The Alchemists: Three Central Bankers and a World on Fire (19 page)

That’s why, Bernanke explained to Trichet in a phone call that Sunday, Lehman Brothers would have no choice but to file for bankruptcy protection first thing Monday morning.

Bernanke, not sounding terribly persuasive, said that he was hopeful that in the six months since Bear Stearns’ failure, banks worldwide had girded themselves for the possibility of another large institution going down. Under no circumstances should you allow this firm to fail, Trichet argued, angry that the Americans would act so recklessly with a company that had deep financial interconnections with major banks all over the earth.

“We have no other options,” Bernanke told Trichet.

“I think,” the Frenchman replied, “that the result of this will be very grave indeed.”

A Wall of Money

T
he decision to let Lehman Brothers go bankrupt, in the end, wasn’t really a decision at all. Never were Ben Bernanke and Tim Geithner and Hank Paulson equipped with a workable plan for preventing the firm from going bankrupt. By the time Lehman was on the brink, the crisis fighters were running up against the legal and political limits of their ability to stop it from going over.

That, however, wasn’t what they told the outside world at the time. They wanted to project confidence and calm, to give the impression that the Lehman bankruptcy was a deliberate decision they’d made out of their conviction that the financial markets were sufficiently prepared for the possibility of such a failure—which had seemed imminent ever since the near collapse of Bear Stearns six months earlier. That was the message Fed officials voiced to reporters, their contacts in the markets, and even other central bankers.

“It was a bit crazy how calm they seemed,” said one European central banker. “They were taking a big risk, and it seemed like a political choice that Paulson had made, but they framed it in terms of ‘the markets are well prepared for this.’”

Privately, other central bankers blamed Paulson and the Bush administration more than they did Bernanke and Geithner. But even those sympathetic colleagues didn’t understand the dilemma that the Fed had faced. “For central banks with different traditions and governments with the ability to guarantee their banks, they found it inconceivable that we would be constrained the way we were,” said one American official. In any case, the result was plain: By allowing a financial institution of such great international economic reach to go bankrupt, the Fed had failed the global community of central bankers.

There was no time for remorse, however. On Monday, September 15, 2008, after a sleepless weekend dealing with Lehman, Geithner and his colleagues at the New York Fed faced a whole new crisis: American International Group, an insurance company with a $1 trillion balance sheet and 116,000 employees, was on the brink of collapse.

AIG had operations in almost every corner of the world economy: writing insurance policies against fire for homeowners, guaranteeing pension plans for municipalities, leasing 747s to airlines. But what had accounted for a surprising portion of its earnings in the previous few years—and the part of the company that now threatened to bring the whole thing down—was its financial products division. It had developed a wildly lucrative business of guaranteeing those seemingly high-quality mortgage bonds created by Wall Street. With AIG standing behind such securities, investors considered them virtually riskless. The insurer, meanwhile, viewed the odds of losing money on insuring these supersafe bonds as so low that it didn’t reserve any money for payouts.

As the mortgage securities AIG guaranteed lost value, its clients—global banks including the French Société Generale, Germany’s Deutsche Bank, and the United States’ Goldman Sachs—demanded that AIG put up billions of dollars to ensure it would make good on the potential losses. But the firm’s insurance arms were heavily regulated and couldn’t just shift cash over to its financial products division.

Typically, AIG could have easily borrowed money in order to buy itself time to sell off some of its profitable businesses. But the banks were hardly in the mood to extend $75 billion in loans to a troubled company. They had their own problems—becoming the next Lehman chief among them. Raising the money on the stock market wasn’t an option either. After Lehman Brothers filed for bankruptcy protection that Monday morning, the Dow Jones Industrial Average fell 504 points, one of the largest single-day drops in its history, and many of the overseas investors who had made large-scale investments in big U.S. financial companies in the earlier phase of the crisis had seen their money all but wiped out. The appetite of investors for new shares of a troubled insurer was nonexistent.

Geithner became convinced that the collapse of AIG would be catastrophic for the financial system—even though, as late as Lehman Brothers weekend, essentially no one within the Federal Reserve understood the risks the company had been taking or what might happen if it were to go under. The Office of Thrift Supervision was nominally in charge of overseeing AIG, due to the firm’s long-ago acquisition of a savings and loan, but this most hapless of U.S. financial regulators was hardly up to the task of regulating a company that large and complex.

Fed leaders had to do some very quick, very scary guesstimation. “
The failure of AIG
, in our estimation, would have been basically the end,” Bernanke said in a lecture years later. “It was interacting with so many different firms. . . . We were quite concerned that if AIG went bankrupt, we would not be able to control the crisis any further.” There was, at least, a plausible option for the Fed—unlike with Lehman, for which there had been no good legal options for a bailout. This time, Washington wouldn’t let down the world. Under the same “unusual and exigent” emergency lending authority it had used with Bear Stearns, the central bank could make the multibillion-dollar loan to AIG that private banks were at that moment unable or unwilling to make. The loan would, in a sense, be “secured” by AIG’s insurance businesses, which the firm would have to sell in order to raise repayment funds. But there was no way to know for sure if taxpayers would ever get their money back.

When Bernanke and Paulson went to Capitol Hill the evening of Tuesday, September 16, to explain their plan for a Fed bailout of AIG, the reaction was one of incredulity. Senate majority leader Harry Reid clutched his head in his hands. “I want you to understand that you have not received the official blessing of Congress,” he said.

“Do you have $80 billion?” asked Representative Barney Frank, to which Bernanke replied, “I have $800 billion,” referring to the size of the Fed’s balance sheet at the time. If anything, that understated the resources at Bernanke’s disposal: For an institution that can print money, there are no real limits.

Bernanke and Geithner, in their own minds, applied a rigorous and ruthless logic when making their decisions about which institutions they would bail out and which they wouldn’t. They depended on the exact financial circumstance of the company in question and the legal options available. To the outside world, though, their actions looked simply like flailing around.

A metaphor in wide circulation in the fall of 2008 was of dominoes: One investment bank falls, knocking over an insurance company, knocking over a commercial bank, and so on. But, as Bush adviser Edward P. Lazear would argue later,
a more apt comparison was with popcorn
. Rather than one failure predictably following another, they happened nonsequentially, as if the financial firms were all kernels of popcorn in a pan. There was one common source of heat: the realization that losses on a wide range of securities—mortgages at first, but ultimately lots of other kinds of lending—were going to be far greater than anyone had imagined possible. The kernels don’t pop at the same time; some don’t pop at all. But they were all exposed to heat. The great struggle for the world’s central bankers in the days after AIG was to find a way to turn off the stove.

On September 16, as Bernanke and Geithner focused on what to do about AIG, another kernel looked ready to explode. Reserve Management Co. was one of the earliest innovators of a product that had transformed the way many people around the world save, as well as how many companies fund themselves. Introduced in 1971, the Reserve Primary Fund, like all money market mutual funds, performed many of the functions of a bank, both for savers and for borrowers, but without all the costly regulation and overhead of a bank. What does a bank do? It takes money from people who wish to save and lends it out to others who wish to invest. A money market mutual fund does the same thing: Savers deposit money, and the managers of the fund invest that money in safe, short-term investments—commercial paper issued by General Electric to manage its cash flow, for example, or Treasury bills issued by the U.S. government. Or the repurchase agreements that investment banks use to fund themselves.

Unlike a bank, though, a money market fund doesn’t have to maintain a large cushion of capital—it invests nearly all of its investors’ money in securities. It doesn’t have the costly overhead of bank branches and tellers, so it can generally pay a higher rate of interest to savers and demand lower interest rates from borrowers. But it also lacks the range of government guarantees that the banking system has—federal deposit insurance, as well as access to emergency Fed lending. Indeed, the funds exploded in popularity in the 1970s and ’80s in no small part to get around regulations, specifically caps on bank interest rates. Nonetheless, the investments seemed so safe that Americans parked their cash in them in remarkable quantities: $3.8 trillion by August 2008, or $12,000 for each American man, woman, and child, more than half the total amount of money on deposit at U.S. banks.

The Reserve Primary Fund accounted for only $62 billion of that total. And of its $62 billion in assets, only a bit more than 1 percent—$785 million—was invested in securities from Lehman Brothers. Yet when Lehman went under, the entire fund came close to collapse. From its public disclosures, investors were well aware that the Reserve Primary Fund had significant investments in Lehman. The evening of Sunday, September 14, as the investment bank appeared headed for bankruptcy, Reserve Fund managers fretted that they could see people withdrawing money from the fund as a result—up to $1.5 billion, they figured, according to e-mails that became public in subsequent litigation. At 8:37 a.m. on Monday, they had already received $5 billion in redemption requests.

When people demanded their money back, it meant that the fund’s managers needed to sell other assets to get the necessary cash. And the week of September 14, 2008, was one of the worst weeks in the history of finance to try to sell commercial paper and other short-term investments. The Reserve Primary Fund may not have been a bank, but it was experiencing a run on the bank nonetheless. It announced Tuesday evening that it would have to “break the buck,” meaning that shares in the fund normally worth $1 would in fact be worth only 97 cents.

In response, investors started pulling their money out of other money market funds, making $169 billion in withdrawals the very next day. A vicious cycle was setting in: As investors yanked their money from the funds, the funds were forced to dump commercial paper into the market to free up cash, causing their value to fall further, creating more losses. At the same time, the withdrawals threw into doubt the funding that many U.S. corporations use to pay for everyday operations.

As the New York Fed’s market monitoring staffers made their daily calls to sources on the trading desks of Wall Street and beyond, and more senior Fed officials sounded out old contacts of their own, they were told of a situation that seemed on the verge of spinning out of control: More funds would break the buck, putting $3.8 trillion of Americans’ savings at risk. And all that money being pulled out of mutual funds meant less cash available for banks, as well as companies that fund their operations with commercial paper. If the money market funds went, so would the solvency of banks that had weathered the collapse of Lehman and the near collapse of AIG, along with the ability of much of corporate America to make its payroll.

“
We came very, very close
to a depression,” Bernanke told
Time
magazine in 2009. “The markets were in anaphylactic shock.”

•   •   •

M
odern economies can be astonishingly resilient to shocks. Pop a giant stock bubble, as occurred during the dot-com crash of the early 2000s, and the downturn might be mild as investors lick their wounds, capital is diverted to other uses, Webvan employees get new jobs, and everybody goes about their business. But mess with the very core of the financial system—people’s confidence that their savings are secure—and the consequences are far more dire.

The idea that money itself may be unsafe triggers an almost primal fear in even the most levelheaded of investors. The problem in the Panic of 2008 wasn’t that some investments lost value. It’s that many of the investments that lost value—money market mutual funds being a prime example—had been viewed as absolutely safe. The basic reality of modern monetary systems had been laid bare: Money is simply an idea, a concept—a giant confidence game, even. People wanted out.

That was the feeling in the air that week in September 2008. The question was, what would the world’s central bankers do about it? Could Walter Bagehot’s time-honored approach to stopping a panic—lending freely to illiquid, not insolvent, firms at a penalty interest rate—be made to work when the panic was happening almost everywhere on earth at the same time, and in markets where traditional rules didn’t apply?

The Fed’s strategy for dealing with the panic was emblematic of its overall approach to the crisis. Bernanke, the Great Depression scholar, had particular admiration for Franklin Delano Roosevelt’s strategy during the 1930s. Not every program his administration undertook did much good, but there was a spirit of experimentation, of throwing everything the government had against the wall to see what would stick. As the money market funds trembled, Bernanke directed his troops to adopt the same approach: Try everything.

First, just three days after the Reserve Fund broke the buck, came the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, or AMLF. With Fed staffers in New York and Washington already stretched thin with crisis fighting, the program was administered by the Federal Reserve Bank of Boston, which had particular expertise in money market funds: The city is home to a number of the major mutual fund groups, as well as State Street, a bank that carries out transactions for many of the funds. The idea was to use infrastructure that had long been in place to channel money to banks to back up the money market funds instead. The Fed would lend money to banks, which could then buy the securities the money market funds were selling off and pledge them to the Fed, with the banks themselves taking no financial risk for their role as intermediary.