Stress Test

  Nothing was working. John Mack talked to Pandit, but a Morgan Stanley merger with Citi would have raised similar drunks-in-a-ditch problems. China’s sovereign wealth fund explored an investment in Morgan Stanley, but the talks fell apart quickly. Mack told us the Japanese bank Mitsubishi UFJ was interested in a major investment, but Hank and I were skeptical. We told Mack he needed a faster, more enduring solution, and we pressured him to try Jamie again. Mack basically told us to let him do his job. The perception that I was racing to arrange a bunch of shotgun weddings apparently led some Wall Street executives to dub me eHarmony.

  On Sunday, Bill Dudley and Terry Checki, another top New York Fed official, walked into my office and said what I had been reluctant to admit to myself: There was no way we were going to be able to force Goldman and Morgan into the arms of Citi and JPMorgan, and even if we could we might just end up fatally weakening two banks at the center of the system. They had an alternative. We would convert both investment banks into bank holding companies like Citi and JPMorgan, if they would commit to raising a substantial amount of capital immediately. The change in status wouldn’t do much to affect their access to financing from the Fed—they were already borrowing from the Fed through the PDCF and TSLF against a broad range of collateral—but it would create the impression that they were under the umbrella of Fed protection.

  I didn’t think that impression alone would save Goldman and Morgan Stanley, so the additional capital was non-negotiable; I said we wouldn’t accept “naked” bank holding company designations. But they had less trouble raising capital than I had feared. As he had predicted, Mack secured a $9 billion commitment from Mitsubishi in exchange for 20 percent of his firm. Goldman Sachs attracted a $5 billion investment from Warren Buffett, a welcome show of confidence in America’s financial system from America’s top investor, and another $5 billion in capital through a public offering.

  We had at least temporarily defused two more system-threatening crises. We had also extinguished the stand-alone investment bank model, ending an era of major Wall Street securities firms operating outside Fed supervision without meaningful constraints on leverage.

  Some critics would later say we could have saved Bear and Lehman if we had offered them bank holding company status earlier, but Bear and Lehman were much weaker. The markets had lost confidence in their balance sheets, their ability to finance their assets, and their management. Simply changing their regulator wouldn’t have erased the deep flaws in their businesses. Goldman and Morgan were perceived to be stronger, which is why Buffett and Mitsubishi invested in them in their darkest hour. They had stronger businesses and higher levels of capital and liquidity. The markets simply lost confidence in their ability to survive a general withdrawal of funding. Again, that’s the definition of a financial crisis, a systemic loss of confidence that sweeps up the relatively strong along with the weak, the merely illiquid along with the insolvent.

  Of course, in a financial crisis, insolvency can be in the eye of the beholder. If AIG had been forced to mark all its assets to their depressed market prices during a selling frenzy, then sure, it would’ve been insolvent. Just about every financial firm would’ve been insolvent. But we thought that once the crisis passed and asset prices once again reflected some notion of their true underlying value, there was a reasonable chance AIG’s assets would be worth more than its liabilities. We were ultimately right, though we helped make that true by the cumulative force of the actions we took to rescue the financial system and broader economy.

  By contrast, Lehman looked insolvent in almost any state of the world. There was a reason potential buyers were aghast when they saw its books. It had chased the boom for far too long; as late as May 2007, it led financing for a wildly overpriced $22 billion acquisition of the real estate firm Archstone. Bank of America, Barclays, and the Wall Street consortium all thought it had a capital hole in the tens of billions of dollars. One 2013 study estimated Lehman was at least $100 billion in the hole when it filed for bankruptcy, possibly as much as $200 billion. And unlike AIG, which had strong revenue-generating insurance businesses unrelated to its trading book, Lehman had nothing but its overvalued assets and its damaged reputation as a trading house. If we had done for Lehman what we did for AIG, we just would have financed a run on an unsalvageable institution. We didn’t believe its core investment banking business was strong enough to generate the resources necessary to cover the losses in the rest of the firm.

  Today, though, the world still believes we made a conscious choice to let Lehman go. That’s the standard journalistic account, shared by many economists and financial players. It’s understandable, considering what we did with AIG and others later, and considering the initial Washington comments; they were designed to avoid the damaging (though accurate) perception that we had been powerless to save a large and interconnected institution, but they helped feed the myth that we had chosen failure. Even some of my former colleagues at the Fed and Treasury still think we could have rescued Lehman; Alan Greenspan said so publicly. But I do not believe we could have done it without violating the legal constraints placed on the Fed, and without damaging our ability to deal credibly and effectively with the terrible challenges still ahead of us. To save Lehman, we would have needed a private company willing and able to buy most if not all of it, and we didn’t have one.

  Some critics have argued that in a truly existential crisis, central bankers have responsibilities that transcend the law. They say we should have done whatever had to be done to avoid a chaotic collapse of Lehman and worried about the consequences later. We had shown that we were willing to be creative, break precedent, and take substantial risk to try to preserve the stability of the financial system. But we were not going to grant ourselves extralegal power.

  Even in a world where we somehow rescued Lehman, and then still went ahead and rescued AIG, we would not have eliminated the fundamental factors driving the crisis. The economy was collapsing, and the financial system would have kept lurching toward disaster—undercapitalized, overleveraged, still burdened by mortgage assets the markets wouldn’t touch, still under threat of a broader run. It took the fall of Lehman and the impending collapse of AIG to persuade President Bush and Hank to seek legislative authority to try to repair the entire system. And even in the post-Lehman panic, Congress would not grant that authority until it had another opportunity to stare into the abyss.

  IN THE heat of the existential weekend, Hank sent Congress his draft legislation for the Troubled Assets Relief Program, better known as TARP, or “the Wall Street bailout.” His bill requested $700 billion to buy mortgage-related assets, with almost no limits on his authority. It described the Treasury secretary’s decisions under TARP as “non-reviewable,” stating that they “may not be reviewed by any court of law or any administrative agency.” The entire draft was only three pages. It made no effort to establish conditions on recipients of the emergency relief or provide relief to foreclosed homeowners. It was really just a set of bullet points, even though it was presented as the basis for legislative text.

  Congressional leaders, who had seemed shell-shocked but willing to act after Hank and Ben warned them about a second depression on Thursday evening, now just seemed angry. “This proposal is stunning and unprecedented in its scope—and lack of detail, I might add,” said Senate Banking Committee Chairman Chris Dodd. “I can only conclude that it is not just our economy that is at risk, but our Constitution as well.” Many congressional Republicans, after eight years of almost unbroken support for the Bush administration, were even more hostile to Hank’s draft. “It is aimed at rescuing the same financial institutions that created this crisis,” declared Dodd’s Republican counterpart, Richard Shelby. Editorial boards savaged the plan as an outrageous power grab and a taxpayer giveaway to Wall Street.

  I liked it. While Hank’s legislative tactics might have been a bit unsubtle, I thought his bill’s sweeping grant of authority to the executive branch was essential. We don’t
expect Congress to micromanage battle plans during wars, and I felt the same way about financial wars. I had little faith in Capitol Hill’s ability to design a smart bill with adequate firefighting tools at that fraught populist moment of fear and anger and ignorance. Congressional switchboards were lighting up with calls clamoring for Old Testament justice, but this was not the time to focus on punishing the arsonists. It was the time to focus on putting out the fire.

  In fact, my initial concern with the language in Hank’s proposal to Congress was that I wasn’t sure it granted Treasury broad enough powers. Publicly, Hank was pledging to use the $700 billion to buy toxic assets, not explicitly to invest in financial institutions, but Ben and I wanted to make sure he also had the authority to inject capital directly into banks. We were pretty sure that would be necessary, as it had been for Fannie and Freddie; historically, that’s how banking crises get solved. I thought toxic-asset purchases might be helpful, but I wasn’t sure how they would work. But once I was sure the language in the bill was broad enough to allow capital injections as well, I was fine with it.

  As long as TARP could be used to recapitalize the system, I just wanted Congress to pass it as fast as possible while screwing it up as little as possible. I know this sounds terribly antidemocratic, but it was ridiculous, at a time when we needed overwhelming force to do unpopular things, to expect elected officials to design the details of an exceedingly complicated rescue in the midst of a full run on the global financial system. I remember Rahm Emanuel, a House Democratic leader who needed his mouth washed out with soap even more than I did, called me to say he had a great fucking idea: What if we broke TARP into two $350 billion tranches, with separate congressional approval required for the second tranche?

  “No, that’s a terrible fucking idea!” I replied.

  I argued that it would be hard enough to get politicians to take a tough vote to save their country once. Why try to force them to do it twice?

  With his usual subtlety, Rahm let me know I was an idiot. He said Congress would never just hand Hank a $700 billion check. I realized he was not really asking my opinion about a plan he had in mind. He was informing me about a plan he had already put in motion.

  I didn’t press the point. I figured Rahm knew the politics of Washington better than anyone. And I had a couple more existential crises to worry about.

  SIX

  “We’re Going to Fix This”

  On Monday, September 22—one week after Lehman disappeared, one day after the independent investment bank model disappeared—France’s president, Nicolas Sarkozy, summoned me to his suite at the Carlyle hotel. He was in town for the UN General Assembly. He wanted to talk about the crisis.

  I had hosted a lunch for Sarkozy at the New York Fed back when he was a candidate, and I thought he was pretty compelling—direct, confident, admiring of the United States, open about France’s challenges. This time, we had barely sat down before he started yelling at me about Lehman Brothers. He was upset about its ruinous collapse, but he was especially enraged about a story in that morning’s Wall Street Journal about some assets Lehman had transferred out of Europe before going bust. President Sarkozy was convinced we had conspired to hurt French investors.

  I was not in a diplomatic mood, and I cut off Sarkozy mid-rant.

  “Mr. President, you’ve been badly briefed,” I said. “Nothing you’re saying is true.”

  President Sarkozy seemed surprised—he wasn’t accustomed to rude interruptions—and his aides seemed appalled. But he quickly calmed down, and we had a good conversation. He must have sensed my exhaustion. I had just been through a bad week for the ages. And the next week wasn’t looking any better.

  THE FALL of Lehman was a symptom of the unsustainable leverage and runnable short-term financing throughout the system that made the broader crisis inevitable. If Lehman had found a buyer or some other way to avoid a disorderly collapse, AIG or some other firm would have played the Lehman tipping-point role. Lehman was acutely vulnerable, but not uniquely vulnerable. It had built the farthest out in the floodplain, but it wasn’t the cause of the flood. Ken Garbade, an excellent economist at the New York Fed, compared the financial system that September to an egg standing on its end. Any breeze could have blown it over.

  That said, the fall of Lehman was a serious blow, shattering confidence around the world. It was the most destabilizing financial event since the bank runs of the Depression. Corporate bond spreads widened twice as much after Lehman as they widened after the crash of 1929. The Fed had to quadruple its foreign exchange swaps to meet the global scramble for dollars over the next two weeks. The $20-billion-a-month market for securities backed by credit cards, auto loans, student loans, and other consumer credit virtually vanished overnight. In the broader economy, businesses that saw demand and credit drying up—and saw their suppliers and customers facing the same problems—began downsizing their staffs and reining in their investments to prepare for the long winter ahead. There was political fallout, too; after Senator McCain observed on the day Lehman blew up that “the fundamentals of the economy are strong,” Senator Obama took a lead in the polls that he never relinquished.

  After Lehman, I lost whatever minimal tolerance I might have had for letting moral hazard or political considerations impede our efforts to attack the crisis. I supported anything that would discourage running or encourage investing; I opposed anything that would weaken confidence or stability. We had to do whatever we could to help people feel their money was safe in the system, even if it made us unpopular, even if it helped individuals and institutions that didn’t deserve help.

  But when the next financial domino fell, we didn’t act to restore confidence. In one of the least appreciated episodes of the crisis, the U.S. government made things worse.

  The domino was Washington Mutual, the nation’s largest thrift, another big player on the frontier of the mortgage market. WaMu had been racking up losses throughout the crisis, and its stock price had dropped 90 percent. After Lehman fell, depositors pulled $17 billion out of WaMu in ten days, and even its forgiving regulators at the OTS could no longer vouch for its health. The FDIC usually waits until Fridays to close failing banks, so it has the weekend to prepare for a smooth reopening under new management, but WaMu faced such a frenetic run that the FDIC shut it down that Thursday.

  WaMu was slightly smaller than Bear Stearns, with about $300 billion in assets, but it was by far the largest FDIC-insured bank ever to fail. It was ten times the size of IndyMac, and almost four times the inflation-adjusted size of Continental Illinois, the bank whose 1984 rescue by the FDIC spawned the term “too big to fail.” A crisis so many had dismissed as a Wall Street problem, irrelevant to Main Street, had just claimed a major victim inside the traditional banking system.

  Sheila Bair, a former Republican Senate staffer who was President Bush’s FDIC chair, quickly agreed to sell WaMu for $1.9 billion to JPMorgan Chase, which would take over the failed bank’s uninsured and insured deposits. But the FDIC did not require JPMorgan to stand behind WaMu’s other obligations, as we had required it to do for Bear Stearns, leaving WaMu’s senior debt holders exposed to severe losses. That sounded like a nice deal from JPMorgan’s perspective—it had coveted WaMu’s West Coast and Florida banking branches to complement Chase’s traditional East Coast operations—but I thought it would be a disaster for the nation.

  As the emerging-market crises and the entire history of financial crises made clear, imposing haircuts on bank creditors during a systemic panic is a sure way to accelerate the panic. Lehman had been a chilling reminder of how rapidly inchoate fear could escalate when lenders didn’t get paid back. Bank creditors couldn’t be sure which institutions might end up like Lehman or WaMu, so they ran from everyone rather than risk getting burned by a default. Even those who didn’t think the situation necessarily called for running often felt like they had to run when they saw others running.

  In most states of the world, haircuts are a perfectly sens
ible response to failure. In my time at the IMF, I had supported requiring haircuts for bondholders as a condition of assistance to Ecuador and Pakistan, because those crises were not systemic. There didn’t seem to be much contagion risk. The message sent by those haircuts was that Ecuador and Pakistan had been unsafe investments, not that countries or even emerging markets were unsafe investments. Creditors lost money, but lending is a risky business.

  The investors who bought WaMu’s debt also should have known the risks; governments shouldn’t get in the habit of guaranteeing bad bets. And the FDIC was required by law to resolve failed banks through a “least cost” approach that minimized the hit to its deposit insurance fund; standing behind WaMu’s debts could have exposed the fund to serious losses. But Congress had provided the FDIC with a “systemic risk exception” that gave it the flexibility to protect bank creditors in moments of extreme instability. I couldn’t imagine a more extreme situation. What was the point of systemic risk authority if it didn’t apply to the worst systemic emergency since the Depression? Imposing losses when we had the power to prevent them would send a clear signal to other creditors of U.S. banks that they too were exposed to losses and should put their money somewhere safer if they didn’t want haircuts.

  It seemed obvious to me that in a moment of extreme vulnerability, haircuts would only intensify the crisis, but Sheila didn’t see it that way. She was determined to guard against moral hazard and protect the FDIC insurance fund. She saw this as a teachable moment, a chance to show the world that the irresponsibility of WaMu and its bondholders would be punished. She made the same argument the Germans and other moral hazard critics had made against IMF assistance during the emerging-market crises: It will only encourage bad behavior in the future.