Stress Test

  “He said he didn’t want to import our cancer,” Hank told me.

  He sounded shocked and deflated. When we went downstairs to tell the bankers that the consortium would not be necessary—and that they should prepare for a harrowing Monday—Hank announced in his inimitably blunt style that the British had screwed us. Chris Cox, a former congressman who still carried himself like a politician, then strangely thanked the bankers for their patriotic service to the nation. “Those were generous words—more generous than the people in this room deserve,” I grumbled. I was in too dark a mood to congratulate bankers for trying to protect themselves from a life-threatening storm they had helped cause.

  As frustrated as we were, the British regulators had legitimate concerns. Their banking system was five times larger than ours as a percentage of their economy; in some ways, it was also more vulnerable. They didn’t think Barclays was strong enough to take on the vast bulk of Lehman’s risk during a time when the world was deteriorating rapidly. It’s possible that their concern was increased by their sense that the Fed wasn’t willing to take part in the deal, since we hadn’t committed to put skin in the game as we had with Bear. In the end, I’m confident the Fed would have helped finance a deal with a willing buyer, and I think Hank would have supported that, no matter what his people had told the press. But Fed assistance would not have eliminated the risk to Barclays, much less the British requirement for a shareholder vote, and I don’t see how it would have changed the British position.

  In any case, we were out of options. We had shown with Bear that we could facilitate the rescue of an investment bank by another financial institution, but without a willing buyer, we didn’t think we could legally do the rescue ourselves. We had shown that we could push the boundaries of our authority to take on some modest risk, but the Fed’s emergency authorities limited how much risk we could take; we were the central bank of the United States, and we weren’t going to defy our own governing law to lend into a run. We could make loans to solvent institutions against solid collateral. We had some discretion about what we deemed solid, but we couldn’t inject capital to repair Lehman’s hole, and we couldn’t guarantee Lehman’s obligations.

  Hank and I got on a speakerphone to brief Ben and Don that Barclays was out and Lehman was going to fail. “It’s going to be a calamity,” I said. They asked if I had an alternative plan, but I didn’t. We were out of ideas for the moment.

  At that point, all we could do was to try to limit the damage from Lehman’s collapse. We decided to amplify the power of our liquidity programs, substantially expanding the scope of our lending facilities for investment banks and commercial banks to prepare for a further erosion of market funding. We agreed to accept any collateral that could be used in tri-party repo for loans through the PDCF. We would also exchange Treasuries for securities rated as low as BBB-minus through the Term Securities Lending Facility instead of insisting on AAA-rated paper. And we decided to continue to lend tens of billions of dollars to Lehman’s broker-dealer arm, secured by its higher-quality assets, until it could wind down its trades. We hoped this could soften the blow to the system.

  The only good news that Sunday evening—and it was very good news, though we weren’t in a celebratory mood—was that Bank of America agreed to buy Merrill Lynch for $29 a share, a $50 billion transaction in the nick of time, removing at least for the moment another gigantic threat to stability.

  AIG, by contrast, was still in dire straits. And my team studying the potential effects of its failure was deeply concerned about contagion. AIG insured the lives, health, property, vehicles, and retirement accounts of millions of American households, and it insured 180,000 businesses that employed two-thirds of the U.S. workforce. It also had $2.7 trillion of derivatives contracts, and its credit default swaps provided much of the financial system with protection against disaster. If it collapsed, the world’s largest financial institutions would suddenly find themselves without the benefit of that catastrophic risk insurance just when they needed it most. A default could also create uncertainty around AIG’s retail insurance businesses, and by extension, damage global confidence in the insurance industry.

  Still, Willumstad’s latest proposal—he wanted the Fed to lend AIG $40 billion to get the rating agencies off its back—seemed like another bridge to nowhere. Even though Lehman’s imminent failure would make the system more fragile, and more vulnerable to the sudden collapse of another systemic firm, I still wasn’t convinced we had a viable way to save AIG.

  We had one additional problem that night: Lehman’s board was refusing to admit it was lights out. During the crisis, we always tried to avoid panic by making big announcements on Sunday nights before Asian markets opened, so investors would have as much time as possible to digest the information. But Asia had already opened and Lehman had yet to announce its bankruptcy filing. The 158-year-old firm was still hoping for a last-minute reprieve.

  Hank and I pressured Cox to stop hesitating and get Lehman to file. This would be the largest bankruptcy in U.S. history by far—Lehman was six times the size of WorldCom—and Cox was reluctant to tell its executives what to do. He didn’t want their blood on his hands. But we needed to announce our expanded liquidity programs, without giving the impression they could be a lifeline for Lehman. Hank, who had lost patience with the SEC, yelled at Cox to pick up the phone and get Lehman to move.

  “You guys are like the gang that couldn’t shoot straight!” he said.

  Cox eventually called Lehman’s board, with my counsel Tom Baxter on the phone, and together they made it clear there was no other option. Lehman finally filed at 1:45 a.m.

  I felt defeated. We had tried to do what we could with the powers we had, improvising strategies on the fly, but the fire was burning out of control. We had stretched the limits of the Fed’s authority in all kinds of ways, but those limits were real. The Fed couldn’t carry the burden of averting disaster on its own. We needed the full resources of the U.S. government to be deployed. The political system would have to help rescue the financial system. As Hank and I walked down a corridor back to my office, I said to him: “Now you’ve got to go to Congress.”

  Ben and I had been telling Hank for months that ultimately, there would have to be a comprehensive legislative solution to the crisis, authorizing the government to take a lot more risk. Hank had already used the authority Congress had given him that summer to commit $200 billion to shore up Fannie and Freddie, but it would take a lot more money and authority to shore up the rest of the system. Hank now agreed it was time to seek emergency legislation. The backlash would be brutal, but we couldn’t keep doing late-night repairs with duct tape and comfort letters. We had to avoid another Lehman-style collapse. One would be awful enough.

  I got a few hours of sleep that night in a bedroom in the New York Fed’s Italianate “turret,” a little alcove behind an elevator on the twelfth floor. Tom Baxter told me that during the 1990s, the convicted former CEO of the Bank of Credit and Commerce International had been held prisoner there during legal proceedings related to the BCCI scandal. I would sleep in that dark room for the next two weeks, when I slept at all.

  MY MONDAY began with a call from the ECB’s Jean-Claude Trichet, who had been so complimentary about our Bear intervention. Now he wanted to know, in a French-accented blend of astonishment and derision, whether we had lost our minds. How could we let Lehman go? Why would we want to create a global panic?

  We hadn’t done it on purpose. We had run up against the limits of our authority and the fears of the British regulators. But after all the no-bailouts rhetoric, the world naturally assumed we had consciously decided to teach Wall Street a lesson.

  Much of the media reaction actually suggested Lehman’s failure was a good thing, a fearless act of discipline on our part, a welcome corrective to a festival of moral hazard. On the left, the New York Times editorial page called it “oddly reassuring,” while on the right, the Wall Street Journal declared “the government
had to draw a line somewhere.” I took no comfort from that nonsense. We hadn’t chosen to draw a line. We had been powerless, not fearless. We had tried but failed to prevent a catastrophic default. That’s still poorly understood, in part because Hank and Ben, who had the thankless job of explaining our actions, decided not to admit defeat in public. They thought at the time that confessing we didn’t have the firepower to save Lehman would intensify the panic, which may have been right.

  The panic was intense anyway. The financial markets, contrary to many confident predictions, did not behave as if they were prepared for Lehman’s collapse. Stocks fell nearly 5 percent Monday, with financial stocks such as WaMu (down 27 percent) and Citi (down 15 percent) falling hardest. Hedge funds withdrew $10 billion from accounts at Morgan Stanley, and the cost of insuring against default by Goldman Sachs nearly doubled, as markets began to lose confidence in the investment bank model no matter how strong the individual institution. The commercial paper market seized up; even General Electric, one of the highest rated firms in the world, struggled to borrow to roll over its massive financial subsidiary’s short-term funding. And the yields on one-month Treasuries plunged from 1.37 percent to a mere 0.36 percent, a chilling flight to safety.

  The most extreme flight was from AIG, whose shares dropped another 60 percent to less than $5 after drastic downgrades by the rating agencies, a harsh landing for a stock that traded above $150 at its peak. The state of New York gave the firm permission to use $20 billion from its regulated insurance subsidiaries to meet its margin calls at AIG Financial Products, but the temporary relief only highlighted its desperation. The company was bleeding to death.

  The more our Fed team studied AIG and the insolvency regime for insurers, the less confidence they had in the potential for an orderly resolution. And the deeper they got into the firm, the more they feared its collapse would critically damage a system that was already on the brink. Virtually every major financial institution in the world had some exposure to AIG. Some of those positions were hedged, but it wasn’t clear whether the hedges would be of much value in a collapsing financial system. And even if the direct exposures to an AIG default didn’t seem crippling, the danger lurked in the market reaction to AIG’s failure, which would increase the expected probability of other failures. No one would know who was safe, so everyone would tend to assume the worst about their counterparties, a recipe for escalating fire sales and liquidity shortages. A series of memos from my staff warned of multiple spillover effects. For example, European banks that had lowered their capital requirements by buying protection against credit risks from AIG would lose that protection, so they would suddenly face $18 billion in increased capital requirements at the worst imaginable time to raise capital.

  There was little hope of finding a private-sector solution for AIG, but I thought we had to make a good-faith effort to explore one. After consulting with Willumstad, I asked JPMorgan and Goldman Sachs to send their top bankers to the New York Fed that morning, and see if they could arrange a credit line for AIG. “Do not assume you can use the Fed balance sheet,” I said. The group soon concluded that AIG needed at least $75 billion just to stay alive. With capital markets freezing up after the Lehman default, it seemed implausible that banks would be able to find that kind of cash. They were hoarding liquidity. They didn’t have billions of dollars lying around to risk on a massive insurer that was bleeding liquidity. They had to worry about protecting themselves.

  That left the Fed as the only realistic option. Lending to an insurer still felt like a serious Rubicon to cross, but we had crossed plenty of Rubicons. As Ben pointed out, the troublesome parts of AIG behaved more like an investment bank than an insurer, and we were already lending to investment banks. Ben and Hank both recognized before I did that we had to do something about AIG.

  It was hard to feel light while the world burned, but the acerbic Barney Frank, who shared my aversion to moral hazard fundamentalism, made me smile on a call that Monday. If nothing else, he mused, the terror of the free fall could dampen enthusiasm for government inaction, and shock the political world into taking the crisis seriously.

  “Maybe this will shut up the crazies,” he said.

  YOU KNOW things are dark when you have to convene a 3 a.m. conference call. I began the call with top Treasury and Fed officials by reviewing AIG’s systemic risks. The U.S. financial system seemed even more exposed to AIG than it had been to Lehman. Europe and Asia were also more exposed to AIG. And not only was AIG larger than Lehman, with a more complex derivatives book, its decline had been much swifter, which would be even scarier to markets.

  “If they default, you’ll see default probabilities explode on all financial firms,” I said. In other words, mass panic on a global scale.

  A few days earlier, I thought there was no way we should help an insurance company. By early Tuesday, September 16, I had changed my mind. Letting AIG fail seemed like a formula for a second Great Depression. It was essential that we do everything in our power to try to avoid that.

  That morning, JPMorgan and Goldman told me they definitely couldn’t arrange a private loan to AIG. Now we had to decide whether we had the legal authority to act. By law, the Fed can only lend against reasonably solid collateral, but I thought AIG could clear that hurdle, even though Lehman had not.

  Investment banks rely almost entirely on trust and confidence. They’re nothing without their reputation for stability. That’s why old bank buildings are usually made of stone, with massive pillars in front of them, and that’s why Bear and Merrill—as well as Lehman—needed buyers once their own reputations for stability were shot. But AIG was different. It had more than a brand name. It had seventy-four million policyholders in 130 countries who paid it premiums. Unlike the investment banks, whose franchise value consisted mostly of the willingness of other firms to trade with them, AIG had a vast global empire of income-generating insurance businesses, which over time could offset the losses from its quasi hedge fund. I called Warren Buffett later that morning to see what he thought about the earnings power of AIG’s traditional insurance subsidiaries. He was pretty positive about their underlying value, which made me more confident that we could meet the legal test of being secured to our satisfaction. Those insurance businesses would have a good chance of retaining their value if their parent company didn’t go down.

  I spoke to Ben Bernanke, Hank Paulson, Don Kohn, and Kevin Warsh early Tuesday morning before a regularly scheduled FOMC meeting, which my colleague Chris Cumming attended in my place so that I could deal with the crisis. I told them it now looked like AIG would need a loan of $85 billion, an almost incomprehensible amount at the time. “It has to be big if you want it to be decisive,” I said. I acknowledged that any rescue would create some moral hazard, not to mention a why-AIG-but-not-Lehman? public relations challenge. “I don’t have the burden of explaining to the public the zig and the zag,” I said. That unpleasant privilege, I pointed out, would fall again to Ben and Hank.

  We would be exposing the Fed to the risk of an imploding insurance company, and there was a real possibility that our loan would simply buy the world time to prepare for a horrific default. Kevin was uncomfortable, understandably so. We all were. But I argued that rescuing AIG was our least-worst option. It would look like a lurch, but within the limits of our authority, it was our only hope of averting unimaginable carnage.

  “We’ve got no viable alternatives,” I said. “We’re in the devastating position of having no power to fully protect the system from the consequences of default.”

  While we were considering whether to act, we learned that AIG was preparing to file for bankruptcy. I immediately called Willumstad. “Don’t do that yet,” I said. When he asked why, I told him the Fed was considering some help. That was the end of Washington’s no-bailouts stance.

  Ben decided we couldn’t risk another sudden collapse of a systemic institution at a moment of such intense turbulence. And Hank agreed to write another comfort letter p
ledging Treasury’s support for the Fed’s efforts to save AIG.

  We were in the grips of a financial hysteria much worse than I had seen in Mexico, Indonesia, or Korea. British regulators had frozen some of Lehman’s client accounts, so overseas hedge funds were scrambling to retrieve their funds from Goldman Sachs and Morgan Stanley to avoid similar fates, even though both firms had reported decent earnings that day. Meanwhile, U.S. depositors were withdrawing about $2 billion a day from WaMu, twice as much as they had withdrawn after the run on IndyMac. The “TED spread,” a measuring stick for fear in the banking system, was about to surpass the record set after the 1987 stock market crash.

  Tuesday’s most chilling development outside AIG was a money market fund “breaking the buck,” which meant it could no longer promise investors 100 cents on the dollar. Money market funds were widely viewed as virtually indistinguishable from insured bank deposits, as similarly safe vehicles for storing cash with slightly better interest rates. But many money market funds had invested in commercial paper and other instruments that turned out to be riskier than they had thought. One fund, the Reserve Primary Fund, had even added to its stash of Lehman paper over the summer while everyone else was unloading it, which sparked a run on the fund after Lehman fell. The Lehman paper made up only about 1 percent of the $62 billion fund, but since the fund had no capital buffers to absorb losses, that was enough to create the stench of death; by that evening, the flood of requests for redemptions amounted to nearly two-thirds of the fund.

  The Reserve Fund asked the New York Fed for help to avoid breaking the buck, but my team said no. We didn’t think we could stop the run, and agreeing to their request would have amounted to an implied backstop for the entire $3.5 trillion money market industry. The Fed didn’t have the legal authority to guarantee money market funds and protect their investors from losses.