In FED We Trust (34 page)

The change for Morgan Stanley and Goldman Sachs marked the end of a business model: lucrative, lightly regulated investment banks that borrowed far more heavily than commercial banks and did lots of trading for their own accounts as well as for clients. Now, as bank-holding companies, the firms would become less leveraged, less profitable, and more regulated. For the Fed, the change made official what was already becoming apparent: it was the overseer of all of Wall Street now, a fact that Congress would later be asked to ratify by designating the Fed as the nation’s “financial stability regulator.”

Morgan Stanley and Goldman Sachs further insulated themselves from the ongoing turmoil by raising additional capital on their own, as Paulson had hoped they would. With assurances from Paulson that the U.S. government wouldn’t screw them later, Japan’s Mitsubishi UFJ Financial Group proceeded with a previously planned, though renegotiated, $9 billion investment in Morgan Stanley, giving Mitsubishi a 21 percent interest in the venerable firm. Goldman Sachs quickly raised $5 billion in capital from legendary investor Warren Buffett and another $5 billion from others.

Next up was Washington Mutual, known as WaMu, an aggressive Seattle mortgage lender whose roots dated to 1889. In 2003, WaMu’s chief executive, Kerry Killinger, famously boasted, “We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs, and Lowe’s — Home Depot did to their industry.” But the subprime loans that WaMu executives pressed their loan officers to make, it turned out, weren’t as profitable as lattes and sixty-roll cartons of toilet paper — particularly when the housing bust arrived.

On September 25, after a spectacular run that saw 9 percent of WaMu’s deposits flee in ten days, the federal Office of Thrift Supervision seized the bank and its two thousand branches, and turned the whole sinking mess over to the FDIC. That agency, created in the Depression to cope with bank failures just like this, found a ready buyer for the bulk of WaMu’s business: JPMorgan Chase, the savior of Bear Stearns, which had been wooing WaMu for months. It paid $1.9 billion for all WaMu branches, deposits, and loans, and agreed to stand behind its financial contracts — $40 billion less than
the lender was worth at the peak of market value in late 2003. Shareholders, however, were wiped out, including private-equity investors who had sunk $7 billion into WaMu shares back in April.

From the outside, the financial rescue looked efficient if somewhat brutal. But inside government, debate erupted over whether to protect the holders of WaMu’s debt. With Bear Stearns, the Fed had provided that protection. At Fannie Mae and Freddie Mac, the Treasury had done the same. WaMu, though, fell within the jurisdiction of the FDIC, whose strong-willed chairman, Sheila Bair, vowed this one would be different.

A lawyer from Kansas who got her start in Washington with Senator Bob Dole, Bair worked at the Treasury early in the Bush administration, then took a teaching job at the University of Massachusetts at Amherst. She was called back to Washington — by then — White House aide Kevin Warsh, among others — to take over the FDIC in an only-in-Washington saga.

Bush’s initial choice for the top FDIC job, Diana Taylor, a New York state bank regulator and companion of New York mayor Michael Bloomberg, was thought to have been shot down because the National Rifle Association objected to Bloomberg’s gun-control stance — an accusation the NRA denies. Whatever the reason, the job was then offered to Bair. Senate Democrats investigating Bair were advised by a former Clinton aide to whisk her through before the administration caught on to her views. In fact, Bair turned out to be a far more assertive regulator than the Bush White House had anticipated.

Early in his term as chairman, Bernanke had courted Bair, once going to her office and sitting next to her at a computer keyboard to fashion a compromise on a prolonged argument over the U.S. government’s implementation of an international agreement on bank capital. But during the Great Panic, Bernanke, Paulson, and Geithner found her stubborn and myopic. They grew impatient with her staff, and they envied the political agility that made her a hero on Capitol Hill as an advocate for beleaguered homeowners. Bair was also a fierce and relentless defender of the FDIC fund, putting protection of
that kitty above all else, frustrating Bernanke, Geithner, and Paulson, who saw preventing the collapse of the American financial system and economy as a greater goal. After all, the Fed was stretching its legal mandate almost daily to save the economy while Bair was arguing legal technicalities and institutional self-interest. More than once, Paulson had met one-on-one with Bair and, with the single-minded focus on the client that had made him a success at Goldman Sachs, had pushed her to alter her position.

At WaMu, Bair decided, neither insured depositors — those with $100,000 or less in the bank — nor the FDIC insurance fund would take a hit. Instead, holders of WaMu debt would suffer along with WaMu shareholders. Bair had a good argument for this: the law required FDIC to find the “least-cost” solution to any failing bank in all but extraordinary circumstances. Letting WaMu debt holders feel the pain would save the FDIC money — and ultimately protect taxpayers, since they stand behind the deposit-insurance fund — while reminding investors that they should scrutinize banks before buying their bonds, the sort of “market discipline” that was supposed to keep bank managers from taking foolish risks.

Geithner strongly objected to Bair’s reasoning. Yes, he said, investors needed a reminder not to expect a government bailout, but pursuing that objective at a moment of intense financial panic was somewhere between imprudent and dangerous. And there was a way out: a 1991 law said that the least-cost rule could be waived for a “systemically important” institution if the FDIC, Fed, and Treasury, in consultation with the president, agreed.

Geithner first complained directly to Bair, who would not be moved. He then called Don Kohn, who had been mediating between the FDIC and the Office of Thrift Supervision. And he lobbied John Dugan, the comptroller of the currency and regulator of national banks, the ones most vulnerable if the terms of the WaMu deal undermined investor confidence. Geithner was beginning to sound like a shill for the banks. He knew that. But in the midst of the Great Panic, the government couldn’t sweat such details.

Bernanke, on the other hand, wasn’t as worried as Geithner. He was reluctant to pull the “systemic risk” emergency cord — especially since JPMorgan Chase was willing to take over all of WaMu’s operations and stand behind all the bets it had made in financial markets. Ultimately, Geithner and WaMu debt holders
lost. The latter group was left waiting to see if any money would fall their way in a bankruptcy proceeding against WaMu’s parent, but there wasn’t much.

The reaction to whacking the bondholders in the middle of the Great Panic instead of bailing them out was much as Geithner feared. “This is an unprecedented destruction of senior bondholders such that bank bond investors may be thinking to themselves ‘why bother?’” analysts at Royal Bank of Scotland screamed. “There is now a precedent set which is taxpayer friendly and 100 percent risk asset hostile” — that is, hostile to private investors who had bought bank stock or debt. The move raised big questions that the Fed, Treasury, and FDIC didn’t answer, questions that lingered well into 2009: Which investors in banks are to be protected, and which are not? Who is going to bear the losses — the shareholders? The bondholders? The other bank creditors? The investors and institutions who sold insurance to the creditors in the credit default swaps markets? The taxpayers?

Close behind WaMu was Wachovia, a big North Carolina bank that had gambled — and lost — on the real estate market when it bought Golden West, a California mortgage powerhouse. In July, Wachovia, the nation’s fourth-largest bank — more than twice as large as WaMu — had hired Bob Steel from Paulson’s Treasury to be its chief executive and rescuer. Steel initially hadn’t intended to sell the bank, but in the wake of Lehman’s bankruptcy, he found it impossible to raise the capital needed to maintain Wachovia’s independence. He shopped the bank to Goldman Sachs and Morgan Stanley without success, and talked with Spain’s Santander and San Francisco’s Wells Fargo. Meanwhile, Vikram Pandit, Citigroup’s CEO, was aggressively pursuing Wachovia as a way to expand the deposits that Citigroup desperately needed. On Wednesday, September 24, Steel stopped playing hard to get and tried to reach Pandit to begin takeover talks; they finally connected by e-mail at 4:27
A.M.
on Friday, September 26.

By the end of Friday, it was clear to Wachovia and its regulators that the bank would not be able to open Monday without a new owner or massive federal lending. The reaction to the WaMu deal and the uproar in Congress over the
Paulson-Bernanke bank-rescue plan had hit Wachovia hard. As September began, its stock sat at nearly $17, but by Thursday morning, it was down to $14.57, and at the end of trading on Friday, it had fallen to $8.02. The cost of buying insurance on its debt — known as the credit default swaps — soared. Steel intensified his talks with both Citigroup and, particularly, Wells Fargo.

On Saturday, the twenty-seventh, Dick Kovacevich, chairman of Wells Fargo, told Steel and federal regulators that he was contemplating making an offer for all of Wachovia’s shares, an offer that wouldn’t require any government assistance — far more generous than anything Citigroup was contemplating. Warsh stayed in touch with Kovacevich from the Fed, while Geithner was handling Citigroup’s Pandit from New York.

The next day, on a Sunday-morning conference call that began around 11
A.M.
, Warsh, Geithner, Richmond Fed president Jeff Lacker (in whose turf Wachovia fell), and federal bank regulators listened to Wells Fargo’s offer. It was notably lacking in the generosity of a day earlier. Kovacevich said that his bank might still be willing to buy Wachovia without government aid, but not if he had to move immediately. If the Fed wanted a deal done Sunday, then he wanted an assist from the government. Kovacevich told Steel as much early Sunday evening. By then, the Four Musketeers were trying to find a way to make sure the nation’s fourth-largest bank would open for business when the sun rose the next day.

The Fed contemplated but ultimately rejected making an “unusual and exigent” loan. Wachovia was a bank, and the law provided a road map for coping with the collapse of a big bank. The only rub was that it meant dealing with Sheila Bair. They decided to do it anyhow.

Bair wanted to do to Wachovia what she’d done to WaMu — take it over, sell the pieces, and wipe out stockholders and bondholders. After all, any losses that the FDIC had to swallow to rescue Wachovia would have to be assessed across the entire banking system in higher premiums on FDIC deposit insurance. “I don’t think that the small banks should have to pay for the sins of the big banks,” she said.

Geithner blew up. Wachovia has to open on Monday, he argued. It must be sold this weekend, the buyer needs government assistance, and the debt
holders need to be protected. “It has to be this way,” he said. “We just went to Congress for $700 billion. The policy of the U.S. government is that there will be no more WaMu’s.”

Don Kohn, the calm, straight shooter who was the Fed’s vice chairman, mediated. Eventually, Bair acquiesced; and the Fed, the Treasury, and the FDIC declared Wachovia to be “systemically important,” the first such declaration since Congress legislated the notion in 1991. Wachovia was, after all, the fourth-largest bank in the country, and if that didn’t make it systemically important, then what did? The officials agreed to provide “open bank assistance” — subsidizing the takeover of a bank before it formally failed — for the first time since 1992. Bair called Wachovia’s Steel to tell him that the FDIC would be auctioning off his company that night.

An on-again, off-again conference call among government officials was convened around 8
P.M.
On the line: Bernanke, Kohn, and Warsh at the Fed in Washington; Geithner in New York; Bair in her office a few blocks away from the Fed headquarters; John Dugan, the comptroller of the currency and Wachovia’s chief regulator; and David Nason, the assistant secretary for financial institutions at Treasury. The call stretched into the night. Because Wachovia’s Steel was his former lieutenant, Paulson stayed away from the deliberations, but he asked to be called when there was a resolution. He kept waking up and wondering why the call hadn’t come. Shortly after midnight, Wachovia made a last-ditch attempt to remain independent by offering the FDIC a stake in the bank in exchange for government aid. The bid was rejected.

In the end, Bair had to choose between Citigroup and Wells Fargo — an unhappy choice as far as she was concerned because both offers could drain the insurance fund she protected vigorously. She and the other officials kept talking, breaking off the call for her staff to do more number crunching, and then resuming the conversation.

The Fed — unaccustomed to all-night meetings — didn’t have a twenty-four-hour cafeteria or an all-night diner nearby. One long, late Sunday of the
Great Panic, Michelle Smith, the Fed’s chief spokeswoman, called her husband and asked him to pick up sandwiches from a Panera near their house in Virginia and deliver them to the Fed headquarters. Early in September, as the crises continued, the Fed made a deal with a nearby Subway to stock a refrigerator on the governors’ corridor with turkey and ham sandwiches — each with an individual expiration date. The emergency rations came in handy that night.

Finally, the Fed officials conducted a Socratic dialogue — via telephone — with Bair and her staff to speed up the decision.

“Has your staff told you what the [FDIC fund’s] expected loss is with Citi?” they asked.

“We think it is zero,” said Bair. In other words, the most likely scenario wouldn’t require the FDIC to absorb any losses. And Wells?