Capitol Hill.
The scene in the House of Representatives was not reassuring. After a morning of polemical speeches, voting started after lunchtime. On screens around the world one could see the grinding process of congressional democracy in action. At 1:49 p.m., at the end of the normal voting period, the votes stood 228 to 205, against. The party leadership on both sides were staring into the abyss. To give the whips a chance to rally their troops, the voting period was extended and the TV cameras followed “as top lieutenants in both parties clutching lists of votes . . . clustered in the well and made unusual forays into what is normally enemy territory across the aisle.”59 Five minutes later it was clear that they had come up short. The gavel came down minutes before two p.m. and the bill failed. Tellingly, of the 205 votes in favor of Hank Paulson’s TARP plan, 140 came from the Democrats and only 65 from the Republicans. Of those opposed, 133 were Republicans and 95 Democrats.
After the Fed and the Treasury had allowed Lehman to fail, America’s elected representatives had refused to back their own government’s emergency rescue effort. The reaction in the markets was one of terror. The Dow Jones index plummeted by 778 points, wiping $1.2 trillion off the value of American businesses in a matter of hours. It was the biggest loss on record, worse than on 9/11, when the index had plunged by 684 points.60 The shock to global confidence was devastating. It produced a terrifying synchronization of the crisis on both sides of the Atlantic.
III
As the Americans were trying and failing to patch together the first TARP deal, in London Gordon Brown’s government was frantically trying to persuade Spain’s Santander to buy out the branch network of mortgage lender Bradford & Bingley and its £22 billion in deposits. That would leave the UK Treasury holding £41 billion in mortgages that no one wanted to touch.61 When the UK had bailed out Northern Rock a year earlier, it had still seemed as though it might be an isolated incident. Now it was clear that the entire British financial system was at stake. It was lethally dependent on the wholesale funding market and that was shutting down.
The Fragile UK Banking System: Mortgage Exposure and Sources of Funding (figures are % of assets/liabilities)
Mortgage
Deposits
Wholesale
Equity
Abbey National
53
34
21
1.7
Alliance & Leicester
55
45
52
3.0
Barclays
6
26
19
2.5
Bradford & Bingley
62
51
44
3.2
Halifax Bank of Scotland
37
38
36
3.6
HSBC
4
48
17
6.2
Lloyds TSB
28
42
27
3.4
Northern Rock
77
27
68
3.1
Royal Bank of Scotland
8
43
24
4.8
Standard Chartered
17
58
20
7.1
Average
34.7
41.2
32.8
3.86
Source: Tanju Yorulmazer, “Case Studies on Disruptions During the Crisis,” Economic Policy Review 20, no. 1 (February 2014). Available at SSRN: https://ssrn.com/abstract=2403923.
The fear was that panic would soon spread from specialized mortgage lenders like Northern Rock to bigger banks like HBOS and from there to the commercial bank RBS, whose balance sheet, on paper at least, had recently ranked as the largest of any bank in the world. On the Continent, the Belgian-Dutch-Luxembourgeois giant Fortis was on the point of being shut down. Its balance sheet matched that of Lehman.62 The French government was struggling to keep the Franco-Belgian lender Dexia alive. Angela Merkel and her finance minister, Peer Steinbrück, were in knife-edge negotiations over Hypo Real Estate, which was being dragged down with Depfa, its adventurous Dublin affiliate.63 Each rescue involved a combination of writing down losses, recapitalizing with public money, guaranteei
ng private borrowing, deal making with other banks and emergency liquidity from the central bank.