5
FROM BEAR TO LEHMAN: INCONSISTENCY WAS THE HOBGOBLIN
A foolish consistency is the hobgoblin of little minds.
—RALPH WALDO EMERSON
The six months between the collapse of Bear Stearns into the waiting arms of JP Morgan Chase and the collapse of Lehman Brothers into bankruptcy was interesting, in the sense of the apocryphal Chinese curse. (May you live in interesting times.) In March the Federal Reserve, supported by the Treasury, kicked in almost $30 billion to facilitate the shotgun marriage of Bear to JP Morgan, presumably because a disorderly failure of Bear might have devastated the financial system. But in September, the Federal Reserve, again with the full support of the Treasury, refused to provide any money at all to facilitate a sale of Lehman—even though Lehman’s failure did devastate the financial system. Go figure.
These two monumental decisions were among the most eventful of the entire financial crisis. While it is hard to know which was more controversial, the decision to let Lehman fail was clearly more consequential. After all, when Lehman went under, it took the rest of us down with it. Financial experts and historians will long debate the wisdom of saving Bear and letting Lehman go. This chapter asks why the authorities did so.
TURNING BEARISH ON BEAR
Bear Stearns was the smallest, and arguably the scrappiest, of the Big Five Wall Street investment banks. The firm had long prided itself on dancing to its own drummer. That meant, among other things, that it often pursued contrarian strategies—such as buying distressed assets, holding them until markets normalized, and then selling them for a tidy profit. So Bear’s top management wasn’t easily scared off when the subprime mortgage market started to falter—not even when two of its own subprime funds failed in July 2007. The firm was also very profitable, especially for its top executives. The top five took home over $1.4 billion in cash and stock sales over the years 2000–2008.
Bear was also contrarian in another sense. Ten years earlier, during the height of the 1998 financial crisis, it had earned the enmity of the other Wall Street banks when it alone refused to accept its pro rata share of the emergency buyout of what was left of the faltering hedge fund Long-Term Capital Management (LTCM). Bear’s refusal left a bitter aftertaste that Wall Streeters remembered in March 2008.
One way in which Bear Stearns set its own course during the bubble was by becoming a huge player in the mortgage business, especially in the subprime mortgage business. Mortgage securitization became the largest component of Bear’s fixed-income division, which was in turn the company’s most profitable line of business, generating almost half the firm’s revenues. For example, even though it was much smaller than its Wall Street rivals, Bear ranked in the top three in underwriting private-label mortgage-backed securities from 2000 to 2007.* In addition, a series of acquisitions and expansions had turned Bear Stearns into a full-service, vertically integrated mortgage machine. Its various divisions originated home-mortgage loans, bundled them for securitization, and sold the resulting securities—profiting at each step in the chain.
This heavy concentration in mortgage finance was one of the reasons Bear was widely considered the weakest of the so-called Bulge Bracket firms when the financial world started teetering on Paribas Day. Its image was not helped by a November 2007 front-page story in the Wall Street Journal describing its longtime CEO, James “Jimmy” Cayne, as a detached, marijuana-smoking executive who paid more attention to his world-class bridge game than to his company. About two months after that story appeared, Cayne was out, and Bear’s president, Alan Schwartz, was elevated to the top job. Schwartz was destined to hold that job for only about two months.
Speculators in panicky markets have been aptly described as a pack of jackals looking to attack the slowest antelope in the herd. The jackals had plenty of teeth: They could pull assets out of the target firm, stop lending to it, sell the firm’s stock short, or buy its CDS—thereby betting loudly on default. And did I mention, they could spread rumors that the firm was going down?
In March 2008, Bear Stearns was widely viewed as that slow antelope, with Lehman Brothers running just slightly faster. The rating agencies had called Bear’s creditworthiness into question. Several notable counterparties, including Citigroup and JP Morgan Chase, had pulled away from it. Warren Spector, Bear’s top expert on the firm’s exotic fixed-income positions, had been purged, leaving Schwartz, an investment banker who was gamely trying to acquire bond-market expertise in a hurry, in charge. But as one of Bear’s top fixed-income executives put it, his crash course “was like Bonds 101.”
On Monday, March 10, 2008, rumors—vigorously denied by the company—began to circulate that Bear Stearns was experiencing liquidity problems. Other rumors held that one or more of its Wall Street rivals was spreading the rumors—it’s a tough crowd. Remember that Bear, like the other Wall Street giants, financed itself to a stunning degree with cheap, very short-term credit—mainly repos. By the end of 2007, Bear was borrowing over $100 billion in the repo market; most of it overnight.
Overnight loans must, of course, be rolled over every day. Usually that’s routine. But a piece of bad news, or even a rumor of bad news, can transform a company from a good credit risk to a bad credit risk in the eyes of the market literally overnight. One day that fateful week, a top aide informed Treasury Secretary Paulson that Bear was under severe stress and might last only another month or so. Paulson, who had been around the block a few times, replied wisely: “I don’t buy that. When confidence goes, it goes.” He was right. Bear Stearns didn’t survive the week.
The firm opened for business Monday morning with $18 billion on hand in cash and highly liquid securities. Enough to withstand a run, right? Not even close. By the end of that day, with rumors flying, Bear’s liquidity was down to $12.5 billion. It was bleeding cash. Counterparties were getting nervous about dealing with Bear, and some were refusing to do so. On Tuesday afternoon, Goldman Sachs startled Bear by declining a routine trade, and the news spread like wildfire. By Wednesday night, Bear’s access to the repo market was withering away. The next morning, Alan Schwartz was on the phone with Tim Geithner, then president of the Federal Reserve Bank of New York, warning that his company was in dire straits. Dire, indeed. By Thursday night, Bear Stearns was down to $2 billion—it had run out of cash in less than a week. Bankruptcy looked imminent, even though Bear executives insisted that the company’s problem was illiquidity, not insolvency.
In practice, however, the distinction didn’t matter much. According to rumors, a bunch of hedge funds had pulled their brokerage accounts from Bear Stearns, bought insurance on the CDS market against the bank’s default, and then started shorting the stock like mad—which naturally pushed up the prices of the CDS. True or not, it looked as though a firm that had lived by the sword was about to die by the sword.
Financial firefighters from the Fed, the Treasury, the SEC, and others worked through the night that Thursday, debating the pros and cons of a “bailout” and trying to figure out how one might be done, if that was the decision from on high. The decision itself came early Friday morning before the markets opened: The Fed, using JP Morgan Chase as an intermediary, would lend Bear $13 billion to get it through to the weekend. (The number itself was not announced.) That decision was both stunning and monumental. It constituted crossing the Rubicon.
Why? Remember that Bear Stearns was not a bank. (Technically, the loan went to JP Morgan.) It had never been supervised by the Fed. Don Kohn, the Fed’s vice chairman, called it “an irreversible decision that would have consequences that were very hard to say at the time.” As reporter David Wessel observed, “The fact that the Fed 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 Bernanke briefed them Friday morning.”
To justify its unprecedented action, the Federal Reserve invoked a little-known clause of the Federal Reserve Act, Section 13(3)—which was destined to become a very well-known clause. Section 13(3) empowered a supermajority of five of the seven governors to make emergency loans “to any individual, partnership, or corporation” under “unusual and exigent circumstances.” It was an obscure power that few people knew the Fed had and which had not been used since 1936. In one of those little footnotes to history, the Federal Reserve Board had only five sitting governors at the time, and one of them (Rick Mishkin) was on a transatlantic flight. Fortunately, a post-9/11 escape hatch held that a unanimous vote would suffice if fewer than five governors were available and the need was urgent. It was urgent, so a 4–0 vote did it. That loan would prove to be the first of many uses of the now-famous Section 13(3) during the crisis. The Fed had broken the ice.
The loan to Bear Stearns, historic as it was, got the firm through only to the close of business on Friday, March 14. The Fed could still claim it was sticking with Bagehot: lending to a solvent but illiquid institution against good collateral, especially as this initial loan was paid back in full, with interest. The weekend would be devoted to another task: finding a buyer for what was left of Bear Stearns. As it turned out, there was only one feasible buyer: JP Morgan Chase. The financial giant had been serving as Bear’s clearing bank in the repo market, so it knew enough about the company’s assets to be able to perform the requisite due diligence rapidly. It was also interested in acquiring some of Bear’s operations. Perhaps most important, JP Morgan had the “fortress balance sheet” needed to absorb Bear Stearns, with all its attendant risks.
In a remarkable swapping of roles, the Fed and the Treasury turned into a pair of investment banks, trying to broker a deal between two Wall Street firms: Bear Stearns, to which the Fed had just lent $13 billion, and JP Morgan Chase, which the Fed regulated. A sticky wicket, to be sure. And in this particular poker game, the government team didn’t hold a good hand. JP Morgan’s CEO, Jamie Dimon, an acclaimed deal maker, had the ace in the hole: He was the only viable bidder in what amounted to a weekend fire sale. Paulson realized that: “Because we had only one buyer and little time for due diligence, we had little negotiating leverage.” So it was: Name your price, Mr. Dimon.
That weekend, a veritable army of JP Morgan bankers descended on Bear Stearns headquarters—conveniently, the two firms were almost neighbors in Midtown Manhattan—to pore over the books. They did not like some of the things they saw. In particular, Bear Stearns owned about $30 billion in dodgy mortgage-related assets that JP Morgan did not want at all. (It already had its own pile of mortgage garbage.) And that’s exactly what Dimon told the Fed and the Treasury.
To Bernanke and Geithner, that $30 billion represented a major stumbling block. Lending to Bear Stearns via JP Morgan for a few days was one thing. While the action was highly unusual, at least Section 13(3) koshered it. But actually buying a portfolio of mortgage assets that JP Morgan considered too risky for its own shareholders was quite another. After all, the Fed’s effective “shareholders” were the taxpayers.* If the Fed took these questionable assets onto its own balance sheet, taxpayers would be assuming risks that Dimon didn’t want his own shareholders to bear. It was not a question of legal niceties. The Fed’s lawyers could easily structure the transaction as a loan, rather than as a purchase—which is what they ultimately did.* Rather, it was a substantive policy question: Was it proper for the Federal Reserve to take on that much risk? After all, the law demanded—in true Bagehot fashion—that every Federal Reserve loan be well collateralized. The Fed was not supposed to absorb losses.
The central bank, wary of stepping over the traditional Bagehot line, first tried to get the Treasury to pony up the cash. The elected government should be responsible, right? Maybe. But that would have required an act of Congress, which was plainly impossible on such short notice—and probably would not have passed in any case. Then the Fed asked the Treasury to indemnify it against losses. Treasury lawyers nixed that idea, too.
There was the Fed, stuck between the proverbial rock and a hard place. Bernanke could let Bear Stearns fail that weekend—with whatever consequences that might entail—or put his head on the chopping block by buying a $30 billion pile of dodgy mortgage-related assets of uncertain value, and putting the taxpayers at risk for any losses. He chose the latter.
That decision both sealed the deal and set the stage for much of what would come later. JP Morgan agreed to absorb the first $1 billion of losses, leaving the next $29 billion—if it came to that—for the Fed to pick up. With that guarantee in hand, JP Morgan offered to buy all of Bear Stearns’ common stock for $2 a share—a price that valued the dying company at less than the market value of its Madison Avenue headquarters building! JP Morgan’s board minutes later revealed that they had reduced their $4 bid to $2 “because the government would not permit a higher number . . . because of the ‘moral hazard’ of the federal government using taxpayer money to ‘bail out’ the investment bank’s shareholders.” The purchase price was later raised to $10 a share to ensure that Bear Stearns’ shareholders would not vote the “merger” down. Behind the scenes, and invisible to almost everyone, the details of the shotgun marriage that had been hurriedly arranged that Sunday then took about three months for all to agree on.
WHY SAVE BEAR?
The Bear Stearns “bailout,” as it was immediately branded, was instantly controversial and remains so to this day. Start with the pejorative term “bailout.” The Fed didn’t see the operation as a bailout, and neither did Bear Stearns. After all, the stock had traded as high as $93 in February 2008. Now, in March, shareholders would get only $2 a share (which later became $10). Jimmy Cayne alone lost about a billion dollars. Furthermore, the company was not rescued; it was dead—absorbed into JP Morgan Chase. At Bear’s headquarters, the feeling was more of a funeral than of a bailout. So, who actually got bailed out? Basically, it was Bear Stearns’ creditors—mostly other financial businesses that would have lost money in a bankruptcy proceeding.
Critics immediately pounced on the Fed’s decision—from all sides, including from the inside. Remember, the Treasury was still in the background—it had not put a nickel at risk. To outsiders, this looked like a Federal Reserve operation, led by Geithner with Bernanke’s blessing, although Treasury Secretary Paulson was intimately involved every step of the way. Consequently, the Fed took most of the heat. But since there was enough heat to go around, Paulson took his share, too.
The moral hazard ayatollahs excoriated the “bailout” on the usual grounds. After all, anything that eased the pain of failure, according to this doctrine, would make future investors less wary of taking the kinds of imprudent risks that almost killed Bear Stearns. For example, Anna Schwartz, who had been Milton Friedman’s coauthor, called it a “rogue operation.” On April 3, Bernanke, Geithner, and the Treasury’s Robert Steel appeared before the Senate Banking Committee to explain the Bear deal. Senator Jim Bunning (R-KY), the former Major League pitching star and perennial foe of the Fed, told them he was “very troubled” by the bailout: “That is socialism, at least that’s what I was taught.” He then added an ominous and prescient question: “And what’s going to happen if a Merrill or a Lehman or someone like that is next?” Fortunately for Bernanke and Geithner, Bunning’s question time ran out at that moment, and they did not have to provide an answer—at least not until September.
But the criticism from Fed “insiders” must have stung even more. In an April 8 statement that garnered a huge amount of attention, Paul Volcker told the Economic Club of New York that the Fed had gone to “the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices.” That sounded like a rebuke, and given Volcker’s august stature at the Fed, his words were like criticism from Mount Olympus. Breaking the Fed’s usually unbreakable solidarity, Vincent Reinhart, who had been the Fed’s top staffer until 2006, publicly criticized the Bear Stearns decision as “the worst policy mistake in a generation,” predicting that it would set a precedent: From now on, any time a large financial institution teetered on the brink, the Fed would be expected to bring money to the table. (Could he have been thinking about Lehman?) Three months later, Richmond Federal Reserve Bank president Jeffrey Lacker, perhaps the FOMC’s most conservative member, made headlines in London with a speech denouncing the Bear Stearns decision on moral hazard grounds.
As we shall see, both the moral hazard criticisms and the “bailout” charges would weigh heavily on future decisions, including the one on Lehman Brothers. But first let’s ask why the Fed and the Treasury, well aware of the potential moral hazard involved, decided to bail out Bear Stearns’ creditors, anyway.
The first natural thought is incorrect: that the Bear Stearns rescue was an application of the age-old too big to fail doctrine. The too big to fail idea is that some companies, financial or not, are simply so large that their failure, especially if abrupt, would do so much damage to other companies, to consumers, and to the overall economy that the government has to intervene in some way.* The doctrine is actually misnamed. In some cases, the preferred solution may be to lay the company to rest slowly and peacefully, with minimal disruption to other parties. So the idea should probably be called “too big to fail messily.” But labels, once assigned, have a way of sticking. For better or for worse, this doctrine is called “too big to fail.”
But didn’t I just say that Bear Stearns was probably not too big to fail? It was, of course, a very large company, with assets of $395 billion as of November 30, 2007. But remember, it was only the fifth-largest Wall Street house—the others ranged in size from $691 billion (Lehman Brothers) all the way to $1.12 trillion (Goldman Sachs) at the time. Bear was a pup by comparison. And I haven’t even mentioned the big banks or insurance companies. As of the end of 2007, there were seven bank holding companies with assets above $395 billion. The nation’s largest thrift institution, Washington Mutual (WaMu), had assets of $327 billion. And four big insurance companies had assets exceeding $360 billion. These numbers were all in the public domain and were well known to financial aficionados. So, if Bear Stearns was too big to fail, then at least sixteen other financial firms were, too. If you had taken an expert opinion poll on the question in February 2008, I believe most observers would have judged that Bear was below the too big to fail threshold. I know I did.
Why, then, were the Fed and the Treasury unwilling to let Bear Stearns go under that weekend? The primary reason was fear that Bear was too interconnected to fail—in several respects.
First, it was closely linked to many other financial companies, especially hedge funds. One of Bear’s major business lines was acting as the prime broker for hundreds of hedge funds—executing trades, holding collateral, receiving and disbursing monies, and so forth. These funds, in turn, accounted for a substantial share of the trading in a variety of markets. If Bear Stearns went belly-up, the authorities feared, markets all over the world would be severely disrupted. Remember the domino theory? That was the governing doctrine.
Second, and related, Bear Stearns was counterparty to what were probably hundreds of thousands of derivatives transactions. Nobody knew how many. As Paulson later told the Financial Crisis Inquiry Commission (FCIC), “If Bear had gone, there were hundreds, maybe thousands of counterparties that all would have grabbed their collateral, would have started trying to sell their collateral, drove down prices, create[d] even bigger losses.” Notably, that was exactly the rationale that had been given ten years earlier when the Fed arranged the private-sector rescue of LTCM—an operation in which Bear, remember, refused to participate.
Third, according to Bernanke’s subsequent testimony to the FCIC, even though Bear Stearns was “not that big a firm [so it wasn’t a case of too big to fail] . . . our view was that because it was so essentially involved in this critical repo financing market, that its failure would have brought down that market, which would have had implications for other firms.”
Fourth, Bear’s risk profile was far from unique. If Bear fell, other firms might not be far behind. As Paulson later put it, “Perhaps if Bear had been a one-off situation, we would have let it go down. But we realized that Bear’s failure would call into question the fate of the other financial institutions that might share Bear’s predicament. The market would look for the next wounded deer, then the next, and the whole system would be at serious risk.” To others, of course, that argument cut exactly the opposite way: Saving Bear implied a tacit commitment to save Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs if necessary. In fact, the government would later save three of the four.
In a nutshell, Bear Stearns was deemed to be too interconnected to fail. But was it true? We’ll never know, although the multiple catastrophes that followed the Lehman Brothers bankruptcy six months later give the claim substantial credence. Regardless, the Federal Reserve and the Treasury believed it was true and acted on that belief. The Treasury, however, was still keeping its head down. And no wonder. How would you like to explain to the voting public that the government had just put $29 billion at risk to save hedge funds, derivatives traders, and the triparty repo market? (The what?)
The “too interconnected to fail” doctrine seemed novel and somewhat obscure at the time. And in a sense it was, although the LTCM case ten years earlier was a clear precursor. In that famous case, however, the Federal Reserve had not contributed a penny of its own money to seal the deal. Rather, it used its good offices (née arm twisting) to persuade all the major Wall Street firms except Bear to keep LTCM alive long enough that its failure would not trigger a cascade of other failures. The March 2008 Bear Stearns rescue was actually the second major application of the too interconnected to fail doctrine, but with an important twist: This time, the Fed put a lot of money on the line.
What were the arguments on the other side? The first has already been mentioned: The action would set a precedent, as Vince Reinhart predicted. Once the Fed got into this business, getting out would be hard.
Second, the precedent created moral hazard, not so much from top executives and shareholders of other Wall Street firms—Bear’s, after all, suffered huge personal losses—but from individuals and businesses that had extended credit to a shaky Bear Stearns. They, after all, were the ones the taxpayers actually bailed out. Would they be more careful next time, or just assume that another government bailout would save their skins? If the latter, one of the checks and balances safeguarding the financial system—vigilant creditors—would be impaired.
Third, some people argued that the Bear Stearns rescue overstepped the Fed’s legal authority. They were wrong: Section 13(3) clearly made the Fed’s actions legal. But perhaps it was a stretch of congressional intent. Indeed, about two years later, in the Dodd-Frank Act, Congress took this power away from the Fed. As amended by Dodd-Frank, Section 13(3) no longer authorizes emergency loans to particular financial institutions—only to all “participants in [a] program or facility with broad-based eligibility.”
One other important footnote to history: On Sunday, March 16, the same day that JP Morgan Chase announced its purchase of Bear Stearns and the Fed announced its approval of the deal, the Fed’s Board of Governors created the Primary Dealer Credit Facility. The PDCF made it much easier to lend money to securities firms by, for example, broadening the range of eligible collateral. Bear executives maintained that they could have averted bankruptcy without requiring assistance, if they had been given access to the PDCF. Jimmy Cayne told the FCIC that the PDCF came “just about 45 minutes” too late to save his firm. No one will ever know.
FRETTING OVER FANNIE AND FREDDIE
After Bear Stearns Day, and maybe because of the Bear Stearns rescue, things went quiet for a while—sort of. Some pretense of normalcy returned to the markets, and tales of financial woe stopped dominating page 1. The S&P 500, which had dropped almost 18 percent between October 9, 2007, and March 14, 2008, gained back about half of that between March 14 and May 2. Both risk spreads and the costs of protecting against default via credit default swaps generally declined. For example, the much-watched three-month TED spread (between LIBOR and Treasuries) dropped from 204 basis points to just 77 basis points. A number of big banks and the four remaining investment banks went into the market and successfully raised capital.
Nonetheless, beneath the surface, the pot was boiling. The house-price, mortgage-finance, and foreclosure problems were getting worse, not better. No one really knew how much junk was hidden on (and off) the books of several big banks. The huge and unregulated over-the-counter (OTC) derivatives markets remained a dark and scary continent. The rapid unraveling of Bear Stearns was a warning shot that called into question the high-risk Wall Street business model of combining high leverage with precarious liquidity. Lehman Brothers replaced Bear as the slowest antelope in the herd. And then there were the two limping mortgage finance giants, Fannie Mae and Freddie Mac.
Fannie Mae (originally the Federal National Mortgage Association—FNMA) was established in 1938 as a government-sponsored enterprise to increase the flow of funds into housing and to create a liquid secondary market on which mortgage loans could be traded. It was converted into a publicly held corporation in 1968 to get it off the federal budget. Freddie Mac (originally the Federal Home Loan Mortgage Corporation—don’t ask me how FHLMC became “Freddie Mac”) was chartered in 1971 to compete with Fannie and, by so doing, make the secondary mortgage market more efficient. Both companies had shareholders who sought capital gains and dividends, which is what shareholders do, and executives who sought to please their shareholders, which is what corporate executives do.
All normal, except for one crucial fact: The two companies had a number of special features that left markets with the impression that they were quasi-government enterprises. Most important, the fact that Fannie and Freddie each had a line of credit from the U.S. Treasury created the presumption that if push ever came to shove, the Treasury would stand behind their debts.* There was, in fact, no explicit, legal guarantee of Fannie/Freddie obligations by the U.S. government. Nonetheless, there was an almost universal belief in an implicit guarantee: The government would never allow Fannie or Freddie to default on its debts. And, indeed, when push came to shove, it did not.
After Treasuries, Fannie’s and Freddie’s securities were considered the safest assets anyone could buy. Many risk-averse investors, including banks, municipalities, and foreign governments, viewed the debt obligations of Fannie and Freddie as almost as safe as Treasuries, though with higher yields—a good deal. In consequence, the mortgage twins were able to float debt at rock-bottom interest rates, below those paid by the bluest of blue-chip corporations. That advantage, in turn, gave Fannie and Freddie a heavy competitive edge in the mortgage business—which they exploited to grow into financial behemoths. The two GSEs were thus an awkward blend of public purpose and private gain that would come back to haunt taxpayers later.
Several things followed from the implicit government guarantee and the fact that Fannie and Freddie traditionally dealt only in higher-grade mortgages. As one Freddie executive said to me early in the crisis, “We own the good stuff.” Relatively speaking.
First, the mortgage twins were allowed to operate with extremely high leverage and under a pretty light regulatory regime. At the end of 2007, as the housing crash was gathering steam, Fannie and Freddie were leveraged about 75 to 1. Yes, that meant that a mere 1.4 percent loss on their assets would have left both of them insolvent.
Second, by charter, Fannie and Freddie were not allowed to diversify into other asset classes. Mortgages, mortgage guarantees, and mortgage-related securities constituted roughly 100 percent of their earning assets. In some sense, these three were the same assets in different guises. Thus, in words that no one ever used, Fannie and Freddie were actually designed to fail if the proverbial 100-year flood ever swallowed up the housing market. When it did so after 2006, Fannie and Freddie were doomed.
Third, a change in their business strategies during the bubble left them even more vulnerable. Pressured both by affordable housing goals from the Department of Housing and Urban Development (which, in turn, came from Congress) and by competition for market share from Wall Street, and egged on by the lure of profit, Fannie and Freddie starting guaranteeing and purchasing riskier mortgages. The share of subprime MBS owned by Fannie and Freddie rose from 16 percent in 2001 to 33 percent by 2004. No longer did the twins hold just “the good stuff.” However, as Gramlich observed, “the GSEs do not play nearly as great a role in the subprime mortgage market as they do in the prime market. Many subprime mortgages do not meet the underwriting standards of Fannie Mae and Freddie Mac.” Fortunately, by the time things started to fall apart in the summer of 2007, the share of the two housing GSEs in subprime MBS was back down to 17 percent. Nonetheless, that meant they were still saddled with a good share of dodgy mortgages.
A few observers have singled out losses on Fannie’s and Freddie’s low-income and subprime-mortgage portfolio as the preeminent weakness that undermined the entire financial system. For example, Peter Wallison, who was a member of the FCIC, states in his dissent that “I believe that the sine qua non of the financial crisis was U.S. government housing policy.” Another vocal critic is New York Times reporter Gretchen Morgenson, who, with coauthor Joshua Rosner, claims in their book Reckless Endangerment that “Fannie Mae led the way in relaxing loan underwriting standards.”
Most experts, however, view that characterization as a caricature. For example, the FCIC Report condemned “the business model of Fannie Mae and Freddie Mac (the GSEs), as private-sector, publicly traded, profit-making companies with implicit government backing and a public mission, [as] fundamentally flawed.” Nonetheless, it concluded that “GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis.” Many other financial experts with whom I have discussed this matter see Fannie and Freddie as supporting actors, far from the star of the show. So do I.
However large or small their role in the crisis, no one can accuse Secretary Paulson of failing to see the troubles at Fannie Mae and Freddie Mac brewing. Yet just a few days after Bear Stearns Day, the two government-sponsored enterprises’ weak regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), actually reduced the companies’ capital requirements. Yes, that’s right. It allowed Fannie and Freddie to operate with even higher leverage than before. Why? So they could provide more support to the wilting housing market. In return, the two companies promised—vaguely, with no specific numbers—to go into the market and raise more capital.
Nonetheless, you may still be wondering: Even higher leverage? That sounds crazy—until you recall that the financial conflagration by then had consumed virtually all of Fannie’s and Freddie’s private-sector competitors. When it came to housing finance, the two GSEs were essentially the only players left standing. But regardless of whether OFHEO’s action was right, the move weakened Fannie’s and Freddie’s already-weak defenses.
Losses in the housing market continued to mount, of course, and Fannie and Freddie absorbed their share, which shrank their capital bases further. Confidence in the two GSEs sank, and so did their share prices. The cost of insuring their debt in the CDS market soared, as did their borrowing rates. It was beginning to look like a death spiral.
In mid-July 2008, Paulson asked Congress to authorize him to inject capital into Fannie Mae and Freddie Mac, and to increase their lines of credit (thereby making the implicit government guarantee explicit), just in case the Treasury had to prop them up. President Bush reluctantly approved the action. He didn’t like the GSEs, but he knew they were essential to the foundering housing finance markets: “The first order of business, he said, was ‘save their ass.’” Using a slightly less colorful metaphor that would soon come back to haunt him, Paulson told a Senate committee that he needed a “bazooka.” Why such heavy artillery? Because, in his words, “If you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you have it, you may not have to take it out.”
In late July, Congress gave Paulson the bazooka he requested. It also increased the Treasury’s lines of credit to Fannie and Freddie, and strengthened their regulator. OFHEO was replaced by the new Federal Housing Finance Agency (FHFA), which, among other things, was granted the power to put Fannie and Freddie into conservatorship or receivership, if necessary. Within weeks, Paulson would be firing the bazooka he said might not be used.
On September 7, the government placed both Fannie and Freddie into conservatorship. The impossible had happened again. “Conserve” was the right word. By August 2012, the government had spent about $140 billion, net, to keep Fannie and Freddie alive and functioning, but was expecting to recoup most of that—eventually. Paulson and Bernanke must have sighed in deep relief that day in September 2008. As the Treasury secretary recounted in his memoir, “The GSE crisis left me dead tired. I told [White House Chief of Staff] Josh Bolten that solving [it] was the hardest thing I had ever done.” But there was barely time for Paulson and Bernanke to catch their breaths. Notice the date: September 7, 2008, a week before the titanic financial system hit the iceberg. The stage was now set for the biggest melodrama of them all: the fall of Lehman Brothers.
ARMAGEDDON ACTUALLY ARRIVES
The consequences of adverse economic events are typically exaggerated by the Armageddonists—a sensation-seeking herd of pundits, seers, and journalists who make a living by predicting the worst. Prognostications of impending doom draw lots of attention, get you on TV, and sometimes even lead to best-selling books with titles like How to Profit from the Coming Disaster in __________. But the Armageddonists are almost always wrong. The economy and even the more mercurial financial system are more resilient than doomsayers give them credit for. Train wrecks don’t often occur. Thus, OPEC did not bring the West to its knees in the 1970s, the Great Inflation of that decade did not destroy the U.S. monetary system, higher taxes in 1993 did not end capitalism as we know it, and the stock market crash of 2000–2002 did not kill anything but the stock market itself.
The fallout from the bankruptcy of Lehman Brothers was the exception that proved the rule. Just about everything got vastly worse than almost anyone anticipated, making the gloomiest prognostications the most accurate ones. And it all happened at warp speed. September 15, 2008, will surely go down as a day of infamy in economic history—and as the turning point in the crisis. The question for the ages is Why?
Lehman Brothers, much more so than Bear Stearns, was one of the grand old names of Wall Street. The 158-year-old firm had survived the Civil War, the Panic of 1907, the stock market crash of 1929, the Great Depression, and much else. It had also been on the jackals’ list of slow antelopes for years. Every financial ruction, it seemed, led to speculation that Lehman might be on the ropes. As the greatest financial crisis of them all unfolded in 2007 and 2008, it became clear that Lehman had loaded up both on mortgage-related securities, especially commercial real estate mortgages, and even on some big-ticket real estate like office buildings and shopping centers. Maybe that wasn’t such a smart move for a company whose expertise was financial. But euphoria has a way of clouding judgment, and Lehman was riding the bubble with great profit.
Its heavy exposure to commercial real estate is what distinguished the firm from its Wall Street brethren, including Bear Stearns. In other respects, however, Lehman Brothers looked much like the other giant investment banks. In particular, it was a prime example of the new Wall Street model of high leverage and heavy reliance on low-cost, short-term borrowing to generate huge profits. At the end of the first quarter of 2008, Lehman had nearly $200 billion worth of repos outstanding. After the demise of Bear Stearns, the fragility of this heady but combustible mix grabbed the attention of many observers—certainly including Bernanke and Paulson,* but also including many speculators and short-sellers. The new Wall Street model looked shaky, and in the market’s view, Lehman was probably the next to go.
On Bear Stearns Day, Lehman’s CEO Richard “Dick” Fuld knew that his company was in the crosshairs, and when the stock market opened on the next Monday, Lehman’s stock was, indeed, pummeled. As he later lamented to the FCIC, “Bear went down on rumors and a liquidity crisis of confidence. Immediately thereafter, the rumors and the naked short-selling came after us.” It certainly did. But Lehman managed to hold things together for another six months.
Lehman’s primary regulator was the same as Bear’s: the somnolent SEC. After the Bear Stearns bailout, however, and especially after the Fed began lending to broker-dealers, the central bank started watching over Lehman Brothers and the other three Wall Street giants—with supervision, stress tests, requests for data, and the like. The central bank was worried about Lehman’s safety and soundness, and, even more so, the systemic risk it might pose if it failed. Among other things, Lehman was counterparty to almost a million derivatives contracts and a huge borrower in the repo market. Ominously, several of its derivative and repo counterparties began reducing their exposure to Lehman in the days and weeks after Bear; a few canceled or limited their lines of credit. As Paulson understood, when confidence goes, it goes. After Bear, confidence in Lehman Brothers looked like it was going fast.
In the first week after the Bear Stearns bailout, Fuld and other Lehman executives began to emphasize in public statements and interviews that the firm had plenty of capital and liquidity—and (mainly sotto voce) that it could now also borrow from the Fed. Plenty of capital and liquidity, don’t worry. Wasn’t that what Bear Stearns had said?
As late as its May 31, 2008, quarterly filing with the SEC, Lehman’s balance sheet showed $26 billion in stockholders’ equity—which it claimed was more than adequate to support $639 billion in assets. (That’s leverage of 25 to 1.) It also boasted $45 billion in ready liquidity. But that same balance sheet showed about $21 billion in real estate and about $72 billion in “mortgage and asset-backed securities.” No one believed all that stuff was worth $93 billion. If it was marked down by, say, 30 percent, the equity would be gone—which made the Fed and the Treasury deeply skeptical about Lehman’s solvency. Worse yet, as it later came to light, Lehman was using accounting subterfuges to conceal some of its debt, thereby making its net worth and leverage look better than they actually were.
During the fateful March-to-September period, Fuld knew that his company needed to raise more capital and improve its liquidity position. But neither was easy. Lehman did succeed in raising about $15 billion in preferred stock and longer-term debt by June, but that was not nearly enough. Lehman’s pool of liquidity still relied far too heavily on posting mortgage-related assets as collateral for short-term loans—the very strategy that had sunk Bear Stearns. The markets were growing wary of this strategy. How good was the collateral? Was Lehman really solvent?
At one point in July 2008, Fuld suggested that the Fed protect Lehman by turning it into a bank holding company. But Geithner rejected the idea as “gimmicky.” It was a gimmick the Fed would eagerly embrace later, when the fates of Morgan Stanley and Goldman Sachs hung in the balance. Shortly after Fuld’s spurned request, the New York Fed’s Bill Dudley, who later succeeded Geithner as its president, proposed a Bear Stearns–like solution for Lehman, including a $55 billion loan from the Fed. It was a casual suggestion, not thoroughly researched, and apparently not taken seriously at the time—maybe not even by Dudley. In retrospect, that casual suggestion could have been an incredible bargain.
It wasn’t the only idea that didn’t fly. Over the summer months, a long-running negotiation for a large equity investment by the Korean Development Bank stumbled several times before finally dying at just about the time Fannie and Freddie were taken over. A flirtation with Bank of America (BofA) dragged on for a while but ultimately went nowhere because the government was unwilling to kick in any money. At one point late in the game, BofA’s CEO Ken Lewis told Paulson that he could purchase Lehman only if the government would take over most of the risk connected with a $40 billion pool of dodgy assets. In retrospect, that was chicken feed, but Paulson refused. Instead, Bank of America bought Merrill Lynch—on the very day that Lehman went bankrupt.
It was the on-again-off-again romance with Barclays Capital, the British investment giant, that almost came to fruition. It started back in April 2008, when the Treasury’s Bob Steel, a former Goldman banker, called his friend Bob Diamond, then president of Barclays, in London. With a directness that stunned Diamond, Steel asked, “Is there a price at which you’d be interested in Lehman? And if so, what would you need from us?” The U.S. government was back in the investment banking business. A surprised Diamond promised to think about it—and he did. Acquiring Lehman at a bargain price would give Barclays something the British firm coveted: a big seat at the Wall Street table. But the idea went nowhere for months.
By early September things had deteriorated further for Lehman, which appeared to be on the brink. It was about then that Barclays’ executives decided it was time to revive the Lehman idea, provided the New York investment bank could be purchased for a song—as looked likely. Both the Treasury and the Fed approved, to put it mildly. Apart from being British–and hence not the Treasury’s problem or the Fed’s—Barclays was one of the few financial giants that had weathered the storm pretty well. Just as JP Morgan Chase had the balance sheet to save Bear Stearns, Barclays had the balance sheet to save Lehman Brothers—if the price was low enough. And Steel had strongly hinted that the U.S. government would not only broker the deal, but even throw in some cash. Over the frantic weekend of September 12–14, Barclays sent a team to New York, led by Diamond, to perform whatever due diligence they could in a hurry.
But things had changed between March and September. Partly because of the adverse publicity from Bear Stearns and partly because of the huge open-ended commitments made to Fannie Mae and Freddie Mac, Paulson was now drawing the proverbial line in the sand: Any deal for Lehman would have to be done without public money, in sharp contrast to Steel’s suggestion to Diamond in April. Indeed, Paulson would later cite fear of creating moral hazard to explain the fateful decision to let Lehman go.
On a conference call with Bernanke and Geithner, Paulson “stated unequivocally that he would not support spending taxpayers’ money—the Fed’s included—to save Lehman. ‘I’m being called Mr. Bailout,’ he said. ‘I can’t do it again.’” To lock in his position, I suppose, Paulson’s aides leaked his no-taxpayer-money pledge to the press on Thursday, September 11. By Friday it was all over the media—a fait accompli. This infuriated Geithner at the New York Fed. According to reporting by the Wall Street Journal’s David Wessel, Geithner “thought that publicly drawing ‘a line in the sand’ during a financial crisis was lunacy.” He told Paulson that “the amount of public money you’re going to have to spend is going up, more than you would have otherwise! Your statement is way out of line!” Estimates of how much public money the U.S. government would have had to kick in for Barclays to make a deal range anywhere between $12 billion and $60 billion. Any such number is a pittance compared with the trillions that the Fed and the Treasury committed later.
The decision to do the deal with only private money made the Lehman problem much harder to solve. Nonetheless, a last-ditch weekend attempt by Geithner and Paulson to cobble together an LTCM-like deal, whereby a consortium of Wall Street firms would band together to fill the hole that Barclays needed filled, almost succeeded. But, as they say, close only counts in horseshoes.
In the end, the problems extended beyond Lehman’s dubious balance sheet. Unbeknownst to the Americans, British law required a shareholder vote to approve the transaction, and that could take a long time—far longer than Lehman was likely to survive without assistance. In the interim, someone would have to guarantee Lehman’s debts. That was presumably Barclays, for the Fed would not do it—and that was not to be. Britain’s financial regulator, the Financial Services Authority (FSA), and the Chancellor of the Exchequer, Alistair Darling, were dealing with their own problems across the Atlantic. Darling told Paulson that the UK government didn’t want to “import our cancer.” When Lehman failed, the Brits did so, anyway—in a big way.
A special waiver was needed to override the shareholder-vote requirement, and the FSA was not about to give one. Nor would Darling push them to do so. So, on Sunday, September 14, the Barclays deal went the way of the Bank of America and Korean Development Bank deals—nowhere. Ironically, it was the British government that wound up killing the prospect of a “private sector solution” for Lehman. Lehman filed for bankruptcy protection that night.
WHO LOST LEHMAN—AND WHY?
You could say it was the British government. But that would ignore the fact that an awful lot of water had flowed under an awful lot of bridges before that fateful Sunday.
Paulson, who was both a Republican and a markets man who formerly ran Goldman Sachs, was perhaps overly concerned about the moral hazard issue in the aftermath of Bear Stearns. Still, he had a point. Public funds had been deployed to save Bear, Fannie, and Freddie. If they were now made available to Lehman, it would imply—once again—that the U.S. government was waiting in the wings to bail out any major financial institution. Moral hazard would have proliferated, and Mr. Paulson would, indeed, have become Mr. Bailout. But, of course, he became Mr. Bailout, anyway.
These thoughts, valid as they were, represent only one side of the moral hazard ledger, however. In simplest terms, the trade-off looked like this: On one side, saving Lehman would deepen an existing moral hazard problem. On the other side, Bear Stearns had been rescued, moral hazard notwithstanding, in order to stave off possibly serious contagion to a wide variety of innocent bystanders—perhaps as many as 310 million Americans. If that was a winning argument in March, why wasn’t it a winning argument when Lehman went on the chopping block in September? That was Geithner’s worry. In his view, it was worth committing some public money again—if they could find a buyer for Lehman, as they had for Bear.
But the moral hazard argument for letting Lehman fail was not Paulson’s or Bernanke’s first line of defense. They first enunciated the belief that because six months had elapsed since Bear Stearns, the markets had ample time to prepare—both financially and psychologically—for the possible demise of Lehman Brothers. Counterparty risks were understood and accounted for, they argued. Hedges, not to mention shorts, were in place. The markets were allegedly ready for a Lehman failure, should it come. Here is what Bernanke told the House Financial Services Committee just nine days after Lehman failed:
. . . 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.
It was a sanguine view, to be sure, but it was not Bernanke’s and Paulson’s alone. Several prominent market “experts,” including Goldman Sachs’ CEO Lloyd Blankfein, voiced the same opinion. Within hours of Lehman’s demise, they were proved wrong.
A third rationale held that Lehman Brothers, despite its larger size and global reach, was actually less interconnected with other firms than Bear Stearns had been. It was not, for example, the prime broker for hundreds of hedge funds. On this reasoning, Bear had been rescued because it was too interconnected to fail, especially with the repo market, not because it was too big to fail. One could therefore rationalize drawing a line that saved Bear but let Lehman go.
Maybe. But that line of defense always looked dubious, and it was not emphasized by the Fed. After all, Lehman was twice Bear’s size, and its zillions of derivative and repo contracts connected it to numerous counterparties all over the world. Without detailed insider information on Lehman’s various businesses, the actual degree of entanglement was hard for outsiders to gauge. Indeed, one wonders how well the authorities understood it. Once Lehman fell, however, the judgment was rendered quickly: Lehman Brothers turned out to be way too interconnected to fail.
Fourth, and most important, the Treasury and the Fed adopted the position that they hold to this day: that they lacked the legal authority to rescue Lehman. Remember, the crucial decision days were September 12–14, which came several weeks before Congress appropriated $700 billion for the TARP (Troubled Assets Relief Program), an appropriation that probably never would have passed without the Lehman failure. The Treasury had no slush fund with which to prop up Lehman—or so they claimed. Once the meltdown turned truly frightening, however, the Treasury quickly discovered such a fund, as we shall see.
The Fed, of course, did not require a congressional appropriation. It was authorized by Section 13(3) to lend to anyone—as long as the collateral on the loan was “secured to the satisfaction” of . . . whom? Why, the Fed itself! On March 14, the Fed had judged that Bear Stearns’ dodgy mortgage assets—the stuff Jamie Dimon wouldn’t take—met this rather lax test. But on September 14, it judged that Lehman Brothers’ even worse mortgage and real estate assets did not. Why the difference? Here is how Bernanke explained it later:
To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JP Morgan Chase by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JP Morgan. In the case of AIG, we judged that emergency Federal Reserve credit would be adequately secured by AIG’s assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan.
In short, a loan secured by Lehman’s assets would not be “secured to the satisfaction” of the Fed because Lehman was not just illiquid; it was insolvent.
Mostly for this reason, Paulson, Bernanke, and Geithner had made a fateful decision even before the last possible private buyer (Barclays) dropped out: If no private-sector solution could be found, they would let Lehman Brothers fail and deal with the consequences, because saving Lehman with a loan from the Fed was illegal. This critical judgment will reverberate for years. Bernanke, Geithner, and the Fed’s legal staff decided that lending to Lehman—against collateral that few could honestly characterize as “good”—would stretch the law beyond its breaking point. They believed they had no choice.
The consequences of letting Lehman go down turned out to be more severe than probably anyone imagined. The financial system literally started to fall apart. Why? We’ll be in a better position to answer that question after the next chapter, which examines the cascade of failures and near failures that followed the Lehman bankruptcy. But a large part of the answer is staring us right in the face already.
Bear Stearns—and to a lesser extent Fannie and Freddie—had, indeed, established a precedent. Call it moral hazard if you wish, though not many financial companies aspired to go the way of Bear. But whatever you call it, the market had acquired the view that the government was not going to let any financial giant fail messily. Market participants are marvelously adaptable people. According to one piece of folk wisdom, they can make money playing by any set of rules—as long as they know what the rules are. The Lehman decision abruptly and surprisingly tore the perceived rulebook into pieces and tossed it out the window. Market participants were thus cut adrift, no longer knowing what game they were playing. That’s a formula for panic, for the replacement of greed by fear—which is exactly what happened on Lehman Day, September 15, 2008.
THE WATERSHED
There is close to universal agreement that the demise of Lehman Brothers was the watershed event of the entire financial crisis and that the decision to allow it to fail was the watershed decision. Virtually every discussion of the financial crisis divides history into two epochs: “before Lehman” and “after Lehman.” As we have noted, the whole economy seemed to fall off the table immediately after September 15. The reasons, of course, emanated from the larger financial system, as we will see next.