13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (28 page)

The failure of the MLEC implied that the major banks might be facing more than a simple liquidity crisis and might need more capital. At this point, sovereign wealth funds (investment funds owned by other countries) were still willing to supply that capital. Between October 2007 and January 2008, CITIC (China) committed to invest in Bear Stearns, the Abu Dhabi Investment Authority and the Government of Singapore Investment Group invested in Citigroup, China Investment Corporation invested in Morgan Stanley, and Temasek (Singapore), the Korean Investment Corporation, and the Kuwait Investment Authority invested in Merrill Lynch.
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But the next time banks needed capital, it would be much harder to find.

The next firestorm erupted in March 2008 with the collapse of Bear Stearns, then considered the weakest of the big five stand-alone investment banks. Bear Stearns was brought down by a modern-day bank run.
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On a proportional basis, it was more exposed to structured mortgage-backed securities than its rivals, and it was also highly dependent on short-term funding—cash that came from very short-term borrowing, much of it overnight.
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This meant that its creditors could refuse to roll over their loans from one day to the next and demand their money back instead. If that happened, there was no way Bear could pay them back, since many of its assets were illiquid; structured securities can be hard to sell on short notice, and selling them under pressure would cause their prices to collapse. If some creditors thought that this might happen, they would try to get their money out first, which would provoke other creditors to do the same, triggering a bank run as everyone scrambled to avoid being last in line.

All banks have this potential weakness, since they borrow short and lend long—they borrow money that they promise to return on short notice (deposits), and lend it out for long periods of time (mortgages). The rush by creditors to get their money out first is a classic feature of financial crises around the world, particularly in emerging markets. In the United States since the 1930s, deposit insurance has generally prevented bank runs by depositors—but that insurance did not cover the institutions lending money overnight to Bear Stearns and the hedge funds who parked their securities at Bear.

In early March, rumors surfaced that Bear Stearns was in trouble. Those rumors quickly became self-fulfilling as nervous creditors and hedge fund clients began cutting their exposure to the bank, causing Bear’s cash to drain away. Treasury and the Fed faced the prospect that a major investment bank might go bankrupt, tying up its assets in bankruptcy court for months or years and leaving its creditors and counterparties without access to their money. The Fed first attempted to lend Bear money by using JPMorgan Chase as an intermediary (as an investment bank, Bear was not eligible for direct loans from the Fed). When this failed to bolster confidence, Paulson, Bernanke, and Geithner brokered the sale of Bear to JPMorgan for a paltry $2 per share. Even at that price, JPMorgan refused to go along without a government backstop, so the New York Fed agreed to assume all the losses on $30 billion of Bear’s illiquid securities.

The deal was soon renegotiated to a purchase price of $10 per share, with JPMorgan now assuming the first $1 billion of losses on the $30 billion pool, which was parked in a special-purpose entity named Maiden Lane.
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But it remained a coup for JPMorgan, which was paying for Bear Stearns approximately what its
building
was worth
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—and for its CEO, Jamie Dimon, who happened to be on the board of directors of the New York Fed. The day the acquisition was announced, hoping to prevent the remaining stand-alone investment banks from suffering the same fate as Bear Stearns, the Federal Reserve also announced the creation of the Primary Dealer Credit Facility—a program allowing investment banks for the first time to borrow money directly from the Fed.
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This constituted a dramatic expansion in the government’s safety net for the banking system.

But the financial epidemic continued to spread as the fall in housing prices accelerated. Because of the complex way in which CDOs and other structured securities had been manufactured, falling housing prices and increasing defaults had a disproportionate impact on the prices of many such securities, which fell in value by 50 percent or more.
*
For example, in July 2008, Merrill Lynch sold a portfolio of CDOs with a face value of $30.6 billion to Lone Star Funds for only $6.7 billion, or 22 cents on the dollar—and even loaned Lone Star $5 billion to close the deal.
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No one knew how many of these toxic assets were sitting on major banks’ balance sheets, or how much they would lose if they were forced to sell. Each quarter, banks were taking major write-downs—reducing the accounting value of those assets to reflect their deteriorating quality.
^†
In 2007, Citigroup took $29 billion in write-downs, Merrill Lynch $25 billion, Lehman $13 billion, Bank of America $12 billion, and Morgan Stanley $10 billion.
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But no one knew if the assets were being written down to their true values, or how long the write-downs would continue. In 2008, Citigroup would take another $63 billion in write-downs, Merrill $39 billion, Bank of America $29 billion, Lehman $14 billion, JPMorgan Chase $10 billion, and Morgan Stanley $10 billion. The suspicion was spreading that if they were forced to acknowledge the true decline in value of their assets, some major banks might turn out to be insolvent.

The next major institutions to come under pressure were Fannie Mae and Freddie Mac, the privately owned but government sponsored enterprises (GSEs) that backed up the housing market. Although Fannie and Freddie had been relatively late to the subprime party, their balance sheets were completely exposed to the housing market, and falling housing prices tore a widening hole in those balance sheets, threatening their survival. This spooked the housing market, which was unlikely to continue functioning without their guarantees. It also frightened foreign governments, China first among them, that had bought hundreds of billions of dollars of bonds from Fannie and Freddie and were counting on the U.S. government to protect them from default.

In July 2008, Paulson asked for and obtained the right to back up Fannie and Freddie with taxpayer money, betting that this alone would stem the panic; “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out,” he said at the time.
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But it was not enough. On September 7, Fannie and Freddie were taken over by the government and placed in a conservatorship—the equivalent of a managed bankruptcy.
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The government promised to keep the GSEs in operation, and in exchange got a controlling ownership share and the right to manage them. Shareholders lost most of their money and the CEOs were replaced. In effect, the federal government took over two pillars of the financial system because they were too big to fail. Reactions were generally positive, in part because no one wanted to defend the quasi-private, quasi-public status of the GSEs. Other financial institutions had long complained about the unfair advantage that Fannie and Freddie enjoyed because of their government relationship, which made it cheaper for them to borrow money.

In the end, this was the last bailout that everyone could agree on. And it bought Paulson, Bernanke, and Geithner precisely one week.

Until September, most government support had been provided by the Federal Reserve in the form of new lending programs (the guarantee for Bear Stearns’s assets was structured as a loan) and lower interest rates. By acting as a lender of last resort, the Fed hoped to engineer a “soft landing” from the boom—the goal its founders sought back in 1913. However, this strategy was about to reach its limits, leaving Paulson, Bernanke, and Geithner with the choice between letting the free market take its course and end in financial and economic disaster, or engineering a massive government intervention in the financial system. The terms of that intervention would reveal the lasting influence and power of the Wall Street ideology—that big, private, lightly regulated financial institutions are good for America.

The precipitating factor was again the collapse of an investment bank—Lehman Brothers, now the smallest of the big four stand-alone investment banks. As with Bear Stearns, rumors emerged that Lehman was short on cash, and those rumors quickly became self-fulfilling. Over the weekend of September 13–14, the government cast about for a buyer. But this time, Paulson and Geithner made clear that they did not want to step in with taxpayer money. Paulson complained, “I’m being called Mr. Bailout. I can’t do it again”; more circumspectly, Geithner observed, “There is no political will for a federal bailout.”
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On Saturday night, knowing that no federal money would be available, Jamie Dimon said to his troops at JPMorgan Chase, “We just hit the iceberg. The boat is filling with water, and the music is still playing. There aren’t enough lifeboats. Someone is going to die.”
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When a plan for Barclays to acquire Lehman fell through on Sunday, the backup plan was bankruptcy early Monday morning.

Paulson, Bernanke, and Geithner declined to orchestrate a massive rescue that would have required a large loan from the Fed guaranteed by a claim on most of the bank’s assets. (The principals have all insisted that they did not have the legal authority to rescue Lehman, because the bank did not have sufficient collateral to support an emergency loan from the Fed—but that argument only appeared weeks later.) They hoped that, since the Bear Stearns emergency in March, financial institutions had prepared themselves for the possibility of Lehman’s collapse. As Bernanke said in congressional testimony, “[W]e judged that investors and counterparties had had time to take precautionary measures.”
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Unfortunately, those institutions had learned the opposite lesson—that the government would
not
let Lehman collapse. As Andrew Ross Sorkin wrote, describing the days before the Lehman bankruptcy, “[M]ost people on Wall Street … assumed that the government would intervene and prevent [Lehman’s] failure.”
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The financial sector assumed it could have its cake and eat it too: the government would give it unlimited license to make money in the boom,
and
would shelter it from harm in the bust. But it turned out that the government did not have the resources to protect all of the major banks; this time, the resource in short supply was the political capital necessary to bail out another bank in the face of congressional and public criticism.

The Lehman bankruptcy triggered a chain reaction that ripped through the financial markets. American International Group, which was already struggling with the consequences of its derivatives trades, faced downgrades by all three major credit rating agencies, which would trigger collateral calls that could force it into bankruptcy.
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On Tuesday, with the collateral damage caused by Lehman’s failure beginning to spread, the Fed stepped in with an $85 billion credit line to keep AIG afloat, fearing that if the insurer defaulted on its hundreds of billions of dollars in credit default swaps, its counterparties would suffer devastating losses—or, at the least, fear of those losses would cause the financial markets to grind to a halt.

Also on Tuesday, the Reserve Primary Fund, one of the largest money market funds, announced that it would “break the buck”; because of losses on Lehman debt, it could not return one dollar for each dollar put in by investors. As a result, money flooded out of money market funds, forcing Treasury to create a new program to provide insurance for those funds. The flight from money market funds dried up demand for the commercial paper used by corporations to manage their cash, raising the specter that major corporations might not be able to make payroll. This forced the Fed to establish a program to buy commercial paper from issuing corporations—in effect lending money not just to banks, but directly to nonfinancial companies.

Banks that relied heavily on short-term funding saw their sources of cash dry up as investors realized that
any
financial institution could fall victim to a bank run. Washington Mutual collapsed as depositors pulled out their money, causing the largest bank failure in U.S. history, and Wachovia, on the brink of failure, was acquired by Wells Fargo. Desperate to hold on to the cash they had, banks stopped lending. Money essentially moved in only one direction, toward U.S. Treasury bills—the presumed safest of all investments—and it stayed there. No one else could get any credit, and without credit the financial system cannot function.

On Thursday, September 18, the financial crisis burst onto the American political stage. Paulson and Bernanke went to Congress asking for $700 billion to buy toxic securities. A controversial three-page summary of their proposal gave the treasury secretary virtually unlimited power to use the money as he saw fit. Congress responded by passing the Emergency Economic Stabilization Act, but not until October 3, after its initial defeat in the House of Representatives triggered a frightening run on the stock market. That bill’s central provision, the Troubled Asset Relief Program (TARP), gave Treasury $700 billion to buy “troubled assets” from financial institutions.

In the October 13 meeting at Treasury that opened this chapter, $125 billion of TARP money was committed to nine major banks. In addition to investments in smaller banks, another $40 billion was invested in Citigroup and Bank of America, two of the original nine banks, in later rescue operations; more TARP money was used to finance Federal Reserve guarantees of toxic assets held by those two banks; and $70 billion was invested in AIG to allow it to pay down its credit line from the Fed.
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In addition, the FDIC promised to insure up to $1.5 trillion of new bank debt, and the Federal Reserve committed trillions of dollars to an ever-expanding list of liquidity programs intended to provide cheap money to the financial system: the Term Auction Facility, the Term Asset-Backed Securities Loan Facility, the Money Market Investor Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, and so on.