On the Brink (31 page)

Tim, Ben, and I reviewed our options with great care in an hour-long conference call at 8:00 a.m. that included Fed vice chairman Don Kohn and governors Kevin Warsh and Elizabeth Duke. Whatever else happened, we could not let AIG go down.

Unlike with Lehman, the Fed felt it could make a loan to help AIG because we were dealing with a liquidity, not a capital, problem. The Fed believed that it could secure a loan with AIG’s insurance subsidiaries, which could be sold off to repay any borrowing, and not run the risk of losing money. These subsidiaries were also more stable because of the strength of their businesses and their stand-alone credit ratings, which were separate from the AIG holding company’s ratings and troubles. By contrast, prior to Lehman’s failure, its customers had already begun to flee, causing the Fed to face the prospect of having to lend into a run. Moreover, the toxic quality of Lehman’s assets would have guaranteed the Fed a loss, meaning the central bank could not legally make a loan.

We set a plan of action: Tim would figure out the details of the bridge loan, while I worked on finding a new CEO for the company. We had less than a day to do it—AIG’s balances were draining by the second.

I asked Ken Wilson to drop everything and help. Within three hours he had pinpointed Ed Liddy, the retired CEO of Allstate and one of the savviest financial executives in the world. He reached Liddy in Chicago, then ran upstairs to my office to tell me to call him. I offered Ed the position of AIG chief on the spot. The job would be a thankless one, but I could think of no one else who had the ability and the grit to take it on.

On Tuesday morning, the consequences of Lehman’s failure were becoming more and more apparent. I received an astounding call from Goldman CEO Lloyd Blankfein. He informed me that Lehman’s U.K. bankruptcy administrator, Pricewaterhouse-Coopers, had frozen the firm’s assets in the U.K., seizing its trading collateral and third-party collateral. This was a completely unexpected—and potentially devastating—jolt. In the U.S., customer accounts were strictly segregated, and were protected in a bankruptcy proceeding. But in the U.K., the bankruptcy administrator had lumped all the accounts together and frozen them, refusing to transfer collateral back to Lehman’s creditors. This was particularly damaging to the London-based hedge funds that relied on Lehman as their prime broker, or principal source of financing.

Just about all the hedge funds in London and New York, whether or not they had any relationship with the bankrupt securities firm, became unnerved and leaped to a frightening conclusion: they should avoid doing business with any firm that could end up like Lehman. This was bad news for Morgan Stanley and Goldman, the leading prime brokers. Trading frequently and maintaining big balances, hedge funds were among their best, most profitable customers. Lloyd was afraid that if something wasn’t done, Morgan Stanley would fail, as clients began to run and hedge funds pulled their prime brokerage accounts. And even though Goldman had plenty of liquidity and cash, it could be next.

“Hank, it is worse than any of us imagined,” Lloyd said. If hedge funds couldn’t count on the safety of their broker-dealer accounts, he went on, “no one will want to do business with us.”

Hedge funds were just the tip of the iceberg. Liquidity was rapidly evaporating all over. When investors—pension funds, mutual funds, insurance companies, even central banks—couldn’t withdraw their assets from Lehman accounts, it meant that in the interlinking daisy chain of the markets, they would be less able to meet the demands of their own counterparties. Suddenly everyone felt at risk and increasingly wary of dealing with any counterparty, no matter how sterling its reputation or how long a relationship one firm had had with another. The vast and crucial Treasury repurchase market, under duress since August 2007, began to shut down.

This was awful news. When institutional investors, for example, purchased securities like corporate bonds, they frequently hedged their positions by selling Treasuries. But if they did not have the Treasuries in their inventory, they used the repo market to borrow them from other investors.

With Lehman’s failure, major institutional investors ceased lending securities for fear that their counterparties would fail and not return the securities as promised. Among the key investors now balking were reserve managers at some of the world’s central banks, which had been earning extra income by lending part of their vast holdings of Treasuries overnight. Some small central banks had started pulling out of the repo market the week before as rumors had circulated about the imminent failure of Lehman; by Monday, their bigger counterparts in Asia and Europe were doing the same
.

In a classic “flight to quality,” everyone wanted to get hold of Treasuries, the safest security in the world. In Tuesday’s midday auction we received over $100 billion in orders for $31 billion in four-week bills. The rate on the bills was an astoundingly low 0.10 percent—a drop of 1.15 percentage points from the previous week. The consequences of this flight were enormous to global credit markets.

The sudden shortage of Treasury securities resulted in an unprecedented level of “fails to deliver,” that is, investors who were unable to deliver securities they had previously borrowed. On September 12, the Friday before Lehman went down, these fails stood at $20 billion; one week later they would soar to $285 billion. By September 24 they would reach $1.7 trillion, before peaking at $2.3 trillion in early October—an extraordinary amount, never experienced before, and multiple times higher than any prior episode in history.

Major investors who desperately wanted Treasuries for safety or to hedge purchases of other securities could not purchase them because no investors were willing to lend securities from their portfolios. Major broker-dealers stopped selling Treasuries for fear that they would not be able to deliver the Treasury securities they sold. And without being able to hedge their positions with Treasuries, investors were reluctant to make any further purchases in other credit markets. The credit markets essentially were grinding to a halt.

Over the next couple of hours that morning, I must have made or taken a score of phone calls from senators and congressmen. These were short and to the point: we were doing our best to hold the system together; the bankruptcy of Lehman was regrettable, but there had been no buyer; AIG was a problem, and we were working hard on a solution.

Its impending failure was sending shock waves around the world. Peer Steinbrück, the German finance minister, called to say that it was unthinkable AIG could go down. Christine Lagarde, the French finance minister, echoed his view: everyone was exposed to AIG, and its failure would be catastrophic. “I assume you are going to do the right thing,” she said to me. I told her what I had told Steinbrück—“I can’t make any commitments”—but I assured her we were doing everything we could.

As I dealt with the phone calls, I learned that McCain had gone on NBC’s
Today
show earlier and declared, “We cannot have the taxpayers bail out AIG or anybody else.” I didn’t want American taxpayers stuck with a bailout, either, but Ben, Tim, and I could see no other alternative, and I didn’t want McCain—or Obama—to use populist language that would inflame the situation. So I called McCain to encourage him to be more careful in his choice of words.

“You should know that if this company were to go down, it would hurt many, many Americans,” I explained. In addition to providing all kinds of insurance to millions of U.S. citizens, AIG was deeply involved in their retirements, selling annuities and guaranteeing the retirement income of millions of teachers and healthcare workers. I asked him to refer to our actions as rescues or interventions, not bailouts. The next day McCain would temper his criticism, using some of my language, only to be criticized for flip-flopping.

By noon, European stocks had tumbled, the U.S. markets were starting to dip, and the news was about to get worse. Lehman’s failure and AIG’s escalating difficulties had begun to roil money market funds. Typically, these funds invested in government or quasi-government securities, but to produce higher yields for investors they had also become big buyers of commercial paper. All morning we heard reports that nervous investors were pulling their money out and accelerating the stampede into the Treasury market. The Reserve Primary Fund, the nation’s first money market fund, had been particularly hard-hit because of substantial holdings of now-worthless Lehman paper.

Many Americans had grown accustomed to thinking that money market funds were as safe as their bank accounts. Money funds lacked deposit insurance but investors believed that they would always be able to withdraw their money on demand and get 100 percent of their principal back. The funds would maintain a net asset value (NAV) of at least 1.00, or $1 a share. No fund had dipped below that level—or, in industry parlance, “broken the buck”—since the bond market rout of 1994. Funds that broke the buck were as good as dead: investors would all withdraw their money.

In retrospect, I see that the industry’s setup was too good to be true. The idea that you could earn more than what the federal government paid for overnight liquidity and still have overnight liquidity made absolutely no sense. It had worked for so long only because people didn’t ask for their money. But when Lehman failed, people started to ask.

Around 1:00 p.m., Bill Osborn, the chairman of Northern Trust and a good friend from Chicago, called with a firsthand report. “I hate to bother you, Hank,” he said. “But there is no liquidity in the markets. The commercial paper market is frozen.”

Bill proceeded to tell me about problems he was having with his money market funds. Because the market for commercial paper had seized up, the funds were under real pressure from withdrawals, and he was looking for ways to avoid breaking the buck. He was working on a way the parent company could support the funds financially without taking the obligation on its balance sheet. But this solution required accounting relief. He’d already called the SEC but wanted to let me know of the looming problem.

I told Bill that I was focused on AIG, but that the Fed was working on a number of liquidity programs to get people to start buying paper again.

“They can’t come soon enough,” he said. “I’ve never seen anything like this.”

Nor had I. Begun as an alternative to banks for U.S. consumers, money funds had more than 30 million retail customers. In recent years, the business had become increasingly corporate—and global. Companies used the funds for their cash management needs, and money poured in from overseas investors—Singaporeans, British, and Chinese—eager to get a little more yield than on straight Treasuries.

This kind of money was “hot,” likely to flee at the first sign of trouble, and I feared the start of a run on the $3.5 trillion industry, which provided so much critical short-term funding to U.S. companies. I immediately thought of my meeting with Jeff Immelt the day before, and his trouble selling commercial paper. I called Chris Cox, who told me that he was aware of the accounting issue; his accounting policy people were already working on it, but there was no obvious solution.

Tim, Ben, and I spoke throughout the day so Tim could keep us updated on the size of the AIG problem. We had a President’s Working Group meeting set for 3:30 p.m. When I arrived at the Roosevelt Room, the president, the vice president, and my fellow members of the PWG, with the exception of Tim, were all there. I outlined AIG’s dire situation, detailing the incompetence of its management and the need to prevent its collapse, given its worldwide financial products and the number of money market and pension funds that held its commercial paper.

“How did we get to this point?” the president asked in frustration. He wanted to understand how we couldn’t let a financial institution fail without inflicting widespread damage on the economy.

I explained that AIG differed from Lehman, because Lehman had issues with both capital and liquidity, whereas AIG just had a liquidity problem. The investment bank had been loaded with toxic assets worth far less than the value at which they were carried, creating a capital hole. Nervous counterparties had fled, draining liquidity.

In AIG’s case the problem wasn’t capital—at least we didn’t think so at the time. The insurer held many toxic mortgages, but its most pressing problem was a derivatives portfolio that included a large amount of credit default swaps on residential mortgage CDOs. The decline in housing values, and now the cuts in AIG’s ratings, required it to post more collateral. Suddenly, AIG owed money seemingly everywhere, and it was scrambling to come up with $85 billion on short notice.

“If we don’t shore up AIG,” I said, “we will likely lose several more financial institutions. Morgan Stanley, for one.”

I noted that an AIG collapse would be much more devastating than the Lehman failure because of its size and the damage it would do to millions of individuals whose retirement accounts it insured. I added that I was worried about the flight I saw from money market funds and commercial paper. Chris Cox let us all know the Reserve Primary Fund had just broken the buck.

The president found it hard to believe that an insurance company could be so systemically important. I tried to explain that AIG was an unregulated holding company comprising many highly regulated insurance entities. Ben chimed in with a pointed description: “It’s like a hedge fund sitting on top of an insurance company.”

Ben said that under the Fed’s plan, the government would lend AIG $85 billion, charging the company LIBOR plus 850 basis points, or about 11.5 percent at that time. The government would end up with 79.9 percent ownership, substantially diluting the existing equity, and would gradually liquidate the company to pay off the Fed’s loan.

“Someday you guys are going to have to tell me how we ended up with a system like this and what we need to do to fix it,” the president said, noting that we would have to put together a more consistent and comprehensive approach to the crisis.

I couldn’t have agreed more. Sunday night, with Lehman about to file for bankruptcy, I had warned the president that we might have to ask Congress for broader powers to stabilize the financial system as a whole. Now, while still in firefighting mode as we dealt with the five-alarm emergency of AIG, I didn’t raise the issue of going to Congress again. But I knew that when the time came, President Bush would support me.