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

CHAPTER NINE

On Friday, June 27, 2008, Lloyd Blankfein, exhausted after a nine-hour flight to Russia, took a stroll around the square outside his hotel in St. Petersburg. He had just arrived in the city on a Gulfstream, along with his wife, Laura, and Gary D. Cohn, Goldman’s president and chief operating officer. A history buff, Blank fein had finished David Fromkin’s A Peace to End All Peace: The Fall of the Ottoman Empire and the Creation of the Modern Middle East during the flight.

The other members of the Goldman board weren’t due to land for several hours, so Blankfein had some time to himself. It was a pleasantly warm afternoon, so he decided to take in the sights. Towering above him across the square, the gold dome of St. Isaac’s Cathedral was radiant against the overcast sky. That night the Goldman board and their spouses would be treated to a private tour of the State Hermitage Museum, which was housed in six buildings of the former imperial palace along the Neva River.

If all around him the financial world was in a state of chaos, Blankfein had reason to feel contented about Goldman on the eve of its board meeting. The firm was once again proving itself to be the best on Wall Street, weathering—so far, at least—the toughest market anyone could remember.

And what better place to be gathering than in Russia? What China was to manufacturing, Russia was to commodities, and commodities were king at the moment. Oil, most crucially, was going for $140 a barrel, and Russia was pumping out millions of barrels a day. For a moment, it could make anyone forget about the problems back in the United States.

Every year the board of Goldman took a four-day working trip abroad, and since being handed the reins of the firm from Hank Paulson two years earlier, Blankfein had insisted that they meet in one of the new emerging economic giants, one of the BRIC nations: Brazil, Russia, India, or China. It seemed only appropriate: It had been one of Goldman’s economists who had coined the appellation for those four economies, to which the world’s wealth and power were now shifting. To Blankfein it was a matter of walking the talk.

St. Petersburg was only the first part of the trip, where they’d be given an update on the firm’s finances and have a strategy-review session; it would be followed by two days in Moscow. Goldman’s chief of staff, John F. W. Rogers, had used his pull to set up the board meeting with Russia’s tough prime minister, Vladimir Putin, whose anticapitalist ideology made it clear that he would be no patsy to the United States.

As Blankfein ambled back to the Hotel Astoria, past the massive equestrian monument to Nicholas I, he pondered his fears: What if oil prices were to slide, say, to $70 a barrel? What then? And what about Goldman itself? Despite his proven success, Blankfein admitted to being “paranoid,” as he often described himself.

Being in Russia did bring back some anxious memories. It was here in 1998 that things went very wrong for Goldman when the Kremlin caught the world unawares by suddenly defaulting on the nation’s debt, sending markets around the world into a tailspin. They called it a contagion: Soon afterward, Long-Term Capital Management was struck.

The chain of events caused Wall Street firms to rack up enormous trading losses, and the damage at Goldman was eventually so severe that it had to push back its plans to go public.

As the current market troubles unfolded, Goldman was being mercifully spared the kinds of hits that Lehman, Merrill, Citi, and even Morgan Stanley were taking. His team was smart, but Blankfein knew that luck had played a big role in their accomplishments. “I really think we are a little better,” he had said, “ but I think it’s only a little better.”

Certainly, Goldman had its share of toxic assets, it was highly leveraged, and it faced the same funding shortfalls caused by the seized-up markets as did its rivals. To its credit, though, it had steered clear of the most noxious of those assets—the securities built entirely on the creaky foundation of subprime mortgages.

Michael Swenson and Josh Birnbaum, two Goldman mortgage traders—along with the firm’s chief financial officer, David Viniar—had been instrumental in making the opposite wager: They had bet against something called the ABX Index, which was essentially a basket of derivatives tied to subprime securities. Had they not done so, things could have turned out differently for Goldman, and for Blankfein.

Blankfein couldn’t help but notice all the Mercedes clogging the streets as he walked back to his hotel room. And that was only the most visible conspicuous consumption taking place. Flush from their profits not only from gas and oil but from iron, nickel, and a host of other increasingly valuable commodities, Russia’s so-called oligarchs were buying up supersized yachts, Picassos, and English soccer teams. Ten years ago, Russia could not pay its debts; today it was a fast-growing, $1.3 trillion economy.

Goldman’s own complicated history with Russia dated back much earlier than its stunning default. Franklin Delano Roosevelt once offered to make Sidney Weinberg, Goldman’s legendary leader, ambassador to the Soviet Union. “I don’t speak Russian,” Weinberg replied in turning down the president. “Who the hell could I talk to over there?”

After the collapse of the Soviet Union, Goldman was among the first Western banks to try to crack its market, and three years after the fall of the Berlin Wall, Boris Yeltsin’s new government named the firm its banking adviser.

Profits proved to be elusive, however, and Goldman pulled out of the country in 1994 but would eventually return. By 1998 it had helped the Russian government sell $1.25 billion in bonds; when, two months later, after the default, the bonds proved to be virtually worthless, the firm again withdrew. Now it was back for a third try, and Blank fein was determined to get it right this time.

The next morning, at 8:00, the Goldman board began its session in a conference room on the ground floor of the Hotel Astoria, which had been in operation since 1912 and was named after John Jacob Astor IV. Legend had it that Adolf Hitler had planned to hold his victory celebration there the moment he forced the city to surrender, and was so confident in his triumph that he had had invitations printed in advance.

Blankfein, dressed in a blazer and khakis, gave the board an overview of the company’s performance. As board meetings go, it had been unexceptional.

But it was the following session that was perhaps the critical one. The speaker was Tim O’Neill, a longtime Goldmanite, who was virtually unknown outside the firm. But as the firm’s senior strategy officer, he was a major player within the firm. His predecessors included Peter Kraus and Eric Mindich, both of whom were considered Goldman superstars, and O’Neill definitely had Blankfein’s ear.

Board members had received a briefing book three weeks earlier and understood why this session was so vital: In it O’Neill would outline survival plans for the firm. He was effectively serving as the office’s fire marshal. Nothing was burning, but it was his responsibility to identify all the emergency exits.

The issue facing them was this: Unlike a traditional commercial bank, Goldman didn’t have its own deposits, which by definition were more stable. Instead, like all broker-dealers, it relied at least in part on the short-term repo market—repurchase agreements that enabled firms to use financial securities as collateral to borrow funds. While Goldman tended to have longer term debt agreements—avoiding being reliant on overnight funding like that of Lehman, for example—it still was susceptible to the vagaries of the market.

That arrangement was something of a double-edged sword. It could bet its own money utilizing enormous amounts of leverage—putting up $1, for example, and using $30 of debt, a practice common in the industry. Bank holding companies like JP Morgan Chase, which were regulated by the Federal Reserve, faced far more restrictions when it came to debt-fueled bets on the market. The downside was that if confidence in the firm waned, that money would quickly evaporate.

Blankfein sat nodding in approval as O’Neill made his case. What had happened to Bear, he explained, was not just a one-off event. The independent broker-dealer was considered a dinosaur well before the current crisis had begun. Blankfein himself had watched Salomon Smith Barney be absorbed by Citigroup, and even Morgan Stanley merge with Dean Witter. Now, with Bear gone and Lehman seemingly headed in that direction, Blankfein had good reason to be worried.

Blank fein’s own rise to the top at Goldman underscored for him just how fast things could change: A decade earlier he had been the short, fat, bearded guy who wore tube socks to the firm’s golf outings. Today he was the head of the smartest and most profitable firm on Wall Street.

In one sense the arc of his career was classic Goldman Sachs. Like the firm’s founders and its longtime leader Sidney Weinberg, Blankfein was the son of working-class Jewish parents. Born in the Bronx, he grew up in Linden Houses, a project in East New York, one of the poorest neighborhoods in Brook lyn. In public housing you could hear neighbors’ conversations through the walls and smell what they were making for dinner. His father was a postal clerk, sorting mail; his mother was a receptionist.

As a teenager Blankfein sold soda during New York Yankees games. He graduated as valedictorian of his class at Thomas Jefferson High School in 1971, and at the age of sixteen, with the help of scholarships and financial aid, he attended Harvard, the first member of his family to go to college. His perseverance revealed itself in other ways. Because he was then dating a Wellesley student from Kansas City, he took a summer job at Hallmark to be near her. The relationship, however, did not last.

After college came Harvard Law School, and after graduating in 1978, he joined the law firm of Donovan, Leisure, Newton & Irvine. For several years he practically lived on an airplane flying between New York and Los Angeles. On the rare weekends he found time to relax, he would drive out to Las Vegas with a colleague to play blackjack. They once left their boss a memo: “If we don’t show up Monday it’s because we’ve hit the jackpot.”

By now Blankfein had started on the track toward becoming a partner at the firm, but in 1981 he had what he termed a “prelife crisis.” He decided that he wasn’t meant to be a corporate tax lawyer and applied for jobs at Goldman, Morgan Stanley, and Dean Witter. He was rejected by all three firms but a few months later got his foot in the door at Goldman.

A headhunter sought him out for a job at J. Aron & Company, a little-known commodities trading firm that was looking for law school graduates who could solve complex problems and then explain to clients precisely what they had done. When he told his fiancée, Laura, who was also a corporate lawyer, with the New York firm of Phillips, Nizer, Benjamin, Krim & Ballon, that he was taking a job as a salesman of gold coins and bars, she cried.

Several months later, Blankfein became a Goldman employee when the firm acquired J. Aron in late October 1981.

After the oil shocks and inflation spikes of the 1970s, Goldman was determined to expand into commodities trading. J. Aron gave the firm a powerful gold and metals trading business and an international presence, with a significant London operation. But while Goldman was disciplined and subdued, J. Aron was wild and loud. When Goldman ultimately moved the trading operations of J. Aron into 85 Broad Street, its immaculately groomed executives were stunned to see traders with their ties wrenched loose and their sleeves rolled up, who shouted out prices and insults alike. When angered, they pounded their desks with their fists and threw their phones. This was not the Goldman way. And while Goldman prided itself on its culture and its calculated hierarchy, J. Aron had no use for formalities. After joining, when Blankfein asked what his own title was, he was told: “You can call yourself contessa, if you want.”

Goldman’s Mark Winkelman was given the task of taming this unruly crowd. The Dutch Winkelman was one of Goldman’s first foreign partners, known for his analytical brilliance; he was one of the first executives on Wall Street to recognize the importance of technology for trading, as computers became smaller and more powerful. Winkelman first noticed Blankfein when he saw the short salesman wrestle the phone away from a trader who was trying to yell at a client who had cost him money.

He shielded his protégé from a wave of job cuts at J. Aron that came the following year, the first widespread layoffs at Goldman. Blankfein was fortunate in other respects as well. Goldman had decided to make a major push into trading bonds, commodities, and currencies, and to take on larger risks. The firm had been a pioneer in commercial paper and a leader in municipal finance, but remained an also-ran in fixed income, compared with Salomon Brothers and others. Winkelman and Jon Corzine overhauled that part of the business and recruited talent from Salomon.

Impressed by Blankfein’s well-honed diplomacy and his obvious intelligence, Winkelman placed him in charge of six salesmen in currency trading and, later, the entire unit.

Robert Rubin, who then ran fixed income with Stephen Friedman, was opposed to the move.

“We’ve never seen it work to put salespeople in charge of trading in other areas of the firm,” Rubin told Winkelman. “Are you pretty sure of your analysis?”

“Really appreciate your experience, Bob, but I think he’ll do all right,” Winkelman responded. “Lloyd’s driven, and he is a very smart guy with a very inquiring mind, so I have some confidence.”

The young lawyer soon demonstrated his trading prowess by structuring a trade that allowed a Muslim client to obey the Koran’s proscriptions against interest payments. At the time, the complex $100 million deal, which involved hedging Standard & Poor’s 500 contracts, was the biggest Goldman had ever done.

Blankfein was also a serious reader, taking stacks of history books with him when he went on vacation. Never flashy or self-promoting, he was an almost ideal embodiment of the culture at Goldman, where no one ever said, “I did this trade,” but rather, “We did this trade.”

Winkelman was crushed when he was passed over for Corzine and Hank Paulson in the top jobs at Goldman in 1994. Blankfein, who was made partner in 1988, was one of four executives named to take over Winkelman’s responsibilities. Winkelman left the firm.

By 1998, as co-head of fixed income, currency, and commodities, Blankfein was running one of the most profitable businesses at the firm, but he was not seen as an obvious candidate for the top job.

Eventually, Paulson was won over by Blankfein’s raw intellect and made him his co-president, prompting John Thain to leave the firm. For his part, Blankfein shaved his beard, lost fifty pounds, and quit smoking. When Paulson was nominated as Treasury secretary in May 2006, he announced that he had selected Blankfein as his replacement.

For as long as Blankfein could remember, Goldman had been thinking that it might need a partner. In 1999, during Paulson’s stewardship, he had held secret merger talks with JP Morgan, soon after the firm had gone public. Those discussions ended abruptly when Paulson came home to his apartment one day and had an epiphany: “Legally, we would be buying Morgan, but JP Morgan was so much bigger than Goldman Sachs that in reality they would be taking us over, and they would bury us,” he later recalled. “I also knew that somehow we’d figure out how to do everything they could do.”

During the Clinton administration’s first term, Congress was working on the legislation that would repeal the Glass-Steagall Act of 1933, tearing down the walls dividing banks, brokers, and other financial businesses. At the time, lobbyists for Goldman actually persuaded the committee writing the bill—which became the Gramm-Leach-Bliley Act of 1999—to include a minor amendment they had sought in the event that they ever wanted to become a bank holding company. That provision allowed any bank that owned a physical power plant to continue to own it as a bank holding company. Of course, Goldman was the only bank that owned a power business.

Blankfein reflected on this history as O’Neill finished his presentation with a series of questions: Do we need to become a commercial bank? What does it mean if we become a commercial bank? How can we use deposits? How do we build a deposit base?

Blankfein was quick to speak up afterward to encourage discussion. “Deposits provide funding only for certain activities,” he reminded the group.

Gary Cohn tried to explain the situation in greater detail, saying that they wouldn’t be allowed to make bets with all of the deposits and advising them that they would “have to go out and buy some mortgages or go into the credit card business or originate mortgages.” These were businesses in which Goldman had no experience, and entering them would mean changing the company in a fundamental way.

Sitting beneath twenty-foot-high chandeliers in the conference room, the directors and executives batted around a number of different ideas—developing an Internet bank, growing the firm’s private-wealth-management business. After an hour of debating alternatives, O’Neill shifted the discussion in another direction by proposing a different alternative: buy an insurance company.

Insurance might have seemed, at first glance, an even more radical departure for Goldman than becoming a commercial bank. But Blankfein made the case that the two industries were more similar than dissimilar. Insurers use premiums from ordinary customers, just as bankers use deposits from customers, to make investments. It was no accident that Warren Buffett was a big player in the industry; he used the float of premiums from his insurance companies to finance his other businesses. Similarly, what was known in insurance parlance as “actuarial risk” was not unlike Goldman’s own risk-management principles.

Goldman could not buy just any insurer, however; it would have to be a company large enough to put more than a dent in Goldman’s already hefty balance sheet. The top name on O’Neill’s list was AIG, American International Group, which by some measures was the biggest insurance company in the world. The stock price of AIG had recently been decimated, so it might even be economical. Doing a deal with AIG had not, in fact, been a new idea; a possible merger had been talked about in hushed whispers at 85 Broad Street for years. Previous leaders of Goldman, John Whitehead and John Weinberg, both of whom were friends of Hank Greenberg, had suggested to him that the companies should perhaps do a deal some day.

Everyone in the group had a view about AIG. Rajat K. Gupta, senior partner emeritus of McKinsey & Company, was intrigued, as was John H. Bryan, the former CEO of Sara Lee and one of Paulson’s closest friends.

Bill George, the former head of Medtronic, the medical technology giant, appeared a bit more hesitant, and Gary Cohn said frankly that the idea made him nervous. They all looked to one particular board member for direction: Edward Liddy.

As the chief executive of Allstate, the major auto and home insurer, Liddy was the one person in the room with actual experience in the insurance business. Some five years earlier Liddy had even tried to sell his firm to AIG, and Greenberg had dismissively rejected his pitch. “I think you ought to keep it,” Greenberg told him.

Whenever the subject of insurance had come up at previous board meetings, Liddy had been unenthusiastic. “It’s a totally different game,” he had warned. His view on the matter hadn’t changed, no matter how much of a bargain AIG may have seemed. “It isn’t worth getting entangled with AIG,” he insisted.

The morning session ended without any decisions being made about AIG, but the insurer came up again after lunch for an entirely different reason. AIG traded through Goldman as well as other Wall Street firms, and like many other companies would put up securities as collateral. There was just one problem: AIG was claiming that its securities were worth a good deal more than Goldman thought they were. Although Goldman’s auditor was looking into the matter, there was another snag: the auditor, PricewaterhouseCoopers, also worked for AIG.

In a videoconference presentation from New York, a PWC executive updated the board on its dispute with AIG over how it was valuing or, in Wall Street parlance, “marking to market,” its portfolio. Goldman executives considered AIG was “marking to make-believe,” as Blankfein told the board.

Strangely, however, no one in the room in St. Petersburg made the critical connection; no one raised the collateral dispute as evidence of a potential fatal flaw in Goldman’s consideration to merge with AIG—that the company itself was in serious trouble and had resorted to overvaluing its securities as a stopgap. Instead, the afternoon session proceeded with upbraiding PricewaterhouseCoopers: “How does it work inside PWC if you as a firm represent two institutions where you’re looking at exactly the same collateral and there’s a clear dispute in terms of valuation?” Jon Winkelried, Goldman’s co-president, pointedly asked.

It was the second time PWC had been criticized during a Goldman board meeting. Goldman’s board had first learned of the collateral dispute with AIG in November 2007. At the time, the sum involved was more than $1.5 billion. Nervously, Goldman started buying up protection in the form of credit default swaps—insurance—against the possibility that AIG would fail. Given that no one at the time seriously thought that would ever happen, the insurance was relatively cheap: For $150 million, Goldman could insure some $2.5 billion worth of debt.

The Goldman board ended its day in St. Petersburg in a more leisurely manner. With the northern sky still light well after 10:00 p.m., the thirteen directors and their spouses rode gondolas along the city’s storied canals.

On Sunday, the board flew down to Moscow for the second part of the meeting, gathering at the Ritz-Carlton, on the edge of Red Square. Mikhail Gorbachev was the speaker at their dinner that evening. Power in Russia was still very much in the hands of Vladimir Putin, even though Dmitry Medvedev had recently been elected to succeed him. Many foreign investors feared that Russia’s commitment to open and free markets was quickly fading, particularly in light of the power grabs in the energy industry.

Gorbachev, who had initiated the changes that led to the end of communist rule, struck several Goldman directors as oddly deferential to the Kremlin. “Russia is now realizing its potential as a democratic state, opening itself up to new ideas and outside investment.”

Some directors joked that if the last hotel wasn’t bugged, this one certainly must be.

In a strange coincidence, late that afternoon another key figure in American finance arrived in Moscow. Treasury secretary Henry Paulson had come there on a stop on a five-day European tour that would later take him to Berlin, Frankfurt, and then London.

He had been on the road a great deal that month—visiting the Persian Gulf states; attending the Group of Eight meeting of finance ministers in Osaka, Japan; and now passing through Europe and Russia. The highlight of his trip, he hoped, would be London, where he had been preparing to give what he believed would be an important speech at Chatham House, an international affairs research group, in St. James’s Square. Crafted with the help of his lieutenant David Nason, the talk would herald a proposed overhaul of financial regulation. As he continued to be concerned about firms like Lehman, he knew he needed to call for new tools to deal with troubled institutions. He wanted to get ahead of the problems while things still seemed stable.

On the flight over he had reviewed the speech, making last-minute changes, knowing that he’d have little time to do so once he arrived in Moscow. “To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large, complex financial institution,” he planned to say. “As former Federal Reserve chairman Greenspan often noted, the real issue is not that an institution is too big or too interconnected to fail, but that it is too big or interconnected to liquidate quickly. Today our tools are limited.”

It was a risky gambit to announce to the world that the government lacked the authority to prevent a major failure—such a sentiment could undermine confidence in the markets even further—but he also knew that it needed to be said, and even more so, that the situation needed to be fixed.

On Sunday night, Paulson had dinner with Finance Minister Alexei Kudrin in the Oval Dining Room at Spaso House, the residence of the American ambassador in Moscow. On Monday he had scheduled a busy day, including half a dozen meetings, a radio interview, and private sessions with Medvedev and Putin. Paulson had earlier told reporters that he wanted to discuss with the Russians “ best practices” for huge state-owned investment funds known as sovereign wealth funds, which were primarily associated with wealthy Middle East nations.

But before he ended his evening on Saturday, he had one last meeting after dinner. Just days earlier, when Paulson learned that Goldman’s board would be in Moscow at the same time as him, he had Jim Wilkinson organize a meeting with them. Nothing formal, purely social—for old times’ sake.

For fuck’s sake! Wilkinson thought. He and Treasury had had enough trouble trying to fend off all the Goldman Sachs conspiracy theories constantly being bandied about in Washington and on Wall Street. A private meeting with its board? In Moscow?

For the nearly two years that Paulson had been Treasury secretary he had not met privately with the board of any company, except for briefly dropping by a cocktail party that Larry Fink’s BlackRock was holding for its directors at the Emirates Palace Hotel in Abu Dhabi in June.

Anxious about the prospect of such a meeting, Wilkinson called to get approval from Treasury’s general counsel. Bob Hoyt, who wasn’t enamored of the “optics” of such a meeting, said that as long as it remained a “social event,” it wouldn’t run afoul of the ethics guidelines.

Still, Wilkinson had told Rogers, “Let’s keep this quiet,” as the two coordinated the details. They agreed that Goldman’s directors would join him in his hotel suite following their dinner with Gorbachev. Paulson would not record the “social event” on his official calendar.

That evening, the Goldman party boarded a bus to take them the dozen or so blocks to the Moscow Marriott Grand Hotel on Tverskaya Street. Some felt as if they were taking part in a spy thriller, what with the security detail and the grandeur of downtown Moscow. The directors walked through the bright lobby with its large fountain and were escorted upstairs to the Treasury secretary’s rooms.

“Come on in,” a buoyant Paulson said as he greeted everyone, shaking hands and giving bear hugs to some.

For the next hour, Paulson regaled his old friends with stories about his time in Treasury and his prognostications about the economy. They questioned him about the possibility of another bank blowing up, like Lehman, and he talked about the need for the government to have the power to wind down troubled firms, offering a preview of his upcoming speech. “Nonetheless,” he told them, “my own view is that we have tough times ahead of us, but based upon history, I think we may come out of this by year’s end.”

It was that comment that Blankfein recalled the following day to a director over breakfast. “I don’t know why he’d say that,” Blankfein said quizzically. “It can only get worse.”