Stress Test

  The New York Fed’s executive floor was being renovated, so most of our team huddled in windowless conference rooms in our temporary offices on the thirteenth floor, trying to assess how bad things would get if Bear Stearns defaulted. We also sent a group to Bear to examine its books. So did JPMorgan Chase, which was interested not only as Bear’s tri-party repo clearing bank, but as a potential buyer for some or all of its businesses.

  The initial news was all bad. Bear’s books were full of ugly surprises, and JPMorgan was unwilling to buy anything without more time for due diligence. At 2 a.m., I trudged off to a nearby hotel with a horrible pit in my stomach, hoping to get some rest ahead of the market open. Friday was going to be brutal. Our only obvious option was the standard announcement that the Fed stood ready to provide liquidity to the markets. That wouldn’t be much foam on the runway.

  At 4 a.m., my staff woke me up with a phone call and said I should come back to the office. The news, for the most part, had gotten even worse.

  The closer Fed officials looked at Bear’s connections with the broader financial system, the more they feared its sudden failure would unleash utter chaos. Bear was not that big—only the seventeenth largest U.S. financial institution at the time—but it was completely enmeshed in the fabric of the system. It had nearly four hundred subsidiaries. It had trading positions with five thousand counterparties around the world. And it had borrowed about $80 billion in the tri-party repo market, presenting even greater risks of runs on money markets and investment banks than we had confronted the previous August with Countrywide.

  About a third of Bear’s repo collateral was in the form of mortgage securities. So if Bear went down, its repo lenders would have to unload its collateral, which would depress the price of those securities and the value of everyone else’s collateral, intensifying the downward spiral. Repo borrowers would face margin calls or lose access to credit, as lenders would stop rolling over loans. And as clearing banks, JPMorgan and Bank of New York Mellon faced catastrophic losses if they kept providing intraday credit to borrowers who could easily become the next Bear. Just about everyone would want to limit exposure to just about everyone else.

  Bear also had 750,000 open derivatives contracts. While our work with the Fourteen Families on derivatives infrastructure had made it easier for firms to determine their direct exposure to Bear, they had no idea how much exposure their counterparties had. During a panic, they would be inclined to assume the worst and pull back from everyone potentially exposed to a Bear default. As the British statesman David Lloyd George once said, “Financiers in a fright do not make a heroic picture.” While the direct impact of Bear’s failure would be bad, the real danger was that it would spark runs or margin calls on other firms perceived to have similar vulnerabilities or exposure to counterparties with similar vulnerabilities, triggering a chain reaction of fear and uncertainty that could imperil the entire system.

  “Too big to fail” has become the catchphrase of the crisis, but that night, our fear was that Bear was “too interconnected to fail” without causing catastrophic damage. And it was impossible to guess the magnitude of that damage. There were too many other firms that looked like Bear in terms of their leverage, their dependence on short-term funding, and their exposure to devastating losses as the housing market dropped and recession fears mounted.

  But there was one piece of better news. Tom Baxter, our general counsel, taking a page from the Doomsday Book, the binder full of information about the New York Fed’s emergency powers that he had helped write years earlier, proposed an idea that could keep Bear alive through the weekend, a “back-to-back” loan involving JPMorgan. Rather than lending directly to Bear, Tom said, we could make a short-term loan to JPMorgan that it would “on-lend” to Bear, while pledging some of Bear’s securities as collateral. That would give Bear enough liquidity to survive the weekend, so we would have a couple of days to seek a more permanent solution. Many lawyers look for reasons to say no; Baxter was creative and intrepid about finding ways we could act.

  We knew we would be crossing a line the Fed had not crossed since the Great Depression, indirectly lending to a brokerage house that was supposed to function outside the bank safety net. We would insist on enough collateral to secure the loan to our satisfaction—meeting the legal test that we have a reasonable expectation that we wouldn’t lose money even if Bear defaulted—but, in reality, we’d be taking some risk. The moral hazard risk was real, too. We didn’t want investment banks, or any nonbanks, to think they could rely on our safety net, and several of my senior colleagues in New York—including Bill Dudley, who ran the Fed’s markets function, and Meg McConnell, my close adviser—thought the loan was a bad idea.

  On a 5 a.m. conference call with Washington, I walked through the arguments for and against the loan, urging the dissenters to make their case. With limited time and limited sleep, we would be making a momentous decision, and I wanted everyone fully aware of the objections and possible repercussions. But I thought the loan was the right thing to do; we had to buy time to at least try to avert disaster. Ben and Don asked all the right questions, but they agreed we should do whatever we could to prevent the chaos we thought would accompany the failure of a major investment bank. If Bear collapsed, any institution that looked anything like Bear could be the next domino to fall.

  Lehman Brothers, for example, had nearly one-third of its repo collateral in mortgage securities, just like Bear, and was widely considered the next weakest of the large investment banks. The end of Bear could easily mark the start of a run on Lehman, with Merrill Lynch next in line. In fact, all five of the large investment banks, and many other nonbanks, shared a common vulnerability, borrowing short and lending long without the stability of insured deposits or access to the discount window. Among the defining features of a panic is the fact that markets become less discriminating—more likely to run from everyone rather than try to figure out whose fundamentals seem strong. At a time when creditors were pulling back loans, counterparties were demanding more margin, and investors were fleeing for safety, not even the relatively strong institutions were safe.

  After two hours of discussion and angst, I reminded everyone that we had to make a decision before the markets opened, and I recommended we go ahead.

  “Let’s do it,” Ben said.

  THE RUN on Bear continued on Friday, March 14. The rating agencies, with characteristically late and lousy timing, downgraded Bear’s debt to near-junk status. By the closing bell, its stock price, which had peaked at $168 a year earlier, dropped below $30. Gold soared to an all-time high, a classic sign of market phobia.

  Bear was history. Schwartz thought he had some time to find a buyer, because he mistakenly thought that our loan would mature in four weeks, but that was wishful thinking. Hank and I told Schwartz he had to make a deal before markets opened in Asia on Sunday night. He was not pleased.

  On Saturday morning on the way into the office, I stopped to see Volcker at his Manhattan apartment. He greeted me with a mischievous reference to the Dutch boy with his finger in the dike. “How’s your finger?” he asked.

  I had come to explain to Volcker what we were doing, not just because I valued his advice, but because I wanted to marinate him in our terrible choices. Volcker had a sterling reputation as the wise man of public policy—the brave Fed chairman who tamed runaway inflation in the 1980s—and no opinion in the world of finance carried more weight. I made it clear that I did not think the Fed could keep Bear afloat, and I was not prepared to lend into the run while Bear sought a path to redemption. I said our plan was to see if we could find someone strong enough to buy them and guarantee their obligations before Asia opened. Failing that, we were searching for ways to try to cushion the impact of a major default.

  Volcker was pretty sympathetic. He recognized that the situation was awful and could easily get much worse. Central banks exist to try to reduce the damage in situations like this. It wouldn’t be easy to find a buyer with the d
esire and the balance sheet to take on Bear’s risk during a major financial crisis, but Volcker understood that we didn’t have any good options.

  Although several firms took a look at Bear, it wasn’t much of an auction. It quickly became clear that Bear’s options were JPMorgan or bankruptcy. I stayed in touch with JPMorgan Chase CEO Jamie Dimon all day Saturday while his team combed through Bear’s books. By nightfall, Dimon said he was prepared to pay $8 to $12 a share—less than the current $30 price, but more than the $0 the stock would be worth Monday after a bankruptcy filing.

  It seemed too good to be true, and it was. On Sunday morning, Dimon called back to say the deal was off. The problem, he said, was not the price. It was the potential losses in Bear’s mortgage book. Nearly three-fourths of the assets were subprime or only slightly safer, and he wasn’t prepared to take those on at any price.

  “There’s just too much risk,” he said.

  Dimon had served on the board of the New York Fed for three years, and he came across as smart, tough, and good at his job. I had heard him give an impressive presentation at a New York Fed conference about the challenges of risk management, and why bankers tend to underestimate risk. I didn’t think he was bluffing about his reluctance to take on more mortgage risk and stand behind Bear’s trading book at a time when mortgages were in crisis, traders were panicked, and a recession loomed. His reservations sounded rational and credible. Still, Jamie knew he was the only likely bidder for Bear—and he had warned us that if Bear failed, the four other investment banks might fail as well, which wouldn’t be good for anyone. I got the sense he might be willing to do a deal with some government assistance.

  I called Ben and then Hank with the news. Hank was a bullet-headed former Goldman investment banker and CEO, as imposing and action-oriented as Ben was deferential and measured. He used to say his general approach to life was that if you see a problem, run at it, not away from it. He was open and direct, giving the impression that he laid it all out there, but he was also an insightful reader of people and their needs, which helped make him a formidable dealmaker. We worked really well together, even though we were from completely different worlds. He had asked me to be his deputy when he became Treasury secretary. Our working relationship became so close that some of Hank’s aides complained he spent too much time on the phone with me. I know they sometimes felt I pushed him toward interventions that their conservative Republican administration hoped to avoid.

  Hank and I spent the rest of Sunday morning on the phone with Dimon, separately and together. Dimon argued that buying Bear would weaken his bank. I argued that a disorderly collapse of Bear would be rough on JPMorgan, too.

  “Jamie, what makes you think you’ll be unaffected by this failure?” I asked. “You’ve got the biggest derivatives book out there. You’re the clearing bank. You’ve got all this exposure. I don’t get why you think you’d be OK.”

  Eventually, Dimon proposed that we take some of Bear’s risk off his hands. U.S. law severely limits the risks the Fed can take, and in general, central banks shouldn’t design one-off interventions to prevent the failure of individual firms. So I asked Hank if Treasury could tap the Exchange Stabilization Fund, the pot of money Treasury had used to rescue Mexico in 1995, to assume some of the risk in a Bear deal. His lawyers said no, the Treasury could not do that.

  I talked to Ben and Don, and suggested that the New York Fed take on some of Bear’s assets. Given the risks to the system, they were willing. I still thought it would be better for the Fed if we had some financial protection from Treasury, so I told Hank we’d do it only if the Treasury indemnified us from any losses. He said he’d try. I then told Dimon we were willing to take on some of Bear’s risk. And I called Larry Fink, the CEO of the investment firm BlackRock, the only firm without potential conflicts of interest that had the expertise to advise us quickly, and asked him to send a team to evaluate the portfolio of Bear’s assets that Dimon wanted to leave behind.

  By the early afternoon, we had hashed out a deal. We would help JPMorgan buy Bear Stearns. Hank pressured Dimon to keep the price low, to avoid the perception that we were subsidizing a windfall for Bear’s shareholders. So the offer was just $2 a share, or $236 million for a firm that had been valued at $20 billion the previous year. And at our insistence, JPMorgan agreed to stand behind Bear’s obligations immediately, even though the deal wouldn’t close immediately. That was a huge risk to take during a panic, a risk someone had to take to prevent Bear’s remaining customers and creditors from fleeing, a risk we believed we couldn’t take ourselves. All the Fed could do was lend against collateral, not provide an open-ended guarantee.

  The New York Fed agreed to lend JPMorgan $30 billion to facilitate the merger, backed by $30 billion worth of Bear’s investmentgrade assets. Larry Fink of BlackRock assured me that if we held on to the assets for a few years, we would probably break even, with at most a few billion dollars in losses; I made him repeat that on a call with Ben and Hank. I told Ben I thought that met the legal test under 13(3) that we be “secured to our satisfaction,” and he agreed.

  But late in the afternoon, Hank’s lawyers told him Treasury couldn’t indemnify the Fed without congressional approval. I was incredulous, and we both yelled at his lawyers for a while, but they were unyielding, and I decided they were probably right. Hank felt bad he couldn’t deliver, and it was pretty remarkable to discover how little authority the secretary of the Treasury had to try to avert a major financial crisis in the United States. His attitude was: Just tell me what I can do, and I’ll do it. So I proposed he write me a letter, publicly supporting the loan and noting that if the Fed incurred losses, they would reduce the profits we return to the Treasury each year. Hank called it his “all money is green letter,” and while it merely stated fiscal facts, I thought it gave us some cover, implicating Treasury in the risks we were taking.

  While we were scrambling to prevent a disorderly bankruptcy of Bear, we were also trying to put foam on the runway in case we couldn’t. That weekend, a team at the New York Fed was designing a new credit facility intended to provide liquidity to the investment banks and the broader markets in case Bear collapsed. But once we found a deal for Bear, we still decided to go ahead with the foam-on-the-runway plan. That Sunday night, at roughly the same time as the Bear announcement, we launched the Primary Dealer Credit Facility, which provided a lending facility like the Fed’s discount window to the big four surviving investment banks.

  That night, we convened a call to explain these actions to the CEOs of the major financial institutions, and to ask them not to make a fragile situation worse. We had Jamie start by announcing that all their trading positions with Bear were now with JPMorgan, a relief to all of them. Hank and I then urged them to act responsibly. We didn’t want them to pull back further and accelerate a spiral that could end up destroying all their firms. Our message was: You have a collective interest in making this work. How you respond will help determine whether the system holds. And we will be watching.

  Vikram Pandit pointed out that the system would remain in limbo until Bear’s shareholders approved an extremely unattractive deal. He asked: What if this falls apart? Then what do we get for acting responsibly? Dimon shot back a question of his own: “What happens to Citigroup if this institution goes down?”

  DIMON HAD a point, but so did Pandit. Bear’s shareholders were furious that their firm was being valued at less than Alex Rodriguez’s contract with the Yankees. And Bear’s clients and counterparties continued to run out of fear the merger wouldn’t close. This uncertainty was a serious problem for Dimon. He told Hank and me he would raise his offer if he could be assured the merger would go through.

  That was fine with me. I didn’t much care what JPMorgan paid for Bear, as long as the deal got done and the system calmed down. Reopening the deal would also give us leverage to improve the terms for the government. We ended up getting JPMorgan to agree to take the first $1 billion of any losses from Bear’s mortga
ge assets, which we agreed to hold in a new special purpose vehicle. (We named it Maiden Lane, after a street next to our building.) Meg warned in an email that it would look like we were launching a subprime SIV, which “seems like a PR thing we’ll need to manage very aggressively from the start to keep it from becoming a big joke.” But it was good to have a larger margin of safety.

  Hank had his own concerns. He was still uncomfortable allowing the shareholders of a failed firm to benefit from a government rescue. But Ben and I helped persuade him that allowing JPMorgan to offer a somewhat better deal to the shareholders of Bear Stearns mattered less than the stability of the financial system. Dimon upped his offer to $10 a share, and the deal was done.

  WELL, ALMOST done.

  The New York Fed and JPMorgan spent the next three months locked in brutal behind-the-scenes negotiations, arguing over which Bear Stearns assets the Fed would take and how much they were worth, fighting over every security and every mark. Dimon wanted to leave as much risk with us as possible, especially now that he had given us a $1 billion cushion against losses. Tensions were running high. Everyone was on edge. On one occasion, well after midnight, Dimon unleashed a tirade at Tom Baxter so heated that Tom hung up on him; Tom then called me to say that the New York Fed could no longer negotiate with Dimon. I let him vent for a while, but eventually I interceded, Jamie apologized to Tom, and we were able to resume the negotiations.

  Still, Dimon was relentless, and he put tremendous pressure on his team to be equally relentless. Near the end of the talks, I remember, I got on a call with Steve Black, one of Dimon’s top lieutenants, to explain our final offer.

  “Are you telling us as president of the New York Fed that this is the way it’s going to be?” Black asked.