Stress Test

  I thought that in the midst of the worst panic any of us had ever seen, any effort to minimize FDIC losses through haircuts in an individual case would lead to more bank failures and much bigger FDIC losses down the road. More failures would eventually require more aggressive government interventions, creating more moral hazard rather than reducing it. I couldn’t understand why the risks in allowing WaMu to default on its debts weren’t completely obvious, especially after Lehman’s default had paralyzed credit markets and shocked the world. The FDIC was playing with fire. I called Ben, Don, and Hank to try to convince them to turn Sheila around.

  “This is not the moment for more haircuts,” I said.

  They heard me out and acknowledged my concerns, but even though their support would have been needed for the FDIC to use its emergency powers, they couldn’t compel Sheila to use those powers. And they were reluctant to pressure her. Sheila was a formidable advocate for her agency and its insurance fund, savvier about politics and the media than any of us. So despite my objections, the FDIC orchestrated a deal that let WaMu default on its creditors. Shareholders and subordinated debt holders were mostly wiped out, which was understandable. But senior debt holders were exposed to serious haircuts as well. The price of WaMu’s senior debt traded at only 25 cents on the dollar the next day, Friday, September 26.

  As soon as the deal was announced, the perceived risk of lending to U.S. banks increased dramatically. The markets ran first and fastest from Wachovia, a much bigger bank that was also in trouble, and now looked like it could be the next candidate for similar haircuts. The price of insuring Wachovia’s senior debt against default doubled that Friday, while its ten-year bonds swooned from 73 cents on the dollar to 29 cents. Other banks were hammered, too. The cost of insuring Citigroup against default jumped almost 50 percent in a day. The U.S. government had sent a message that creditors of U.S. financial institutions were not safe, precisely the wrong message to send at a time of peril. Wachovia’s creditors were so unnerved they demanded repayment of half the bank’s long-term debt that day, trying to call in more than $50 billion in loans.

  WaMu’s demise did not get much media attention, partly because the world was still processing the shock of Lehman and AIG, partly because an amazing drama was unfolding that day at the White House. Senator McCain had suspended his campaign and swooped back into Washington, ostensibly to seek a solution to the crisis. But after President Bush convened a White House meeting with congressional leaders and both candidates, McCain and House Republicans seemed to scuttle the solution to the crisis, refusing to support TARP. Hank ended up getting on his knees to beg Speaker Pelosi not to abandon the bill because of Republican gamesmanship.

  I understood why the campaign theater overshadowed the WaMu news. And we desperately needed TARP, so the political circus swirling around it was genuinely consequential. Still, WaMu was an overlooked mess that unnecessarily intensified the crisis. WaMu’s demise was in some ways as damaging to confidence as the Lehman debacle, because WaMu’s haircuts were totally avoidable. They sent a message to the world that the U.S. government was not seriously committed to defusing the financial crisis and containing the economic damage, even when it had the capacity to do so, even after the nightmare of Lehman. Perhaps the only good news was that the damage caused by the failure to protect WaMu’s senior creditors led to some important changes in our approach to the intensifying crisis.

  WACHOVIA WAS clearly the next domino.

  It was a big domino, more than twice as big as WaMu, even bigger than Lehman, with a solid funding base of twenty-seven million deposit accounts. But the $800 billion Charlotte-based bank had been choking on Golden West’s bad mortgages since the start of the crisis, and after WaMu’s turbulent collapse, Wachovia was doomed. Depositors withdrew more than $5 billion from Wachovia on Friday. For the third straight weekend, we would have to try to find a solution for a failing giant before the markets opened Monday morning.

  Wachovia had two suitors: Citigroup, which had been America’s largest bank before Bank of America’s recent acquisition spree, and San Francisco–based Wells Fargo, which was less massive but also less vulnerable. By Sunday, both banks had said they could not do a deal unless the FDIC took some of the risk on Wachovia’s questionable assets. Sheila was resistant to anything that could expose the FDIC’s insurance fund to losses, which would translate into higher premiums for all FDIC-insured banks. Sheila’s WaMu plan had been designed to limit the immediate cost to the fund, regardless of the potential damage to the overall banking system. She wanted to replicate that strategy for Wachovia: sell off the bank, wipe out the shareholders and junior debt, and haircut the senior debt.

  “I don’t think the small banks should have to pay for the sins of the big banks,” she explained on a Sunday conference call.

  I lost my composure, and my words were pretty harsh. I felt guilty that I hadn’t been more persuasive in preventing the panic-accelerating haircuts at WaMu. I was frustrated by what I considered the FDIC’s narrow and parochial focus on protecting its fund during a global emergency, when our other tools seemed so limited. I had heard enough moral hazard fundamentalism. And I was sick of the insinuations, so prevalent in Washington, that any advocates of using emergency authorities to quell the panic must be acting at the behest of big banks. The stability of the entire banking system was at risk. The economy was already hurting badly. Trying to teach bondholders a lesson might have felt righteous, but it would ultimately entail more risk for the FDIC if it led to the failures of other banks. Repeating the WaMu haircuts for Wachovia’s senior creditors could have triggered an uncontrollable run on the banking system, a proven formula for an economic depression. It made no sense to keep pouring fuel on a burning fire, accelerating the panic at a time when Hank was asking Congress for $700 billion to calm down the panic.

  “The policy of the U.S. government should be that there will be no more WaMus,” I said.

  That evening, Ben and Don persuaded Sheila to invoke the FDIC’s systemic risk exception for the first time in this crisis, setting aside the “least cost” mandate that would have required haircuts for bondholders. There would be no more WaMus. In a memo justifying the exception for Wachovia, the FDIC’s staff made the late but accurate admission that “the closing of Washington Mutual” was a key source of stress in the system, right alongside Lehman and AIG. Another strict least-cost resolution, they said, “would almost surely have major systemic effects.” No matter what was said publicly, they knew more WaMu-style haircuts could produce another Lehman-style catastrophe.

  At 4 a.m. Monday, Sheila chose Citi’s offer to buy most of Wachovia and stand behind its obligations for just $1 a share. Citi would place $312 billion of Wachovia’s assets inside a “ring fence,” partitioning them from the rest of its balance sheet, but would commit to absorb the first $42 billion in losses from those assets. The government would bear any losses above that, putting a ceiling on Citi’s catastrophic tail risk, reassuring investors that Wachovia wouldn’t drag Citi down if the assets turned out to be worse than expected. The FDIC staff concluded that the Citi proposal was unlikely to cost taxpayers anything, while the Wells offer would probably cost billions.

  Even as she approved the deal, Sheila continued to emphasize her reluctance to put any public money at risk, implying she had bowed to pressure from Treasury and the Fed.

  “I’m not completely comfortable with it, but we need to move forward with something,” she said.

  None of us were completely comfortable with it. Citi and Wachovia both had problems, and I knew their merger raised classic two-drunks-in-a-ditch issues. But all our options were terrible. And Wachovia needed a buyer with a big balance sheet to stand behind its debts, while Citi, which was too dependent on foreign deposits, would benefit from the more stable funding in Wachovia’s domestic deposits. In any case, we couldn’t afford another WaMu. This was another Band-Aid solution, but it beat bleeding to death.

  Afterward, Ben wrote a
note to Sheila that was full of praise—she wanted cover for a no-haircuts rescue—and correct about the deal’s importance.

  “You were able to turn what would have been the largest and most consequential bank failure in history into a medium-size, below-the-fold news story,” Ben wrote. “I don’t think markets appreciate the size of the bullet that was dodged, although everyone will understand it when the history is written.”

  We had elevated no-haircuts-in-a-panic to the level of doctrine. But we still didn’t have the authority to make that commitment fully credible, to assure markets there would be no more WaMus or even no more Lehmans. We needed TARP.

  After the Wachovia decision was in the FDIC’s hands that Sunday night, I stopped by a dinner party at Henry Kissinger’s apartment on the East River. I was late to the conversation, which inevitably turned to the financial crisis. With Kissinger’s guests, I tried to draw a contrast with the chaos of the military conflict we were engaged in on the other side of the world.

  “I know this looks like our Afghanistan,” I said. “But we’re going to fix this. We have the ability to impose a solution. We’re the United States.”

  The House of Representatives would be voting on TARP the next day, and everyone wanted to know what would happen. I didn’t know how the vote counting was going, but I felt confident, perhaps irrationally confident, that Washington would come around and do what seemed so evidently necessary to avoid a calamity.

  “We’ll get the authority we need,” I said. “And then we’ll put out the fire.”

  OVER WACHOVIA weekend, Hank worked out a deal with congressional leaders to expand his bare-bones TARP draft into bipartisan legislation. It included Rahm’s plan to divide the $700 billion into two tranches, plus some executive compensation restrictions for TARP recipients. It also authorized a bunch of new oversight bodies, a nod to the backlash over Hank’s “unreviewable” language.

  Senate Finance Chairman Max Baucus had called me during the negotiations to complain about Hank’s opposition to tougher comp restrictions. I had told him I was with Hank. I didn’t think Congress should mess around with TARP as a way to reform executive compensation—not because I approved of the industry’s lavish salaries and bonuses, but because reducing them seemed like a secondary objective in a crisis. And I wasn’t going to undermine Hank’s position. In general, I opposed conditions that would tie the administration’s hands in using emergency authority. But the restrictions that ended up in the legislation, limited to golden parachutes and tax deductions, seemed pretty modest. I didn’t like the idea of having to go back to Congress for the second tranche, either, but the bill still gave Treasury tremendous discretion over the money. For the most part, I thought the conditions were pretty harmless. And Hank was confident they would attract enough votes to get the bill into law, the most important consideration.

  On Monday, though, the TARP legislation went down to a shocking defeat in the House, 228–205. Most Democrats supported it, but two-thirds of Republicans voted no. The stock market plunged almost 9 percent that day, the largest decline since the Black Monday crash of 1987, wiping out $1 trillion in wealth. Hank called me, as distraught as I had ever heard him. His voice broke as he told me how sorry he was.

  “Tim, I couldn’t get it across the line,” he said.

  In those days, I tended to be the most worried person in the room, but on this issue I was relatively confident. We were the United States of America. I couldn’t imagine that Congress would stand by and let the economy sink into depression. I told Hank he would get what we needed soon. I also reassured him that he was doing a great job, and I meant it. I had tremendous admiration for him. He was decisive and fearless, always willing to take the heat. It was easy for me to clamor for unpopular actions behind the scenes, but Hank had to make the case in the public glare. He had been mocked as “Mr. Bailout,” caricatured as a symbol of Wall Street corruption, portrayed as “King Henry” on the cover of Newsweek. Now he was being ridiculed as hapless and powerless. I knew the criticism hurt, especially the criticism of his motives; he was working around the clock to save the country from disaster. And while he felt awful that he hadn’t been able to persuade members of his own party to put politics aside, that was their fault, not his.

  The market crash seemed to focus their minds. Before Monday, the public reaction to TARP had been all anti-bailout anger, but now politicians started hearing from constituents whose life savings were disappearing. Senate leaders added some sweeteners to the bill, including extensions of dozens of tax breaks for businesses. The bill also temporarily raised the FDIC’s deposit insurance limit from $100,000 to $250,000, to help protect the kind of account holders burned by IndyMac’s haircuts, and to help prevent runs on traditional banks.

  On Wednesday, October 1, the tweaked version of TARP passed the Senate with broad bipartisan support, 74–25. On Friday, it passed the House as well, as 57 representatives flipped from no to yes. The abrupt reversal evoked the Winston Churchill line about Americans always doing the right thing after trying everything else, but there was also something inspiring about it. A month before a high-stakes election, a Democratic-controlled Congress helped a Republican president with a 27 percent approval rating pass a wildly unpopular but desperately needed bill. We wouldn’t see much of that kind of aisle-crossing during the next administration.

  WHILE THE world watched the TARP debate, we were wrangling behind the scenes over an unexpected twist in the Wachovia deal. Citi’s purchase had been announced Monday, and Wachovia had signed a weeklong exclusivity agreement for Citi to finalize it. But Wells Fargo made a new offer Thursday: $7 a share for the whole company, seven times Citi’s offer, with no government help needed. Sheila decided that since Citi hadn’t yet closed its deal, Wachovia was free to accept the better offer for its shareholders. She emphasized that the Wells deal was also better for taxpayers, since the FDIC wouldn’t have to take any risk.

  When I first heard the change was in the works, I was livid. On a series of conference calls, I once again argued that Sheila’s position was untenable.

  “The United States government made a commitment,” I said. “We can’t act like we’re a banana republic!”

  I was worried that scuttling the Citi deal could end up crippling an already vulnerable $2 trillion institution, weakening it at the worst possible time. Citi’s stock price, after rising on the news of the Wachovia merger, would fall 18 percent on the news the merger was off, its steepest drop in two decades. Markets now assumed that Citi must have needed Wachovia’s domestic deposits to survive. There was no bank more intertwined in global finance than Citi, which handled as much as $2 trillion of the world’s payments every day, and CEO Vikram Pandit, understandably enraged, warned us there was now a good chance it could fail. “This is worrying,” Ben emailed with classic understatement. Pandit argued that even putting fairness aside, the Citi merger would be better for systemic stability.

  “I think he is probably right,” Ben wrote.

  While we were all concerned about damaging Citi, I was even more concerned that breaking a public promise would damage the government’s credibility and destabilize the system. What firm would stick its neck out to backstop a failing company if it thought we’d keep shopping for a better offer after the deal was announced? I thought reneging on our word would make the U.S. government look unreliable.

  There’s no way to put a price on the government’s credibility in a crisis. That was part of my reluctance to trumpet the strength of our weakened financial system when Dick Fuld and others wanted me to reassure the markets before the fall of Lehman. And that’s why I had been so upset that the FDIC intentionally let WaMu default in the wake of all the damage caused by Lehman’s failure. To resolve a crisis, a government has to show the capacity and the will to end it; it has to demonstrate through its deeds that its words can be trusted. Credit and credibility share the same Latin root. It was bad enough when Russian and Indonesian politicians broke promises. We we
re the United States.

  “You can’t run a government like this during a financial crisis,” I protested.

  Hank and Ben were sympathetic, but they let me fight that losing battle on my own. This was Sheila’s call. There was no unified command structure in the U.S. government’s financial wars. And in fairness, this time, Sheila probably didn’t feel like she had much of a choice. Wells Fargo’s privately financed $15 billion offer was certainly more attractive than Citi’s taxpayer-assisted $2 billion offer.

  Still, our constant zigzags looked ridiculous. We were lurching all over the place, and no one had any idea what to expect next. Hank said he wouldn’t need to inject capital into Fannie and Freddie, then did what had to be done and injected $200 billion. Collectively, we helped prevent Bear’s failure, then seemed to suggest we let Lehman fail on purpose, then turned around and saved AIG from collapse. Now we had announced and then unannounced a merger. Our inconsistency had multiple causes: the limits of our authority, which made us look like we were flailing; the balkanization of our authority, which put different tools in the hands of different officials with different strategies and different perceived responsibilities; and the inevitable messiness of fighting a crisis with limited time and incomplete information to make decisions. But whatever the cause, our unpredictability undermined the effectiveness of our response.

  The broader authority in TARP offered the hope of a more comprehensive and consistent strategy. But first our strategy for TARP would have to evolve a bit, too.

  HANK PITCHED the Troubled Assets Relief Program to Congress as a program to buy troubled assets. The plan was to restore confidence in financial institutions by purchasing $700 billion worth of the mortgage securities and other illiquid assets that were weighing down their balance sheets.