by Ron Suskind
When Gorton and Metrick huddled before Gary’s trip to Jackson Hole, and began to talk about the latest wave of fears rippling through the investment markets, their concerns deepened.
Repos, both men felt, had grown into the equivalent of demand deposits for lots of American businesses, especially those on Wall Street. If confidence in the ability of firms to make good on their repos dipped, creditors would all clamor for their money back at the same time, as in a classic bank run. The firms, which had invested in long-term, illiquid assets, would not have enough money at that point to pay back their borrowing. When Roosevelt saw that this had happened in regular old consumer banking, he created the Federal Deposit Insurance Corporation in 1935, to resolve failing banks and guarantee deposits. In the world of Big Finance, however, there’s no equivalent, nothing half so sturdy, backing up a forbidding mountain of debtor commitments.
Gorton had written a ninety-page paper over the summer, which he intended to present the next day at Jackson Hole. The paper, titled “The Panic of 2007,” investigated the causes of that crisis in more depth than just about any other document. The dynamic it described was like a glimpse into the future. Precipitating the crisis, he found, was a drop in the ABX, a newish index put together to get a handle on the CDO market. As the ABX began falling in early 2007, because so many CDOs had been funded by repos or used as collateral in repo transactions, fear spread quickly to the repo market.
If the collateral behind a loan loses its value, the loan suddenly becomes much riskier. In this way, as the CDOs lost value, the repo market dried up and companies began demanding greater collateral as security against a given repo. This meant firms needed to sell off lots of assets to get cash for basic needs, which drove down the market they were selling into even further.
This tightening in the repo market lasted through the fall of 2007, but somehow, by the next summer, it was still widely unrecognized as a central contributor to the year-end contraction in economic activity. When the much larger crisis of 2008 hit, only weeks later, the role of repos would again go underappreciated. Had they relied on repos less, the investment banks would surely have better weathered a crisis of confidence. Lehman’s distinguishing feature—what would set it apart in sickness—was its bloated repo book.
Bernanke gave his speech that morning, August 22, and then left. Gorton went next.
“I thought my talk went badly,” he recalled. “I just went up there with no notes and talked until time ran out—explaining modern capital markets, but not explaining why it was that way. I stopped abruptly because I ran out of time. The audience was people who had focused on inflation and interest rate policy for the last few decades. I must have seemed like an alien landing.”
Gorton felt panic rising inside of him as he watched the attendees sit blithely through his Cassandra turn. He wanted to scream at them—or maybe just scream.
Afterward, as central bankers chatted and mingled, Gorton spotted Austan Goolsbee. He cornered him, mincing no words: “Obama should stand up and say, ‘Look, everybody can’t own a home—sorry. We have to do something about Freddie and Fannie right away, and here’s what we plan to do.’ ”
Goolsbee nodded gamely, but he was busy. They never got to the “here’s what we plan to do” part. Then Larry Summers walked by, a group of acolytes in tow, hanging on his every word.
Gorton followed the posse to a lunch with Mario Draghi, governor of Italy’s central bank and a man on the short list to eventually head the European Central Bank. Draghi, the luncheon speaker, was talking generally about how to shore up regulations to better support financial stability. Summers asked him some questions, Gorton recalled, “with a kind of dismissive pomposity, like a sniffing English don.”
At that point Gorton made for the door. He had had enough. As he booked a flight back east, he vowed to himself never to waste his time going to Jackson Hole again.
5
The Fall
On Wednesday, September 10, John McCain woke up feeling confident. Finally his campaign was picking up the kinetic energy it needed if he hoped to topple the Obama juggernaut. The polling looked auspicious. Obama’s summer lead had been eradicated. Of the first fifteen polls covered that month by Real Clear Politics, Obama was ahead in just four of them. McCain had shown ruthless, all-in political savvy selecting Sarah Palin as his running mate, and he had timed the announcement just so. The morning after his speech at the Democratic National Convention, Obama awoke to McCain’s startling, unexpected choice. The ratings honeymoon that typically follows a lauded convention speech was cut abruptly short. Ten days later, Joe Biden, dumbfounded, merely asked, “Who is Sarah Palin?”
By the tenth, Palin had become a phenomenon. Obama had poured fuel on the fire of Palin mania the day before, remarking in a speech, “You can put lipstick on a pig, but it’s still a pig.” The McCain camp had pounced on the comment, casting Obama’s words as a crude and deliberate attack on Palin. The country’s punditry had then seized on this read. Words such as “anxious” and “concerned” had started to crop up in the liberal chatter. Could McCain really win this thing?
But the Palin groundswell, and the broader battle for the White House, would soon be overtaken by events even larger than the quadrennial election.
The banner headline across the top of that morning’s New York Times read: “Wall Street’s Fears on Lehman Bros. Batter Markets.” The article quoted Malcolm Polley, chief investment officer at Stewart Capital Advisors, saying, “I think the market’s telling you that if Lehman is going to go away, Merrill is probably the next victim.”
Reading the story, Obama couldn’t help but realize that all those conversations with his Wall Street contributors would now give him a material advantage over most other politicians. Even if he couldn’t describe the particulars of a CDO, or the ABX index, he could talk the talk about the markets. And, indeed, the market-driven disaster had arrived.
A year before, when Obama asked his economic team how he should react to the bursting of the bubble in year two of his administration, it had only been a thought experiment. Despite Robert Wolf’s prescient early warnings, the collapse had never really seemed all that imminent.
Thinking about Wolf’s warning from the flying deck of Le Rêve on his forty-sixth birthday, Obama, in an Oval Office interview, reflected on how he had “had the benefit of a couple of friends who, for some time had been warning about the potential of a severe financial crisis because of what was happening in the mortgage markets.
“It was one of those situations where you knew an earthquake might happen but you couldn’t necessarily time the week. When Bear Stearns happened, I think that was a signal that some of the predictions I had heard a year or two years previously, might come to pass.
“At that point, I don’t think we still had a sense of how bad it might get. By the time you get to Lehman’s, obviously, people do have that sense.
“I can’t claim that I had a crystal ball and understood what all the ramifications would be. I don’t think anybody at that point understood how deep this went. The situation just of AIG, to take one example—the magnitude of the bets that had been placed—they were beyond, I think, my comprehension.”
It was, similarly, beyond the comprehension of Obama’s Wall Street patrons, many of whom had gathered at a restaurant in Denver the night before Obama’s acceptance speech at the Democratic convention on August 28. There were, at that point, rumors about the possibility of the government having to take over its huge, public-private mortgage guarantors, Fannie Mae and Freddie Mac. What’s the likelihood? someone asked. They went around the large, twenty-seat table. The vote? Fewer than half thought it could happen. Nine days later, on Sunday, September 7, it did, with Paulson stressing this was a special event, due to the federal guarantee that was still the defining feature of the mortgage giants. Similarly, the Congressional Budget Office had estimated in August that a government bailout of the mortgage giants could amount to $25 billion. To start the fa
teful second week of September, a CBO spokesman said that would be “optimistic.”
Greg Fleming, of course, read the New York Times headline, too. He’d been secretly planning for this eventuality—that if Lehman went, Merrill would be next—since the late spring.
He had been busy selling off parts of Merrill to strengthen the firm’s balance sheet. First was Merrill’s sizable stake in Bloomberg, which the financial information and media conglomerate bought back for $6.8 billion. Next were nearly $30 billion in troubled mortgage-related assets that were sold for just $7 billion, a hit that lightened Merrill’s toxic load, but pressured other firms, including Lehman, to further write down their assets. With Merrill’s balance sheet now as good as it could possibly be, he turned his attention to the only potential suitor.
He had to get to Bank of America to make an overture first, but he couldn’t involve Merrill CEO John Thain, who had made it clear he wasn’t interested in selling the company that he’d just been brought in to lead. Ed Herlihy, Wachtell Lipton’s top mergers and acquisitions lawyer, had worked with Fleming on various deals and had also been JPMorgan’s lead counsel on the government-assisted purchase of Bear Stearns. Fleming decided that Herlihy, a close friend, could act as a discreet facilitator. Herlihy, who was also Bank of America’s lead counsel, called Greg Curl, the bank’s number two, and set up a dinner in New York for Fleming and Curl in late July.
Now the question was what to do next. Fleming went back and forth. To meet with a senior player at Bank of America to discuss a sale of his firm, without notifying his own CEO, was a fireable offense. On the other hand, if he didn’t move now, Merrill might find itself in the abyss. Finally, Fleming could take it no more. The day of the dinner, he phoned Curl, also an old friend, and told him it wasn’t going to work, that they couldn’t meet, that he’d be crossing too many ethical lines. But before they hung up, Fleming deftly suggested that Bank of America was the only fit for Merrill; Curl said, from his side, that Bank of America would be interested in looking at such a deal. Message passed.
Now, sitting in his office as Lehman began to teeter, Fleming ran the endgame calculus: if Lehman went first, Paulson—no matter how often he said there’d be no government bailout—would be in a “too big to fail” nutcracker. He’d offer Lewis and Curl anything they demanded to buy Lehman, a “Jamie Deal” plus. Government cash would go to facilitate that deal, while Merrill would be left without a suitor or government support. Panic began to set in.
By the next morning, Thursday, September 11, the financial markets around the globe were like an overweight man worrying about the tingling in his left arm and the tightness in his chest.
Hank Paulson got on the phone with Ken Lewis at Bank of America. He and Lewis had already chatted several times that week, as Paulson, talking the talk of the mergers and acquisitions banker he once was, tried to convince Lewis that Lehman was a good buy and the right fit for Bank of America. Lewis, despite his long-standing desires to buy a Wall Street bank, was coy.
Paulson, of course, was no longer Goldman’s M&A banker in chief. He was the top domestic appointee of the United States, in an ornate office with a desk used by Alexander Hamilton. His problems in properly defining his role were, more broadly, dilemmas shared by the wider U.S. government. Over the past three decades, it had acted as partner and booster of the profits of large corporations, especially on Wall Street. Were the profits themselves the goal, or was there a large public purpose to government’s engagement?
That question was now being posed. Neither Paulson nor President Bush provided an answer. Paulson’s limited response since the spring was simply that Bear Stearns was a special event that would not be repeated. Even as the fears of financial contagion began to grip global markets since Fannie and Freddie’s fall on Sunday, Paulson stuck to his script. The Treasury would not again be opening the government’s accounts to help a private institution. A “market-based solution,” he said, was the only path. They were on their own.
Ken Lewis, representing the only domestic hope for Lehman, didn’t buy it.
He said that Bank of America would not help Lehman unless they received government assistance similar to the JPMorgan–Bear Stearns deal. Paulson appealed to what he hoped Lewis would see as a wider, even enlightened, self-interest: if Lehman fell, it would surely be bad for the financial sector at large, of which Bank of America, the nation’s largest bank, was a flagship.
Not his problem. In fact, in a shakeout, Bank of America might pick up some deals. Lewis reiterated his desire for a “Jamie Deal,” stressing that buying Lehman meant assuming tens of billions in troubled assets. If Paulson wanted Lewis to act in the “greater good,” as a bulwark against “systemic risk,” then the government would have pay for it, period. After all, Dimon didn’t buy out Bear Stearns because of some wider interest in supporting his industry. He did it because of the Fed’s role in guaranteeing $30 billion in toxic assets. Paulson said that doing that sort of a thing again would put the government on a slippery slope, that the markets had to remain sacrosanct as a basic principle, and that it wasn’t going to happen. He and Lewis agreed to talk again, but as they clicked off, there was a chill on the phone lines.
What Paulson didn’t realize: he’d been beaten to the punch by Fleming.
In a panic, Paulson and his Treasury team shifted their focus to the London-based Barclays, which was eager to widen its Wall Street footprint and had desires for Lehman. Paulson, Geithner, and Bernanke all huddled on a conference call to discuss a known hurdle: British banking regulators would have to approve such a deal, and fast. They were not known for either speed or decisiveness. Paulson groused, “The thing about these Brits is that they always talk and they never close” a deal. Worse, Paulson said he considered the person at the helm of Barclays, John Varley, a “weak man.”
On that last score, Paulson had no worries. Barclays was being driven forward these days by its hard-charging number-two executive, Bob Diamond, an American who’d been a top executive at Credit Suisse First Boston and, before that, Morgan Stanley. Diamond had pulled together a tentative bid for Lehman. Paulson summarily got on the phone with Alistair Darling, who carried the staid and dusty title chancellor of the exchequer of Britain. Darling, along with Barclays, had been running their due diligence on Lehman, looking at balance sheets and projections, and were concerned by what they saw. Darling feared that an acquisition of Lehman would expose Barclays and, by extension, the UK economy to much more risk than they were prepared to accept. Paulson attempted to assuage Darling’s concerns.
Still bluffing like a deal maker, Paulson cited Bank of America as a “backup buyer,” even though talks with the Charlotte-based behemoth had already frosted. But Paulson’s principal argument to Ken Lewis, that of systemic risk, carried even less purchase with a British-bank regulator. He needed to convince Darling that a Lehman failure could have ramifications across the pond. Yes, Darling felt, consequences that would be devastating if Barclays went down trying to effect a rescue.
Nonetheless, Paulson felt he’d made the case, a strong one, about the shared interests between the United States and Britain in a global financial system that all but mocked national borders and long-standing definitions of sovereignty. It had, in fact, been nearly two hundred years since Britain set the precedent for government’s role in stopping a financial panic, firmly establishing the concept that certain institutions in a society were simply “too big to fail.” It was, specifically, the Panic of 1825, when a financial bubble, grown large with speculation on textiles and shipping, burst, leaving many of the banks insolvent. Those in Parliament cried that the banks had been warned about overspeculation, which many bankers had profited from, and that they should be left to their own demise. As the panic spread, depositors crowded into bank lobbies and were turned away by bankers trying to hoard capital to stay afloat. The result: credit froze solid, commerce halted. After a weekend of heated meetings with the prime minister, his chancellor of the exchequer o
rdered the Bank of England’s bailout of London’s banks. The panic soon passed and all was well, until the next panic.
Now, as the U.S. government tried to avoid having to bail out financial institutions—which in this era acted like banks and then co-opted traditional banking functions with wild speculation—Hank Paulson and Tim Geithner felt that, in a crunch, the British would do what was needed.
Obama was on a run through New Hampshire on Friday afternoon, giving a few speeches before flying back to Chicago for a precious weekend of downtime with Michelle and the girls. But already he sensed opportunity.
“The good news is that in fifty-three days, the name George Bush will not be on the ballot. But make no mistake: his policies will,” he said to a large crowd at a gymnasium in Dover. “A few weeks ago, John McCain said that the economy is ‘fundamentally strong,’ and a few days later George Bush said the same thing. In fact, Senator McCain has said that we made ‘great progress economically’ over the last eight years. And here’s the thing. I think they truly believe it.”
Obama, from his many economic briefings, knew how wrong they were, and how, if a financial industry meltdown now further bruised the economy, such statements would seem nonsensical.
Working his phone nonstop between hits in New Hampshire, Obama got word that afternoon from his economic team that Paulson, Geithner, and representatives of all the major banks would be meeting briefly that evening and then all day Saturday and Sunday at the New York Fed headquarters. Wolf sent a note to Obama saying he’d be representing UBS. Obama was delighted; he’d have a source in the room. He told Wolf to make sure to give him regular reports over the weekend.
On Friday evening inside the New York Fed’s large conference room, Paulson and Geithner sat across from the heads of Wall Street. It was a replay, with much higher costs and stakes, of what the banks had done in 1998, when Long-Term Capital Management imploded: they gathered to divide up the damage to keep the financial system from locking up, each taking a share of the hit, except for Bear Stearns. For a decade, Bear Stearns’ intransigence was a bitter pill, making it a moment of prairie justice that the fifth-largest investment bank had its comeuppance in the spring. Now Paulson, who until so recently would have been sitting in the seat now occupied by Lloyd Blankfein, told the group that there would be “no government money” helping this time, and anyone who didn’t cooperate—in a thinly veiled reference to Bear Stearns—“would be remembered.”