In FED We Trust (26 page)

“It was just clear that this franchise was going to unravel if the deal wasn’t done by the end of the weekend,” Paulson said a few days later.

No one at the Fed had ever anticipated a weekend like this one. Although the New York Fed has three dorm-style rooms for emergencies, Bill Dudley,
the markets’ chief, slept on the floor of his small office off the trading floor instead of trying to make it home to New Jersey. Tom Baxter, the Fed’s general counsel, who lives in Staten Island, bought an air mattress and pillow and slept on his office floor, too — and stored the mattress and pillow in a file drawer in case there was a next time. Bernanke himself spent a night or two on the couch in his office.

On Saturday morning, after checking in with Bernanke and Paulson, Geithner went to see Paul Volcker at his Manhattan apartment. It was classic Geithner, acknowledging the older man’s experience and stature, and seeking his advice and his blessing. Geithner had an almost Asian reverence for his elders, making time to play tennis with Greenspan even after he retired. By now, Greenspan’s star was waning. Volcker — who had been vilified by the public for causing a deep recession in the 1980s, though celebrated by the bond market and economists for vanquishing inflation — was on the rise. Indeed, events had turned him into something of a seer. In recent years, he had been a notable and vocal skeptic about financial engineering and had further let it be known that he thought Greenspan hadn’t worried enough about the banks.

Volcker, about a foot taller than Geithner, greeted Geithner with a reference to the little Dutch boy and the dike: “How’s your finger?”

Volcker’s advice: find a buyer for Bear Stearns — quickly.

That was the plan. But it proved difficult.

Hank Paulson figured that every potential buyer knew that Bear Stearns was desperate and available. He was skeptical of rumors that Germany’s big Deutsche Bank might be interested, but called its CEO, Josef Ackermann, anyhow. Deutsche wasn’t interested. Private equity investor J. C. Flowers was interested but couldn’t raise the $20 billion or so he needed. As one option after another disappeared, a solitary potential buyer was left: JPMorgan Chase. No one else was strong enough to say with credibility on Monday morning that it stood behind every trade on Bear Stearns’s books.

On Saturday night, after talking with Jamie Dimon, Geithner and Paulson
were relieved. “I’ve talked to Jamie,” Geithner told his team. “We’ve got a deal. They’re going to buy them.” The price was between $8 and $12 a share — somewhere between $945 million and $1.4 billion. And the Fed wouldn’t need to put in a dime.

To monitor the talks, Paulson dispatched Neel Kashkari. He was thirty-five years old, a junior Goldman Sachs investment banker on the West Coast who had failed at his first attempt at a Washington foothold with an unsuccessful application to be a White House fellow, a prestigious internship for thirty-somethings. When Paulson was named Treasury secretary, Kashkari volunteered, and Paulson hired him. Around 10:15
P.M.
, Kashkari e-mailed Bob Steel, the undersecretary for domestic finance, and David Nason, a securities lawyer who had worked at the SEC before becoming an assistant Treasury secretary, that he had heard from Paulson and Geithner that “the deal is basically agreed to.”

“Tim confirmed that to the group,” Steel e-mailed back, referring to government officials Geithner had been informing. Nason typed back: “Awesome. TG [Tim Geithner] seemed pretty relaxed.”

It sounded too good to be true, and it was. The next morning, Dimon called Geithner to say JPMorgan had changed its mind. After a night of scouring Bear Stearns’s books, the deal looked too risky. In particular, Morgan didn’t want to take Bear Stearns’s mortgage-linked securities. Bear had sold the best of its book already, Dimon told the Fed and the Treasury, and Morgan didn’t want to add to the mass of mortgage securities it already had.

Paulson didn’t get the word right away. He was doing the Sunday talk show circuit, and Kashkari couldn’t immediately reach him. Geithner labored to keep JPMorgan interested while pressing Fed staff to figure out if there was some way the Fed could close the gap. Bernanke stayed in touch by phone but left the on-the-ground negotiating to Geithner. As for Jamie Dimon, he held the best cards, and he knew it. The government wanted to sell Bear Stearns before the markets in Asia opened, and Morgan was the only potential buyer left. Ergo, the government was going to have to subsidize this deal. The only question was who and how much. (One question would linger for months: How much would JPMorgan have lost, given that it had sold insurance to others against a Bear Stearns default in the credit default swaps market?)

Geithner and Bernanke had few doubts that the U.S. government, broadly defined, should pony up, but they knew this was a step beyond the Fed’s traditional role of pumping liquidity into the markets. The lawyers would devise language to get around the requirement that the Fed could make loans, not buy assets. But that would be legal semantics. The fact was, the Fed was about to purchase assets that it would likely hold for up to ten years, assets that had more than a little stink on them. But the spirit of the law was clear: the Fed should not make a deal if it anticipated a loss. Its job was to keep healthy banks functioning and provide liquidity; if a bank was broke, if losses had depleted its capital, that was supposed to be a problem for the keepers of taxpayer money in the executive branch and in Congress.

The Fed’s first choice was to get Treasury to put up the money. Had Bear Stearns been a conventional bank, funding might have come from the Federal Deposit Insurance Corporation, a government agency financed by insurance premiums paid by banks and backed by the full faith and credit of the U.S. government. But Treasury lawyers said they couldn’t spend money without an act of Congress, and there was no time to seek that. The Fed pushed for the Treasury to promise to “indemnify” the Fed if the mortgage-l inked securities ultimately weren’t worth the $30 billion. Paulson was willing to go along. Treasury lawyers rejected that, too, and with that, the Fed’s options came down to a precious few — three, to be exact.

One was to let Bear go under and try to contain the damage. Geithner and Bernanke weren’t willing to take that risk. “It became clear that Bear’s involvement in the complex and intricate web of relationships that characterize our financial system, at a point in time when markets were especially vulnerable, was such that a sudden failure would likely lead to a chaotic unwinding of positions in already damaged markets,” Geithner said. It would have “cast a cloud of doubt” on Lehman Brothers, Merrill Lynch, and others “whose business models bore some superficial similarity to Bear’s, without due regard for the fundamental soundness of those firms.” The consequences, Geithner concluded, would have been “unpredictable but severe” and almost surely would have meant lower stock prices, lower house prices, and less credit for companies and households.

A second option was to buy time to see if the Fed could find an offer to compete with JPMorgan’s. “My question then was whether we could get through another several days to run a more robust auction,” Warsh said. “And the answer I think was that we probably could not.”

Geithner saw it the same way: “The only feasible option for buying time would have required open-ended financing by the Fed to Bear into an accelerating withdrawal by Bear’s customers and counterparties,” he said.

That left the third choice: subsidizing JPMorgan’s acquisition of Bear Stearns. Geithner told Paulson that Dimon was talking about offering $4 or $5 a share for Bear Stearns. Paulson thought that was too much. In large part, he figured that every nickel JPMorgan Chase’s Dimon paid Bear shareholders was another nickel he would be asking the government to provide. But he also believed that shareholders in all financial firms needed to be reminded of the rules of capitalism: shareholders take risks and get the rewards of success and the pain of failure. Paulson called Dimon, and the secretary told the banker that $4 or $5 “sounded high.” JPMorgan offered $2, or about $236 million in all.

An e-mail circulating inside Treasury captured the apparent bargain price Jamie Dimon had struck: “Did you know the LA Glaxy [sic] paid more for Beckham than JP [Morgan] did for Bear??” (The LA Galaxy soccer team signed the British soccer superstar to a five-year $250 million contract in 2007.)

To satisfy Fed lawyers, the Fed subsidy was cast in the rhetoric of a loan. But the Fed was effectively spending $30 billion of its money to buy mortgage-l inked securities that JPMorgan didn’t want. JPMorgan, to the Fed’s discomfort, described them unattractively as “illiquid assets, largely mortgage related” on a Sunday-night conference call with securities analysts, a reference that implied it was sticking the Fed with the worst of Bear’s holdings. The structure of the deal stretched Section 13(3) of the Federal Reserve Act. Because the Fed wasn’t supposed to buy the securities outright, it borrowed a tool from financial engineers whose handiwork had led to the Great
Panic. It created a “special purpose vehicle” to hold the assets. Then it made a loan to that entity and argued that the loan had been secured by those Bear Stearns securities. And if they proved to be worth a lot less than the price the Fed had paid, the Fed — not JPMorgan Chase — would eat the loss.

“It took some time before the political class realized that the Fed had not just lent money to JPMorgan to buy Bear Stearns, but in effect now owned the downside of a portfolio … of possibly dodgy assets,” wrote Phillip Swagel, who had been the Treasury’s top economist at the time, in a 2009 reprise of the Treasury’s actions during the Great Panic.

Beneath such technicalities, though, lurked some big unresolved issues. The Treasury and the Fed were united on the necessity of the Bear Stearns deal, but neither side wanted to take all the blame when the inevitable bailout backlash erupted. To the Fed, the Treasury seemed to be maneuvering to put as much of the responsibility as it could on the Fed. At the Treasury, the often-repeated view was that “all money is green” — that it didn’t matter which branch of the government was putting the money on the table, it was all the taxpayers’ money ultimately. The Fed was uneasy that it was stepping over lines it had traditionally drawn. It wanted a veneer of political cover for using its money for what Fed officials thought was properly the responsibility of the Treasury — if only Congress had given it the power to act.

At the very least, Bernanke and Geithner wanted Treasury to endorse putting taxpayers on the hook for an action that went well beyond lending to keep markets lubricated. They settled for a terse thank-you note signed by Paulson, offering his “support” for the Fed’s extraordinary action “as appropriate and in the government’s interest,” and even that took hours of negotiations. Paulson didn’t explicitly say taxpayers were behind the loan — his lawyers said he couldn’t — but he did acknowledge that if the Fed lost money, it would have fewer profits to turn over to the Treasury, so the tab eventually would fall on the taxpayers. The Treasury didn’t release the letter, though. To the surprise of Paulson’s staff, neither did the Fed. It became public only when a congressional committee asked for it later.

The pattern was established. Paulson was a stubborn, forceful, and experienced negotiator. He didn’t care if the folks on the other side of the table detested him. Bernanke was different. He was, by nature, more conciliatory.
And he was prepared to do
whatever it takes
to save the economy — even if that meant taking flak inside the Fed for allowing Paulson to push him around or stretching the Fed’s mandate and intervention in the economy beyond what was customary.

On Sunday afternoon, the Fed board met to ratify the $30 billion deal and invoke the “unusual and exigent” clause for the third time in less than a week. Mishkin was back from Finland and in on this vote — by phone from New York. He believed the Fed had no choice. “The issue is not recession,” he said. “The issue is can we get something that we just can’t control.”

Mishkin and his wife had plans to see
Sunday in the Park with George
in New York on Sunday afternoon, and he went, anticipating that he would have to leave for a Fed board meeting. When the call came during the second act, Mishkin left the theater and took the call in his car, which he had parked nearby for this purpose.

This being New York, the driver of a passing car noticed him in the car and thought he’d spotted a choice parking place about to open up.

He knocked on Mishkin’s window.

“Go away!” Mishkin told him, gesticulating with one hand while holding his cell phone with the other. Eventually, the guy got the message. “We are bailing out Bear Stearns, and this guy is knocking on my damn window,” he recalled. “It was like a
Seinfeld
episode.”

Mishkin and his colleagues did more than sign off on the Bear deal that Geithner had negotiated. Declaring circumstances to be unusual and exigent, they formally and publicly expanded the ranks of firms to which the Fed would lend directly to include all remaining securities firms of consequence through what they called Primary Dealer Credit Facility, or PDCF. The objective was to shore up confidence in the remaining investment banks by making clear that they could borrow directly from the Fed, reducing the risk of a Bear Stearns — like run on any other investment bank. As the New York Fed’s Dudley put it, “The Primary Dealer Credit Facility essentially
puts the Federal Reserve in the position of tri-party repo investor of last resort.” (Translation: The shadow banking system was collapsing, and the Fed was taking its place, one market at a time.) It was a good idea; it wouldn’t prove sufficient.

Except for Geithner, the regional Fed bank presidents hadn’t been part of the conversations about Bear Stearns. Bernanke and Kohn tried to reach them all Sunday. San Francisco’s Yellen was on a plane on her way to Washington for Tuesday’s FOMC meeting and missed the call from Kohn. Alerted by a San Francisco Fed staffer, she dialed into a conference call that the Fed had with reporters to fill them in on the details. The twelve bank presidents had planned to have dinner together Monday night at the Fairmont Hotel in Washington, where they always stay during FOMC meetings. An e-mail alerted them that Bernanke was going to show up to field questions about Bear Stearns along with Geithner, who came late.