In FED We Trust (35 page)

“We think it is positive,” she answered, meaning the FDIC would have to come up with money eventually. That made the call easier.

Around 4
A.M.
, Bair finally picked a winner: Citigroup. It would acquire the bulk of Wachovia’s assets and cover all the deposits and
all
its debt. Wachovia shareholders would get the leftovers that Citi didn’t want. Some $312 billion worth of loans — mainly Wachovia’s, but some Citi’s — would be put in a pot. Citi would eat the first $42 billion in losses, and the FDIC would be stuck with any losses greater than that. Citigroup executives were elated. Not only did they get a sorely needed source of ordinary deposits, but Citi’s balance sheet also would be strengthened by absorbing Wachovia’s assets.

The Wachovia-Citigroup deal was announced first thing Monday morning. To keep customers — and other banks — from immediately fleeing Wachovia, the Richmond Fed issued an unusual public vow that it stood “ready to provide liquidity as needed” to Wachovia through the Fed’s discount window. But the marriage was not to be. Final negotiations on the terms of the
Citigroup-Wachovia deal dragged on. Steel described them as “extremely complicated and difficult,” partly because Citigroup wanted to buy some but not all of the company’s operations.

On Tuesday evening, Kevin Warsh, the bankers’ go-lo guy at the Fed, got a call from Wells Fargo’s Kovacevich. “I’ve got great news,” said Kovacevich. “I’d love to buy Wachovia …and without government help.” What had changed? For one thing, a long-discussed revision to tax rules governing bank mergers had been announced by the Internal Revenue Service on Tuesday, September 30, making Wachovia a lot more attractive to Wells Fargo.

Warsh walked down the hallway to Bernanke’s office, where he found the chairman talking to Kohn. “You’re not going to believe this,” he said. They summoned Scott Alvarez, the Fed’s general counsel, and alerted Geithner. They all agreed they couldn’t take the baton back from Bair. It would have to be her call.

Meanwhile, Kovacevich called Treasury with the same message he had given Warsh. Although some of his advisers didn’t want to tell Bair, Paulson called to alert her.

At 7:15
P.M.
Thursday, Wachovia’s CEO Bob Steel was on a plane about to take off from New York for Charlotte when his cell phone rang. It was Sheila Bair.

“Have you heard from Kovacevich?” she asked. No, Steel said.

Well, you will, she told him. He’s going to offer you $7 a share, and you should give it serious consideration. Steel asked Bair to call Wachovia’s general counsel, Jane Sherburne, with the details. Seared by Wells Fargo’s back-and-forth earlier, she insisted on an agreement signed by Wells Fargo. At 9:04
P.M.
, Steel got an e-mail with a formal, signed offer. At 11
P.M.
the Wachovia board met and, after an hour’s discussion, decided to jilt Citigroup and go with Wells Fargo. Bair was thrilled: the FDIC was off the hook. Steel, though facing a lawsuit from Citigroup, was thrilled, too: his shareholders, who would have received next to nothing from the Citigroup deal, were getting $7 a share — and, unlike Citi, Wells Fargo would take the entire company.

The Wachovia — Wells Fargo deal was announced the next day, Friday, at 7
A.M.
— only four days after the Wachovia-Citigroup union had been
announced. Shortly afterward, the Fed, the FDIC, and other government players convened by conference call — again.

Geithner was ballistic over the about-face. This was bad for Citigroup, a big and troubled bank that was hugely important to the system. Though his detractors saw protecting Citi as his main concern, Geithner argued that the switch to Wells Fargo would destroy the government’s credibility in cutting Sunday-night deals to sell failing institutions. “You cannot run a government in a financial crisis like this,” said Geithner. “You can’t let people rebid every time the world changes.”

Bair, though, stuck with Wells Fargo, and other Fed officials were reluctant — having turned Wachovia over to her — to try to take it back. Citi executives were understandably livid. Pandit called Geithner, who got Warsh on the phone; a couple of Pandit’s top lieutenants joined the call. Not only had they lost Wachovia, but they also now looked like bank executives who couldn’t negotiate an airtight merger agreement.

Nonetheless, Fed officials finally agreed not to try to undo Bair’s decision. Instead, Warsh — working the phone from his apartment in New York and later from his office in Washington — spent days trying to get the two would-be buyers to divide the Wachovia business between them. Warsh failed in that, but he did win Citigroup’s agreement not to try to block the deal — a development the Fed feared would have been extremely unsettling to markets and bank customers.

While Fed officials were sorting out Wachovia, the House of Representatives rejected the Bush administration’s bank rescue plan on Monday, September 29, by a vote of 228 to 205. The opposition came from both the right and the left in the House, and reflected a groundswell of outrage from voters who saw Wall Street getting bailed out while homeowners were getting forced out. The looming November election was a factor: of the twenty-one most vulnerable Republicans, eighteen voted against the bill; of the fifteen most vulnerable Democrats, ten voted against it.

The vote was a stunning rebuke of Bernanke and Paulson, who had told everyone that the economy as we knew it would end if Congress rejected the proposal. The markets believed the prediction, even if a majority of Congress didn’t. The Dow Jones Industrial Average fell by 778.68 points: a 7 percent drop. In all, the stock market lost $1.2 trillion that day — nearly twice the $700 billion price tag on the bailout bill, which had created the Troubled Asset Relief Program, or TARP.

The next morning, Paulson ran into Michele Davis, his spokeswoman and policy coordinator, in the Treasury building. “I think we’re going to have to put equity into the banks,” he said. Despite what Paulson had told Congress, buying toxic assets was going to take too long. Davis gave him a blank stare. “We haven’t even gotten the bill through Congress,” she remembered thinking. “How are we going to explain this?” She told her boss: “We can’t say that
now.”
He took the advice.

The Senate passed the bill on Wednesday, October 1, and the House, on a second try, passed it on Friday. At the end of that week, the Dow Jones Industrial Average was down 1,096 points, or nearly 10 percent, since Lehman’s demise. It would lose another 1,874 points the following week.

Even after Bear Stearns, Lehman Brothers, AIG, WaMu, Wachovia, the sinking stock market, and all the other raging symptoms of widespread distress, getting the $700 billion rescue bill through Congress was difficult. Bernanke took a small measure of comfort in that. It suggested that Congress wouldn’t have acted, even if he and Paulson had made an earlier attempt.

Now Paulson, realizing that taking bad loans off the banks’ books would not suffice, told his staff to work with the Fed on a plan to put capital into the banks, the option Bernanke had long favored. “It became increasingly clear” — to everyone, including Paulson — “as the crisis got very severe that we needed something quick, and capital injection was quicker than asset purchases,” Bernanke said. The Treasury couldn’t buy a large enough quantity of toxic assets quickly enough to have any big impact on the banks. Even after Congress had given Treasury hundreds of billions to spend, the Fed still couldn’t escape its role as first responder.

Meanwhile, money market funds and other investors were still reluctant to buy commercial paper, or IOUs, from big companies — particularly from financial outfits such as General Electric’s GE Capital. Though the Fed and Treasury had stemmed the run on money market funds, commercial paper markets continued to worsen. As the Fed explained: “The volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day.” This was the sort of liquidity issue the Fed existed to solve, but the problem — once again — wasn’t in the Fed’s traditional banking territory but in the shadow banking system.

Bernanke and Kohn talked to Paulson about tapping the TARP to provide liquidity to the commercial paper market, particularly the commercial paper that was not backed by any collateral. The Treasury balked. Only a month earlier, the Fed had cited the lack of any collateral in refusing to make a loan to a dying Lehman. Yet it was now looking for a way to make loans to GE Capital and others that were backed only by the corporations’ promise to pay. No collateral or asset would protect the Fed if the borrower went bust. (During the Depression, Congress had given the Fed the power to make such unsecured loans, but that law had been repealed in the 1950s.)

This time, the Fed wasn’t looking for a legal reason to say no. It wanted to find a way to get to yes. Working with Don Kohn, a couple of smart Fed economists — veteran Patrick Parkinson in the Fed’s research division and Bill Nelson, a young Yale Ph.D. in the monetary affairs unit — found a solution so clever that even some within the Fed wondered if the “unusual and exigent circumstances” statute had been stretched too far.

The idea, announced October 7, was to borrow a trick from the financial engineers: create a “special purpose vehicle,” a custom-made financial entity; require companies that want to borrow to pay a fee up front; and set aside this money to create a cushion to protect the Fed if any company didn’t pay the money back. Fed lawyers swallowed hard, essentially relying on Fed
economists’ arguments that the loan was, as the law required, secured and had very little risk of losing money. The Fed was inventing new tools on the fly. “Aggressive surgery for aggressive cancer” is how Bernanke put it.
Whatever it takes
.

Within a week, the Fed was lending more than $225 billion through what it called the Commercial Paper Funding Facility. By January 2009, borrowing was up to $350 billion. Through the end of May, none of the borrowers had defaulted — and the size of the CPFF was shrinking as this part of the market began to function more normally. But Fed officials quietly acknowledged that the deteriorating economy raised the odds that it would someday take a loss on these loans.

By early October, the Great Panic had gone global. Iceland imploded, unable to carry the weight of the foreign debt that its banks had taken on during the euphoria of the boom. The U.K. government, using a provision of a law passed to fight terrorism, seized Icelandic assets in Britain to guarantee the deposits that British savers had made in Icelandic banks. European governments rushed to rescue their banks. Ireland stunned other countries by unilaterally guaranteeing the previously uninsured deposits of its six largest banks and their debts, pressuring other countries to do the same, lest deposits flee their banks for Ireland. Germany followed a week later. The British government one-upped everybody by putting £50 billion of capital into its banks, winning plaudits for doing what Paulson and Bernanke had not yet done. Stock prices were falling around the world, and the manifestations of stress in credit markets — the gap between yields on government securities and everything else — were worsening. Oil prices were falling, but even that had a troubling aspect: it showed a weakening of demand around the world.

“October was critical,” Bernanke said. “We came very close in October to Depression 2.0.”

Bernanke saw both a need and an opportunity for a show of force by
the world’s major central banks. He had been talking regularly by phone with Bank of England governor Mervyn King, his friend from their days at MIT. Until September, the British central bank had been worried that the sinking British pound posed an inflation threat. Since the beginning of the Great Panic in August 2007, the Bank of England had shaved rates by only three-quarters of a percentage point, while the Fed had axed them by 3.25 percentage points. Bernanke argued that a global crisis demanded a global response and suggested that perhaps the Fed could cut rates together with other central banks. King was sympathetic.

The European Central Bank also was ready to cut rates, finally. In July, the ECB had been so preoccupied with inflation that it had actually
raised
interest rates by a quarter percentage point. But now all the schadenfreude about the mess made in America gave way to anxiety about Europe’s banks and its economy. At a press conference on Thursday, October 2, ECB president Jean-Claude Trichet had — for the first time — hinted that the Europeans were prepared to reverse field. He reinforced that message in a phone conversation the following Monday with Bernanke. The Fed chairman, in turn, signaled the depth of his concern in a speech later that afternoon to the National Association for Business Economics: “Severe financial instability, together with the associated declines in asset prices and disruptions in credit markets, can take a heavy toll on the broader economy if left unchecked.”

BERNANKE’S DASHBOARD
October 3, 2008