In FED We Trust (33 page)

Bernanke knew the government eventually would put capital into the banks; that had happened in every significant banking crisis in history. However, he saw no reason to challenge Paulson’s public statements and focused instead on making sure that the legislation was flexible enough to permit government purchases of bank stock.

Paulson, though, botched the theater. He, and the reputation of the entire bank rescue initiative, never recovered even though Congress did okay the money. Responding to advice from congressional leaders, who told Paulson to let them write the details, the Treasury offered a bare-bones, three-page
draft of the proposed legislation. It sought to give the Treasury secretary the unlimited power to buy “mortgage-related assets” and defined the term “mortgage-related assets” broadly as “any securities, obligations, or other instruments” that are “based on or related to” residential or commercial mortgages. Treasury’s general counsel, Bob Hoyt, assured colleagues that the phrase was broad enough to cover buying bank shares. But Paulson wasn’t contemplating large-scale purchases of bank shares at that point.

Indeed, Paulson was so determined to avoid hurting bank stock prices or scaring off any outside investors in banks that he left himself no wiggle room in congressional testimony. “There were some that said we should just go and stick capital in the banks, preferred stock,” he told the Senate Banking Committee. “And that’s what you do when you have failures. You know, that’s what happened in Japan. That’s what happened in other spots. … But we said, the right way to do this is not going around and using guarantees or injecting capital.” Two days later, he told the House Financial Services Committee the same thing.

The alternative, he said, was to use the money to buy “toxic assets” — mainly securities linked to mortgages that weren’t worth anything near their face value — from the banks. But Paulson had a hard time explaining the strategy. Was the game plan to buy these toxic assets from the banks as cheaply as possible so that the banks, freed of this burden, would find it easier to raise capital privately so they could increase lending? Or was the plan to pay more for the assets than the market said they were currently worth, giving the banks some profits they would use to fatten their capital cushions without going to the hostile markets.

The dilemma was obvious to those who knew anything about banking. “If you end up paying too little … you’re not giving them the support that they need,” Senator Bennett, the Utah Republican who was a senior member of the Senate Banking Committee, told Paulson and Bernanke when they testified on the request. “If you end up paying too much, then there’s no upside potential for the taxpayer, when the time comes for you to liquidate these.”

“You’re right,” Paulson told him. “The problem is easier to define than to solve. And we believe that we’re going to get the right group of experts, and we’re going to come up with a solution, and it will be different with different asset classes and in different situations.”

It was a tension that Paulson would never be able to resolve to the satisfaction
of either the politicians in Congress or the public. A few months after leaving the Treasury, Paulson reflected on lessons he had learned while on the job. “It’s difficult,” he said, “to get the politics, the policy, and the market reaction all right at any one point in time. It’s virtually impossible to get all three of them right, but if you get any one of them very wrong, then you’re not going to succeed.”

In any event, House Republicans were not buying Paulson’s argument. To quell the rebellion, Vice President Dick Cheney and the Fed’s Kevin Warsh — in his role as the Fed’s liaison to Republicans — went to Capitol Hill to try to persuade them on Tuesday morning, September 23, accompanied by Keith Hennessey of the White House staff. Hennessey tried Great Panic 101: “Our entire banking system is dramatically undercapitalized. They bought mortgages and complex securities they didn’t understand, and they didn’t check to see if the mortgages were any good,” he said, according to a copy of his presentation. “While the core of the problem was mortgages … and the purchase of overvalued mortgage-backed securities, the underlying problem is that banks don’t have enough capital.”

Referring to the post-Lehman fallout, Hennessey said, “The really scary thing is what happened in the second half of last week. Investors had been losing confidence in individual institutions. Investors began to lose confidence in the entire financial industry.

“If Ben Bernanke hadn’t dumped tons of liquidity on the market, we would have been in a financial meltdown,” he told them. Hennessey had a metaphor ready that he didn’t use: it’s like losing a quart of oil every mile you drive down the highway. If you don’t fix it, the engine block will crack.

The night before Bernanke and Paulson were to testify before the Senate Banking Committee, a copy of Bernanke’s testimony was provided to congressional
committees. That’s routine. The leak that followed was less routine. Well before morning, the
New York Times’s
Web site posted a story describing what the Fed chairman was going to say — except that Bernanke had decided to do a changeup.

Shortly before 8
A.M.
, he showed his staff a handwritten alternative to the remarks they had vetted and distributed. “I’m not going to be talked out of this,” he said. His staff was uneasy. Any switch in text was bound to provoke confusion, since copies of his prepared testimony now had been distributed to the press as well. And the argument he was making was hard even for some Fed staffers to follow. Bernanke went ahead anyhow.

To bolster Paulson’s case for buying assets, Bernanke turned professorial. “I’d like to ask you for a moment to think of these securities as having two different prices,” he said to the committee. “The first of these is the fire-sale price. That’s the price a security would fetch today if sold quickly into an illiquid market. The second price is the hold-to-maturity price. That’s what the security would be worth eventually, when the income from the security was received over time.” One could almost see him writing on the blackboard at Princeton as he spoke.

“If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits. First, banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down.”

It sounded as if Bernanke was suggesting the Treasury buy the assets from banks at an inflated price to pump up their profits and thus their capital. What he meant, he explained later, was that the presence of the Treasury as a buyer would push up the price of the assets closer to their long-run value. But even sophisticated observers misunderstood him.

At an early-morning Fed staff meeting the next day, September 24, a staffer unfamiliar with the snafu lauded the chairman’s comments. “Well, Michelle didn’t like it,” Bernanke said, referring to Michelle Smith, his chief spokeswoman. “Don’t worry,” Bernanke said, “I’m going to fix it.”

The next morning, Paulson had been asked to meet with the rebellious House Republicans who had been so hostile the day before to Cheney, Warsh, and Hennessey. His staff told him that Bernanke couldn’t make it.
Paulson knew he needed Bernanke’s calm credibility and pleaded with Bernanke to join him. Bernanke changed his plans and showed up to bolster Paulson. The House Republicans listened but were not persuaded.

After that closed-door meeting, Bernanke appeared before the Joint Economic Committee of Congress and said his previous day’s comments “might have been slightly misunderstood.”

He tried again: “Many of these assets are now currently being sold only under distressed circumstances to illiquid markets. And that leads to very low pricing, pricing which I refer to as fire-sale pricing. It’s that fire-sale pricing and the markdowns that it creates for banks that is one of the sources of why capital is being reduced and why banks are unable to expand credit.”

If the Treasury began bidding for these assets, the price would rise above the fire-sale price, he argued. “However, I am not advocating that the government intentionally overpay for these assets. Rather, what I’m saying is that it’s possible for the government to buy these assets, to raise prices, to benefit the system, to reduce the complexity, to introduce liquidity and transparency into these markets, and still acquire assets which are not being overpaid for in the sense that under more normal market conditions, and if the economy does well, most all of the value can be recouped by the taxpayer.”

That hearing was followed by another, this one in the cavernous chamber of Barney Frank’s House Financial Services Committee, where an even more serious weakness of the Bernanke-Paulson road show was exposed: Wall Street was in a panic, and both men knew the rest of the economy would suffer unless the government acted swiftly and forcefully. But the voters hadn’t felt the pain yet and concluded that the banks, not the rest of the country, were being bailed out. Sympathetic congressmen served up softball questions so Bernanke and Paulson could use the televised hearing to reach beyond the Beltway.

But Walter Jones, a Republican, read a letter from a $40,000-a-year worker from eastern North Carolina: “These bailouts should be about as welcome as malaria. I’ve read the Constitution. Nowhere does it say that taxpayers are the default dumping ground for mortgages made to people who cannot afford them.”

To which Jones added: “They do not see why we have to be bailing out those people whose greed quite frankly got them into trouble.”

Bernanke acknowledged the “communications” issue and tried his best to sway the hearts and minds of the voters: “People are saying, Wall Street, what has that got to do with me? That’s the way they’re thinking about it. Unfortunately, it has a lot to do with them. It will affect their company. It will affect their job. It will affect their economy. That affects their own lives, affects their ability to borrow and to save and to save for retirement, and so on. So it’s really a question of saying, there’s a hole in the boat. You did it. Why should I help you? Well, there’s a hole in our boat. We need to fix it, and then we need to figure out how to make sure it doesn’t happen again.”

During a break in that hearing, Bernanke’s spokeswoman, Michelle Smith, told him that Bush had scheduled a television address to the nation on the financial crisis for 9
P.M.
She knew that Bernanke, a fan of Washington’s sorry baseball team, the Nationals, shared season tickets with White House Chief of Staff Josh Bolten and had plans to go to that night’s game.

“You can’t go to the baseball game,” Smith said.

“It’s my last game [of the season],” he protested.

“You can’t go,” she insisted.

“I know,” he said, with resignation.

The Nationals lost to the Marlins, 9-4.

The next day, Thursday, September 25, Bernanke again accepted some of Smith’s advice.

Presidential candidate Barack Obama had called opponent John McCain about issuing a joint set of principles, hoping that such an extraordinary move would help avoid a meltdown. McCain took the call, countering with a suggestion that the two suspend campaigning. Before Obama got back to him, McCain announced unilaterally that he was leaving the campaign trail and flying to Washington to help break the stalemate. The two candidates ended up at the White House Thursday afternoon with Bush and the bipartisan leadership of Congress.

The event turned into a PR disaster for everyone — a partisan free-for-all that tarnished the reputations of nearly everyone in the room. After the meeting disintegrated, Democrats caucused to consider whether to go before the
waiting cameras. Paulson walked in and begged them: “Don’t blow this up, please.” The Democrats shouted back that his fellow Republicans were the problem. In what became one of the most celebrated — though, alas, unphotographed — moments of Washington’s response to the Great Panic, Paulson dropped down to one knee, as if in prayer. “Hank,” said Pelosi, “I didn’t know you were Catholic.”

Wisely, Bernanke wasn’t there. He had taken Smith’s advice to stay away. And as Paulson went back to Capitol Hill to negotiate what eventually became the $700 billion Troubled Asset Relief Program (TARP), Bernanke stayed away. It was time to leave politics to the politicians.

W
hile Congress bickered, the Four Musketeers were struggling to prevent the American financial system from going under. With no master plan, the Fed — assisted by the Treasury and bank regulators — continued to administer emergency, experimental medicine to failing banks and desperate markets.
Whatever it takes
.

In a little more than a week in mid-September, the nation’s banking landscape had been radically transformed: Lehman had collapsed, and Bank of America had bought Merrill, leaving only two big investment banks — Morgan Stanley and Paulson’s Goldman Sachs. Then, on September 21, the Sunday following Lehman’s bankruptcy, the Fed turned these last two investment banks into bank-holding companies, a power granted by Congress that the Fed had used sparingly in the past. The change in legal status seemed a technicality to most people, and the news was overwhelmed by headlines about the chaos on Capitol Hill. But Morgan Stanley’s and Goldman Sachs’s makeover gave them the Fed’s public promise of protection and a permanent source of lending in a crisis — unlike the supposedly “temporary” lending access they had been granted post — Bear Stearns. In exchange, the companies had to submit to Fed oversight and limits on how much they could borrow. (Before the Great Panic was over, American Express and GMAC,
the auto-finance arm of General Motors, also would become bank-holding companies, further extending the Fed’s reach.)