In FED We Trust (4 page)

On Sunday morning, September 14, U.S. officials were troubled to discover that the British FSA was, in fact, an obstacle. Geithner and SEC chairman Cox had been talking frequently with Hector Sants, the FSA head. They had assumed he was at least neutral, if not an ally. He was proving anything but.

The technical issue was that the Fed and Treasury insisted Barclays guarantee all of Lehman’s liabilities so the firm could open for business Monday morning, just as JPMorgan Chase had done with Bear Stearns earlier. Without that, no one would be willing to do business with Lehman the next day. At the last minute, though, Barclays discovered that stock-exchange listing rules would require a shareholder vote on such a guarantee — unless the FSA waived the rule. The FSA refused to grant the waiver. Geithner pressed the New York Fed’s lawyers for some way that the Fed might provide the guarantee, but they couldn’t find a way. The deal died.

Paulson and Geithner concluded that the British regulator, with good reason, didn’t want its bank to swallow a problem as large as Lehman. (Barclays later bought Lehman’s core U.S. business from the bankruptcy court, including a $1 billion Manhattan skyscraper, for $1.75 billion.)

Without a buyer, the only alternative to bankruptcy was a Fed-financed takeover of Lehman, one that would have cost two or maybe three times as much as the $30 billion the Fed spent on Bear. Neither Paulson nor Bernanke nor Geithner audibly advocated that step, according to their own recollections and those of others involved.

There would be no show of Roosevelt-like resolve this time. Lehman signed bankruptcy papers on Sunday, September 14, a day that will live in financial infamy because it coincided with, or triggered, a devastating intensification of the Great Panic.

Paulson, Geithner, and Bernanke came into the weekend with different pressures. Paulson had been singed by previous bailouts and, though given extraordinary leeway by President Bush, was hardly getting encouragement from the White House or Republicans in Congress to bail out another big financial house. He wanted to avoid spending taxpayer dollars, and he had great confidence in his ability to push CEOs to do deals that would serve both their own and the U.S. economy’s interests.

Geithner was nearly always the most “forward leaning” of the three, the one most ready to intervene to stop something bad from happening. Though closest to the center of pain on Wall Street, he was also convinced that smart
people could find a good-enough solution to almost any crisis and then could deal with the unintended consequences later.

Bernanke usually was as eager to act as Geithner and as worried about the damage that a major financial institution’s collapse would cause at a time of panic and distrust. But Bernanke, too, had been facing intense pressure over the Fed’s new activist role. He was hectored from all directions by fundamentalists who saw the Fed’s role in the Bear Stearns rescue as a dangerous precedent.

“We got a lot of flak on Bear Stearns,” Bernanke said in a September 2008 interview. “It’s not that long ago that we had the Jackson Hole meetings” — an annual Fed conference in the Grand Tetons — “and a lot of economists there were saying: ‘Oh, you know, you should be in favor of the market. Let them fail. The market will deal with it.’”

Bernanke thought that was idiocy. “I was unpersuaded,” he said. “I believed that a failure of a major institution in the midst of a financial crisis would not only create contagion through effects on counterparties, but would likely have a tremendous negative effect on broader market confidence.”

But worry that the Fed had gone too far was heard deep inside the Fed — and not just with fundamentalists. One Fed official confided later in September that he had acquiesced in the decision to let Lehman go. Why? “Because I thought people had anticipated it. They [Lehman Brothers] were still very big [but] they had shrunk a lot. It was time to find out what would happen if we didn’t stand behind all these guys. It had been a long time coming.” With hindsight, that tough-guy stance looked, at best, naive.

All the pressures notwithstanding, Paulson, Geithner, and Bernanke were all willing to put in
some
Fed money to close a deal with Barclays — even Paulson, otherwise he wouldn’t have kept talks going with the British when it was clear that some government money might be needed to close a deal. But once the Barclays deal fell through, neither Bernanke nor Geithner was prepared to nationalize Lehman without Paulson’s backing — even if their lawyers found a way to do so. The three had started the weekend hoping that they could sell Lehman and prevent a catastrophic collapse of the firm.

But in what would prove a colossal mistake, they hadn’t come prepared with a plan to prevent a bankruptcy if they couldn’t sell Lehman as they had
managed to sell Bear Stearns. Once a sale proved impossible, they would be forced to scramble to explain why they didn’t do more.

Nobody at the Fed expected it to be pretty, but none anticipated the severity of the reaction that came the day after Lehman died. The Dow Jones Industrial Average lost over 4 percent of its value, and losses were just as steep in international markets.

Criticism, though, came not only from stock tickers: the rest of the world was stunned, too. Christine Lagarde, the French finance minister, called the decision “horrendous” in an interview with French radio network RTL. “For the equilibrium of the world financial system, this was a genuine error.” The same complaint came from the European Central Bank. “[T]he failure of Lehman Brothers could have and should have been avoided,” said Lorenzo Bini Smaghi, a University of Chicago Ph.D. and a member of the European Central Bank’s executive board. In private, Jean-Claude Trichet, Bernanke’s counterpart at the ECB, said the same thing. Another ECB banker a few weeks later confided: “We don’t let banks fail. We don’t even let dry cleaners fail. It never occurred to us that the Americans would let Lehman fail.”

One of the distinguishing features of the Great Panic was that the United States was the source of the disturbance, not the financial stalwart that would protect more vulnerable or mismanaged economies from harm. Ten years earlier, during the financial crisis that swept through Asia to Russia to Latin America in the late 1990s, small-country central bankers asked their local banks if they had
borrowed
from U.S. banks and thus were vulnerable to being cut off from the flow of money if the small country’s finances looked shaky. This time, in a reversal, the same central bankers asked their local banks if they had
lent
to U.S. financial institutions and thus faced potentially huge losses should an American behemoth fail.

Back in Washington, Paulson went to the White House press room Monday morning and made what sounded like an unambiguous declaration that he had been unwilling, not unable, to save Lehman: “I never once considered
that it was appropriate to put taxpayer money on the line … in resolving Lehman Brothers.” That was not true. Paulson said months later he meant that he never considered using taxpayer money to keep Lehman alive as a standalone company.

Nine days later, on September 24, Bernanke and Paulson sat side by side on Capitol Hill. Bernanke, always extremely careful to avoid any sign of disagreement with Paulson in public, also implied that a choice had been made. “In the case of Lehman Brothers,” he said, reading from prepared testimony, “the Federal Reserve and the Treasury declined to commit public funds to support the institution. The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized — as evidenced, for example, by the high cost of insuring Lehman’s debt in the market for credit default swaps — that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures.”

Paulson and Bernanke’s statements were more than after-the-fact window dressing. Although Lehman was already dead, the cause of death wasn’t a secondary issue. Lehman’s collapse caused — or coincided with — so much financial turmoil in large part because of the lack of a consistent story. Did the government let Lehman fail to teach Wall Street a lesson? Or were they legally powerless to save it? Was Bear Stearns a one-time-only rescue? Would the United States let other major financial firms fail? Every financial firm viewed its trading partners with suspicion.

“Everything fell apart after Lehman,” Alan Blinder, a Princeton economist — Bernanke’s former colleague — and former Fed vice chairman, later wrote. “People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear’s rescue, the Lehman decision tossed the presumed rulebook out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not? After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.”

Bernanke and Paulson implied initially that they deliberately let Lehman go. But their later accounts were, well, different. In a January 2009 interview, a few days before leaving Treasury, Paulson said that the truth could not be spoken in September 2008. “We were unable to talk about it in a way in which we wanted to talk about it,” he said. “You’re unable to say: ‘We let it go down because we were powerless to do anything about it.’” After Lehman’s collapse, Merrill Lynch had been saved for the moment, but Paulson feared Morgan Stanley would be threatened next and perhaps his own Goldman Sachs would be next. In that climate, publicly admitting that the U.S. government was impotent to stop Lehman’s failure would have made everything worse. “You don’t want to say ‘the emperor has no clothes,’” Paulson explained.

Bernanke never disavowed his testimony, and nothing in it was untrue. But as time passed, he emphasized the legal constraints that had stopped the Fed and Treasury — rather than repeating the sense that the markets were ready for Lehman’s collapse. With a commercial bank, one that took deposits that were insured by the federal government, the law established ways to tap the Federal Deposit Insurance Corporation to rescue a systemically important bank, he said. But Lehman wasn’t a commercial bank. The law didn’t provide a clean way for the government to take over or close an investment bank — no matter how important.

The law said that the Fed could lend to nearly anyone if the Fed board in Washington declared circumstances to be “unusual and exigent,” provided that the loan was to be “secured to the satisfaction” of Geithner’s New York Fed. That was a problem, both Geithner and Bernanke said days after Lehman’s bankruptcy. With Bear Stearns, the Fed had a reasonable chance of selling the assets it bought at close to what the Fed had paid for them, or so they argued. But Lehman was literally worthless. Its debts were overwhelming its assets, and much of its collateral already had been pledged for other loans. There wasn’t enough wiggle room in the law to do a deal as big as Lehman, they insisted.

By the end of 2008, Bernanke, Paulson, and Geithner had coalesced around the explanation that — without a buyer — neither the Treasury nor the Fed had the authority to spend what it would have taken to save Lehman. “Neither the Department of the Treasury, the executive branch, nor the Federal Reserve had been given the authority by the Congress that would … have made it possible for the government to put in capital on a scale necessary to
avoid default,” Geithner told the Senate during his January 2009 confirmation hearings to replace Paulson as Treasury secretary.

Bernanke also made it clear that had Congress given the Fed and the Treasury more authority sooner — for example, had the Troubled Assets Relief Program (TARP) been enacted earlier — he would not have let Lehman fail. “We could have saved it. We would have saved it,” he said in an interview in October 2008. “Even then, it would have been politically tough because of the risks to the taxpayer that would have been involved. And, of course, if Lehman hadn’t failed, the public would not have seen the resulting damage and the story line would have been that such extraordinary intervention was unnecessary.”

Two harrowing days after Lehman’s collapse, with markets bruised and panic spreading, the Fed shelled out $85 billion to prevent AIG, the big insurer, from following Lehman to bankruptcy court. While the federal government took an 80 percent stake in the insurance company and planned to replace senior management, the move undermined the case that the Fed and the Treasury had been unable to save Lehman.

To be sure, there were legal differences: AIG had profitable operating businesses that were pledged as collateral for the Fed loan. But the primary motivation was more practical than legal: Bernanke and Paulson believed that the global financial system
could
absorb Lehman’s bankruptcy without catastrophe. A second shock only two days later was a different matter.

“Why not Lehman and why AIG?” Bernanke asked aloud in an interview days after he’d helped keep the insurance giant from bankruptcy. The short answer: AIG was bigger. The markets weren’t expecting it to go. And Lehman had just gone under.

“The impact of AIG’s failure would have been enormous,” Bernanke continued. “AIG was bigger than Lehman and was involved in an enormous range of both retail and wholesale markets. For example, they wrote hundreds of billions of dollars of credit protection to banks, and the company’s failure would have led to the immediate write-downs of tens of billions of dollars by banks.
It would have been a major shock to the banking system.” Even banks that weren’t intertwined with AIG would have been hurt, he said. “Since nobody really knew the exposures of specific banks to AIG, confidence in the entire banking system would have plummeted, putting the whole system at risk.”