In FED We Trust (29 page)

One mystery in August 2008 was why the U.S. economy was doing as well as it was, a fact that gave Bernanke and the rest of the Fed some comfort. “Although it is widely described as the worst financial crisis since World War II, the real economy in the United States is still growing, albeit at a slower
rate,” Stanley Fischer, the Israeli central banker and Bernanke’s thesis adviser, told the conference. He offered three alternative scenarios: Fiscal and monetary policy actions had worked. The obvious financial mistakes of the recent past weren’t damaging to the economy. The worst was yet to come.

Bernanke, Kohn, and Warsh returned to Washington from Jackson Hole determined to keep Fischer’s pessimistic scenario from coming true. They spent Labor Day weekend at the Treasury building, plotting the government takeover of Fannie and Freddie. Fortunately, this takeover wouldn’t have to be executed in a single sleepless night.

On Labor Day afternoon, Bernanke and Paulson finally left the Treasury — Bernanke to see Washington’s baseball team, the Nationals, play the Philadelphia Phillies, while Paulson and his wife biked through Washington’s forested Rock Creek Park. Paulson, though, couldn’t get his mind off Fannie and Freddie. While his wife rode on ahead, Paulson pulled out his omnipresent cell phone and called Bernanke. The two conferred about the unresolved details of the takeover while the home crowd cheered a Nationals’ victory. Aware that Lehman and Merrill Lynch were teetering, Paulson wanted to get Fannie Mae and Freddie Mac settled soon. Fannie had raised capital on its own and was in better shape than Freddie, but the Treasury decided it was impossible to treat them differently.

In the days that followed, a firm plan emerged. Bernanke and Paulson pressured Fannie and Freddie’s regulator, James Lockhart, head of the Federal Housing Finance Agency, to use the powers Congress had just provided. The government would put the companies into “conservatorship” — essentially taking control of them and replacing their chief executives. And Paulson would fire the bazooka: Treasury would promise up to $100 billion in taxpayer money to companies if they needed it. By promising the markets that the government would keep the companies solvent — known on Wall Street as a “keep well” commitment — Paulson and Bernanke hoped investors would keep lending the companies money.

The Treasury and the investment bankers from Morgan Stanley it had hired for advice thought $25 billion was the most Fannie and Freddie could possibly need. But they asked aloud: “What is the investor in China going to say?” The U.S. officials wanted to leave no doubt that the two companies would be strong enough to pay their debts: $50 billion would be impressive, but $100 billion was an overwhelming sum, so that’s the number they settled on. (Five months later, the Geithner Treasury would double the offer to $200 billion to shore up confidence in the two companies as their losses mounted.)

The chief executives of Fannie Mae and Freddie Mac — Dan Mudd, a Marine veteran and former General Electric executive, and Dick Syron, an economist and business executive who had been president of the Boston Fed in the 1990s — knew something was up, but they had no idea that the government was plotting a takeover. On Thursday night, September 4, Mudd and Syron were asked to show up separately at the Federal Housing Finance Agency offices the next day. The hope was to keep the meetings secret, but
Wall Street Journal
reporter Damian Paletta had been tipped off and was waiting outside when Mudd and his squad arrived. Paletta then spotted Bernanke arriving. Soon headlines were flashed around the world.

The presentations had been rehearsed. Lockhart and Paulson did most of the talking. Bernanke was there to show that the Fed was behind them. “This is important to the economy,” Paulson first told Mudd and then, in a meeting later that afternoon, Syron. “The quality of your capital is not what we would have hoped for,” Paulson explained. “Nobody did anything wrong. There’s a flawed business model.” He gave them a choice: accept the government’s conservatorship, or we will use our power to force it down your throats.

The Freddie and Fannie boards of directors met on Saturday, first with the government officials and then without them. Freddie caved first; then — with some hesitation and talk of fighting the government in court — Fannie did the same. This time, Paulson got the all-important theater right. Faced with a determined secretary of the Treasury and chairman of the Federal Reserve, their powers newly bolstered by Congress, the two companies decided there was little point in resisting.

By Monday, the two chief executives had been replaced, and the government
was in control. The companies — to the relief of both Bernanke and Paulson — opened for business Monday with only a few hiccups. Freddie’s and Fannie’s preferred shareholders were wiped out, but the government had protected debt holders. Paulson saw the whole episode as one of his successes and pronounced it to be “nearly perfect.”

Bernanke marveled at Paulson’s ability to organize the military-style operation. New chief executives were at work on Monday, and human resources consultants were on hand to keep key staff from defecting. “The Fannie/Freddie thing was a brilliant operation, absolutely necessary,” Bernanke said later. “It stabilized an important part of the financial system at a critical time.” Yet despite the explicit federal government support for the companies, investors continued to demand higher rates on their debt than on U.S. Treasury debt or government-guaranteed bank debt — pushing up the rates that most American home buyers had to pay on new mortgages.

It soon became clear, too, that the Treasury, the Fed, and the regulator didn’t have a well-defined strategy for running the companies. They found new chief executives and a way that they hoped would keep the markets, and the Chinese, lending to the companies. But they hadn’t a way to resolve the long-standing tension between operating the companies prudently to make profits and using them as an arm of the government to support the beleaguered housing market. The result was that neither Fannie nor Freddie collapsed and caused a financial catastrophe, but the two huge now government-sun companies weren’t as effective in rescuing the mortgage and housing markets as had been hoped. Fannie’s ex-CEO, and Marine veteran, Dan Mudd later likened the takeover to the U.S. invasion of Iraq. “The troops got to Falluja in a couple of weeks and seized the radio towers, but there was no plan to run the country once the shooting stopped,” he said.

Bernanke and Paulson, though, had other things to worry about. Lehman Brothers’ Dick Fuld was calling. In less than a week, the Fed chairman and the Treasury secretary, along with the president of the New York Fed, would be unable — or unwilling — to prevent the largest bankruptcy in U.S. history. Fannie and Freddie had been painstaking and exhausting. Now things were about to get really serious.

B
ernanke, Geithner, and Paulson expected collateral damage from the enormous Lehman Brothers bankruptcy, but their preparations didn’t come close to anticipating how badly global financial markets would react. They hadn’t put nearly enough foam on the runway.

This wasn’t for lack of trying. On Sunday, September 14, after it became clear that Lehman would not be salvaged, the other big Wall Street firms were told to open their books to one another at the New York Fed. Firms that had bet one way with Lehman could settle up with firms that had bet the other way, reducing the eventual burden on the bankruptcy court. Some did, but not many.

From Washington, Bernanke called his counterparts in Frankfurt, London, and Tokyo to alert them to Lehman’s bankruptcy. That didn’t do much to limit the damage, though.

At noon, the Fed board in Washington convened to expand recently created emergency-lending programs to shield other securities firms by expanding the collateral eligible for Fed loans in an effort to keep the tri-party repo market going. The Fed told Wall Street: if you lend to someone and get stuck with the collateral because they can’t pay you back, we’ll take the paper off your hands. The dealers jumped at the offer: the week before Lehman, none of them were
borrowing from the Fed, not even Lehman; a few days after Lehman’s demise, both the remains of that firm and others were borrowing nearly $60 billion.

Geithner used the runway-foaming metaphor to explain the strategy for containing the damage from Lehman’s now inevitable bankruptcy. Kevin Warsh, the Fed governor, just as aptly explained it: “We hoped a lot of the underbrush was cleared away so that when the fire started there wouldn’t be an inferno.” Foam or underbrush, it didn’t work as well as they had hoped.

Largely unanticipated problems overwhelmed the preparations. The Fed was lending Lehman’s U.S. brokerage unit more than $50 billion a day to keep it functioning, but the firm’s bankruptcy was messier than anyone had contemplated — and the mess was global. Finance houses all over the world had lent Lehman money and couldn’t get it back, or even get clarity if they would ever get repaid.

The havoc in the financial markets didn’t leave Bernanke, Geithner, or Paulson much time for contemplation. All three men could see another big plane — AIG — about to crash. Worse, the engines on the two remaining independent investment banks, Morgan Stanley and Paulson’s former employer, Goldman Sachs, were now sputtering.

It became apparent to Bernanke that the government was now in the business of forcing instant mergers to save and restructure the American financial system. Bernanke wondered: What is going to solve this? What is going to stop this? As the deal to save Lehman Brothers fell apart, he had an epiphany: “That weekend really hit home to me that this was a fiscal issue.”

Paulson came to the same realization. In an early Monday morning telephone call, he told the president that the time to ask Congress for money was approaching. For months, Congress had been on the sidelines saying, in effect: Let the Fed do it. Wink, wink. And we’ll just yell at the Fed in public. That day was past.

AIG’s chief executive, Robert Willumstad, first alerted Geithner on Thursday, September 11, that the giant insurance company was having trouble borrowing short term. Geithner was stunned. AIG had been on the worry list but wasn’t
thought to be in imminent danger. With Geithner and Paulson watching closely, the company and its bankers spent the weekend trying to raise money from private equity sources, sovereign wealth firms, and others. Late Sunday, Geithner briefed key members of the New York Fed’s board of directors, telling them that — at that point — he couldn’t imagine that an insurance company posed such a big risk to the financial system that the Fed should bail it out. Big banks, investment banks, hedge funds, sure, Geithner knew they had placed and taken so many big bets with so many other players in the game that the collapse of any one of them could overturn the table. But an insurance company?

Over the next twenty-four hours or so, Geithner got a crash course in New York State rules for managing the insolvency of an insurance company; in the size and reach of the hedge fund that AIG had built without any regulator realizing what it was doing; in the number of banks, particularly in Europe, to whom AIG had sold insurance against borrowers’ defaulting; and in the consumer businesses that would likely suffer runs if the parent company failed. At each turn, options for the giant insurer looked worse.

At the end of the weekend, Paulson returned to Washington, leaving behind ex — Goldman banker Dan Jester to monitor the situation. The markets were having a horrendous day. “I left expecting the markets to be bad, but I didn’t really totally understand — none of us did — what ‘bad’ was,” Paulson recalled later. The Dow Jones Industrial Average lost 500 points, or 4.4 percent.

Amid a plunging stock market, AIG gave up trying to raise capital and turned, instead, to trying to borrow $75 billion from a syndicate of banks to keep itself alive long enough to sell off some of its most attractive businesses. The effort was hurt by Monday afternoon’s downgrading of AIG’s debt by the major rating agencies, which forced the company to post more collateral under the terms of its lending agreement.

On Tuesday morning, AIG and its bankers told Geithner and Paulson’s man Jester that there would be no private rescue for AIG. The sums were just too big for Wall Street to manage at a time of such anxiety. JPMorgan Chase and Goldman couldn’t raise $50 billion — and even if they could have, that wasn’t enough.

AIG’s difficulties grew more intense by the hour. With its debt downgraded and its stock price plummeting, the insurance giant’s trading partners
were refusing to do business with it. Over the weekend, AIG executives had told the Fed and the Treasury it had enough money to make it until Thursday. By Tuesday morning, AIG said they could make it till the next day. By Tuesday afternoon, they were saying they might need $4 billion by the end of the day — and even that proved optimistic.