Stress Test

  I hesitated. I didn’t want JPMorgan to claim I used my power as its regulator to force a deal, or that the Fed had unilaterally changed the terms of the deal.

  “We’d just like to know,” Black repeated a bit more slowly. “Are you telling us as president of the New York Fed that this is the way it’s going to be?”

  Now I got it. Black just wanted to be able to tell Dimon that he had fought as hard as he could.

  “Yeah,” I said. “I am telling you as president of the New York Fed that this is as far as we will go. We are done.”

  And so we were. But the agony of papering the Bear deal made a lasting impression on me. It showed how hard it was to value assets that markets wouldn’t touch during a crisis, and how vulnerable the government was to getting stuck with the worst. “Let’s hope the BlackRock people have our backs,” Meg emailed me at one point. “We don’t have a clue what we’re doing.” Meg has a flair for darkness, but she was right to worry that we knew very little about the securities, except that Jamie and his team didn’t want them. Ultimately, though, BlackRock and the small internal Fed team did a great job evaluating them; by the end of 2013, the Fed would be projected to earn a profit on Bear. But my skepticism about government purchases of complex illiquid assets would become important later in the crisis.

  The entire Bear episode was a turning point for the Fed, erasing our long-standing lines between commercial banks we considered “inside the safety net” and the many firms operating outside that net. We had used our power to help prevent the disorderly collapse of a private firm, protecting creditors and counterparties from losses. We didn’t want to do any of those things; we saw them as the least-bad options. But I thought we were pretty creative, considering the exceptional pressure and the constraints on our authority, in persuading a private financial institution to guarantee Bear’s obligations and devising a way to lend against distressed assets with underlying value. Trichet called me to say we had done a masterful job containing the panic.

  Larry called with a decidedly different take: “You’re going to get killed over this!” He said the Bear merger would look like a corrupt bailout, a sweetheart deal for one of my board members. He said he didn’t agree with those critiques, although as always he had an endless list of things we could have done better. I told him he sounded like the author William Greider, who savaged the Greenspan Fed in his populist critique Secrets of the Temple.

  “It’s going to be like Greider, but much worse,” Larry replied.

  I had learned about the lousy politics of crisis response during my time at Treasury, but it was still jarring to be a target myself, with critics questioning not just my choices but my motives. “That is socialism!” Republican Senator Jim Bunning of Kentucky thundered when Ben and I testified before Congress about Bear. Our Fed colleague Jeff Lacker publicly accused us of encouraging recklessness and laying the groundwork for the next crisis. Even Volcker declared the Fed had gone to “the very edge of its lawful and implied powers.” He didn’t say we went over the edge, but it was open season on the Fed, sometimes even from within the Fed. Richard Fisher, no fan of what we had done, sent me a gracious email with the message “Illegitimi non carborundum,” a slogan my grandfather had kept on his kitchen wall. It means: “Don’t let the bastards get you down.”

  I thought the moral hazard fundamentalists were missing the point. Bear’s shareholders absorbed huge losses; the final deal was 94 percent below the stock’s peak. Bear’s senior executives lost their jobs and much of their wealth. The firm itself disappeared. It was hard to imagine that other firms would take much comfort from Bear’s plight or have any desire to follow Bear’s path. And JPMorgan took extraordinary risks to guarantee Bear’s obligations, even though its competitors would clamor for “Jamie deals” later in the crisis. We did create some moral hazard by protecting creditors and counterparties from the consequences of a Bear default, but that was unavoidable. We wanted to avoid what we saw during the systemic panics of the nineties, when the fear of cascading defaults and haircuts for bondholders and other creditors greatly amplified the damage. Once a run is under way, anything that increases the uncertainty of creditors about if and when they’ll get paid will exacerbate the run. Crisis responders who get obsessed with moral hazard and Old Testament justice make crises worse.

  I was equally unmoved by suggestions that Bear was a case study in the dangers of size, an illustration of the too-big-to-fail syndrome. Bear was only a midsize financial institution, with only one-fourth the assets of JPMorgan, illustrating that when the system is fragile, even relatively small institutions can threaten enormous damage. It also showed that size had some virtues, as JPMorgan was large enough and strong enough to take on Bear’s liabilities.

  Finally, while our critics saw Bear as a cautionary tale about complex new derivatives, I saw it as a familiar story about a failure to manage risk. Bear had borrowed too much and too short. In a time of mania, it used its financing to buy stuff that lost much more value than it had thought possible. Then its lenders got nervous and demanded their money back, money that it no longer had on hand. The real lesson of Bear was that in a world of extreme leverage and short-term financing, confidence can vanish in a heartbeat, and liquidity along with it.

  This was not an uplifting lesson, because all those vulnerabilities were still present in the financial system, especially outside the commercial banks. But I was comfortable with what we had done. That spring, at the Microsoft CEO summit in Seattle, Warren Buffett came to the session where I made a presentation. He said he believed our interventions had saved the system from an unspeakable calamity.

  “I was sort of hoping you wouldn’t do it, because then everything would have crashed and I would have been first in line to buy,” he said with a grin. “It would have been terrible for the country, but I would’ve made a lot more money.”

  I still felt incredibly dark about the state of the system. It doesn’t bolster investor confidence to see a financial stock plunge from $57 to $2 a share over three days, no matter how aggressive the government response. I was worried about the potential risk that Lehman and other firms posed to the system, worried about repo, worried about the land mines we didn’t know about yet. But in some ways, the low point for me was 2 a.m. that Friday morning, March 14, 2008, when I lay down in that hotel room thinking we had no way to prevent Bear from filing and the markets from collapsing. When I returned to the office a few hours later, the world still looked horribly dark, but at least I felt like we were trying to do something about it. It wasn’t exactly a comforting feeling, but I liked it better than helplessness.

  FIVE

  The Fall

  Now that the Fed had started lending to investment banks, and had even helped prevent the collapse of an investment bank, I told my team we needed to climb inside the investment banks. If they were going to enjoy access to Fed liquidity, we needed to understand and limit the risks they were taking. We couldn’t rely on the SEC anymore. For the first time, the New York Fed sent a small team of full-time monitors into the surviving large investment banks: Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs. Unlike the commercial banks, none of them had a stable funding base of insured deposits. All four were highly leveraged and vulnerable to runs, especially Lehman and Merrill; Goldman and Morgan Stanley seemed less precarious. But we pressured all of them to raise capital, increase their liquidity, and lengthen the maturity of their financing—basically, to batten down their hatches before the next storm.

  The four investment banks did manage to raise $40 billion in capital in the spring of 2008, a reflection of the lull in the crisis after we helped salvage Bear and announced our new lending programs. The stress in the broader markets eased a bit. There were even internal Fed debates about whether the system had stabilized enough to let our “unusual and exigent” programs expire.

  But I told my colleagues: “Just because it feels calm doesn’t mean it is calm.” This felt like another false d
awn, not a return to normalcy. Markets that overshoot on the way up tend to overshoot on the way back down, and I thought backing off our commitments to provide liquidity would further damage confidence.

  “If we add to uncertainty in the markets about the duration of support, and raise concern about premature withdrawal in an environment where macro/financial uncertainty is still acute, we probably reduce our ability to bring about more repair/robustness to the markets,” I wrote in an internal email.

  The macro picture looked grim. Washington was so nervous about an election-year downturn that Hank had united Republicans and Democrats behind a $150 billion fiscal stimulus package, a rare bipartisan effort to jump-start consumer spending by sending Americans tax rebate checks. But the deterioration in the economy was overwhelming this stimulus. Unemployment rose a half point to 5.5 percent in May, the largest monthly increase in two decades. One in every eleven mortgages was past due or in foreclosure. Auto sales were plunging. And gasoline was soaring past $4 a gallon, stripping consumers of disposable income, significantly reducing the benefit of their tax rebates. Not only did record oil prices damage the economy, they triggered another round of inflation paranoia, which was discouraging the Fed from cutting interest rates to boost the economy. The ECB actually raised rates, which I found stunning and inexplicable. We wouldn’t make the same mistake, but Ben did ask if there was anything else the Fed could do to lean against oil prices. I thought the few modest tools available were within the control of the executive branch.

  “This mess is primarily for the Administration,” I replied in an email.

  My focus was the financial system, and how to make it more resilient to additional shocks. We were especially worried about the risks in tri-party repo, so we persuaded the clearing banks, BoNY and JPMorgan, to push the market toward less short-term financing of less risky securities. We hoped that would reduce the danger of an uncontrolled run. We were also concerned that the spaghetti-like tangle of overlapping positions in derivatives markets could create uncertainty if another major firm failed. To shrink the plate and untangle some of the spaghetti, we encouraged the Fourteen Families to “tear up” offsetting trades of credit default swaps, getting dealers who had bought and sold the same insurance contract to step out of the offsetting trades and match up the counterparties. That way, if the dealer in the middle failed, the other firms wouldn’t be exposed. We ended up eliminating about one-third of the outstanding contracts.

  I was still painfully aware of our limited ability to contain the crisis. The ad hoc Bear intervention had worked out, because JPMorgan was willing and able to take on risks the Fed couldn’t. But the government needed more formal powers to wind down failing large financial institutions and guarantee their obligations, like the FDIC already had for commercial banks. Hank and Ben took this “resolution authority” idea to the Hill, but Barney Frank, the Democratic chairman of the House Financial Services Committee, told them it had no chance. Hank and Ben and I also talked about seeking the ability to inject capital into struggling institutions or buy their toxic assets. Those ideas also went nowhere at the time, though they would become crucial down the road. It turned out that things had to get a lot worse before Congress would even consider expanding our authority to make things better, a common problem in crisis response.

  Anyway, things would soon get a lot worse.

  IF BEAR had looked like an outlier, I might not have felt such a deep sense of foreboding that spring. But Lehman had 75 percent more assets than Bear, much more real estate exposure, an even larger thicket of derivatives deals, and nearly $200 billion worth of repo financing that could evaporate quickly. In May, the hedge fund manager David Einhorn, who had bet heavily against Lehman, publicly accused the firm of overly optimistic accounting, and in June, Lehman announced a $2.8 billion second-quarter loss, prompting Dick Fuld to oust his longtime deputy and demote his chief financial officer. Lehman’s stock price dropped nearly 75 percent below its peak. Fuld urged Hank and me to push the SEC to ban short selling, but that seemed like a shoot-the-messenger solution. The markets could see that Lehman was carrying assets at 80 or 90 cents on the dollar that other firms had written way down. And they were justifiably worried about what they couldn’t see.

  One thing we saw when our monitors dug into Lehman and the other investment banks was that their internal stress tests had not been very stressful. Most of them had never imagined that their repo funding could be vulnerable to a run, obviously a faulty assumption after Bear. We forced them to study much darker scenarios to see how vulnerable they would be to a sudden loss of funding. In May, the New York Fed staff calculated that Lehman would need $84 billion in additional liquidity to survive a severe run, a scenario we dubbed “Bear Stearns,” and $15 billion to survive a somewhat less severe run we called “Bear Stearns Light.” In a June 25 memo, our team concluded that Lehman had borrowed too much, too short, against too many illiquid assets, resulting in a “weak liquidity position”—a pretty mild way to put it.

  But when Lehman’s risk managers ran their own less conservative version of Bear Stearns Light, they concluded they would weather the storm with $13 billion in cash to spare. Merrill Lynch seemed almost as vulnerable as Lehman, and almost as deep in denial. “Merrill needs to embrace conservatism in its liquidity analysis and acknowledge that it needs to improve its liquidity position,” our team wrote in another dry understatement. Throughout my time at the Fed, we found that the firms with cultures that valued risk management and risk managers tended to be stronger and more conservatively financed. When Merrill CEO John Thain brought his team to see me that spring, there was an awkward moment when it became clear he didn’t know the name of his chief risk officer, who was sitting right next to him.

  Some would later argue that the moral hazard of the Bear Stearns rescue made this kind of complacency inevitable, that investment banks and other major institutions now had reason to believe they would be bailed out of their mistakes. I didn’t think there was much evidence to support that. Investors had financed a huge increase in leverage at investment banks long before the Fed had intervened with Bear. And Bear’s fate was not an appealing outcome for others to follow. The firm lost its independence, and its shareholders lost most of their money. We did get JPMorgan to protect Bear’s creditors, but the markets didn’t seem to think we would necessarily be willing or able to do that again. The remaining investment banks were larger and much harder for another firm to absorb; what bank would be strong enough to do what JPMorgan had done with Bear? Even after our extraordinary actions in March, counterparties gradually reduced their exposures to Lehman, and the cost of insuring against its default began to rise again over the summer.

  One institution that did overestimate Lehman’s ability to survive was Lehman. Hank and I repeatedly pressured Fuld to sell his firm or at least raise much more capital, but he was late to act and deeply unrealistic about the strength of his position. At one point we persuaded him to ask Warren Buffett to invest in Lehman, but Fuld demanded a much higher price than Buffett was willing to pay. Fuld often called me to complain that his competitors were spreading rumors, or to suggest it was our responsibility to help his firm get out of its worst investments. Like many of those atop the more vulnerable financial institutions in the summer of 2008, Fuld seemed to think that he was a victim and our job was to save him from an unfair world.

  By contrast, the leaders of the stronger firms seemed more realistic, more willing to face the darkness. Around that time, a team of the best economists at the New York Fed gave a presentation to our board on the potential losses ahead for banks, based in part on outcomes from recent recessions. Jamie Dimon laughed at them. He told them to throw out their historically based estimates and triple their projected losses.

  Fuld didn’t seem to understand that Lehman faced a crisis of confidence that the Fed couldn’t fix. He once came to see me with the omnipresent crisis attorney Rodge Cohen to ask if we could let Lehman become a bank holding company
like JPMorgan or Citi. That would have provided the impression of Fed protection, but on its own it wouldn’t have done much to expand Lehman’s access to Fed financing, which it was already receiving through the Primary Dealer Credit Facility (PDCF) we had launched over Bear weekend. I told Fuld it would only reinforce the perception of desperation, without addressing Lehman’s deeper capital and liquidity problems. Fuld and his executives were also full of ideas for the government to buy their real estate assets at generous prices, or to help them spin off “bad Lehman” into a vehicle called SpinCo while leaving “good Lehman” to prosper. They didn’t seem too eager to sell those assets themselves, because the losses likely would have eaten up their capital reserves.

  Of course, our successful intervention to prevent Bear’s collapse might have influenced Fuld’s refusal to believe we would ever let Lehman collapse. There may have been people whispering in his ear that the Fed had vast secret powers to rescue anyone. But his reluctance to act probably had less to do with moral hazard than self-delusion. After nearly forty years at the firm and fifteen years as CEO, Fuld felt like Lehman was his baby, and he couldn’t help but believe the firm was worth way more than the market did. He also owned millions of shares.

  I used to joke that there would be less moral hazard in the Fed liquidity facilities if financial executives had to put up their own homes as collateral, ahead of the assets of their firms. That would be real skin in the game. When I was visiting my former Treasury colleague Lee Sachs on Martha’s Vineyard that summer, we saw a graceful oceanfront mansion during a walk along the beach. Lee, who had worked at Bear Stearns in happier times, told me it belonged to the firm’s former president.

  “That one right there should’ve been the first loss,” I said.