In FED We Trust (24 page)

Like several of the subsequent Fed interventions in the money markets, this one was devised largely by Bill Dudley. An economist with a Ph.D. from the University of California at Berkeley, Dudley had spent twenty years at Goldman Sachs, ending up as its chief U.S. economist. Geithner hired him to run the New York Fed’s markets desk — the place where the Federal Reserve actually buys and sells in the markets. Dudley arrived at the beginning of 2007 in the opening acts of the Great Panic, which turned his new post into a 24/7 job. He even did a press briefing on the TSLF from a hospital room where his wife was recovering from surgery. (When Geithner became Obama’s Treasury secretary, Dudley edged out Fed governor Kevin Warsh to become president of the New York Fed.)

The thinking behind the move was simple: Bernanke was trying to unclog what he dubbed the “credit channel.” Since the investment houses’ collateral was increasingly suspect, he reasoned, giving them a chance to replace bad paper with something nearly as good as cash would get credit flowing again. Confidence would rise. Players would know that even in the event of default, securities with already depressed prices wouldn’t be dumped on the market, avoiding the acceleration of a downward spiral. The TSLF didn’t increase the size of the Fed’s portfolio or the total amount of credit it was providing to the economy. The Fed wasn’t yet printing extra money. But the Fed had taken a big step toward using its portfolio to arrest the Great Panic. By temporarily trading a chunk of its own holdings of the safest securities in the world, U.S. Treasury debt, for the far riskier ones the investment houses would be off-loading from their books, the Fed was expanding its “lender of last resort” protection beyond commercial banks. It was a maneuver designed to offer liquidity to the system but was not a long-term solution, because the investment banks were still on the hook if those securities turned out to be worthless because the ultimate borrowers defaulted. The money wasn’t flowing out yet, but Bernanke and the others had just left the vault door ajar.

A few hours after the Fed announced the TSLF, Geithner hosted a closed-door lunch for Bernanke in the New York Fed’s Washington Dining Room, one
of several get-togethers he had convened so the Fed chairman could meet Wall Street’s brass. Paul Volcker and Alan Greenspan were familiar faces long before they became Fed chairmen. Each had a mystique that conveyed competence and wisdom. But Wall Street was not Bernanke’s milieu, and it showed. “Greenspan was at home at the markets,” one executive at the lunch said. “I don’t think Bernanke has a feel for this stuff.”

That was a problem. The notion that the Fed did banks (Citigroup, Bank of America, JPMorgan Chase) and the SEC did investment houses (Bear Stearns, Lehman Brothers, Goldman Sachs) went up in smoke on Wednesday, March 12.

That evening, Bear CEO Alan Schwartz called Rodgin Cohen, the dean of the banking bar, for strategic advice. Cohen’s firm, Sullivan & Cromwell, wasn’t representing Bear Stearns, although it had handled a few projects for the firm. But Cohen was the go-to banking lawyer in a crisis — so much so that he had ended up with a client in nearly every significant financial controversy in modern memory.

Cohen heard Schwartz out, then said: “We’ve got to call the Fed.” Moments later, the lawyer had Tim Geithner on the phone. “I think I’ve been around long enough to sense a very serious problem, and this seems like one,” he said. That message alone was more dire than anything Bear Stearns had delivered directly to the Fed.

“If Alan is worried, he needs to call me,” Geithner replied.

Schwartz did so the next morning. He explained that, while Bear Stearns was continuing to look for a partner to provide long-term financing, its problems weren’t only long term. Two days earlier, he told Geithner, Bear Stearns had opened for business with $18 billion in cash or securities that were so easily sold that they were as good as cash. By day’s end, $6.5 billion of that was gone. The firm was down to its last $11.5 billion. This was the bad news that builds on itself once word gets out, so the next few days would be deeply challenging.

The problems were the ones that would recur throughout the Great Panic: credit and collateral. Commercial banks use deposits, insured by the government, so they aren’t wholly reliant on short-term borrowing. Investment banks like Bear Stearns hadn’t any deposits, so they were reliant on borrowing in the markets, often overnight. Bear had pledged collateral in the repo
market, the market that had caused a scare for Geithner in the Countrywide episode months earlier. The repo market, in its collective wisdom, had now decided that Bear Stearns collateral wasn’t good enough to secure loans, even when that collateral was U.S. Treasury securities.

Bear couldn’t borrow, and without borrowing, it couldn’t do business. It was the twenty-first-century equivalent of a bank run in a world organized for twentieth-century finance. “I just never, frankly, understood or dreamed it could happen as rapidly as it did,” Bear Stearns’s Schwartz said.

Neither did Geithner nor Bernanke. In fact, though, the problem — the reliance on borrowing in the wholesale markets to keep the business going without realizing how ephemeral credit was — had been building for a long time.

Months later, Fed governor Kevin Warsh tried to put it in perspective. “You know that line in
Fletch
when Chevy Chase tells a doctor that it was a shame that ‘Ed’ died so suddenly. ‘He was in intensive care for eight weeks,’ the doctor says. To which Chevy Chase replies: ‘But in the very end, when he actually died … that was extremely sudden.’”

“Same thing here,” Warsh said about Bear Stearns. “Very sudden, but …”

By Thursday night, Bear Stearns was down to $2 billion in cash. The company asked Gary Parr, a Lazard Frères investment banker who had been helping the firm to try to raise money, to contact the most likely savior: Jamie Dimon of JPMorgan Chase. Parr interrupted Dimon’s birthday dinner with his family at Avra, a Greek restaurant, and told him Bear needed $30 billion. Dimon balked. Well, Parr replied, how about buying the whole company overnight? Schwartz followed up with a call to Dimon.

Dimon, in turn, called Geithner. JPMorgan didn’t have enough information to make an overnight decision to buy Bear Stearns. “Tim, look,” he said, “we need more time. Just do something to get them to the weekend.”

Geithner took Dimon seriously. Once a contender for the top job at Citicorp before he was tossed out by his mentor, Sandy Weill, in 1998, Dimon
was one of a handful of top financial executives to escape the worst of the subprime fiasco. He went from Citi to run Bank One, a big bank based in Ohio that was acquired by JPMorgan in 2004. By 2007, Dimon was at the top of one half of the original J. P. Morgan empire — the other half was at Morgan Stanley. Citi was struggling. Dimon, a Democrat, would have been on the list of potential Obama appointees to the Treasury — the job Geithner eventually got — had a banking résumé not become a disqualification for the post.

Bear Stearns’s fate was in the hands of a very tight fraternity. Dimon was a member of the Federal Reserve Bank of New York’s nine-person board of directors. That board hired Geithner and set his salary, an extraordinary historical anomaly that gives the regulated the power to pick the regulator.

From the beginning, the regional Fed banks were organized not as government agencies, but as private companies in which local banks own shares, a remnant of a time when central banks raised capital privately as well as publicly. Under the 1913 law, each bank has nine directors, the majority chosen by the banks in the district. Three are bankers. Three are nonbankers picked by the local banks. Three are chosen by the Fed board in Washington to represent the public. On the New York Fed’s board, Dimon fell into the first category, a banker picked by bankers. Richard Fuld, CEO of Lehman Brothers, was in the second; since Lehman wasn’t a bank in the legal sense, he was a nonbanker picked by bankers. Stephen Friedman — the former CEO of Goldman Sachs and then a member of Goldman’s board of directors — was in the third, legally a nonbanker picked to represent the public. He chaired the New York Fed board and stayed in close touch with Geithner.

Later in the Great Panic, Goldman would change its legal status and become a Fed-regulated bank-holding company. Under Fed rules, holding shares and sitting on Goldman’s board made Friedman ineligible to represent the public on the New York Fed board. The Fed, with the approval of the Fed governors in Washington, quietly gave Friedman a waiver to serve through the end of 2009, but was embarrassed when the
Wall Street Journal
reported that he had been adding to his Goldman stake during the tumult of late 2008 as the Fed was making moves that benefited Goldman. Friedman quit
the New York Fed board in May 2009. He said his continued presence there was an unwelcome distraction for the Fed, and insisted unapologetically that his actions had been “mischaracterized” and above reproach.

Directors of regional Fed banks didn’t vote to approve Fed loans like the one Bear Stearns was seeking; the loans went to the Fed board in Washington, where all the power was with government employees like Bernanke. And directors weren’t supposed to participate in formal conversations about their own institutions. But the incestuousness was obvious, the kind of crony capitalism that the U.S. government criticized in Indonesia and other developing countries. Geithner was hired by bankers he was supposed to supervise and, now, was being asked to bail out. The arrangement underscored the New York Fed’s peculiar relationship with Wall Street. It was supposed to be a regulator and guardian of the public interest, but sometimes was seen — by banks, by other factions inside the Fed, and by the public — as Wall Street’s advocate, rather than its overseer. And on some days, it was more advocate than overseer.

Geithner’s most prominent predecessors, Paul Volcker and Gerry Corrigan, were career Fed (and, in Volcker’s case, Fed and Treasury) employees who balanced the perception of excessive chumminess with gruff schoolmaster personalities and physiques. Volcker towered over everyone in the room unless he happened to show up at a Knicks game, while Corrigan played the beefy Irish rugby player. Volcker made his mark as the Fed chairman Jimmy Carter appointed to restore global confidence in the American economy, the man who brought inflation down from the double digits. While at the Fed, Corrigan was known as the chief worrywart, frequently warning of the fragility of the financial system or imminent crisis.

Geithner’s public persona as a technocrat and his slight build didn’t offer him the advantages that Volcker and Corrigan had. The circumstances didn’t help either. He believed firmly that protecting the American economy at a time like this meant rescuing the banks, even if they had caused their own misery. But that didn’t stop the critics from suggesting that he was looking out for the banks’ interests first.

“So what can taxpayers expect from an increase in the Fed’s discretionary authority over investment banks?” asked Carnegie Mellon economist Allan
Meltzer. “The likely answer is rescues, delays, and lax supervision — followed by taxpayer-financed bailouts. Throughout its postwar history, the Fed has responded to the interests of large banks and Congress, not the public.”

While Bear Stearns and its investment bankers desperately sought a partner with very deep pockets, the guardians of the U.S. financial system convened an almost nonstop series of conference calls. On Thursday afternoon, “the DK committee” — named for Don Kohn — chewed over the situation: Kevin Warsh, Bob Steel at Treasury, John Dugan at the Office of the Comptroller of the Currency, and Geithner. The climactic call came around 7:30
P.M.
when Bernanke and Paulson came on the line and the SEC staff told them all that Bear Stearns was going to have to file for bankruptcy the next morning. It was showtime.

Geithner, as he usually did, divided the work among small task forces. He stayed at the office until midnight, then left for a couple of hours’ sleep at a nearby hotel. Before he left, he asked his staff to e-mail Kohn, Warsh, Steel, and a few others to dial into a 6
A.M.
conference call. A couple of staffers at the Securities and Exchange Commission were on the e-mail; the chairman, Christopher Cox, a former Republican congressman from California, was not.

But that plan was discarded. Geithner came to the office to get financial firefighters on the phone around 4:45
A.M.
Bernanke, Kohn, and Warsh dialed in from home. So did Treasury’s Paulson and Steel, and several top staffers, including the Fed’s lawyer, Scott Alvarez, and Bernanke’s spokeswoman, Michelle Smith.

The SEC was legally Bear Stearns’s chief regulator, but Cox, its chairman, wasn’t on the call. Apparently, he wasn’t missed. Top officials at both the Fed and the Treasury had decided the SEC and its chairman weren’t up to the job of coping with the collapse of an investment bank. Cox was largely a bystander. Around 7:40
A.M.
an SEC staffer, Robert Colby, deputy director of the trading and markets division, e-mailed the Fed’s Don Kohn and the Treasury’s Bob Steel and begged someone to call Cox and fill him in.

The big question: save Bear Stearns so it could continue to seek a buyer, or let it go under and try to protect the financial system and the economy from the damage. The call stretched on for more than two hours. “There were one or two points where someone said, ‘Well, suppose we don’t? What happens then?’” recalled Don Kohn, the Fed vice chairman. In 1990, the Fed had stood by when Drexel Burnham Lambert went under after it was accused of illegal shenanigans in the market for junk bonds pioneered by Michael Milken, the creative financier who ended up in jail.

But this was a very different time.

“It was the whole market environment,” Kohn said. “People were running from all kinds of financial counterparties,” he said. “Bear happened to be the weakest, so it was kind of the leading edge of the run. But it was clear that spreads were spiking out” — meaning that investors were demanding unusually high yields to buy anything besides the safest securities — “that banks and other financial firms were having increasing trouble raising money, that hedge funds were cutting back their exposure to all kinds of counterparties. It just felt like the system was kind of imploding. And everybody was running for the safest asset: Treasury bills.” Neither the overseers of the nation’s financial plumbing nor anyone else understood the workings of the system until the pipes were seriously clogged.