Stress Test

  We wanted to have more than one bidder, so we were pleasantly surprised when the British bank Barclays also expressed interest in Lehman. Bob Diamond, an American who ran Barclays’s investment banking arm, told me he’d only do the deal on the cheap; like a teenager playing hard to get, he also said he wouldn’t make the first call. So I gave Fuld his number. A few minutes later, Fuld called back and told me Diamond had said he wasn’t interested. I told him yes, Diamond was interested. Fuld called him again and Diamond again rebuffed him. Fuld angrily called me to complain again. This was starting to feel like an Abbott and Costello skit.

  “I don’t know what’s going on here,” Fuld said.

  Finally, Diamond told Fuld he’d take a look, but the market was moving faster than he was. On Thursday, Lehman’s stock price fell another 42 percent. Repo lenders were running from Lehman, just as they had run from Bear; they would reduce their lending by more than $50 billion that week. Hedge funds were scrambling to withdraw funds from the brokerage accounts they held at Lehman. JPMorgan demanded $5 billion in additional collateral from Lehman, and warned it might request $10 billion more over the weekend. Hayley Boesky, a PhD astrophysicist who was the New York Fed’s head of market analysis, sent an email with the subject line: “Panic.”

  “On a scale of 1 to 10, where 10 is Bear-Stearns-week-panic, I would put sentiment today at a 12,” she wrote.

  Lehman’s repo book was three times as large as Bear’s. It had eight thousand subsidiaries around the world, more than one hundred thousand creditors, and more than nine hundred thousand outstanding derivatives contracts. It didn’t seem likely to go quietly.

  “There is full expectation that LEH goes, WaMu and then ML,” Boesky wrote. That was shorthand for Lehman, Washington Mutual, and Merrill Lynch. “All begging, pleading for a large-scale solution which spans beyond just LEH.”

  ALL WEEK long, Hank had stuck to a consistent message in his private calls to the market: The government will not subsidize the purchase of Lehman. He warned Bank of America and Barclays that there was no political will for a Bear Stearns reprise. He did suggest in those calls that an LTCM-style consortium of private firms could help absorb some of Lehman’s risk, but he insisted there would be no more taxpayer money for failed institutions. This wasn’t really Hank’s decision; he couldn’t tell the Fed how to use its authority. But Ben had expressed similar aversions in our internal calls, though he did not rule out a role for the Federal Reserve.

  As a private negotiating posture, I thought that made some sense. We didn’t want Ken Lewis or Bob Diamond to expect taxpayer help to buy Lehman. And it was true that after Bear and Fannie and Freddie, Washington had become a cauldron of Old Testament populism and moral hazard fundamentalism. We didn’t want to bolster the impression that government handouts were available upon request.

  But whatever the merits of no-public-money as a bargaining position, I didn’t think it made sense as actual public policy. The Bear intervention had been a well-designed solution to a serious problem. I believed that if we could find a buyer to play the JPMorgan role and buy Lehman, and we had to take some risk to close the deal, it would be in the best interest of the country for us to do so, whether we liked it or not. In normal times, we wouldn’t worry too much about the fate of an individual firm. But in a colossal crisis, you never want to allow a messy liquidation of a major institution unless you can draw a circle of protection around the rest of the system’s core, a firebreak to contain the flames. And the Federal Reserve simply did not have the power to provide that critical protection. If Lehman failed, and the U.S. government publicly proclaimed that we were done with bailouts, rational investors would simply run from other financial institutions. I didn’t mind no-bailouts as a negotiating stance, as long as we understood that, ultimately, private money wasn’t going to defuse a global panic on its own.

  By Thursday night, when Hank forcefully repeated his no-public-money stand during a conference call with Ben and SEC Chairman Chris Cox, I began to worry that he actually meant it. He declared that he didn’t want to be known as “Mr. Bailout,” that he couldn’t support another Bear Stearns solution. I could hear the influence of his political advisers, who had been trying to steer Hank away from supporting any Fed role, urging him not to let me talk him into another Bear. I understood that Hank was under intense pressure; Congress was up in arms about his reversal on Fannie and Freddie, and many Republicans feared the bailout issue could put Senator Obama in the White House. Still, I thought we needed to “preserve optionality,” as Bob Rubin used to put it. I didn’t want us to commit to inaction and box ourselves in.

  On Friday morning, it looked like Hank’s team had done just that, converting a private negotiating stance into public policy. Major papers, newswires, and business TV channels had stories detailing the government’s unwillingness to use taxpayer funds to rescue Lehman, all citing sources close to Hank. “Paulson Adamant No Money for Lehman,” reported Bloomberg News. Hank’s political aides had leaked his talking points: that markets had been preparing for a Lehman bankruptcy for months, that the Primary Dealer Credit Facility was now in place to smooth the process, that the Bush administration would not tolerate taxpayer-assisted deals. I told Hank this was a huge mistake, irresponsibly damaging to confidence. This was not the time to tell the markets they were on their own. By committing to do nothing now, we’d end up having to do more and put more taxpayer money at risk later.

  This was one of the few times during the crisis when there was any distance between Hank and me. There was even some distance between Ben and me. I sensed their advisers pulling them toward political expedience, trying to distance them from the unpalatable moves we had made and the even less palatable moves I thought we’d have to make soon. The natural human instinct in a financial crisis, and especially the political instinct, is to avoid unpopular interventions, to let the market work its will, to show the world you’re punishing the perpetrators. But letting the fire burn out of control is much more economically damaging, and ultimately more politically damaging, than taking the decisive actions necessary to prevent it from spreading beyond the weakest institutions into the core of the system. By pledging not to take on any more risk, I thought we risked fanning the raging flames.

  These disagreements did not turn out to be consequential. Hank and Ben would have the courage to change course and do what needed to be done. We would talk constantly over the next few months, basically a never-ending conference call, making sure we stayed on the same page, preventing nervous colleagues from pulling us back toward inertia. But at that critical moment, I worried that all the anti-bailout rhetoric was jeopardizing our ability to find Lehman a buyer. Neither Bank of America nor Barclays seemed interested in an unassisted deal. And the markets were in full retreat from Lehman; by the final bell Friday, it was down to its last $2 billion in cash. If we couldn’t find a solution over the weekend, we’d have a corpse on Monday.

  We convened the leading financial CEOs at the New York Fed that evening for an emergency meeting. We met in a dark conference room behind wrought-iron gates on the first floor, where we could hear the rumble of the subway trains underground. Faces were drawn and tense. Careers and fortunes were in jeopardy. No one in the room could be sure their firm would survive. None of us had seen anything like this in our lifetimes.

  Hank, who had just flown up from Washington, explained that Lehman was on the edge of failure, and that we had to explore ways to prevent that. One option, he said, was a merger with another firm, and there were two potential buyers. But neither of them was willing to take on all of Lehman’s risk. Someone would have to finance the rest of the deal before the Asian markets opened Sunday night, and it wouldn’t be the government. I echoed that no-public-money stance, though I carefully tried to frame it as a general Washington aversion.

  “There is no political will in Washington for a bailout,” I said.

  Vikram Pandit of Citigroup soon raised a question on everyone’s mind: Wh
at about AIG and Merrill? I told the group to focus on Lehman first, but Pandit was right to think beyond it. We had three existential crises that weekend, not just one.

  Merrill’s stock had lost more than a third of its value in a week. If Lehman went the way of Bear, Merrill was widely understood to be the next-weakest investment bank, the next obvious target for a run. Meanwhile, AIG’s shares had lost nearly half their value in a week, and the spreads on its credit default swaps had spiked higher than Bear’s before our intervention in March. A senior official in my markets group, Patricia Mosser, sent me an email shortly before I went into the Lehman meeting: “AIG is facing serious liquidity issues that threaten its survival.”

  While I was with the bankers, Hayley Boesky sent another email about panic among hedge funds.

  “Now focus is on AIG,” she wrote. “I am hearing worse than LEH. Every bank and dealer has exposure to them.”

  THE SCENE at the New York Fed that weekend was a surreal frenzy of activity.

  Hank and a few aides set up shop alongside my team in our temporary quarters on the thirteenth floor. It was a generic workspace—we called it our Holiday Inn Express—but it was functional and even advantageous for the crisis, bringing us together in a way our isolated offices on the executive floor couldn’t. The rest of the building was swarming with bankers, lawyers, accountants, and analysts from a panoply of Wall Street firms with an array of interests, eyeing one another with suspicion but aware they shared a mutual interest in averting a systemic meltdown. We tried to keep some separation between the various swarms; a team from Lehman was holed up in our medical office. Hank and I stayed at each other’s side, shuttling from conference room to conference room, from crisis to crisis, stepping out to take calls that rarely improved our mood. There was a lot going on.

  We told the bankers from the night before to divide themselves into three groups: one to analyze Lehman’s toxic assets to help facilitate a potential merger, one to investigate an LTCM-style consortium that could take over the firm and gradually wind down its positions, and one to explore ways to prepare for a bankruptcy and limit the attendant damage. Hank warned them all that we’d be watching carefully, that we’d remember who was and wasn’t helpful. Bear Stearns had been the only major firm to refuse to join the LTCM consortium back in the 1990s, tarnishing its image on the Street. I reminded the bankers that reputational risk aside, Lehman’s demise would threaten all of their firms, potentially crippling the financial system.

  Saturday did not produce good news. Ken Lewis informed us there were about $70 billion worth of toxic assets in Lehman’s portfolio that Bank of America wouldn’t take, up from $40 billion the day before. Basically, BofA wasn’t interested. Barclays told us it would have to leave behind $52 billion of Lehman’s worst assets in any deal. And the Wall Street team scouring Lehman’s books quickly concluded those troubled assets were worth only about half what Lehman claimed. That would leave a substantial capital hole for a private consortium to fill in an industry-assisted deal, with about ten times the risk the Fed took in the Bear case with Maiden Lane.

  Unfortunately, but not surprisingly, the team studying the LTCM option—putting some capital into Lehman before winding it down—decided it made no sense. Lehman’s capital hole was just too big, and even if the consortium managed to finance the deal, it would have to guarantee Lehman’s trading book in the heat of a run. Just as predictably, the team investigating what I dubbed “the lights-out scenario” concluded a Lehman bankruptcy would be devastating to the system.

  That left an assisted deal for Barclays as the only option to avoid catastrophe. Grudging support was building for a consortium to finance Lehman’s bad assets through a private vehicle reminiscent of Maiden Lane—the bankers called it “ShitCo”—so that Barclays could buy the rest of the firm and guarantee Lehman’s trading book. Hank and I met with Dimon and then Blankfein, and they both said they thought the consortium would come through to help a competitor. But they also raised some uncomfortable questions: Did it really make sense to push major institutions to take on billions of dollars in additional risk, when capital and liquidity were scarce and no one thought resolving Lehman would be enough to calm the larger storm? What if we had to reassemble the consortium the following week to avert another failure? What if markets punished strong firms under the assumption that they were now responsible for rescuing their weaker competitors?

  Dimon and Blankfein weren’t being altruistic, but I thought they raised valid concerns. This would all become moot soon, but if the private consortium had balked at financing the entire deal with Barclays, I would have supported having the Fed assume some of the risk. I believe Ben and Hank felt the same way. Preventing a Lehman default had to be our top priority, because we didn’t have the ability to limit the fallout from a messy failure.

  “You need to know that if we can’t work out a solution, we don’t have the capacity to insulate you or the system from the consequences,” I told the group.

  Meanwhile, AIG was looking worse and worse. It had a trillion-dollar balance sheet, 115,000 employees, and a slew of solid insurance businesses. But a hedge fund-like subsidiary called AIG Financial Products had put its franchise at risk, selling insurance against the risk of a housing slump. It had exploited the strength of AIG’s traditional businesses and AAA credit ratings to make gigantic commitments it couldn’t keep. Now it was besieged by margin calls on its contracts insuring CDOs and other troubled mortgage securities, forcing it to scramble for cash just as it was being shut out of the credit markets. And the rating agencies, belatedly as usual, were threatening to dock AIG’s credit rating, which would force it to post billions of dollars of additional collateral.

  “They face the possibility of a multi-grade downgrade from Moody’s on Monday, which would probably be the death knell,” Don Kohn wrote.

  AIG’s main regulator, the Office of Thrift Supervision, had been oblivious to its troubles. Some of my New York Fed colleagues had met with OTS staff to discuss AIG that summer after one of Willumstad’s hinting-at-danger visits to my office, and they had come away alarmed. But I went into that weekend with very little knowledge about the company, because, again, the Fed had no authority or responsibility to supervise insurance companies. Now Willumstad wanted the Fed to provide an open-ended loan, but he didn’t seem to have a plan to strengthen AIG. As Don said, he wanted “a bridge to nowhere.” It still seemed implausible to me that we would rescue the firm. But I assigned a New York Fed team to spend the weekend analyzing the financial world’s exposure to AIG and the damage a default might cause to a fragile system.

  “At the end we could blink if they are too connected to fail, but that will open up an unknown can of worms,” Don wrote. “We should be sure that if we think about this it is a short-term bridge to a permanent solution.”

  On Saturday morning, Willumstad said AIG might need as much as $30 billion. But he clearly had no idea how bad things were. “We think they are days from failure. They think it is a temporary problem,” Ben said in an email. “This disconnect is dangerous.” By the end of the night, after scouring the firm’s books, AIG’s bankers concluded the firm actually needed something like $60 billion.

  Nevertheless, I went home Saturday night feeling relatively optimistic about our two other existential crises. Hank and I had urged Merrill’s John Thain to find a buyer as soon as possible, and he was now in talks with Bank of America about a deal. That helped explain BofA’s lack of interest in Lehman—Ken Lewis apparently preferred Merrill’s army of retail stockbrokers—but it also offered the tantalizing possibility of a rapid private-sector resolution of the Merrill dilemma. And Barclays looked like it was ready to move on Lehman. There were still some unanswered questions—and last-minute Fed assistance still seemed possible to me—but I thought we had a decent chance to avoid the trauma of a default.

  THOSE HOPES were dashed quickly.

  Early Sunday morning, I took a call from Callum McCarthy, a former Barclays ba
nker who was the United Kingdom’s top financial regulator. He told me his agency was unsure whether Barclays had enough capital to take on the risk of buying Lehman, or enough capacity to guarantee Lehman’s book. He also told me Barclays wouldn’t even be legally permitted to stand behind Lehman’s trades before a shareholder vote that could take months to arrange.

  I was absolutely stunned. We were on the brink of Armageddon. We had no alternative to a merger, no other plausible buyer apart from Barclays, and no idea Barclays’s regulators had any problem with the deal. I couldn’t believe that Barclays had gone this far without a green light from its supervisor, but here we were.

  “Are you saying you won’t approve this?” I asked.

  McCarthy wouldn’t say that, but he raised so many logistical and regulatory barriers that he might as well have said that. He suggested that the British banking sector had enough problems without taking on Lehman’s. And he wouldn’t answer my questions about how we could get his government to yes. I tried to emphasize that global stability depended on the deal, that delay was tantamount to a veto.

  “Good luck,” McCarthy replied.

  I walked into Hank’s temporary office. “We’re fucked,” I said.

  We didn’t believe we had the legal authority to guarantee Lehman’s trading liabilities, even using our “unusual and exigent” powers under 13(3). And we didn’t believe we could legally lend them the scale of the resources they would need to continue to operate, because we didn’t believe they had anything close to the ability to repay us. Hank called Alistair Darling, the U.K. finance minister, to see if he could waive the requirement for a shareholder vote so that Barclays could guarantee Lehman’s book immediately. Darling wouldn’t do it.