In FED We Trust (25 page)

Around 7
A.M.
, Geithner tried to bring the conversation to a conclusion. “We’ve got to make a call here before markets open. What’s it going to be?”

The consensus was clear: make the loan. “Let’s do it,” Bernanke said.

The fact that such a significant decision was made on the fly before daybreak speaks volumes. The financial regulatory system had become overwhelmed by the evolution of the markets it was supposed to supervise. “Things happened very quickly and left very little time window,” Bernanke said. “In most cases when firms, banks, have problems, they have a considerable amount of time to take preemptive actions in terms of raising capital, finding a partner, and taking other measures to avoid these problems.”

In the end, the Fed agreed to lend Bear Stearns enough to get to the weekend. Technically, the money went from the Fed’s discount window to JPMorgan Chase to Bear Stearns. But the Fed, not JPMorgan, was on the hook if Bear didn’t pay it back. For its part, Bear had to place $14 billion worth
of collateral Friday to borrow $12.9 billion. When the Fed lends, it takes a “haircut” from the collateral’s market value to be sure that it will avoid losses if the loan isn’t paid back. In this case, the Fed was fully paid back — and got $4 million in interest — on Monday.

Lending to a financial firm outside the Fed’s regulatory net would eventually force long-overdue changes in the U.S. financial regulatory regime: the Fed could no longer pretend that it supervised banks and someone else supervised the shadow banking system. The Fed would now have to begin examining the books of
all
investment banks because the Bear Stearns loan was certain to be seen as a precedent. “Everybody on the phone knew that this was hugely consequential, an irreversible decision that would have consequences that were very hard to say at the time,” Don Kohn said. “My stomach hurt for sure.”

Others would later say that Bear wasn’t too
big
to fail; it was too
interconnected
to fail, a new standard. Bear Stearns had open trades with 5,000 other firms and was a party to 750,000 derivatives contracts. It would not have gone into bankruptcy quietly.

“In my mind, what was foremost was that lots of other folks would be brought down with it with consequences I couldn’t imagine,” Kohn said. “So it just felt like the beginning of the Great Depression or something. If you didn’t do [the loan], you would be destroying lots of financial intermediaries.” What Bernanke had dubbed the “credit channel” in his examination of the Depression was obstructed, and the Fed had to clear it out or bypass it.

The Fed’s ability to come up with billions of dollars overnight to prevent a Bear Stearns bankruptcy and for subsequent loans to borrowers, from insurance companies to car buyers, rested on an undefined phrase — “unusual and exigent circumstances” — in a 1932 federal law that had atrophied from lack of use. “Unusual and exigent” was basically the legal license to do
whatever it takes
.

At its birth in 1913, the Fed lent to businesses only indirectly. Businesses would take IOUs from other businesses, and use those IOUs as security to
borrow from commercial banks. The banks, in turn, would use the IOUs as collateral to borrow from the Fed. By 1932, businesses were finding bank credit scarce. Despite Hoover’s reservations about “a gigantic centralization of banking and finance to which the American people have been properly opposed for the past 100 years,” Congress tucked a provision into a public works bill that gave the Fed the power to bypass banks and lend to any individual, partnership, or corporation.

That authority is still found in Section 13(3) of the Federal Reserve Act: the Fed may lend “to any individual, partnership or corporation” if five members of the Federal Reserve Board in Washington declare the circumstances to be “unusual and exigent.” After the 1932 law passed, the Fed declared the times to be “unusual and exigent” but didn’t do much actual lending: over the five unusual and exigent years from 1932 to 1936, 123 businesses borrowed a grand total of $1.5 million, the equivalent of about $25 million in today’s dollars, adjusted for inflation, a pittance compared with the Bear Stearns loan.

In 1934, Congress further expanded the Fed’s purview, authorizing it to make up to $280 million in
unsecured
loans of up to five years to businesses, particularly small ones, that couldn’t find working capital elsewhere. That brought a brisker trade, but demand fell off sharply in 1935 because terms offered by the government’s Reconstruction Finance Corporation, created by Hoover and expanded by Roosevelt, were more attractive.

By the 1950s, the Fed had changed its mind about the whole idea. Fed chairman William McChesney Martin told Congress that the central bank wanted to stick to “guiding monetary policy and credit policy so as to exert its influence toward maintaining the value of the dollar and fostering orderly economic growth,” and to avoid lending to individuals or companies, a view that prevailed inside the Fed until the Great Panic. In 1958, Congress terminated the Fed’s authority to make the working-capital loans, turning that task over to the Small Business Administration.

Congress left the 1932 “unusual and exigent” escape clause on the books, and the Fed invoked the power in 1966 and 1969 to offer loans to savings banks and savings and loan associations struggling with interest-rate ceilings, though none actually took the money. After that, it pretty much shut down the operation,
refusing even to consider making loans to airlines after 9/11 (although the Fed did help oversee an airline-loan operation created by Congress).

Some of the most savvy on Wall Street, though, realized that the Fed’s capacity to lend instantly in an emergency might be needed in a financial crisis — and wanted to be sure it had the powers it needed. Immediately following the 1987 stock market crash, the then-president of the New York Fed, Gerry Corrigan, leaned heavily on reluctant commercial banks to lend to securities firms. Among those most troubled by the vulnerability of securities firms to the whims of commercial banks were Bob Rubin and Steve Friedman, then cochief executives of Goldman Sachs, the politically well-connected investment bank where Corrigan would end up after retiring from the Fed in 1993.

The problem was that the law delineating the Fed’s powers had vestiges of the old doctrine that limited the Fed to financing agricultural, industrial, and commercial transactions, not speculation — which was just another word for the business of Wall Street. Specifically, the act barred the Fed from lending to anyone who would use the money for “merely investments” or “for the purpose of carrying or trading in stocks, bonds, or other investment securities” other than U.S. government bonds and notes.

At the urging of Goldman Sachs lobbyists, Congress dropped the prohibition in a little-noticed section of broader banking legislation enacted in 1991. Don Kohn, then a Fed staffer, told the Senate Banking Committee at the time that the changed wording of the statute would remove any “ambiguity” about the Fed’s powers to lend to securities firms. The committee agreed. “In … an emergency, the Federal Reserve must be able to ensure the liquidity of the financial system, including if necessary by the use of advances [loans] to securities firms,” the committee report said. Sixteen years later, that tiny legislative maneuver, remembered only by the handful of lawyers and lobbyists involved in it, would prove vital to the Fed’s ability to do whatever it takes.

Bernanke and Geithner knew Section 13(3) of the Federal Reserve Act existed but never thought they would use it. Indeed, within the Fed, there long had been anxiety that any public declaration of circumstances to be “unusual and exigent” would be so alarming it could make matters worse. When the Fed initiated the Term Securities Lending Facility a few days before
Bear Stearns, its general counsel advised that the action went beyond the Fed’s usual money market operations and recommended that it invoke the “unusual and exigent” clause. The Fed board did so but didn’t announce that.

Everyone in on the decision knew that the Fed was going where it hadn’t gone since the 1930s. “We recognized, of course, that the use of this legal authority was, in itself, an extraordinary step,” Geithner told a Senate committee a couple of weeks later. “At the same time, we were mindful that Congress included this lending power in the Federal Reserve Act for a reason, and it seemed irresponsible for us not to use that authority in this unique situation.”

After the Bear Stearns conference call finally ended around 8
A.M.
on Friday, March 14, Bernanke, Kohn, and Warsh — joined by the only other Fed governor in town, Randy Kroszner — immediately went to the Fed’s boardroom to formally approve the Bear Stearns loan. Rick Mishkin, the other sitting board member, was flying home from Finland; two other board seats were vacant. (Recalling that Mishkin had been skiing when the Fed abruptly cut interest rates in January, one Fed colleague suggested he avoid further travel to cold climates.)

The empty seats posed a slight problem: the Federal Reserve Act required five votes to lend to anyone other than an ordinary bank. But a post — September 11 change in the law provided an escape hatch: a unanimous vote of the available governors could approve a loan if it was urgently needed “to prevent, correct or mitigate serious harm to the economy or the stability of the financial system of the United States.” The Fed’s formal approval cited “the fragile condition of the financial markets at the time, the prominent position of Bear Stearns in those markets, and the expected contagion that would result from the immediate failure of Bear Stearns.” Although the Fed didn’t say so publicly on Friday, the vote gave Bernanke and Geithner the authority to lend to any other investment bank.

The subsequent Fed press release was terse even by the usual standards,
saying only that the Fed board had voted to approve the arrangement announced by JPMorgan Chase and Bear Stearns. It offered no details beyond those that JPMorgan had offered: the Fed was making a loan of unspecified size, a “no-recourse, back-to-back loan,” meaning JPMorgan wouldn’t have to pay back the money if Bear didn’t. In a phrase that hadn’t received much attention inside the Fed, both JPMorgan and the Fed said the loan was made for
up to
twenty-eight days. Bear Stearns executives later said they took that to mean that they had four weeks to find an ultimate solution. But Paulson and Geithner both had told Bear Stearns executives that they had lost control of their fate when they accepted the Fed’s money.

The fact that the Fed itself was on the hook was such a departure from tradition that some insiders on Wall Street didn’t grasp instantly what happened when Paulson and Geithner briefed them Friday morning. At Morgan Stanley, for instance, executives who participated in the call didn’t realize that the Fed was putting money at risk until a JPMorgan investor-relations person explained it.

President Bush — inconveniently — was scheduled to speak that Friday at noon at the New York Economic Club, a group of economists and Wall Street executives, all of whom were certain to be focused on Bear Stearns and its implications. Bob Steel, Paulson’s undersecretary for domestic finance, had flown to New York Thursday night to surprise his daughter, who was celebrating her twenty-first birthday at a restaurant in Greenwich, Connecticut. He showed up for dessert but then hurried into New York to join the Bear deathwatch. Friday morning, Steel was dispatched to meet the presidential helicopter and bring Bush up-to-date.

“It seems like I showed up in an interesting moment,” Bush told the crowd at the New York Hilton. They laughed. Then he turned to his role as cheerleader in chief. “In a free market, there’s going to be good times and bad times. And after fifty-two consecutive months of job growth, which is a record, our economy obviously is going through a tough time. …[B]ut I want to remind you, this is not the first time since I’ve been the president that we have faced economic challenges. We inherited a recession. And then there was the attack of September the 11th, 2001, which many of you saw firsthand, and you know full well how that affected our economy. And then
we had corporate scandals. And I made the difficult decisions to confront the terrorists and extremists in two major fronts, Afghanistan and Iraq. And then we had devastating natural disasters. And the interesting thing, every time, this economy has bounced back better and stronger than before.”

Bush alluded to the morning’s announcements and then praised Bernanke. “I respect Ben Bernanke. I think he’s doing a good job under tough circumstances. The Fed has cut interest rates several times.”

As much as the president wanted to take credit for Bernanke’s actions, he was also careful to genuflect at the altar of Fed independence. “We also hold dear this notion of the Fed being independent from White House policy. They act independently from the politicians, and they should. It’s good for our country to have that kind of independence.”

Such words undoubtedly would have been comforting to the Fed’s New York contingent, but none of them had joined the Economic Club lunch. They were too busy working.

The Friday-morning loan solved very little. The run on Bear Stearns continued, just as Paulson had predicted days earlier. “It’s over for Bear Stearns,” he told an aide. “It’s over for the shareholders. We’ve got to find a way out of it that doesn’t tank the [whole] market.”

By day’s end, Bear’s already depressed stock had lost nearly half its remaining value. That night, Paulson and Geithner decided the problem had to be solved before markets opened Monday. Around 7:30
P.M.
, they reached Schwartz in his car on his way from Manhattan to nearby Greenwich, Connecticut. He didn’t have twenty-eight days to find a buyer, they told him. He had the weekend. Either he would sell the company by Sunday night, or he would be forced into bankruptcy.