Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

CHAPTER FOUR

On the oppressively humid evening of Friday, April 11, 2008, Dick Fuld strode up the steps of the Treasury Building, passing the ten-foot-tall bronze statue of Alexander Hamilton that looms over the south entrance. He had come at the personal invitation of Hank Paulson for a private dinner to mark the end of a G7 summit and the beginning of the annual spring meetings of the International Monetary Fund and the World Bank. The guest list featured a group of the most influential economic policy makers and thinkers, including ten Wall Street CEOs and a number of the world’s leading finance ministers and central bankers, including Jean-Claude Trichet, president of the European Central Bank.

Fuld was feeling fairly optimistic—certainly less despairing than he had been earlier. Lehman’s announcement two weeks before that it would raise $4 billion had stabilized the stock, at least for the moment. The entire market was rallying, buoyed by comments from Lloyd Blankfein, CEO of Goldman Sachs, who had emphatically declared at his firm’s annual meeting that the worst of the credit crisis was likely over. “We’re closer to the end than the beginning,” he said.

That was not to say that the gloom in the financial community had completely lifted. Just that morning Fuld had attended a contentious meeting in downtown Manhattan with Tim Geithner at the New York Fed, imploring him to do something about the short-sellers, who he was convinced were just catching their breath. Erik Sirri, the head of the SEC’s Division of Trading and Markets, repeatedly pressed Fuld for proof of any illegal activity, pleading, “Just give me something, a name, anything.” Fuld, who considered Sirri—a former Harvard Business School professor—to be a free-market zealot with no real-world experience, told him he had nothing concrete. He just knew what he knew.

Tonight, as Fuld was ushered across the checkered squares of black and white marble of the Treasury hallways, he tried to clear his mind and prepared to enjoy himself.

The dinner was being held in the Treasury Cash Room, so named because until the mid-1970s, it was where the public went to exchange U.S. government notes and bonds for cash. Opened in 1869, the room was intended to foster confidence in the new federal paper currency—the “greenback ”—that had been introduced during the Civil War. Today, nearly a century and a half later, that confidence was in short supply.

Fuld had been looking forward to the dinner all week, eager for a chance to talk with Paulson face-to-face. Over the past few weeks, they had spoken several times by phone, but given all that was at stake, meeting in person was essential. It would give Fuld a chance to impress upon the secretary the seriousness of his efforts and to gauge where Lehman really stood with Washington.

Amid the procession of financiers slowly filing into the Cash Room, Fuld noticed an old friend in the corner, John Mack, CEO of Morgan Stanley, one of the few people in the room who understood exactly what Fuld was going through. Of all the CEOs on the Street, Fuld felt closest to Mack; they were the longest-running leaders of the major firms, and they would occasionally dine together with their spouses.

There were also a number of other men in the room whom Fuld stopped to shake hands with but didn’t know well—though little did he suspect they would soon become major figures in his life. One was an American banker named Bob Diamond, who ran Barclays Capital, the investment banking arm of the British financial behemoth. Fuld had spoken with him a handful of times, usually seeking donations for his favorite charities. Diamond was polite but noticeably cool as Fuld greeted him, perhaps because Fuld had once invited him over for a casual coffee, unaware that he was based in London, not New York—a little slight that Diamond had never forgotten. Fuld also briefly paid his respects to Diamond’s regulators, Alistair Darling, the head of Britain’s Treasury, and Mervyn King, the governor of the Bank of England. High finance was in general a very small world, though at this particular moment, none of them realized just how small it had become.

As he made his way through the crowd, Fuld kept an eye out for Paulson, whom he hoped to buttonhole before the dinner began. But it was Paulson, wearing a blue suit that seemed one size too big for him, who spotted Fuld first. “You guys are really working hard over there,” Paulson told him, grasping his hand. “The capital raise was the right thing to do.”

“Thanks,” Fuld said. “We’re trying.”

Paulson also expressed his gratitude for the “thoughtful” dialogue that had been initiated among Tom Russo, Lehman’s general counsel, and Rick Rieder, who ran Lehman’s global principal strategies group, with Paulson’s deputy, Bob Steel, and Senator Judd Gregg. Russo had been advocating a plan in which the government would create a special facility—what Russo called a “good bank” proposal—to help provide additional liquidity to Wall Street firms by creating a backstop for their most toxic assets, but he had met resistance. It would simply look too much like another bailout, and Washington wasn’t ready for that—not yet.

“I am worried about a lot of things,” Paulson now told Fuld, singling out a new IMF report estimating that mortgage-and real estate-related write-downs could total $945 billion in the next two years. He said he was also anxious about the staggering amount of leverage—the amount of debt to equity—that investment banks were still using to juice their returns. That only added enormous risk to the system, he complained.

The numbers in that area were indeed worrisome. Lehman Brothers was leveraged 30.7 to 1; Merrill Lynch was only slightly better, at 26.9 to 1. Paulson knew intuitively that Wall Street’s leverage problem could not end well. He also knew that the firms would never rein themselves in; they were all blindly chasing one another. He always reminded himself of a remarkably telling question that Charles Prince, the CEO of Citigroup, had asked him the year before at a similar dinner: “Isn’t there something you can do to order us not to take all of these risks?”

Paulson was worried not just about Lehman; he knew Merill too was awash in bad assets, and mentioned the challenges that Merrill’s new CEO, John Thain (who had been Paulson’s number two at Goldman), was facing with his own balance sheet. But leverage and Merrill’s problems weren’t Fuld’s primary concern at the moment; he was still irked by the short-sellers and once again pressed Paulson to do something about them. If they could be contained, it would give Lehman and the other firms a chance to find their footing and get their balance sheets in order. But if the shorts were allowed to keep hammering away, the overall situation was only going to get a lot uglier.

As a former CEO himself, Paulson could understand Fuld’s frustration. Short-sellers cared only about their own profits and gave little thought to their impact on the system. “I’m sympathetic,” Paulson said. “If there are bad actors, we’ll put them out of business.”

But Paulson was also concerned that Fuld was using the short-sellers as an excuse to avoid addressing the genuine problems at Lehman. “You know, the capital raise, as good as it was, is just one thing,” Paulson told him. “It’s not going to end there.” He reminded him that the pool of potential buyers for Lehman was not a large one.

“Look, Dick,” he continued. “There aren’t a lot of people out there saying, ‘I have to have an investment banking franchise.’ You have to start thinking about your options.”

It was a not-so-subtle hint to start thinking about selling the entire firm. Although the conversation agitated Fuld slightly, they’d had similar discussions before, so he took Paulson’s advice in stride.

The group took their seats, and as each of the speakers rose to talk, the perilous state of the economy became ever clearer. The credit crisis wasn’t just a U.S. problem; it had spread globally. Mario Draghi, Italy’s central bank governor and a former partner at Goldman Sachs, spoke candidly of his worries about global money-market funds. Jean-Claude Trichet told the audience that they needed to come up with common requirements for capital ratios—the amount of money a firm needed to keep on hand compared to the amount it could lend—and, more important, leverage and liquidity standards, which he thought were much more telling indicators of a firm’s ability to withstand a “run on the bank.”

Mr. King, the governor of the Bank of England, offered perhaps the harshest assessment. “You are all bright people, but you failed. Risk management is hard,” he declared. “So the lesson is, we can’t let you get as big as you were and do the damage that you’ve done or get as complex as you were.”

That night, after Fuld had finally found his car and driver outside the Treasury Building, he thumbed out an e-mail on his BlackBerry to Russo. “Just finished the Paulson dinner,” Fuld wrote at 9:52 p.m.

A few takeaways//

1-we have huge brand with treasury

2-loved our capital raise

3-really appreciate u + Reiders work onm [sic] ideas

4-they want to kill the bad HFnds [hedge funds]+ heavily regulate the rest

5-they want all G7 countries to embrace

Mtm stnds [Mark-to-market standards]

Cap stnds

Lev + liquidity stnds

6-HP [Hank Paulson] has a worried view of ML [Merrill Lynch]

All in all worthwhile.

Dick

On the following Tuesday, April 15, Neel Kashkari and Phillip Swagel hurried down past the guard house of the Treasury Building to where Hank Paulson and Bob Steel were waiting for them in the secretary’s black Suburban. The group was due at the Federal Reserve in Foggy Bottom at 3:00 p.m.—in ten minutes—and was running late.

The two men made something of an odd couple. Kashkari, dark with a bald dome, still dressed like the investment banker he had recently been, while Swagel, pale with dark hair and glasses, looked more like a wonky government official. A former academic, he had kept fit and seemed younger than his thirty-four-year-old colleague, even though he was eight years older.

Paulson had invited his young advisers to a meeting with Ben Bernanke so that they could present a confidential memo that the two of them had authored—a memo that had far-reaching implications for the nation’s increasingly unsteady financial system.

At Paulson’s request, they had done nothing less than to formulate a plan for what to do in the event of a total financial meltdown, outlining the steps that the Treasury Department might have to take and the new powers it would require to stave off another Great Depression. They had given the proposal the provocative title “Break the Glass: Bank Recapitalization Plan.” Like a fire alarm enclosed in glass, it was intended to be used only in an emergency, though with each passing day, it appeared more and more likely that the proposal was no mere drill.

As the Suburban raced to Bernanke’s office, Kashkari, who was unflappable by nature, remained calm. After a brief stint as a satellite engineer, he had gone to work as an investment banker for Goldman Sachs in San Francisco, where no one had ever needed to tell him that he was good at his job. He loved meeting with clients and putting his salesmanship to the test; like Paulson, he was an aggressive, get-it-done guy. And like Paulson, he occasionally ruffled feathers with his shoot-first-and-ask-questions-later approach, though few ever doubted his intellectual firepower.

Kashkari had always wanted to work in government, and though he’d met Paulson only once previously, he left him a congratulatory voice mail when Paulson was named Treasury secretary. To his surprise, Paulson responded the next day: “Thanks. I’d love for you to join me at Treasury.”

Kashkari immediately booked a flight to Washington, during which he carefully rehearsed the pitch he would make to Paulson. They met at the Old Executive Office Building, where Paulson was camped out until the Senate could confirm him, and Kashkari had scarcely begun his presentation when he noticed a distracted, slightly irritated look come over Paulson’s face. Kashkari stopped in midsentence.

“Look, here is what I’m trying to do here,” Paulson told him. “I want to put together a small team that will be working on policy issues, all kinds of issues, really, just doing whatever it takes to get things done. How does that sound?”

An astonished Kashkari realized, He’s offering me a job!

As the two men shook hands on the deal, Paulson suddenly remembered an important detail and asked, “Oh, yeah, there’s just one other thing. Are you a Republican?” As luck would have it, he was. Paulson saw him out and directed him to the White House Personnel Office a few blocks away. Kashkari was soon on the team, and now he was about to lead the biggest sales pitch of his career—to the single most influential person in the entire world’s economy.

Four words had dogged Ben Bernanke from the moment he assumed the job of chairman of the Federal Reserve on February 1, 2006: “Hard Act to Follow.” It was, perhaps, an inevitable epithet for the man whom the renowned Washington Post investigative reporter Bob Woodward had also dubbed “The Maestro”—Alan Greenspan, who was to monetary policy what Warren Buffett is to investing. Greenspan had overseen the Federal Reserve during a period of unprecedented prosperity, a spectacular bull market that had begun during the Reagan administration and had run for over twenty years. Not that anyone outside the economics profession had a clue what Greenspan was doing or even saying most of the time. His obfuscation in public pronouncements was legendary, which only added to his mystique as a great intellect.

Bernanke, by contrast, had been a college professor for most of his career, and at the time of his appointment to replace the then-eighty-year-old Greenspan, his area of specialization—the Great Depression and what the Federal Reserve had done wrong in the 1920s and 1930s—seemed quaint. Trying to identify the causes of the Great Depression may be the Holy Grail of macroeconomics, but to the larger public, it seemed to have little practical application in a key government position. Any economic crisis of that magnitude seemed safely in the past.

By the summer of 2007, however, America’s second Gilded Age had come shockingly to an end, and Greenspan’s reputation lay in tatters. His faith that the market was self-correcting suddenly seemed fatally shortsighted; his cryptic remarks were judged in hindsight as the confused ramblings of a misguided ideologue.

As a scholar of the Depression, Bernanke was cut from a different cloth, though he shared Greenspan’s belief in the free market. In his analysis of the crisis, Bernanke advanced the views of the economists Milton Friedman and Anna J. Schwartz, whose A Monetary History of the United States, 1867-1960 (first published in 1963) had argued that the Federal Reserve had caused the Great Depression by not immediately flushing the system with cheap cash to stimulate the economy. And subsequent efforts proved too little, too late. Under Herbert Hoover, the Fed had done exactly the opposite: tightening the money supply and choking off the economy.

Bernanke’s entrenched views led many observers to be optimistic that he would be an independent Fed chairman, one who would not let politics prevent him from doing what he thought was the right thing. The credit crisis proved to be his first real test, but to what degree would his understanding of economic missteps eighty years earlier help him grapple with the current crisis? This was not history; this was happening in real time.

Ben Shalom Bernanke was born in 1953 and grew up in Dillon, South Carolina, a small town permeated by the stench of tobacco warehouses. As an eleven-year-old, he traveled to Washington to compete in the national spelling championship in 1965, falling in the second round when he misspelled “Edelweiss.” From that day forward he would wonder what might have been had the movie The Sound of Music, which featured a well-known song with that word for a title, only made its way to tiny Dillon.

The Bernankes were observant Jews in a conservative Christian evangelical town just emerging from the segregation era. His grandfather Jonas Bernanke, an Austrian immigrant who moved to Dillon in the early 1940s, owned the local drugstore, which Ben’s father helped him run; his mother was a teacher. As a young man, Ben waited tables six days a week at South of Border, a tourist stop off Interstate 95.

In high school, Bernanke taught himself calculus because his school did not offer a class in the subject. As a junior, he achieved a near-perfect score on the SATs (1590), and the following year he was offered a National Merit Scholarship to Harvard. Graduating with a degree in economics summa cum laude, he was accepted to the prestigious graduate program in economics at the Massachusetts Institute of Technology. There he wrote a dense dissertation about the business cycle, dedicating it to his parents and to his wife, Anna Friedmann, a Wellesley College student whom he married the weekend after she graduated in 1978.

The young couple moved to California, where Bernanke taught at Stanford’s business school and his wife entered the university’s master’s program in Spanish. Six years later, Bernanke was granted a tenured position in the economics department at Princeton. He was thirty-one and a rising star, admired for “econometrics” research that used statistical techniques and computer models to analyze economic problems.

Bernanke also demonstrated political skills as his intellectual reputation grew. As chairman of the Princeton economics department, he proved effective at mediating disputes and handling big egos. He also created a series of new programs and recruited promising young economists such as Paul Krugman (who happened to be his ideological opposite). Six years later Bernanke was recruited to succeed Greenspan.

Up until early August 2007, Bernanke had been enjoying his tenure at the Fed, so much so that he and Anna had planned to take a vacation that month and drive to Charlotte, North Carolina, and then on to Myrtle Beach, South Carolina, to spend time with friends and family. Before heading south, he had to see to one final business matter: the Federal Open Market Committee, the Fed’s powerful policy-making panel, which among its other responsibilities sets interest rates, was scheduled to meet on August 7. On that day, Bernanke and his colleagues acknowledged for the first time in recent memory the presence of “downside risks to growth,” but decided nonetheless to keep the Fed’s benchmark interest rate unchanged at 5.25 percent for the ninth consecutive meeting. Rather than try to boost economic activity by lowering rates, the committee decided to stand pat. “The committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected,” the Fed announced in a subsequent statement.

That, however, was not what Wall Street wanted to hear, for concerns about the sputtering economy had investors clamoring for a rate cut. Four days earlier financial commentator Jim Cramer had exploded on an afternoon segment of CNBC, declaring that the Fed was “asleep” for not taking aggressive action. “They’re nuts! They know nothing!” he bellowed.

What the Fed’s policy makers recognized but didn’t acknowledge publicly was that credit markets were beginning to suffer as the air had begun gradually seeping out of the housing bubble. Cheap credit had been the economy’s rocket fuel, encouraging consumers to pile on debt—whether to pay for second homes, new cars, home renovations, or vacations. It had also sparked a deal-making frenzy the likes of which had never been seen: Leveraged buyouts got larger and larger as private-equity firms funded takeovers with mountains of loans; as a result, transactions became ever riskier. Traditionally conservative institutional investors, such as endowments and pension funds, came under pressure to chase higher returns by investing in hedge funds and private-equity funds. The Fed resisted calls to cut interest rates, which would only have thrown gasoline onto the fire.

Two days later, however, the world changed. Early on the morning of August 9, in the first major indication that the financial world was in serious peril, France’s biggest bank, BNP Paribas, announced that it was halting investors from withdrawing their money from three money market funds with assets of some $2 billion. The problem? The market for certain assets, especially those backed by American mortgage loans, had essentially dried up, making it difficult to determine what they were actually worth. “The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating,” the bank explained.

It was a chilling sign that traders were now treating mortgage-related assets as radioactive—unfit to buy at any price. The European Central Bank responded quickly, pumping nearly 95 billion euros, or $130 billion, into euro money markets—a bigger cash infusion than the one that had followed the September 11 attacks. Meanwhile, in the United States, Countrywide Financial, the nation’s biggest mortgage lender, warned that “unprecedented disruptions” in the markets threatened its financial condition.

The rates that banks were charging to lend money to one another quickly spiked in response, far surpassing the central bank’s official rates. To Bernanke what was happening was obvious: It was a panic. Banks and investors, fearful of being contaminated by these toxic assets, were hoarding cash and refusing to make loans of almost any kind. It wasn’t clear which banks had the most subprime exposure, so banks were assumed guilty until proven innocent. It had all the hallmarks of the early 1930s—confidence in the global financial system was rapidly eroding, and liquidity was evaporating. The famous nineteenth-century dictum of Walter Bagehot came to mind: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

After Bernanke told his wife their trip had to be canceled, he summoned his advisers to his office; those who were away called in. Fed officials began working the phones, trying to find out what was happening in the markets and who might need help. Bernanke was in his office every morning by 7:00 a.m.

Only two days later came the next shock. It was becoming a daily scramble for the Fed to keep up with the dramatically changing conditions. The following day Bernanke held a conference call with Fed policy makers to discuss lowering the discount rate. (A symbolic figure in normal times, the discount rate is what the Fed charges banks that borrow directly from it.) In the end, the Fed issued a statement announcing that it was providing liquidity by allowing banks to pledge an expanded set of collateral in exchange for cash—although not on the scale that the Europeans had—to help the markets function as normally as possible. It also again reminded the banks that the “discount window” was available. Less than a week later, Bernanke, faced with continued turmoil in the markets, reversed his earlier decision and went ahead with a half-point cut in the discount rate, to 4.75 percent, and hinted that cuts in the benchmark rate—the Fed’s most powerful tool for stimulating the economy—might be coming as well. Despite these reassurances, markets remained tense and volatile.

By now it was clear even to Bernanke that he had failed to gauge the severity of the situation. As late as June 5, he had declared in a speech that “at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.” The housing problem, he had thought, was limited to the increase in subprime loans to borrowers with poor credit. Although the subprime market had mushroomed to $2 trillion, it was still just a fraction of the overall $14 trillion U.S. mortgage market.

But that analysis did not take into account a number of other critical factors, such as the fact that the link between the housing market and the financial system was further complicated by the growing use of exotic derivatives. Securities whose income and value came from a pool of residential mortgages were being amalgamated, sliced up, and reconfigured again, and soon became the underpinnings of new investment products marketed as collateralized debt obligations (CDOs).

The way that firms like a JP Morgan or a Lehman Brothers now operated bore little resemblance to the way banks had traditionally done business. No longer would a bank simply make a loan and keep it on its books. Now lending was about origination—establishing the first link in a chain of securitization that spread risk of the loan among dozens if not hundreds and thousands of parties. Although securitization supposedly reduced risk and increased liquidity, what it meant in reality was that many institutions and investors were now interconnected, for better and for worse. A municipal pension fund in Norway might have subprime mortgages from California in its portfolio and not even realize it. Making matters worse, many financial firms had borrowed heavily against these securities, using what is known as leverage to amplify their returns. This only increased the pain when they began to lose value.

Regulators around the world were having trouble understanding how the pieces all fit together. Greenspan would later admit that even he hadn’t comprehended exactly what was happening. “I’ve got some fairly heavy background in mathematics,” he stated two years after he stepped down from the Fed. “But some of the complexities of some of the instruments that were going into CDOs bewilders me. I didn’t understand what they were doing or how they actually got the types of returns out of the mezzanines and the various tranches of the CDO that they did. And I figured if I didn’t understand it and I had access to a couple hundred PhDs, how the rest of the world is going to understand it sort of bewildered me.”

He was not alone. Even the CEOs of the firms that sold these products had no better comprehension of it all.

The door of the chairman’s office swung open, and Bernanke warmly greeted the group from Treasury. Like Swagel, he still had the halting manner of an academic, but for an economist, he was unusually adept at small talk. He showed Paulson and his team into his office, where they settled around a small coffee table. Beside the expected Bloomberg terminal, Bernanke had a Washington Nationals cap prominently displayed on his desk.

After a few minutes of chat, Swagel reached into a folder and gingerly handed Bernanke the ten-page outline of the “Break the Glass” paper. Kashkari glanced at his colleagues for reassurance and then began to speak.

“I think we all understand the political calculus here, the limits of what we can legally do. How do you get the authority to prevent a collapse?” Bernanke nodded in agreement, and Kashkari continued. “So, as you know, we in Treasury, in consultation with staffers at the Fed, have been exploring a set of options for the last few months, and I think we have come up with the basic framework. This is meant to be something that if we’re ever on the verge of mayhem, we can pull off the shelf in the event of an emergency and present to Congress and say, ‘Here is our plan.’”

Kashkari looked over at Bernanke, who, having been intently studying the text, had immediately zeroed in on the key of the plan: “Treasury purchases $500 billion from financial institutions via an auction mechanism. Determining what prices to pay for heterogeneous securities would be a key challenge. Treasury would compensate bidder with newly issued Treasury securities, rather than cash. Such an asset-swap would eliminate the need for sterilization by the Fed. Treasury would hire private asset managers to manage the portfolios to maximize value for taxpayers and unwind the positions over time (potentially up to 10 years).”

Bernanke, weighing his words carefully, asked how they had come up with the $500 billion figure.

“We are talking a ballpark estimate of, what, say, $1 trillion in toxic assets?” explained Kashkari. “But we wouldn’t have to buy all of the bad stuff to make a meaningful dent. So, let’s say half. But maybe it’s more like $600 billion.”

As Bernanke continued to study their paper, Kashkari and Swagel took a second to savor the moment: They were briefing the keeper of The Temple—as the Federal Reserve is often called—on what might be a historic bailout of the banking system. Government intervention on this scale hadn’t been contemplated in at least fifty years; the savings and loan rescue of the late 1980s was a minor blip by comparison.

If the “Break the Glass” plan did get past Congress—a problem they’d concern themselves with later—they had already detailed how Treasury would designate the New York Fed to run the auctions of Wall Street’s toxic assets. Together they would solicit qualified investors in the private sector to manage the assets purchased by the government. The New York Fed would then hold the first of ten weekly auctions, buying $50 billion worth of mortgage-related assets. The auctions would, it was hoped, fetch the best possible price for the government. Ten selected asset managers would each manage $50 billion for up to ten years.

Kashkari knew the proposal was very complicated but argued it was worth the risk, as the way things were heading, there was little chance of a “soft landing.” Drastic action was required. “The bill would need to give Treasury temporary authorization to buy the securities, as well as the funding,” he said, “and it would need to raise the debt ceiling, because we only have room for about $400 billion under the current ceiling.

“But because we would be tapping the private sector so heavily, the program would require little in the way of government overhead: no significant hiring by Treasury, for example,” he continued. “But also we need to be mindful of the optics. Only public financial institutions would be eligible. No hedge funds or foreign banks.”

Then Kashkari summarized what he and his colleagues at Treasury viewed as the pros and cons of their proposal. The first and most important point was that if the government acted, banks would continue lending—but not, it was hoped, in the irresponsible way that gave rise to the crisis in the first place. The primary argument against the proposal was that, to the extent that the plan worked, it would create “moral hazard.” In other words, the people who made the reckless bets that initially caused the problems would be spared any financial pain.

The two Treasury officials next presented the alternative approaches, of which they had identified four:

The government sells insurance to banks to protect them from any further drop in the value of their toxic assets.

The Federal Reserve issues non-recourse loans to banks, as it did in the JP Morgan takeover of Bear Stearns.

The Federal Housing Authority refinances loans individually.

Treasury directly invests in the banks.

As he listened, Bernanke stroked his beard and occasionally offered a knowing smile. The meeting ended with no resolution except to take the plan and put it on the shelf until—or unless—it was needed, but Kashkari was gratified that the chairman took it so well—much better, in fact, than his own boss, Hank Paulson, had when Kashkari first decided to test him on the subject of intervening in the financial markets.

Everyone in Paulson’s inner circle at Treasury had heard about when Kashkari barged into his office late one evening in March, finding the secretary in an unusually good mood, chatting with his chief of staff, Jim Wilkinson.

“Hank, I want to talk about bailouts,” Kashkari interrupted.

“What are you talking about? Get out of here,” Paulson said, annoyed.

“Look, we keep talking about how do we get the political will to get the authority we need to really take action, right? Well, we have to have some record that shows we tried. The next president is going to come in and say, ‘Here are the steps that should have been taken, but the previous administration was unwilling or unable to take them, blah, blah, blah.’ You know what that means? The next president is going to bring the hostages home. Obama! Obama is going to bring the hostages home!”

Paulson erupted in laughter at the notion that Obama would somehow ride this crisis the way Ronald Reagan rode the Iranian hostage standoff in the late 1970s. He pointed at Kashkari.

“Ha, ha. Obama is going to bring the hostages home,” Paulson said. “Oh, yeah? Get the fuck out of here.”

A London sky of gray-pink clouds was just beginning to darken on an evening in April when the phone rang for Bob Diamond, the chief executive of Barclays Capital. Diamond had been contentedly honing his putting skills in his office in the bank’s corporate enclave in Canary Wharf, the booming financial district in East London along the river Thames, and a dozen golf balls were strewn about the hole he had cut into the carpet. The office’s walls were lined with Boston Red Sox mementos, which had been hung there not merely to torture visitors from New York City—of which there were many—but because Diamond, a native New Englander, was also a die-hard Sox fan.

He disliked having his precious few minutes of downtime interrupted, but in this instance he was happy to put down his putter and take the call. It was his friend Bob Steel, whom he had just seen briefly on his recent trip to Washington for the dinner party at the Treasury Building.

The two had become close after they joined the board of Barclays at the same time in 2005. They came from different parts of the country and different parts of the business—Steel, from Durham, North Carolina, was in Goldman equities; Diamond, from Springfield, Massachusetts, was a former bond trading executive for Morgan Stanley and Credit Suisse. But they recognized similar qualities in each other: Each came from middle-class families and had worked his way through college.

The arc of their careers more recently had been nearly identical: Both Steel and Diamond, as Yankees in Queen Elizabeth’s court, had made quite a splash in London. For Steel, success had come with starting Goldman’s European equities trading operation, a feat Hank Paulson, his former boss, always remembered. For his part, Diamond had transformed a small investment bank with some 3,000 employees into a major London powerhouse that currently had a payroll of 15,000. Barclays Capital now accounted for about a quarter of the bank’s profits.

The two had remained friends after Steel quit the Barclays board to follow Paulson to Treasury, to the point that each had always been able to count on the other to pick up the phone if he called, whatever the reason.

“Listen, one of my jobs here is to brainstorm,” Steel said somewhat stiffly after greeting Diamond, “and, ah, sort of sketch out various scenario plans. In that capacity, I have a question for you.”

Steel’s uncharacteristically distant tone surprised Diamond, who asked, “Is this official business, Bob?”

“No, no. Look, I’m not calling on behalf of anyone,” he assured him. “The markets have calmed down a bit now, but I am trying to figure out that if things do get worse, and we get to a certain level, if, ah, things can happen.”

“All right, shoot.”

Steel took a deep breath and then asked his question: “Is there a price at which you’d be interested in Lehman? And if so, what would you need from us?”

Diamond was momentarily speechless; Treasury, he realized, was clearly trying to formulate strategic solutions in the event that Lehman found itself in a Bear Stearns-like situation. From long acquaintance he knew Steel to be a no-nonsense pragmatist, not someone who idly floated trial balloons.

“I’m going to have to think about that because I don’t have an answer,” Diamond said carefully.

“Yes, but do think about it,” Steel said.

“Never say never,” Diamond answered, and both men laughed. Diamond had always trotted out that line when reporters pressed him about possible acquisitions, though this was the first time that Steel had been on the receiving end of it.

Steel was well aware of Barclays Capital’s desire to increase its presence in the United States, an ambition that Diamond practically wore on the sleeve of his Savile Row suits. While he had built, from the ground up, a major investment bank that had been a London phenomenon, he had always yearned to be a major player on Wall Street. His restless pursuit of that goal explained why Diamond had so abruptly left Morgan Stanley for Credit Suisse First Boston in 1992, taking much of the repo trading desk with him and inciting the wrath of John Mack. Four years later, Diamond left for BZW, whose remnants were the foundation for Barclays Capital.

Lehman was a logical merger candidate if Diamond—and, of course, his boss and the board in London—wanted Barclays to become an overnight investment banking powerhouse in New York. But he knew it would be an expensive purchase so long as Dick Fuld was running it. Still, an opportunity like this hardly came up often.

What the rest of Wall Street didn’t know at the time was that Barclays had been contemplating another purchase: Diamond had been in conversation with UBS about buying its investment banking franchise and was planning to fly to Zurich later that week for further meetings. He now shared this information with Steel but cautioned him that the talks with UBS were very preliminary, and the last thing Diamond needed was word of them leaking out. As was always a possibility, the deal might not go anywhere.

Lehman, in any case, was in a different league altogether. It wouldn’t be easy selling an acquisition of this magnitude to his board, who were still feeling gun shy after losing an expensive bidding war for Dutch bank ABN AMRO months earlier. But Lehman was the fourth biggest investment house in the United States. If Lehman could be had for a major discount, he’d have to consider the prospect seriously, wouldn’t he?

“Yes,” Diamond said to Steel, “ it’s definitely something to think about.”