Federal Reserve documents 19 page

On Friday morning I had breakfast with Hank at the Treasury. We agreed we had to do what we could to avoid a messy failure of Lehman. I did not press him on statements the Treasury had leaked to the effect that Hank had ruled out putting government money into Lehman.† I knew that those statements were partly the product of Hank’s frustration—understandably, he didn’t like being the public face of Wall Street

bailouts—and partly tactical, an effort to incentivize the private sector to come up with its own solution. I also knew that any government money would come from the Fed, not the Treasury.

Most importantly, I knew from my experience of working with Hank that he would do whatever he could to avoid the horrific consequences we knew Lehman’s failure would bring. We had worked together to rescue Bear Stearns in March, and we continued to believe that had been the right decision. Lehman was 50 percent bigger than Bear had been on the eve of its acquisition and at least as interconnected (its derivatives “book” was twice the size that Bear’s had been). Moreover, financial markets and the economy were, if anything, more fragile now. We still worried about the stability of the repo market—the most important motivation for my support of the Bear rescue. Lehman’s repo borrowings were twice what Bear’s had been.

It appeared that Lehman’s fate would be determined over the weekend. Tim Geithner invited the CEOs of major financial institutions to a meeting Friday evening at the New York Fed. Lehman and Bank of America, as a potential acquirer, were excluded. Attendees included the heads of the other major investment firms—Lloyd Blankfein of Goldman Sachs, John Thain of Merrill Lynch, and John Mack of Morgan Stanley—as well as the heads of major U.S. banks, including Jamie Dimon of JPMorgan Chase, Vikram Pandit of Citigroup, and Bob Kelly from Bank of New York Mellon. Foreign banks at the table included Credit Suisse (Brady Dougan), the French bank BNP Paribas (Everett Schenk), the Royal Bank of Scotland (Ellen Alemany), and the Swiss bank UBS (Robert Wolf).

Tim’s goal was a deal that would save Lehman. The process would move on two tracks. On the first track, teams of specialists would evaluate Lehman’s assets and try to determine its true value. A team from Bank of America had already made a start. We were encouraged that some interest in Lehman was now arriving from a new quarter, the British bank Barclays. One of the world’s largest and oldest banks (it traced its roots back to 1690), Barclays, like Bank of America, wanted to increase its presence in investment banking.

On the second track, the Wall Street CEOs would, in cooperation with the Fed, the Treasury, and the SEC, try to develop alternative plans for Lehman. Most likely, we thought as the weekend began, the CEOs would provide financial support or guarantees to assist the acquisition of Lehman by either Bank of America or Barclays. Alternatively, in the absence of a single purchaser, we would look for some cooperative arrangement through which the industry as a whole might prevent the disorderly collapse of the firm. The analogy to the rescue of Long-Term Capital Management again came to mind. Almost exactly ten years earlier, the New York Fed had provided a group of financial CEOs a meeting venue (and sandwiches and coffee), but no financial assistance. With the Fed acting as a facilitator, the CEOs chipped in enough money to allow LTCM to wind down gradually.

As in the LTCM episode, in September 2008 we hoped the private sector could find a solution for Lehman, if it came to that. But this time the CEOs had far more concern about the stability of their own companies. Moreover, stresses at Merrill Lynch and the massive insurance company AIG were becoming

increasingly evident, and some participants worried that Lehman would be only the first of a series of market shocks. Getting them to contribute funds, particularly to help competitors, might prove difficult.

MEANWHILE, AS WHAT became known as Lehman weekend approached, popular, political, and media views were hardening against the idea of the Fed and the Treasury taking extraordinary measures to prevent the firm’s failure. It seemed that the most that would be tolerated was our perhaps looking for a private-sector buyer. At their nominating convention in early September, rank-and-file Republicans had been unequivocal: no bailouts. The powerful senior Republican on the Senate Banking Committee, Richard Shelby, echoed that view. (President Bush and Senator John McCain, the Republican presidential nominee, held more nuanced positions.)

The media piled on. London’s respected Financial Times noted the government takeover two weeks earlier of Fannie Mae and Freddie Mac, adding, “Further such rescues should be avoided like the plague.” The Wall Street Journal opined: “If the feds step in to save Lehman after Bear and Fannie Mae, we will no longer have exceptions forged in a crisis. We will have a new de facto federal policy of underwriting Wall Street that will encourage even more reckless risk-taking.” Our challenge that weekend went beyond finding a solution for Lehman. We would have to do so in the face of bitter criticism.

Some of the critics were ideologues (the free market is always right) or uninformed (the economy will be just fine if a few Wall Street firms get their just deserts). Some simply railed against the unfairness of bailing out Wall Street giants but not the little guy on Main Street. Personally, I felt considerable sympathy for this last argument. (I would wince every time I saw a bumper sticker reading “Where’s my bailout?”) But it was in everyone’s interest, whether or not they realized it, to protect the economy from the consequences of a catastrophic failure of the financial system.

The opponents’ most substantive argument was that, whatever the short-run benefits of bailouts, protecting firms from the consequences of their own risky behavior would lead to riskier behavior in the longer run. I certainly agreed that, in a capitalist system, the market must be allowed to discipline individuals or firms that make bad decisions. Frank Borman, the former astronaut who became CEO of Eastern Airlines (which went bankrupt), put it nicely a quarter-century earlier: “Capitalism without bankruptcy is like Christianity without hell.” But in September 2008 I was absolutely convinced that invoking moral hazard in the middle of a major financial crisis was misguided and dangerous. I am sure that Paulson and Geithner agreed.

“You have a neighbor, who smokes in bed. . . . Suppose he sets fire to his house,” I would say later in an interview. “You might say to yourself . . . ‘I’m not gonna call the fire department. Let his house burn down. It’s fine with me.’ But then, of course, what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood?” The editorial writers of the Financial Times and the Wall Street Journal in September 2008 would, presumably, have argued for letting the fireburn. Saving the sleepy smoker would only encourage others to smoke in bed. But a much better course is

to put out the fire, then punish the smoker, and, if necessary, make and enforce new rules to promote fire safety.

The firefighting argument applied equally well to Lehman Brothers. We had little doubt a Lehman failure would massively disrupt financial markets and impose heavy costs on many parties other than Lehman’s shareholders, managers, and creditors, including millions of people around the world who would be hurt by its economic shockwaves. In the many discussions in which I was involved, I never heard anyone from the Fed or the Treasury suggest that letting Lehman fail would be anything other than a disaster, or that we should contemplate allowing the firm to fail. We needed to put the fire out.

Tough talk in the negotiation was still required, of course. If the private-sector participants were certain that the government would swoop in with a solution, they would have little incentive to commit their own funds. Tim Geithner, in talking points prepared for the Friday evening meeting and sent to me for my approval, proposed to give the CEOs plenty of incentive to come up with their own plan to prevent Lehman’s collapse.

“A sudden and disorderly unwind could have broad adverse effects on the capital markets, with a significant risk of a precipitous drop in asset prices,” he proposed to tell them. “The financial community needs to come together to fashion an orderly resolution. . . . I cannot offer the prospect of containing the damage if that doesn’t occur.” Tim was clear about the risks of letting Lehman fail, and I believe that most or all of the CEOs appreciated the risks as well.

What Tim wanted, what we all wanted, was for the CEOs to act in their own and the broader interest and work with the government. As his talking points indicated, he would ask them to lend their analytical talents and provide capital if necessary. The Fed would facilitate necessary regulatory approvals and provide regular collateralized lending (which was within our powers) but not “extraordinary credit support.” The term “extraordinary credit support” was vague, which I assume was Tim’s intention. The gathered CEOs might presume that, even if Lehman was deeply insolvent, the government would find some way to fill the hole. By offering lending but no extraordinary credit support, we would be pushing back against that presumption. As a central bank, we had the ability to lend against a broad range of collateral, but we had no legal authority to overpay for bad assets or otherwise absorb Lehman’s losses.

The weekend was a blur. Paulson, Geithner, Cox, and Kevin Warsh were in New York for the negotiations. With the possibility that the Board would have to meet over the weekend to approve the acquisition of Lehman, I remained in Washington, spending most of my time in my office. Michelle Smith brought sandwiches. We used frequent conference calls to keep the Treasury, the Fed, and the SEC on the same page. (The speakerphone on the coffee table in my office on which I took the calls began to figure in my dreams.) I catnapped on the burgundy leather sofa in my office, going home, briefly, late on Friday and Saturday.

The reports I received on Friday evening and Saturday morning were discouraging. Both Bank of America and Barclays had found losses in Lehman’s balance sheet to be much bigger than expected. They

were looking for the government to put up $40–$50 billion in new capital. I asked Tim whether they were overstating the numbers as a ploy to obtain a better deal or as an excuse to end negotiations. Tim acknowledged the possibility but reminded me that other firms, including Goldman Sachs and Credit Suisse, were independently reviewing parts of Lehman’s portfolio, in preparation for the possibility that, as part of a larger solution, certain assets might be sold or used as collateral for loans. The third-party firms had independently estimated the values of Lehman’s assets—especially the commercial real estate —at well less than Lehman’s values.

As much as I wanted to avoid Lehman’s failure, the reports gave me pause about our two strategies— finding a buyer or building a consortium. None of the firms represented in the New York Fed’s conference room was in terrific financial shape. Would combining shaky balance sheets through an acquisition (by a single firm or a consortium) lead to a stronger financial system, or would it simply result in an even bigger blowup later? My mind went back to my own studies of the Great Depression of the 1930s. The most catastrophic financial failure of that period was the collapse of the Kreditanstalt, the largest bank in Austria, in May 1931. Its failure toppled other banks and, perhaps, helped derail nascent economic recoveries in the United States and Europe. One reason for its failure had been an earlier forced merger with another, weaker Austrian bank, whose own losses had helped pushed the larger bank over the edge.

At this point in the crisis, the U.S. institution with the strongest balance sheet, with the greatest capacity to borrow and invest without raising concerns about its creditworthiness, was the federal government. To me, it seemed increasingly likely that the only way to end the crisis would be to persuade Congress to invest taxpayer funds in U.S. financial institutions. I began to make this point on our conference calls over the weekend.

As Saturday wore on, it became evident that Lehman was deeply insolvent, even allowing for the likelihood that fire sales and illiquid markets had pushed the values of its assets to artificially low levels. Fuld would later claim Lehman wasn’t broke, but the capital figures he cited were based on the firm’s inflated asset valuations and greatly overstated the true capital. Lehman’s insolvency made it impossible to save with Fed lending alone. Even when invoking our 13(3) emergency authority, we were required to lend against adequate collateral. The Fed has no authority to inject capital or (what is more or less the same thing) make a loan that we were not reasonably sure could be fully repaid.

We could have used our lending powers to facilitate an acquisition, but Lehman’s financial weakness was also a big problem for any firm considering buying it. Whatever the long-run benefits of gaining Lehman’s business, its losses would be tough for the acquirer to absorb in the near term. I hoped that we would get some help from the CEOs who had assembled in Tim’s conference room. But they were unenthusiastic, being acutely aware that their own resources were limited and might well be essential to their survival if the crisis worsened.

Bad news arrived on other fronts. The private equity firm J.C. Flowers & Co., run by billionaire

former Goldman Sachs partner J. Christopher Flowers, reported that AIG was also in dire trouble. Losses in its massive derivatives positions were resulting in calls for more collateral by its counterparties. And of course, the three investment banks other than Lehman—Merrill Lynch, Morgan Stanley, Goldman Sachs —had considerable reason for anxiety if Lehman failed. The market seemed poised to attack the weakest remaining member of the herd.

After Lehman, that was clearly Merrill Lynch, which had made many of the same investment mistakes. Established in 1914, Merrill had done more than any other firm to, in founder Charles Merrill’s phrase, “bring Wall Street to Main Street.” It prospered in the years after World War I, betting on the success of motion pictures and chain stores. Before the 1929 stock market crash, Merrill famously warned clients to get out of debt. His firm survived the Depression and by 1941 was the world’s largest securities house. However, Merrill had bet heavily on residential and commercial mortgage lending just as the real estate boom was turning into a bust. After Stan O’Neal resigned as CEO in October 2007, he was replaced by John Thain, the former CEO of the New York Stock Exchange.

I tried to prepare for the FOMC meeting on Tuesday but found it difficult to concentrate on the meeting materials. In between calls with New York, I did what I could to keep others in the loop on the Lehman negotiations. I spoke with the Fed Board members and Reserve Bank presidents and several members of Congress. I avoided false optimism, but I did not want to appear defeatist, either. At 10:00 a.m. on Saturday, I held a conference call with foreign central bankers, including Mervyn King of the Bank of England, Jean-Claude Trichet of the ECB, and Masaaki Shirakawa of the Bank of Japan. Trichet was particularly exercised about the possibility that no solution for Lehman might be found; he said the company’s failure would lead to a “total meltdown.” I told him I agreed and that we would do everything we could. King gave me an important piece of information: He had heard that the Financial Services Authority, which supervised Britain’s banking system, was very concerned about bringing Lehman’s bad assets into Barclays, particularly given uncertainties about the flagship British bank’s own condition. I asked if he could weigh in on the issue and he said he would try.

Sunday morning’s news was worse than Saturday’s. Bank of America was now definitely out of the running for Lehman. (Ken Lewis would later report that he had told Paulson that Lehman’s assets were worth $60–$70 billion less than their official valuation.) The small silver lining was that Lewis was negotiating with Thain to acquire Merrill Lynch, which he viewed as both in better shape than Lehman and a better fit for Bank of America. Bank of America had a huge retail banking footprint, and Merrill, whose army of brokers was nicknamed the “thundering herd,” had the largest retail operation of any of the investment banks. Paulson had strongly encouraged Thain to consider Lewis’s offer, and Thain—an experienced Wall Street operator—knew which way the wind was blowing. Taking Merrill off the market would mean one less large investment bank in danger of failing, although if Merrill was secured the pressure would likely shift to the remaining two firms, Morgan Stanley and Goldman.

Moreover, the Barclays option for Lehman was looking less and less likely. As Mervyn King had

warned, the Financial Services Authority was reluctant to approve the acquisition. The authority, led by Callum McCarthy, worried that, if Barclays acquired Lehman, the responsibility for its bad assets would ultimately wind up on the British government’s doorstep. This could be the case if the acquisition forced a bailout of Barclays. Given the seriousness of the threat posed to global financial stability by a Lehman bankruptcy, I had expected that the British could be brought around. That did not seem to be happening.

A difference between U.S. and UK securities law—first brought to my attention by King, then confirmed by Geithner—also posed a problem. Under British law, Barclays would not be allowed to guarantee Lehman’s liabilities until after the acquisition was approved by Barclays’ shareholders, a process that could take weeks or months. The JPMorgan acquisition of Bear Stearns had calmed markets because JPMorgan was able to guarantee Bear’s liabilities while shareholder approval was pending. With no unconditional guarantee in place for Lehman, a run could destroy the firm, even if Barclays agreed to a deal in principle. Hank reported that he had appealed to his British counterpart, Alistair Darling, chancellor of the exchequer, for a waiver of the shareholder approval requirement. Darling refused to cooperate, on the grounds that suspending the rule would be “overriding the rights of millions of shareholders.” Moreover, he shared McCarthy’s concern that, if Barclays acquired Lehman, the British taxpayer might end up footing the bill for bad investments made by an American company, a hard thing to explain to Parliament.

A call from Tim dashed my remaining hopes. He said that there was no buyer for Lehman. He confirmed that Bank of America was negotiating with Merrill Lynch. Barclays would not be able to resolve its regulatory issues in time to guarantee Lehman’s liabilities. I asked Tim whether it would work for us to lend to Lehman on the broadest possible collateral to try to keep the firm afloat.

“No,” Tim said. “We would only be lending into an unstoppable run.” He elaborated that, without a buyer to guarantee Lehman’s liabilities and to establish the firm’s viability, no Fed loan could save it. Even if we lent against Lehman’s most marginal assets, its private-sector creditors and counterparties would simply take the opportunity to pull their funds as quickly as possible. Moreover, much of the company’s value—certainly the part that had initially interested Lewis and Bank of America—was as a going concern, based on its expertise, relationships, and reputation. In a full-blown run, already well under way, the firm’s going-concern value would be lost almost immediately, as customers and specialized employees abandoned ship. We would be left holding Lehman’s bad assets, having selectively bailed out the creditors who could exit the most quickly, and the firm would fail anyway. “Our whole strategy was based on finding a buyer,” Tim said. It was a question of practicality as much as legality. Without a buyer, and with no authority to inject fresh capital or guarantee Lehman’s assets, we had no means of saving the firm.

It was a terrible, almost surreal moment. We were staring into the abyss. I pressed Tim for an alternative solution, but he had none. It seemed the next step would be to prepare for a bankruptcy, which would be filed shortly after midnight on Sunday night. “All we can do,” Tim said, in a classic Geithner-

ism, “is put foam on the runway.” The phrase itself conveyed what we all knew: Lehman’s collapse, like the crash landing of a jumbo jet, would be an epic disaster, and, while we should do whatever we could, there wasn’t much we could do.

Knowing that Lehman’s collapse would likely cause short-term lending markets to freeze and increase the panicky hoarding of cash, we increased the availability of funding from the Fed. At an emergency meeting at noon on Sunday, the Board substantially broadened the range of assets acceptable as collateral for Fed loans. To backstop the repo market, we said we would accept any asset that was normally used as collateral on the private repo market. We also expanded the size of some of our lending programs and temporarily relaxed Section 23A restrictions on the ability of banks to provide financing to affiliated securities dealers. Bagehot’s advice still guided us: We were fighting a financial panic by providing essentially unlimited short-term credit to fundamentally solvent financial institutions and markets. We would also continue to lend to Lehman on a day-to-day basis, to the extent that it had acceptable collateral, to facilitate Barclays’ purchase of Lehman’s broker-dealer subsidiary (a relatively healthy, but relatively small, part of the firm). Barclays would repay us when the acquisition was completed. All these steps, I thought, might help reduce the effect of Lehman’s failure.

In the short run, unfortunately, our efforts would be like throwing a few buckets of water on a five-alarm fire. Lehman’s failure fanned the flames of the financial panic, and the bankruptcy proceedings would drag on for years—more proof, if it were needed, that traditional bankruptcy procedures are entirely inadequate for a major financial firm that fails in the midst of a financial crisis.

For Wall Street old-timers, the events of the weekend would evoke some nostalgia. Two iconic Wall Street firms that had survived world wars and depressions, Lehman and Merrill, had disappeared in a weekend. I felt no nostalgia at all. I knew that the risks the two firms had taken had endangered not only the companies but the global economy, with unknowable consequences.

A few Board members and senior staff were still in the building on Sunday evening. Some of the staff were assisting efforts to unwind some of Lehman’s derivatives positions, in the hope of reducing the chaos that we knew would follow the company’s filing. I updated my colleagues and made a few more calls to foreign central banks and to Capitol Hill. I joined yet another conference call with the New York Fed and the Treasury. Then I went home.

* In congressional testimony in March 2010, Mary Schapiro—who would become the SEC chair in January 2009, succeeding Chris Cox— would acknowledge that the SEC’s voluntary supervision of Lehman and other investment banks fell short. The program, she said, “was inadequately staffed almost from the very beginning” and “really required more of a banking regulators’ sort of approach” rather than the SEC’s “disclosure and enforcement mentality.”

† Paulson, in his memoir, said Geithner did press him on the issue: “Tim expressed concern about my public stand on government aid: he said that if we ended up having to help a Lehman buyer, I would lose credibility. But I was willing to say ‘no government assistance’ to help us get a deal. If we had to reverse ourselves over the weekend, so be it.”

CHAPTER 13

AIG: “It Makes Me Angry”

Lehman’s bankruptcy filing, at 1:45 a.m. Monday, September 15, reverberated through financial markets —at first abroad, then in the United States. Don Kohn, Kevin Warsh, Tim Geithner, and I convened a 9:00 a.m. call to assess the market developments. By day’s end, the Dow Jones industrial average would plummet 504 points, its worst one-day decline in seven years. AIG’s stock price would drop by more than half. And shares for Morgan Stanley and Goldman Sachs, the two remaining independent investment banks, would lose an eighth of their value.

Even though the stock market would be the focus of that evening’s financial news, as it was on most days, we were far more concerned with funding markets, including the repo and commercial paper markets, where the cost of borrowing would as much as double on Monday. Swings in stock prices can have modest economic consequences, at least in the short term. But the economy would remain at great risk until funding markets, which supplied crucial credit to financial and nonfinancial companies alike, began to operate normally again.

Rather than lend to a company or financial institution that could default, investors fled to the safety of U.S. Treasury securities on Monday, demanding as little as a 0.21 percent rate to lend to the government for one month. Banks hoarded cash and the federal funds rate spiked to 6 percent—far above the FOMC’s 2 percent target—until the New York Fed could flood money markets with a temporary infusion of $70 billion that morning.

At 10:00 a.m., staff economists, as usual on the day before an FOMC meeting, briefed the Board on the economic outlook. We could speculate, but it was too soon to know the extent of the wider damage from the weekend’s events. At 6:00 p.m., Senator Obama, by this time the Democratic nominee for

president, called for an update. I told him that the economic consequences of the Lehman failure, while uncertain, could be very serious. He listened carefully and asked a few questions. His tone was subdued, and if he had any opinions he kept them to himself. We also discussed Fannie and Freddie. I talked up their recent takeover by the government as an essential, positive first step toward stabilizing the housing market. I said that the clearest message of recent events was that Congress would need to overhaul the financial regulatory system. We agreed on that, but we also agreed that nothing was likely to happen until after a new president was inaugurated in January.

AS THE LEHMAN drama played out over the weekend, we had also been keeping an eye on AIG, whose trillion-dollar insurance operations spanned 130 countries. CEO Robert Willumstad, who had joined AIG three months earlier, after long experience at Citigroup, had told Tim the previous Friday that the company could soon run out of cash. On Friday evening, AIG executives had asked Board staff members about the possibility of a loan from the Federal Reserve. They warned about the prospect of an imminent downgrade of the company’s credit rating, which would lead to even more demands for cash and collateral as counterparties sought to protect themselves from a possible default.

We had no responsibility for regulating or supervising AIG; nevertheless, we had it on our radar over the summer. AIG’s biggest business was selling ordinary life insurance and property insurance, and its U.S. operations were overseen primarily by state regulators. These regulators were supposed to ensure that AIG’s subsidiary companies were properly run and prepared to meet the claims of policyholders. However, the holding company that tied together AIG’s many businesses (including its foreign operations and businesses not involved in insurance) was not subject to oversight by insurance regulators. Because it happened to own a small savings and loan, the gargantuan holding company came under the regulatory purview of the small and understaffed Office of Thrift Supervision—an incredible mismatch of expertise and resources. Until the days leading up to Lehman weekend, the OTS hadn’t hinted that AIG might be in serious trouble, although Willumstad’s appointment in June had come after the company reported significant losses on securities tied to subprime mortgages.

AIG GOT ITS START in China in 1919, when an adventurous twenty-seven-year-old college dropout from California, Cornelius Vander Starr, quit his job as a clerk at a steamship company in Yokohama, Japan, and moved to Shanghai. There he founded a general insurance company, the American Asiatic Underwriters, in a two-room office. In 1967, after decades of impressive expansion, Starr created the holding company AIG to serve as an umbrella for businesses in North America, Europe, Latin America, and the Middle East as well as Asia. Maurice “Hank” Greenberg succeeded Starr as CEO in 1968 and took the company public a year later. The son of a taxi driver from the Bronx, Greenberg ran away from home at seventeen to fight in World War II and helped to liberate the Dachau concentration camp. Described as “dominant, brilliant, irascible, short tempered, controlling, obsessive,” he transformed AIG

Date: 2016-04-22; view: 725