In FED We Trust (36 page)

As the British and European central bankers mulled Bernanke’s suggestion of a unified show of force, he got a call from Mark Carney, the Canadian central banker, who was definitely interested. Economies and financial markets were far worse than the central bankers had anticipated. Financial markets were, reasonably, anticipating more rate cuts. Moving in unison, Bernanke argued, could bring economic benefits greater than moving separately. It was an act of global theater, to be sure, but the very act of coordination — which had been sorely lacking in the Great Panic until then — could bolster consumer and business confidence, he figured.

After a series of one-on-one phone chats with other central bankers, Bernanke sensed something close to a consensus emerging. With that, he proposed a conference call early Tuesday morning, Washington time, to include himself, Britain’s King, Europe’s Trichet, and Canada’s Carney. Japan’s central banker was invited to listen in, even though rates there were already so low he couldn’t join the rate cutting. Everyone agreed on a one-half percentage point cut and on the wording of a 141-word statement that each would issue. The central bankers then turned to the formality of getting the consent of their separate committees. To fulfill his end of the bargain, Bernanke convened the FOMC by videoconference around 5:30
P.M.
, and they voted to drop the federal funds rate target to 1.5 percent.

At 7
A.M.
Washington time the next day, October 8, the central banks Bernanke had convened, plus the Swiss and the Swedes, simultaneously announced the cut in rates and released the negotiated statement. Although heavy on the anti-inflation rhetoric favored by central bankers, particularly Europeans, the main message was that the “recent intensification of the financial crisis” was increasing the risks of recession and decreasing the risks that inflation would take off.

The markets didn’t cheer this time. The Dow Jones Industrial Average lost another 189 points, or 2 percent, to close 9258.10 — down 14.6 percent in six days, while investors continued to move massive sums of money to super-safe U.S. Treasury bills, and away from riskier debt securities. “It obviously didn’t calm the markets,” Bernanke said with resignation a week later. “The markets were still very stressed about the view that the financial system had
a significant chance of collapsing. What it told me was that monetary policy wasn’t the only tool. Credit market condition were so frozen and stress on banks and some specific institutions so intense. And monetary policy works with a lag.”

The economy and the markets couldn’t wait. Though the number of untried items on Bernanke’s “blue sky” list was getting shorter, a few novelties remained. Hours after the internationally coordinated rate cut was announced, Bernanke went to Paulson’s office at Treasury to talk with him and Sheila Bair. The two men were determined to persuade her to take an extraordinary step: to declare that the banking system was at risk — the whole thing, not a particular institution — and to offer an FDIC guarantee not just of deposits, but also of all new borrowing that banks did on financial markets. Even though TV cameras weren’t showing depositors lining up outside bank doors, money was fleeing the vaults. The government had to stop the run to save the system, Bernanke said. This would be the ultimate repudiation of the WaMu deal: now, the government would guarantee that investors who lent money to banks would be paid back.

A government guarantee is just as much a taxpayer subsidy to banks and the investors who lend to them as low-cost government loans. Heads, private investors win; tails, taxpayers lose. A blanket guarantee was an extraordinary move, but Bernanke and Paulson saw an extraordinary threat — the possibility of a run on the entire American banking system.

Bair balked. The FDIC traditionally rescued banks one at a time, not en masse. Confidence in the banking system would not be helped if the FDIC insurance fund was depleted, she said. Bernanke and Paulson pushed hard. A day or two later, she came back with a memo outlining what the FDIC was prepared to do. It would offer guarantees — but only for 90 percent, not 100 percent of the money that an investor had put in. And it would guarantee debt of the banks — the units that took deposits — but not of their parent companies. Bernanke and Paulson rejected both conditions, and
Bernanke offered an opinion by the Fed’s lawyers to support the broader approach.

In the end, Bair acquiesced. The FDIC, for a fee, agreed to guarantee promissory notes, commercial paper, bank-to-bank loans, and other unsecured lending for up to three years. In return, she won a few concessions: FDIC deposit insurance would cover all checking accounts, even if they had more than $250,000 in them, which was important to nonprofits and municipalities. Still, Bair was not happy with the compromise. “Why there’s been such a political focus on making sure we’re not unduly helping borrowers but then we’re providing all this massive assistance at the institutional level, I don’t understand it,” she said a few days later. “It’s been a frustration for me.” Bernanke, though often impatient with Bair, agreed on the wisdom of a more muscular government effort to avoid foreclosures. But that would have to wait until the Obama administration was in power.

Press accounts tend to paint meetings of finance ministers and central bankers from the Group of Seven — the United States, Britain, France, Germany, Canada, Italy, and Japan — as suspenseful and decisive affairs, akin to a conclave of cardinals selecting a new pope. In reality, G7 gatherings are mostly ritualized recitations of positions already expressed publicly. Four or five hours of predictable statements read by officials are typically followed by a communiqué — negotiated in advance by designated staffers — touching on fourteen points, ranging from a vow to promote economic stability to a promise to crack down on money laundering.

Not this time, though, with all the world watching. For the first time in the Great Panic, national governments were making self-protective moves that threatened to make their neighbors worse off, the sort of bad behavior that worsened the Great Depression. The Irish government’s unilateral guarantee of all bank deposits — and the way other European nations had scrambled to catch up — was an early foreshadowing of what could be even worse troubles to come. European prime ministers had met in Europe the Sunday
before the G7 finance ministers gathered in Washington, but were unable to agree on anything. The British had announced plans to do what Paulson had been working on privately with Bernanke but was resisting publicly: using taxpayer money to buy stakes in banks.

The October 10 G7 meeting preceded by a day, as it always does in the fall, the annual meetings of the International Monetary Fund and the World Bank. Scores of other finance ministers and central bankers would be in Washington, D.C., raising the visibility of the G7 meeting, which sets the agenda and tone for the assemblies that follow — and also raising the risk of an anti-American backlash prompted by the bankruptcy of Lehman.

With such prospects in mind, Bernanke concluded that a conventional G7 communiqué would do little to reassure anyone that the leaders of the global economy had a game plan for avoiding another Depression. Early Thursday morning, he spent about half an hour typing up principles that he thought the G7 should embrace.

Labeled “very preliminary,” Bernanke’s nine points amounted to an outline of his “whatever it takes” strategy. Among other things, he proposed that all G7 countries:

• “ensure that domestic and other major financial intermediaries have access to capital from public as well as private sources”
  

• “restart and reliquefy the secondary markets for mortgages and other assets”
  

• take “all efforts to prevent the failure of any systemically important financial institutions” and, when failures were “unavoidable,” to protect “all creditors and counterparties, both secured and unsecured,” an explicit vow not to repeat Lehman
  

• Brothers or WaMu
  

• “unfreeze the interbank market, the commercial paper market, and other money markets” with “guarantees, backstop facilities to purchase short-term paper or other methods”
  

Bernanke showed his draft to Paulson when the two met for a previously scheduled breakfast on Thursday morning at the Fed. Paulson, who found
G7 meetings tedious and unproductive, generally used the term “G7” as an epithet, but he told Bernanke that he liked these suggestions and took the draft Bernanke gave him back to Treasury. Later that day, Nathan Sheets, the Fed’s top international hand and another of its army of MIT Ph.D.’s, checked in with his Treasury counterpart, David McCormick, a West Point grad, Princeton Ph.D., and veteran of the first Gulf War, and Mark Sobel, a veteran civil servant on the Treasury’s international staff.

By the end of the day Thursday, McCormick and his counterparts from the other six countries had negotiated a communiqué to which a modified annex of Bernanke’s points was attached. The G7 convened the next day, Friday, at 2
P.M.
in the Treasury’s gilded Cash Room, where the U.S. Treasury once had conducted banking business with the public. Bernanke sat to Paulson’s right, McCormick to his left. Flags of the participating countries stood behind them.

The German finance minister delivered the usual German “I told you so” speech, warning this crisis would change capitalism forever. But much of the discussion was pragmatic and unscripted. There was consensus the public statement should be terse, direct, and convincing. Countries differed more on
when
rather than
whether
they would take the actions anticipated.

At one point, McCormick leaned to his left and whispered to Mervyn King, governor of the Bank of England, that the best outcome might be a simple half-page communiqué. McCormick, who had been drafting talking points for Paulson and the other ministers to use after the meeting, passed a note to Paulson with a similar suggestion. Paulson scribbled back: “I like it.” McCormick took a draft based on his talking points and the Bernanke-inspired annex and circulated it to other deputies. Each conferred with his boss as the meeting progressed, and the ministers blessed the idea. During a break, the deputies tinkered with the wording.

The final 266-word communiqué incorporated nearly all of Bernanke’s points and some of his wording, albeit with less specificity. A few things were dropped. There was, for instance, no hint of guaranteeing interbank lending, because Trichet was resistant. The proposed pledge to protect all creditors and counterparties if a systemically important institution failed — the “no more WaMu’s” promise — was dropped in favor of a promise to “prevent
their failure.” Bernanke hadn’t taken control from Paulson, but he had helped Paulson get the all-important theater right.

Paulson now started dropping hints in public that the Treasury wasn’t going to use the $700 billion just to buy toxic assets from the banks, but was contemplating buying shares directly in the banks, as Bernanke and some of Paulson’s staff had favored. At a press conference following the G7 meeting, Paulson made it explicit: like the British, the U.S. government would invest taxpayer money to strengthen U.S. banks’ capital footing. The few details offered portrayed the program in as promarket terms as possible. The U.S. government would avoid taking a voting stake in the banks and would design its program “to encourage the raising of new private capital to complement public capital.”

Paulson struggled to explain the about-face, telling the
Washington Post
a few days later: “The facts as I know them changed. We got a bigger impact per taxpayer dollar with the equity injection so we went that route… The philosophy has stayed the same, but the tools we employed changed.”

In fact, few details had been settled. Despite the conversations about using taxpayer money to buy stakes in banks to “recapitalize” them, the overworked Treasury staff had been spending nearly all its time on structuring the complicated auctions to buy toxic assets. On Thursday, October 9, Geithner called Paulson to nudge him to move faster on the details of the capital injection initiative. Treasury decided against hiring an investment bank for help; the conflicts of interest would have been unmanageable, since all the big ones would be on the receiving end of the government’s money. Instead, on Friday, October 10, the Treasury signed a $300,000 contract with the law firm of Simpson Thacher to handle the legal work.

On Saturday, October 11, Bernanke, Geithner, and Kohn moved into the Treasury building, working through the weekend with Treasury officials. As Paulson had hinted a few days earlier, the hope was to use government money as a lever to get the banks to raise capital privately, a sort of matching program. However, it soon became clear that banks were going
to have a very hard time selling their stock in what was already a depressed market.

“Everyone said: you know, that just will not work. The private market for bank stock is essentially closed for business,” said David Nason, the Treasury official. “You’re going to force a lot of people to try to sell common stock at the same time. There are a limited amount of people who want to participate in that. The weak are not going to get it, and the strong might disappoint as well.”

The participants also faced the very tough decision of how to price the dividend rate on the preferred stock the banks would issue the government: it should be low enough to be attractive to banks, yet high enough to avoid sparking populist taxpayer outrage. “The pricing was the hardest thing,” said Nason. “You’ve got two competing concerns: you’ve got the protection of the taxpayer, and you want people to participate. It can’t be too expensive because you want everybody to take it.”

The eventual terms were intentionally generous. The plan depended on luring even firms that didn’t really need the capital — JPMorgan Chase and Goldman Sachs, for instance — to take the money so that no bank would be stigmatized. The tough approach to AIG, Fannie and Freddie, and WaMu was gone, but the second-guessing wasn’t. The Bernanke-Paulson-Geithner approach would later be criticized for allowing banks to continue to pay dividends to common shareholders, for not demanding enough commitment from the banks to increase lending, for not restraining executive compensation more, and for not husbanding scarce taxpayer money needed by weak banks by giving so much of it to stronger banks.