Stress Test

by Timothy F. Geithner

  “Ridiculous request,” Don Kohn agreed in an email.

  Still, the break-the-buck incident had cast suspicion on all prime money market funds. Institutional investors would withdraw more than $300 billion over the next week. The Reserve Fund debacle discouraged risk taking by other money funds, which meant even less buying of commercial paper and less lending through repo, which meant an even more intense liquidity crisis for banks and other institutions. Basically, short-term financing—whether secured by collateral or not—was vanishing. No collateral, no matter how safe historically, was viewed as truly liquid, because there was simply no liquidity in the system to buy it. This would have been the textbook definition of a panic, except no textbook had recorded anything like it.

  It is a testament to the insanity of that time that the Reserve Fund news barely registered with me. Everything was falling apart around us, and I was consumed with designing a proposal for AIG. At 4 p.m., we sent its board the terms for its survival, very similar to the tough terms the private bankers had come up with when they were trying to raise private financing. The New York Fed, with the approval of the Fed board in Washington, would provide an $85 billion credit line to AIG at a penalty interest rate of more than 11 percent; in return, AIG would provide 79.9 percent of the firm, so taxpayers would get most of the benefits if it survived. Hank and I also informed Willumstad that he’d be out as CEO; Hank had persuaded former Allstate chief Ed Liddy to take the job. The government wouldn’t have control of AIG, but we thought we had to install new leadership. Hank and I made it clear we needed an answer soon.

  Willumstad quickly called back with AIG’s lawyers, including the inevitable Rodge Cohen, to ask whether we would soften some of the terms.

  “These are the only terms you’re going to get,” I said.

  The board concluded—correctly, I thought—that AIG’s shareholders would be even worse off in a bankruptcy, so they called back to accept an hour later.

  AIG had told us earlier in the day that it would need $4 billion to make it to morning. Once again, they had dramatically underestimated their problems. They now asked to draw down $14 billion. We had to keep the government’s payment system open late to wire them the cash. And they had to rush collateral in the form of stock certificates and other securities over to the New York Fed in briefcases and grocery carts. They would need $23 billion more over the next three days.

  Before that week, it would have been hard to fathom the Fed lending into a run and being provided a four-fifths stake in a trillion-dollar insurance company. We had torn down yet another wall between the commercial banking sector and the rest of the financial system. We were appalled by what had happened at AIG, but we were determined to do whatever we could to stabilize the system, protect the broader economy, and avoid the kind of mass suffering Americans experienced during the Great Depression.

  “Central banks exist to take out the extreme tail, the catastrophic risk,” I said that night in a briefing for journalists. “In times of crisis, you will do things you thought you’d never do.”

  I knew we’d be accused of rewarding incompetence, of throwing public money down a rat hole. But I believed we had gotten taxpayers a reasonable deal, not just in the financial terms of the loan, but by avoiding even more severe damage to the economy. I’d soon get some early validation of that when Hank Greenberg, AIG’s hard-driving former chief executive and a major shareholder in the firm, visited me to complain that the Fed had been given too much equity in AIG, too much of the upside. I was a bit shocked by the audacity; basically, he wanted us to give back a big chunk of the company. I told him we hadn’t done the deal to make money, and we’d be happy to sell him back some of the equity if he’d be willing to take some of the risk. But what interested me was Greenberg’s confidence that we’d get a positive return from AIG, rather than the tens of billions in losses that everyone else seemed to expect. He’d be right about that, but only because of the force of the government’s actions to stabilize the company and the broader financial system over the next few years. He and other AIG shareholders would end up suing the federal government, claiming that we had been unjustly harsh to the firm we rescued.

  The general reaction to the AIG loan was stunned outrage of a very different kind, and we made no progress in persuading Americans that the rescue had been a prudent and necessary act to protect Main Street from a failing financial system. I never watched TV news, unless you count The Daily Show, and I tried not to read press accounts of our actions. But I knew we were losing the battle for public support.

  In a futile gesture against the overwhelming consensus, I did call a New York Times editor to complain about a damaging story portraying the AIG rescue as a backdoor bailout for Hank’s former colleagues at Goldman Sachs. I had asked Lloyd Blankfein about Goldman’s direct exposure to AIG; when he assured me Goldman’s exposures were relatively small and fully hedged, I made him send me the documentation. Still, the Times wouldn’t correct the record, and my call probably strengthened its suspicions. The same reporter later did a story portraying the entire crisis response team as servants of Goldman, accompanied by a vampire squid–like diagram with me in the middle. In the media, in the public, even in the financial community, we faced withering skepticism about our motives as well as our competence. After all, we had lent a mismanaged insurance company three years’ worth of federal spending on basic scientific research.

  Even Jamie Dimon told me he was surprised we had taken so much financial and political risk over AIG.

  “I don’t know if I would’ve done that if I were you,” he said.

  BY THURSDAY morning, September 18, panic was engulfing the system.

  Yields on short-term Treasury bills had dipped into negative territory, which meant investors were so afraid to invest they were paying the government to hold their savings. Banks such as Wachovia and Bank of New York were scrambling to prop up money market funds they had sponsored in order to prevent them from breaking the buck. The over-the-counter derivatives market was paralyzed. And the investment banks were under siege. Morgan Stanley’s clients pulled an astonishing $32 billion out of the firm on Wednesday, more than the annual economic output of Panama or Jordan; its credit default swaps had tripled since Lehman fell. Even Goldman Sachs, the strongest of the investment banks, watched helplessly as half its $120 billion in liquidity evaporated in a week. While the backdoor-bailout conspiracy theorists railed about Goldman making a killing, in the real world, Goldman was getting killed.

  Blankfein called me that morning before the markets opened. I thought of him as one of the calmer, stronger, smarter forces on Wall Street. He sounded shaken, though perhaps he was just trying to make sure I was sufficiently scared. I don’t remember what we discussed about Goldman’s plight, but I do remember that a few seconds after I hung up, I called him back.

  “Lloyd, you cannot talk to anyone outside your firm, or anyone inside your firm, until you get that fear out of your voice,” I said. “You can replace it with anger or you can cover it up. But you can’t let people hear you like that.”

  At that moment, fear was a sign you were awake and intelligent. Anyone who wasn’t scared had no idea how close we were to the abyss.

  I was scared, too. It looked like the system was going to collapse, taking down the strong firms along with the weak. We had just suffered a financial shock worse than the one that had led to the Great Depression. Market volatility was more than a third higher than it had been after the crash of 1929; bond spreads would rise more than twice as high; the percentage of household wealth lost would be more than five times worse than in 1929. When I spoke to Blankfein, I thought the investment banks were doomed, and I was worried about several major commercial banks. As the unprecedented runs on money market funds and commercial paper accelerated, a wave of defaults by major nonfinancial corporations seemed likely as well. My colleagues and I thought we were looking at another global depression that would hurt billions of people.

  The
world was looking to us, and I knew the Fed alone didn’t have the authority to prevent disaster. It was a horrible feeling. I tried not to be paralyzed by it or sit around whining about our limited options. I tried to be disciplined about focusing on the problems in front of us, thinking about ways we could help make things better, trying to anticipate where the fire would spread next. Keeping busy helped. I spent countless hours on the phone, not only with Ben and Hank and my other colleagues in government, but with just about everyone who mattered in global finance, trying to get a feel for the texture of the markets, the new seams of panic. I talked with Carole, who listened patiently, asked good questions, and gave her thoughtful therapist take on the public reaction to our decisions. We often discussed medical analogies for the crisis—contagion, triage, intensive care, clogged arteries, and cardiac arrest.

  I tried to work out every morning and used that time to think. During the weeks I slept in the turret, I would run along the Hudson, weaving through the early commuters as they trudged to work in the towers of Wall Street, trying not to dwell too much on our responsibility for their fate and the nation’s fate. I ran without my security detail, although they later told me they tried to trail me in a car. I needed to keep moving, which was also my basic philosophy about the crisis. Inertia was the enemy. At my desk, I would scribble boxes and arrows and circles on sheets of Xerox paper, visual representations of our options, as if I were drawing up plays.

  I didn’t have a way to explain the terror of those days until later, when I saw The Hurt Locker, the Oscar-winning film about a bomb disposal unit in Iraq. What we went through on interminable conference calls in fancy office buildings obviously did not compare to the horrors of war, but ten minutes into the movie I knew I had finally found something that captured what the crisis felt like: the overwhelming burden of responsibility combined with the paralyzing risk of catastrophic failure; the frustration about the stuff out of your control; the uncertainty about what would help; the knowledge that even good decisions might turn out badly; the pain and guilt of neglecting your family; the loneliness and the numbness. I liked the protagonist’s deadpan response when he was asked the best way to defuse a bomb: The way you don’t die. In other words, the way that works.

  Throughout the crisis, I felt better, or at least less terrible, whenever we were doing stuff, fighting back, trying new things. The Lehman aftermath was absolutely horrifying, transmitting panic through global markets like never before, but as Barney Frank’s comment suggested, there was something liberating about it, too. It was an unwelcome vindication of the case for action. As much as the public hated bailouts, we were pretty sure people would hate the consequences of uncontrolled default even more. And I had learned during the nineties that the kind of actions that solve financial crises are never popular, that it wasn’t worth trying too hard to make them popular.

  The moral hazard fundamentalists did not stop pressing their case after Lehman. But now that the fire was burning out of control, they were less of a constraint. We could focus more on what to do, how to push the envelope of our existing authority, and how to get the additional authority we needed.

  THE NIGHT Lehman fell, Hank had promised to seek legislation from Congress. But he didn’t go to the Hill right away, and my staff feared the Bush administration was backsliding. During one meandering conference call, my trusted adviser Meg McConnell—a sharp and passionate economist whose criticisms could be withering, even on the occasions they weren’t directed at me—suddenly pressed mute on my speakerphone. She seethed that Treasury needed broader rescue authority yesterday. The world was burning. What more was there to discuss?

  “Just tell the secretary to tell the White House that if they don’t get it quickly, there will be shantytowns and soup lines all across the country!” she yelled at me.

  Hank kept his word, though. On Thursday afternoon, word leaked that Treasury planned to seek authority to buy some of the toxic assets weighing down the system, and the stock market promptly shot up 4 percent. That evening, Hank and Ben went to the Hill to urge congressional leaders to authorize hundreds of billions of dollars in emergency spending to save the economy. Ben warned that if they didn’t act quickly, there wouldn’t be an economy left to save. On Friday morning, Hank publicly announced that he would seek legislation empowering Treasury to buy toxic assets in order to unfreeze the credit markets—and that it wouldn’t be cheap.

  We didn’t have time to wait for a bill to emerge and wind its way into law. The markets, to use Ben’s medical analogy, were in anaphylactic shock. We had two death spirals we needed to stop immediately: the run on money market funds, which was killing the market for the commercial paper that provided America’s top corporations with short-term operating loans, and the run on investment banks, which was threatening to ignite two more Lehman-style explosions.

  The Fed had already put in place an alphabet soup of innovative credit and liquidity programs—the TAF, TSLF, and PDCF, largely designed by my staff in New York, working with a small group from Washington. In the days after Lehman, they created another one, the AMLF, an unwieldy acronym for the even more unwieldy Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. The AMLF was an effort to revive the market for high-quality asset-backed commercial paper, which had shut down after Lehman fell, while easing pressures on money funds, which began dumping the paper after the Reserve Fund broke the buck. It used a slightly circuitous approach to arrest this cycle, lending to banks so they could buy asset-backed commercial paper from money market funds—with the Fed taking the risk. We announced it that Friday morning. Within two weeks, it was financing $152 billion worth of commercial paper, helping financial institutions and some of America’s largest companies make payroll and make investments.

  That same morning, Hank announced that Treasury would use the Exchange Stabilization Fund, the same fund we’d tapped to rescue Mexico in 1995, to guarantee shares in money market funds, a decisive and effective move. The announcement, combined with our moves to provide liquidity to the broader markets, helped prevent other funds from breaking the buck. It was an illustration of the power of government guarantees. When you can credibly commit to protect people from a catastrophic outcome, they don’t have to act in anticipation of it. When you eliminate the incentive to run, you don’t have to finance a run.

  In fact, Hank’s guarantees were so powerful that FDIC chair Sheila Bair called him to say they could trigger a run on the banking system and threaten her agency’s insurance fund, by encouraging bank depositors with more than $100,000 in their accounts to shift their uninsured cash into money market funds. She was right—and to her credit, she had an alternative plan. She suggested Treasury should guarantee only investments that were in money funds before September 19, removing the incentive to shift cash out of FDIC-insured banks. Hank agreed.

  In yet another announcement that busy Friday, the SEC temporarily banned the short selling of 799 financial stocks, a heavy-handed effort to stop the stampede of speculation and rumor mongering. We all had reservations about this. It seemed to signal a debilitating lack of confidence in those 799 firms. I thought there was some risk that preventing investors from hedging their exposures would actually accelerate the flight to safety through other mechanisms. It felt like trying to ban risk aversion, or the expression of negative opinions about firms that often deserved them. But Hank, who normally thought banning shorts was like burning books, believed short sellers were creating more stress than the system could handle. Cox wanted broad political cover before he would take action, so Hank asked Ben and me to encourage Cox to act. I figured it was worth a shot. I basically thought we should throw everything we had at the panic, and I really wanted us to stick together. So I told Cox I thought he should go ahead.

  The ban’s most immediate beneficiary appeared to be Morgan Stanley; CEO John Mack was publicly accusing the shorts of sabotaging his firm. Its liquidity pool had shrunk from $130 billion to $55 billion in a week; it was
borrowing nearly $70 billion from the Fed to make up the difference. Its stock price fell 60 percent before word of the short-selling ban leaked. One New York Fed bank examiner reported in an email that a Citi executive had told her: “Morgan is the deer in the headlights.… It’s looking like Lehman did a few weeks ago.” And everyone on Wall Street knew that if Morgan went the way of Lehman, Goldman would be next.

  That would be more stress than the system could handle.

  WE WERE under no illusions that the short-selling ban or even the prospect of broad congressional relief would magically stop the run on the investment banks. Morgan and Goldman needed immediate solutions. As Blankfein put it later, this would be their “existential weekend.”

  We had no good options, but we thought these last stand-alone investment banks might have a better chance at survival if we pushed them into the arms of commercial banks with stronger funding bases. Fed Governor Kevin Warsh, a Morgan Stanley alumnus, helped steer his former firm into merger talks with Wachovia. Wachovia, however, was as vulnerable as Morgan; during the bubble, it had acquired Golden West, a subprime mortgage lender that had even more toxic “pick-a-pay” option ARMs on its balance sheet than Countrywide or IndyMac. I was mindful of the old bank supervisor’s cautionary tale about the drunk who tries to help another drunk out of a ditch, but ends up falling into the ditch himself.

  At that point, however, we thought we had to explore any combination that could avert another Lehman scenario. I got Hank Paulson, Ben Bernanke, and Chris Cox on the phone together to put pressure on Lloyd Blankfein and John Mack to seek partners. I got Blankfein to call Vikram Pandit about merging Goldman with Citi, but they both hated the idea. I urged John Mack to call Jamie Dimon to push them to reunite Morgan Stanley with JPMorgan Chase, remnants of the original House of Morgan. Neither side liked that idea, either. With some encouragement from Rodge Cohen, who represented Goldman and Wachovia, we tried to broker a marriage of those two firms, but Goldman was daunted by what it found in Wachovia’s books. We even considered Fed assistance, but the financials looked uncertain, and the optics were awful. Hank had just received a conflict-of-interest waiver to work on Goldman issues a few days earlier, while Wachovia CEO Bob Steel, another Goldman alum, had been one of Hank’s deputies at Treasury until a few months earlier.