In FED We Trust (32 page)

“I kind of scared them,” Bernanke later said. “I kind of scared myself.”

Paulson then explained what they wanted from Congress. He outlined a plan to get bad real estate loans off the banks’ books — the “break the glass” plan that had been on the shelf at Treasury for months. He talked about auctions where many sellers (the banks) would vie to offer mortgage-linked securities to one buyer (the Treasury), which would turn to private money managers to manage and eventually sell the portfolios. He told the representatives and senators that the Treasury’s purchases of such securities could drive up their price and thus help the banks, a notion that would prove a sticking point later on.

A couple of members of Congress asked about using taxpayer money to invest directly in banks instead of buying what came to be called “toxic assets.” It was an idea popular with academic experts in finance. And it was one that Bernanke quietly favored. Advocates saw rebuilding banks’ capital cushions as a necessary step toward a return to normal lending. The Democrats liked the idea, but for different reasons: they wanted to be sure the taxpayers got some of the upside if they were going to bail out the banks, and they saw ownership as a lever on what banks did. Paulson was discouraging. Bernanke was silent on the point, reluctant to display any disagreement with Paulson.

How much money do you need? Paulson was asked.

“Several hundred billion dollars, for starting off,” he said, refusing to be more precise. No one needed to be told that he was talking a lot of money.

Republican leaders Senator Mitch McConnell and Representative John Boehner as well as Pelosi, all stunned by the bad news, were quick to assure Bernanke and Paulson that Congress would give them what they needed.

Nevada’s Harry Reid, the Senate majority leader, wasn’t so sure. “This is not an easy thing to do. You are coming here to ask taxpayers to spend hundreds
of billions of dollars. … We’re elected. You’re not. This needs hearings. … I know the Senate. It takes two weeks to pass a bill to flush the toilet.”

His Senate colleagues, both Republican and Democrat, abruptly contradicted him. McConnell said, “If what’s at stake is saving the country, then we can get it done in record time.”

But there were hints of the political difficulties that lay ahead. Senator Richard Shelby of Alabama, senior Republican on the Banking Committee, said, “It sounds like a blank check. When’s this going to end?”

Barney Frank and Chris Dodd pushed to include something for beleaguered homeowners whose mortgages exceeded the value of their houses. “You aren’t selling this plan to a boardroom. You are selling it to the American people,” Frank said, warning Paulson and Bernanke that Congress would impose conditions.

Asked what would happen if it didn’t pass, Paulson replied, “If it doesn’t pass, then heaven help us all.”

The congressional leaders asked Paulson to submit a written plan over the weekend and then — joined by Paulson and Bernanke — faced the television cameras and stoically promised to do
whatever it takes
.

As he drove to the office along Washington’s Rock Creek Parkway a few days later, Don Kohn, the Fed vice chairman, thought to himself with relief: as the Treasury stands up, the Fed stands down — a play on a Bush line about Iraq: “As the Iraqis stand up, we will stand down.” With financial wars as with real ones, though, timing can be everything.

In hindsight, the U.S. economy would have been much better off had Bernanke and Paulson gone to the president and Congress sooner and won the power and money that they later won. After Bear Stearns, both men had talked publicly about the need for new laws to cope with the imminent collapse of brokerage houses or other financial firms that weren’t a conventional bank. But they didn’t describe it as an emergency. And from their conversations with Barney Frank and others, they concluded that the odds of Congress acting on any request were very slim.

“Our political calculation was that we had to wait until we got to the point
where the case would be palpable and clear — that it would be early enough to do some good, but not so early that it wouldn’t be given serious consideration,” Bernanke said a few months later in an interview. “Our sense and our intelligence was, there was no hope of getting something like this, given the very short legislative schedule, given the complexity of such a thing, given the lack of appetite for such a thing. So we didn’t make a serious attempt to get Congress to pass anything,” he explained.

But then, second-guessing himself for a moment, he added, “If we had, we wouldn’t have gotten it … but at least we would have been able to say we tried.”

The turmoil in the financial markets during the week of September 15 didn’t revolve only around newfangled financial instruments, cross-border sophisticated bets, or the collapse of major financial institutions. In fact, the biggest surprise of Lehman’s collapse came from money market funds, the $1-a-share mutual funds that Americans had come to consider as safe as bank accounts. Money market funds had been on the Fed list of things to worry about for months, dating back to the fragility of the tri-party repo market and the Bear Stearns episode. But with so much advance speculation about Lehman’s frailties, it didn’t occur to Bernanke, Geithner, or Paulson — or any of their staff — that a major money market fund would hold a significant chunk of Lehman’s short-term debt. But the Reserve Primary Fund, the oldest of all the money market mutual funds, had 1.2 percent of its $63 billion in Lehman — holdings that would prove devastating and which couldn’t wait for Congress to act.

In a classic run, Reserve Primary Fund shareholders tried to withdraw $24.6 billion in the first twenty-four hours after Lehman’s bankruptcy, less than half of which the fund actually paid. Shortly after noon on Tuesday, the fund’s directors, desperate to avoid having to cut its share price below $1, decided to ask the Fed for help. Bruce Bent II, president of the fund’s
management company, called Geithner’s office and ended up explaining the situation to a secretary who promised to relay the information.

A couple of Fed staffers called back an hour or so later, listened, and said they would pass the request along. “The Fed officials cautioned the participants on the call not to be overly optimistic,” the minutes of the Reserve Fund’s board record drily. Around 3:45, the Fed said, “No.”

At 4:15
P.M.
, the fund issued a press release. The Lehman paper in its portfolio was worthless and the Fund’s shares were worth not $1, but only 97 cents: breaking the buck. The news triggered a run that spread through the $3.4 trillion industry. (Bruce Bent II and his father, Bruce Bent Sr., were later accused of fraud by the SEC, which said they had misled investors, credit rating agencies, and the money market fund’s trustees in failing to disclose “key material facts” about the fund’s vulnerability when Lehman collapsed, among other transgressions. The elder Bent said in a statement that he remained “confident that we acted in the best interest of our shareholders.”)

The run was another manifestation of the U.S. economy’s dependence on the shadow banking system — major financial intermediaries other than the banks, regulated by the government and covered by deposit insurance. Money market funds were formed in the 1970s to
avoid
regulation, to allow investors to earn a higher yield than regulations permitted banks to pay. Neither the funds nor federal officials considered them in any way insured by the government. But suddenly the economy was as vulnerable to a run on money market funds as it was to runs on banks.

And it wasn’t only ordinary savers who stood to get trampled. Scores of brand-name industrial companies — General Electric, Caterpillar, Dow Chemical — relied on the money market funds for their short-term borrowing, often issuing the funds IOUs called commercial paper that were backed only by the companies’ promise to pay. The Fed and the Treasury decided that to avoid a stampede out of money market funds, they had to find a way to assure consumers that the Reserve Primary Fund wouldn’t be followed by scores of other money market funds breaking the buck.

At the Fed, Don Kohn took charge of the response while Bernanke went to Capitol Hill and Warsh to New York. At the Treasury, the job fell to David
Nason, the assistant secretary for financial institutions. Nason recently had recused himself to look for a job. After AIG imploded, he dropped the job hunt and returned to work.

In the frantic search for a solution, talk bubbled up about the Fed lending directly to the money market funds. It turned out SEC rules forbid the funds from borrowing. There was talk about asking the Federal Deposit Insurance Corporation to insure the money market fund deposits; that went nowhere. There was talk about allowing industrial companies to come directly to the Fed for loans, an idea that resurfaced a few weeks later. The money market fund industry itself was split on the question of government aid. The biggest funds thought they could protect themselves and the $1-a-share value and didn’t want to pay for government insurance or invite politicians into their business. The smaller funds were desperate.

Kohn, his office crowded with Fed staffers, worked into the night Thursday to come up with another Fed lending initiative that would get around the inability of the money market funds themselves to borrow. Otherwise, the funds would end up having to dump securities in a falling market. Invoking the “unusual and exigent circumstances” power again, the Fed said it would lend money to banks which, in turn, would use the money to buy commercial paper from money market funds — provided the commercial paper was backed by assets of some sort (often loans or leases) so there was collateral if the issuer of the IOU didn’t pay. The Fed, not the bank, would get the collateral and take the hit if the company that issued the IOU didn’t pay. Within a week, the Fed had financed $73 billion worth of commercial paper; within two weeks, the demand for money was so great that it was up to $150 billion. Step by step, the Fed was becoming the lender of last resort not only to the banks but also to the entire U.S. economy.

The Treasury, moving for the first time to put its money on the table, said it would stand behind any money market mutual fund that agreed to pay an insurance premium so it could insure customers that it wouldn’t break the buck, an extraordinary move by the government. To pay any claims, Paulson turned to the Exchange Stabilization Fund, the kitty Congress had created in 1934. After some back-and-forth between the Treasury and the White House over the legalities, Bush signed an order late Thursday night,
September 18, allowing the Treasury to announce the agreement Friday morning and attempt to stem the outflows. In the end, Treasury didn’t pay any claims, but Congress later forbid future Treasury secretaries from using the Exchange Stabilization Fund for this purpose.

Despite the April 2008 “break the glass” memo, the Treasury hadn’t done much detailed work on exactly what it would ask of Congress if the time came. Work intensified after the AIG loan, once it became clear that a trip to Congress was imminent. The original plan was to ask for $500 billion. But Treasury staff recalled that when Congress had given the Treasury up to $100 billion for Fannie Mae and Freddie Mac, the Treasury thought it was a figure close to infinity, and the markets shrugged and said it wasn’t enough. So Paulson and company agreed to up their request to $700 billion. No one thought that could possibly be insufficient. Once again, they were wrong. Every time officials at the Treasury or the Fed thought they finally had gotten ahead of the Great Panic, they turned out to be insufficiently pessimistic. This would be a distinguishing characteristic of this chapter in American economic history: even when officials thought they were planning for the worst-case scenario, they weren’t.

When it came to dealing with the White House and Capitol Hill, Bernanke largely left the politics to Paulson — and occasionally to Kevin Warsh. Unlike Greenspan, Bernanke didn’t have long-standing relationships with senators like Utah’s Bob Bennett or Chris Dodd of Connecticut, ties that were useful at times like these. Bernanke wanted just two things: the Treasury to have some money in its pockets so the Fed could stop being Paulson’s piggy bank, and a law to give the government the flexibility to buy shares in the banks — to invest taxpayer money in them. The calculus was simple, though very hard to explain to politicians and the public. Banks set aside a certain amount of capital for every loan — the riskier the loan, the more capital. When banks take big anticipated losses, the capital cushion absorbs the pain. With less capital to support lending or purchases of securities, a bank has only two choices: shrink by lending less and selling securities, or raise more capital so it can lend more
and buy securities. The first option can be profitable for a bank and its shareholders, but the economy as a whole greatly prefers the second one.

For his part, Paulson didn’t want to speculate about injecting capital into the banks, even though some inside the Treasury did. His reasoning was both political and practical. Politically, a Bush administration proposal to buy bank shares would be seen as socialism by Republicans and a lever to pursue a social agenda by Democrats. Practically, Paulson figured any hint that the government would buy bank shares would scare off any
private
investors — especially after the terms on which the government had forced capital on AIG and Fannie Mae and Freddie Mac.

“I’d watched Fannie and Freddie, and watched us get authority to inject equity,” he said in an interview later. “And the first thing the market said was, ‘Gee, that’s good.’ The second thing they said was, ‘My gosh, we’re not going to buy any equity until we know the terms the government’s going to come in with.’ So the last thing in the world I wanted to do was to start talking publicly about putting equity in the banks.”

Paulson even discouraged internal conversations about buying shares in the banks. At one Sunday session, Treasury and Fed officials gathered in a Treasury conference room to discuss options for dealing with the deterioration of the banking industry. Midlevel Treasury officials had prepared a series of slides, a few of which weighed the pros and cons of injecting capital, but one of Paulson’s Goldman Sachs crowd, Ed Forst, told them to skip those slides. “Hank doesn’t want to talk about capital injections,” he said. With so many people in the room, Paulson reasoned, word that the Treasury was talking about putting capital into the banks would almost surely leak.