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

CHAPTER ELEVEN

Robert Willumstad could feel the perspiration begin to soak through his undershirt as he strode along Pearl Street at 9:15 a.m. on Tuesday, July 29, in Manhattan’s financial district. Although the humidity was oppressive that summer morning, he was also anxious about his upcoming appointment with Tim Geithner at the Federal Reserve Bank of New York.

Since accepting the position of CEO at AIG just over a month earlier, he had been working long hours to try to get a handle on the company’s myriad problems. With the exception of a weekend trip to Vail over July Fourth to visit his daughter, he had been at the office seven days a week. When he began the job he had announced plans “to conduct a thorough strategic and operational review of AIG’s businesses” and “to complete the process in the next sixty to ninety days and to hold an in-depth investor meeting shortly after Labor Day to lay it all out for you.”

As Willumstad started his investigation, his head of strategy, Brian T. Schreiber, pulled him aside and shared a startling discovery he had made: “It could actually be a liquidity problem, not a capital problem.” In other words, even though this massive insurance conglomerate had hundreds of billions of dollars’ worth of securities and collateral, given the credit crisis, it could find itself struggling to sell them fast enough or at high enough prices to meet its obligations. The situation could become even worse if one of the ratings agencies, like Moody’s or Standard & Poor’s, were to downgrade the firm’s debt, which could trigger covenants in its debt agreements to post even more collateral.

“You scared the shit out of me last night,” Willumstad told Schreiber the following day, after spending the night contemplating the firm’s liquidity issues. The problem would soon be further compounded, Willumstad realized, with the firm scheduled to report a $5.4 billion loss in its second quarter.

On this muggy July day, Willumstad was on his way to see Geithner, whom he had only met for the first time a month earlier, to sound him out about getting some help if the markets turned against him. The Federal Reserve Bank of New York did not regulate AIG, or any insurance company for that matter, but Willumstad figured that between AIG’s securities-lending business and its financial products unit, Geithner might take an interest in his problems. Even more he hoped that Geithner appreciated how closely AIG was interconnected with the rest of Wall Street, having written insurance policies worth hundreds of billions of dollars that the brokerage firms relied on as a hedge against other trades. Like it or not, their health depended on AIG’s health.

“No reason to panic, no reason to believe anything bad is going to happen,” Willumstad said after Geithner had greeted him with his usual firm, athletic handshake and invited him back into his office. “But we’ve got this securities lending program… .”

He explained that AIG lent out high-grade securities like treasuries in exchange for cash. Normally it would have been a safe business, but because the company had invested that cash in subprime mortgages that had lost enormous value, no one could peg their exact price, which made them nearly impossible to sell. If AIG’s counterparties—the firms on the other side of the trade—should all demand their cash back at the same time, Willumstad said, he could run into a serious problem.

“You’ve made the Fed window available to the broker-dealers,” he continued. “What’s the likelihood, if AIG had a crisis, that we could come to the Fed for liquidity? We’ve got billions, hundreds of billions of dollars of securities, marketable collateral.”

“Well, we’ve never done that before,” Geithner replied briskly, meaning that the Federal Reserve had never made a loan available to an insurance company, and he seemed none too swayed by Willumstad’s argument.

“I can appreciate that,” Willumstad replied. “You never did it for brokers before either, but obviously there’s some room here.” After Bear Stearns’ near-death experience, the Fed had decided to open the discount window to brokerage firms like Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman.

“Yes,” Geithner acknowledged, but said that it would require the approval of the entire Fed board and, he added pointedly, “I would only recommend it if I thought I was making a good credit decision.”

He then delivered to Willumstad the same warning that he had given to Fuld the month before when Fuld had sought bank holding company status for Lehman.

“I think the problem is it’s going to exacerbate what you’re trying to avoid,” he said. “When it would get disclosed, that would cause concern among the counterparties. It would exacerbate anything we had.”

Willumstad could see he wasn’t getting anywhere with his argument as Geithner rose to indicate that he had to get to his next meeting, saying only, “Keep me informed.”

On July 29 Lehman’s Gulfstream circled over the airport in Anchorage, Alaska, preparing for its approach to land to refuel. Aboard was Dick Fuld, heading back from Hong Kong, where he and a small Lehman team had met with Min Euoo Sung of the Korea Development Bank.

Fuld was in uncharacteristically good spirits that day, confident that he was finally getting closer to a deal. He had had a productive conversation with KDB, and both sides had agreed to continue talking. It would still be a “long putt,” he knew, but K DB had become his best hope. Min had indicated that he would be interested in buying a majority stake in Lehman. He knew Min was still anxious about Lehman’s real estate portfolio—the toxic assets weighing it—but Min also seemed to be upbeat about the prospect of making KDB a major player on the world stage. There hadn’t been much discussion about price at the meeting at the Grand Hyatt in downtown Hong Kong, but Fuld was confident that a deal might finally be at hand.

Fuld was also pleased with himself for having kept the talks out of the press. He had been so concerned about leaks this time around that he had instructed the team he took with him to the meetings—Bart McDade, Skip McGee, Brad Whitman, Jesse Bhattal, and Kunho Cho—not to answer their phones. McGee had gone so far as to mislead his staff back in New York by leaving a voice mail for Mark Shafir, who had gone on the earlier trip to South Korea, telling him that he had flown to China to visit with clients. Fuld had organized the meeting in Hong Kong, as opposed to the more likely Seoul, partly so that if anyone was tracking the firm’s plane, its destination would lead to less speculation.

On the return trip the Lehman team watched The Bank Job, a British heist movie, on the plane’s large screen. Fuld had already seen it and made the case for an action film instead, but McDade, who was increasingly taking control of the firm, won out.

As they taxied to the refueling station, Fuld’s good mood suddenly vanished: The maintenance crew had discovered an oil leak. As the pilot tried to coordinate a repair, the Lehman team ate lunch on the plane as it sat on the tarmac. But after an hour, it was uncertain whether that damage could be repaired.

McDade started calling his secretary to see if they could book a commercial flight home.

“When’s the last time you flew commercial?” McDade ribbed Fuld, who was plainly not amused.

On August 6, 2008, a team of bankers from Morgan Stanley arrived at the Treasury building and was escorted up to a conference room across from Paulson’s office for what they all knew would be an unusual meeting. Looking for help with Fannie Mae and Freddie Mac, Paulson had called John Mack a week earlier to hire his firm as an adviser to the government. Paulson would have chosen Goldman were it not for the obvious public relations problem or the fact that it was advising Fannie. He also briefly considered hiring Merrill Lynch, but Morgan Stanley seemed the best option.

Mack had originally been reluctant even to take the assignment, for the cost of serving as Treasury’s adviser on Fannie Mae and Freddie Mac was that the firm could not conduct any business with the mortgage giants for the next six months, and therefore stood to lose out on tens of millions of dollars in fees. “How can we tell our shareholders we’re walking away from this kind of money? I’m going to get asked about why I did that,” he told his team.

But after some soul-searching, Mack decided working for the government was the patriotic thing to do. Morgan Stanley would receive a token payment of $95,000, which would barely cover the cost of their secretaries’ overtime.

Just a week earlier the Senate had passed, and President Bush had signed into law, an act that gave Treasury the temporary authority to backstop Fannie and Freddie. Now the question that faced Paulson was: What to do with that authority?

He recognized that he had created an odd dilemma: Investors now assumed the government was planning to step in. That would make it even harder for Fannie and Freddie to raise capital on their own, as investors worried that a government intervention would mean they would get wiped out. Any sort of investment by the government increasingly seemed as if it could become a self-fulfilling prophecy. “Either investors are going to be massively diluted, given the amount of equity they are going to need, or [Freddie and Fannie] are going to be nationalized,” Dan Alpert, managing director of Westwood Capital LLC, had told Reuters that morning. “Without a larger equity capital base, they are going to be incapable of surviving.”

In a Treasury conference room, Anthony Ryan, assistant secretary for financial markets, briefed the bankers on the department’s work to date on the GSEs. Attending from Morgan Stanley were Robert Scully, fifty-eight, the firm’s co-president, who had worked on the government’s bailout of Chrysler nearly three decades earlier; Ruth Porat, fifty, the head of its financial institutions banking group; and Daniel A. Simkowitz, the forty-three-year-old vice chairman of global capital markets.

Ten minutes into Ryan’s presentation, Paulson walked in, looking slightly distracted. “Everyone’s going to scrutinize what we do,” he told the group as he tried to inspire and scare them simultaneously. “I’m going to work you to the bone. But I’m confident of this: It will be the most meaningful assignment of your career.”

Scully pressed Paulson to explain his rationale for the assignment. “Just tell us what you’re really looking to do here,” he said. “Do you want to kick the can down the road?”

“No,” said Paulson, shaking his head. “I want to address the issue. I don’t want to leave the problem unsolved.” He was adamant that the project not become another bureaucratic exercise in producing PowerPoint presentations that would just get filed away. “I, ah, we have three objectives: market stability, mortgage availability, taxpayer protection.”

Scully was still skeptical, certain there had to be some political calculus involved. And, with Freddie’s reported loss of $821 million that morning, doing nothing no longer seemed a viable option.

“Are there any policy options that are off the table or, alternatively, are there any stakes you have in the ground in terms of starting points and approaches to this problem that you’d like us to think about?” Scully probed.

“No, you have a clean sheet of paper,” Paulson said. “All options are on the table; I’m willing to consider everything.”

A young child’s squeal a few doors down suddenly halted the discussion. It was Paulson’s granddaughter, Willa, who was visiting that day and waiting in a small conference room across from his office. Paulson was about to catch a flight with his family to attend the Olympic Games in Beijing. It was, however, a working vacation—he had a busy set of meetings with Chinese officials—and as they all knew, he would be attached to his cell phone.

He apologized to the group for cutting the meeting short.

“I’ll be back in ten days,” he told them. “I want a lot of progress.”

In the first week of August, Min Euoo Sung arrived in Manhattan from Seoul to continue talks with Lehman Brothers. The parties were still far from signing a final agreement, but they were inching closer to nailing down at least the outlines of one.

On that Monday, McDade, who remained skeptical that a deal would come to pass, walked over to Sullivan & Cromwell’s Midtown offices with his colleagues to begin formal negotiations. “They are never going to have the balls to do this,” Mark Shafir said as he headed up Park Avenue with McDade and Skip McGee. Kunho Cho and Jesse Bhattal of Lehman, who were closest to Min, had flown over from Asia to help shepherd a deal. McGee had urged Fuld to stay at the office, despite his insistence on coming to the meeting. “Chill out,” McGee had told him. “You’re the CEO. You have to be the ‘missing man’”—Wall Street parlance for the handy excuse they could use when they closed in on the final terms of the deal but wanted to push for slightly better ones: They’d simply say they still needed approval from the CEO.

McDade also had become increasingly anxious that Fuld’s fragile state wouldn’t help the negotiations. McDade was beginning to fear that Fuld suspected him of attempting to take over the firm. Often when he was in conversation with Gelband and Kirk, his protégés, Fuld would emerge seeming apprehensive, as if imagining they were plotting his ouster. Fuld’s paranoia was only further encouraged when McDade refused to inhabit Joe Gregory’s old office directly next to Fuld’s, citing its “bad karma”; instead, he took an office farther down the hall, where it was harder for Fuld to monitor him.

In truth, McDade was increasingly in control of Lehman. He was in the process of putting together a document called “The Gameplan,” a detailed examination of the firm’s finances and a vision for a way forward. It included a half dozen possible scenarios, most of which included some variation on dividing Lehman in two: a “good bank” that they’d keep and a “ bad bank ” that they’d spin off, thereby ridding themselves, at least on paper, of their worst real estate assets. The plan would enable Lehman to make a fresh start, unencumbered by assets that continued to fall in value. McDade also had pressed Fuld to put Neuberger Berman and the firm’s investment management business up for sale, and an auction was already under way among a series of private-equity firms.

While the rumors about Lehman may have continued unabated, the leaks coming out of the company appeared to be shrinking in volume. A few weeks after McDade was appointed president, McGee gave him a T-shirt with the inscription: “A Person Familiar with the Situation”—a wry reference to how the financial press generically referred to its sources. McGee had told him, “Give it to Scott!” a not-so-subtle dig at Scott Freidheim, who managed much of the firm’s media strategy.

The first meeting that morning at Sullivan & Cromwell was to allow the Koreans an opportunity to review Lehman’s commercial real estate assets. Mark Walsh, the architect of the firm’s foray into the commercial real estate market, gave a presentation to the group. But Min quickly found Walsh unprepared and pulled aside Kunho to tell him as much. “I need to understand this better,” he told him in Korean. “I feel very uncomfortable with the valuations.”

It quickly became clear that Min wanted nothing to do with Lehman’s commercial real estate holdings. For at least an hour it looked like the talks could collapse. But that afternoon the two sides started working on a new structure: Min said he was interested in buying a majority stake in Lehman, but only if it were to spin off its commercial and residential real estate assets into a separate company so that KDB’s investment couldn’t be impacted. The discussions seemed to be going well, except for the fact that Fuld kept calling McDade’s and McGee’s cell phones every twenty minutes to ask for an update.

By the next morning, at 11:00, Min said he had received authorization for Korean regulators to make an initial offer. He said he was prepared to pay 1.25 times Lehman’s “book value”—or the value at which Lehman held its assets on its balance sheet. The deal, which was still subject to a discussion about the firm’s true book value and would have included Lehman spinning off the real estate business, meant that KDB was valuing Lehman somewhere between $20 and $25 a share, a premium over its current share price, which had closed the day before at $15.57.

Whether Min was posturing—as some of the Lehman bankers suspected—remained an open question, but McDade, McGee, and the rest of the Lehman team said they were inclined to accept his offer. However, McDade said he wanted to retreat back to the firm’s headquarters to discuss it with Fuld first. They agreed that both sides would return at 7:00 p.m. in hopes of reaching at least an agreement in principle.

When both sides reconvened several hours later, a surprise guest arrived: Fuld. The goal for the Lehman team was to press Min to sign a letter of intent ahead of the final agreement, even if it meant it would take several more weeks to hammer out the details. That gesture, everyone agreed, would take some pressure off Lehman’s stock.

Fuld took a seat alongside McDade, McGee, and Kunho, an inexplicable scowl on his face. Across from them at the table were Min, his banker, Gary Barancik of Perella Weinberg Partners and his lawyer, Victor I. Lewkow of Cleary Gottlieb Steen & Hamilton.

“Look, we hear you. We understand what you want to do,” McDade said, referring to Min’s plan to acquire a controlling stake in Lehman after it spun off the real estate assets. “Let’s start—”

Fuld interjected. “I think you’re making a big mistake,” he told Min. “You’re going to miss a great opportunity. There’s a lot of value in these real estate assets,” pressing Min to buy at least some of them. As the conversation continued, Fuld suggested that Min’s plan to pay 1.25 times book value was “too low,” instead recommending they negotiate on the basis of 1.5 times book value.

McDade and McGee couldn’t believe what they were witnessing. They had spent the past two days orchestrating a deal based on spinning off the real estate assets, and now Fuld was trying to retrade on their work. Worse, a look of horror crossed Min’s face. Min pulled Barancik aside and whispered, “I’m not comfortable with this,” and in response, Barancik spoke up on behalf of KDB. He said they would only negotiate on the basis of 1.25 times the book value valuation, and then, as his aggravation mounted, started questioning Lehman’s accounting. “I don’t believe that you’ve taken all the write-downs,” he said, reiterating why they weren’t interested in the real estate assets.

“Okay,” Fuld said, his frustration showing. “What do you think our real estate portfolio should be marked at?”

Before Barancik could answer, McDade piped up. “Well, we have a term sheet,” he interjected, trying to steer the conversation back in a more productive direction. “Why don’t we look at that?”

“Look, I just think we need to take a break,” Barancik said, sensing the tension could topple the talks.

As they stepped into the hallway, Fuld, having misread Min’s mood, approached him and again started promoting the idea of selling him the real estate.

McGee, who was standing behind Min and could see this conversation was only antagonizing him, tried to signal Fuld , slicing his finger across his throat to urge him to stop badgering the Korean.

Finally managing to break free of Fuld, Min took Barancik to a small room to study the term sheet—which was more a list of broad principles than a formal agreement. As they reviewed it, Min nodded at each bullet point until he reached the final one, which stipulated that KDB would provide credit to Lehman to help support it. To Min that was an instant red flag. Was Lehman seeking an open-ended credit line, hoping to leverage KDB’s balance sheet to bolster its own standing?

Min, looking pained, grabbed Kunho Cho, his friend when they worked at Lehman together, and asked to talk with him privately. Even before Min spoke a word, Cho could tell it wasn’t going to be good.

“There is a serious credibility problem here,” he said in Korean. “All of this time we have negotiated in good faith consistently, and we were moving toward the goal we all wanted, and now, all of sudden, it’s a new picture.”

Clearly frustrated, Min continued, “Look, it’s not about 1.25 versus 1.5 times book, or a $2 billion versus a $4 billion credit line. It’s none of that. It’s the way you conducted the meeting. I just feel uncomfortable about the way this whole thing has been conducted by Lehman senior management. I cannot continue on this basis.”

Cho, who had helped persuade Min to fly to New York for the meeting, was devastated.

When Min returned to the main conference room he looked apologetically at Fuld, and then at the rest of the bankers assembled around the table. “I’d like to thank you all, but I don’t think we have a structure that works,” he said, and got up to leave. “Gary Barancik can continue the dialogue.”

A dolorous look came over Fuld’s face. “So, you mean, that’s it?” he asked, raising his voice. “You’re just going back to Korea?”

Steve Shafran was at a gas station in Sun Valley, Idaho, one brisk morning in August when Hank Paulson called. Shafran, one of Paulson’s special advisers at Treasury, was on vacation. “Give me an update on Lehman,” Paulson instructed.

Shafran, who turned off the engine of his fifteen-year-old Land Rover, recognizing that this might take some time, had been assigned by Paulson earlier in the summer to a special project: to act as a coordinator between the SEC and the Federal Reserve to begin contingency planning for a Lehman Brothers bankruptcy. The original assignment had actually been to ascertain systemic risk in the banking system and to make sure the various government agencies were talking to one another, but it had soon morphed into focusing almost exclusively on Lehman.

It was by its very nature a secret undertaking, given that he wasn’t allowed to let anyone—least of all Lehman Brothers—know that the government was even thinking about the possibility, no matter how improbable it might be. If the stock market caught even a whiff of it, Lehman’s shares would plunge. But Paulson, who had been speaking to Fuld almost every day, had become convinced that Lehman was going to face a struggle in its attempts to raise capital, and they needed to prepare for the very worst.

Indeed, Paulson had become so frustrated with Fuld’s various plans that he had assigned Ken Wilson to be Fuld’s personal liaison. “I’m going to tell Dick that he’s talking to you,” Paulson told Wilson. “It’s just a waste of time. I’ll talk with him when he’s got something really important to say to me.”

Paulson wasn’t the only one worried about Lehman. Shafran’s assignment followed a series of e-mail exchanges within the Federal Reserve back in June between Bernanke and his colleague, Donald Kohn, the Fed’s vice chairman. Kohn had written to Bernkane to say that he had spent time “thinking about options” for Lehman “ in the event the slow erosion of confidence turns into a rout and liquidity fled quickly. None are good, given the lack of interest by a purchaser.” He followed up with second e-mail: “One of the hedge fund types on Cape Cod told me that his colleagues think Lehman can’t survive—the question is when and how they go out of buinsess not whether.”

For Shafran, dealing with other government agencies was something of a novelty. He had moved himself and his children to Washington only a year earlier, after his wife of twenty-four years, Janet, was killed in a plane accident. They had been living in Sun Valley, where he had gone after retiring from Goldman Sachs. Shafran had worked at the firm for fifteen years, serving as Paulson’s point person in Hong Kong, helping him in his efforts to gain entrée to China. He had come to Washington to start over.

For Shafran the Lehman project was even more awkward than it would be for other Treasury staffers because he was a casual friend of Fuld’s. They knew each other from Sun Valley, where Shafran had become a city councilman in Ketchum and Fuld owned ninety-seven acres in the area (worth some $27 million), with a main home on a private road across the Big Wood River and a cabin on the shore of Pettit Lake, right near Shafran’s. They played golf together at the Valley Club and socialized occasionally. Shafran liked Fuld and admired his intensity.

But now, as Shafran was sitting in the gas station parking lot on the phone, he gave Paulson a progress report. He said he had held some conference calls with the Fed and SEC, and while they thought it was impossible to truly estimate the systemic risk, he felt that they were finally at least paying attention to the challenge. “They are on it,” he said. “I’m comfortable.” He explained that they had identified four risks within Lehman: its repo book, or portfolio of repurchase agreements; its derivative book; its broker dealer; and its illiquid assets, such as real estate and private equity investment.

Paulson knew he couldn’t do much for Lehman himself. Treasury itself did not have any powers to regulate Lehman, so it would be left to the other agencies to help manage a failure. But that made him anxious.

Earlier in the summer, David Nason had held a meeting with the SEC and told Paulson they were not on top of the situation. With streams of spreadsheets of Lehman’s derivative positions splayed before them in the Grant conference room, he had questioned Michael A. Macchiaroli, an associate director at the SEC, about what they would do if Lehman failed.

“There are a lot of positions,” Macchiaroli said. “I’m not sure what we’d do with the positions, but we’d try to net them out, and we’d go in there, and SIPC would come in,” he added, referring to Securities Investor Protection Corporation, which acts in a quasi-FDIC capacity but on a much smaller scale.

“That can’t be the answer,” Nason replied. “That would be a mess.”

“The problem is that half their book is the U.K.,” Macchiaroli said, explaining that many of Lehman’s trades went through its unit in London.

“And their counterparties are outside the United States, and we don’t have jurisdiction over them.” In the event of a disaster, all the SEC could do was try to maintain Lehman’s U.S. broker-dealer unit, but the holding company and all of its international subsidiaries would have to file for bankruptcy.

There were no good answers. Nason had raised the possibility that they might have no choice in an emergency but to go to Congress and seek permission to guarantee all of Lehman’s trades.

But as quickly as he raised the idea, he shot himself down.

“To guarantee all the obligations of the holding company, we would have to ask Congress to use taxpayer money to guarantee obligations that are outside the U.S.,” he announced to the room. “How the hell would we ask for that?”

Across a sweeping meadow from the Jackson Lake Lodge, the towering white peaks of the Tetons offered a majestic view, but one that no longer took Ben Bernanke’s breath away the way it once had. As he walked its trails on August 22 he recalled that it was here, at the Federal Reserve Bank of Kansas City’s summer symposium in the Grand Teton National Park, that he had first made his name nearly a decade ago. For the next three days, however, he could expect little more than criticism, questioning of his actions over the past year, and questions about what role the government should play with respect to Fannie and Freddie. In the summer of 1999, when the mania for Internet stocks was in full bloom, Bernanke and Mark Gertler, an economist at New York University, had presented a paper at Jackson Hole that contended that bubbles of that sort need not be a huge concern of the central bank. Pointing to steps taken by the Federal Reserve in the 1920s to pop a stock’s bubble that only created problems when an economic downturn took hold, Bernanke and Gertler argued that the central bank should restrict itself to its primary responsibility: trying to keep inflation stabilized. Rising asset prices should only be a concern for the Fed when they fed inflation. “A bubble, once ‘pricked,’ can easily degenerate into a panic,” they argued in a presentation that had been the talk of the conference and had attracted the favorable notice of Alan Greenspan.

A year ago Jackson Hole had been a more trying experience for Bernanke. As the credit crisis escalated that summer, Bernanke and a core group of advisers—Geithner; Warsh; Donald Kohn, the Fed vice chairman; Bill Dudley, the New York Fed’s markets desk chief; and Brian Madigan, director of the division of monetary affairs—huddled inside the Jackson Lake Lodge, trying to figure out how the Fed should respond to the credit crisis.

The group roughed out a two-pronged approach that some would later call “the Bernanke Doctrine.” The first part involved using the best-known weapon in the Fed’s arsenal: cutting interest rates. To address the crisis of confidence in the markets, the policy makers wanted to offer support, but not at the expense of encouraging recklessness in the future. In his address at the 2007 conference, Bernanke had said, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” Yet his very next sentence—“But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy”—bolstered what had been perceived as the central bank’s policy since the hasty, Fed-organized, Wall Street-financed bailout of the hedge fund Long-Term Capital Management in 1998: If those consequences were serious enough to impact the entire financial system, the Fed might indeed have broader obligations that might require intervention. It was precisely this view that influenced his thinking in protecting Bear Stearns.

By this year’s conference the Bernanke Doctrine had come under attack. As Bernanke, looking exhausted, sat slumped at a long table in the lodge’s wood-paneled conference room, speaker after speaker stood up to criticize the Fed’s approach to the financial crisis as essentially ad hoc and ineffective, and as promoting moral hazard. Only Alan Blinder, once a Fed vice chairman and a former Princeton colleague of Bernanke’s, defended the Fed. Blinder told this tale:

One day a little Dutch boy was walking home when he noticed a small leak in the dike that protected the people in the surrounding town. He started to stick his finger in the hole. But then he remembered the moral hazard lesson he had learned in school… . “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout, and doing so would just encourage more shoddy construction. Besides, the foolish people who live here should never have built their homes on a floodplain.” So the boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned—including the little Dutch boy.

Perhaps you’ve heard the Fed’s alternative version of this story. In this kinder, gentler version, the little Dutch boy, somewhat desperate and worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. It was painful and not guaranteed to work—and the little boy would rather have been doing other things. But he did it anyway. And all the people who lived behind the dike were saved from the error of their ways.

The previous day, Bernanke, in his address to the symposium, had made a plea to move beyond a finger-in-the-dike strategy by urging Congress to create a “statutory resolution regime for nonbanks.”

“A stronger infrastructure would help to reduce systemic risk,” Bernanke noted.

It would also mitigate moral hazard and the problem of “too big to fail” by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention.

A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.

Bernanke did not mention Fannie or Freddie, but their fate was on the minds of many at Jackson Hole. That Friday Moody’s cut its ratings on the preferred shares of both companies to just below the level of non-investment grade, or junk. Expectations increased that Treasury would have to pull the trigger and put capital in Fannie and Freddie.

Jackson Hole also had, of course, long been a popular destination for the very wealthy. James Wolfensohn, the former Schroder’s and Salomon Brothers banker who became president of the World Bank, was one of Jackson Hole’s celebrity residents, and during the 2008 symposium he held a dinner at his home. In addition to Bernanke the guest list included two former Treasury officials, Larry Summers and Roger Altman, as well as Austan Goolsbee, an economic adviser to Barack Obama, who was about to be officially nominated as the Democratic candidate for president.

That night Wolfensohn posed two questions to his guests: Would the credit crisis be a chapter or a footnote in the history books? As he went around the table and surveyed opinions, everyone agreed that it would probably be a footnote.

Then, Wolfensohn asked: “Is it more likely that we’ll have another Great Depression? Or will it be more of a lost decade, like Japan’s?” The consensus answer among the dinner guests to that question was that the U.S. economy would probably have a prolonged, Japan-like slump. Bernanke, however, surprising the table, said that neither scenario was a real possibility. “We’ve learned so much from the Great Depression and Japan that we won’t have either,” he said assuredly.

“We’ve made a decision,” Paulson announced to his team and advisers in a conference room at Treasury the last week of August about the fate of Fannie and Freddie. “They can’t survive. We have to fix this if we are going to fix the mortgage market.”

Upon his return to Washington from Beijing, Paulson had spent a day listening to presentations from Morgan Stanley and others and had decided that they had no choice but to take action, especially as he watched the shares of both companies continue to slide. To Paulson, unless he solved Fannie and Freddie, the entire economy would be in jeopardy.

Morgan Stanley had spent the past three weeks working on what was internally called “Project Foundation.” Some forty employees had been assigned to the task, working nights and weekends. “It’s easier in jail,” complained Jimmy Page, an associate. “At least you get three meals a day and conjugal visits.”

The firm had undertaken a loan-by-loan analysis of the portfolios of the two mortgage giants, shipping reams of mortgage data from Fannie and Freddie off to India, where some thirteen hundred employees in Morgan’s analytic center went through the numbers on every single loan—nearly half the mortgages in the entire United States.

The Morgan Stanley bankers had also conducted a series of phone calls with investors to get a better sense of the market’s expectations. The outcome was, as Dan Simkowitz described it to the Treasury team: “The market cares what the Paulsons think. John Paulson and Hank Paulson. They want to know what John Paulson thinks is enough and they want to know what Hank Paulson is going to do.” (John Paulson was the most successful hedge fund investor of the past two years, having shorted subprime before anyone else, making some $15 billion for his investors and personally taking home more than $3.7 billion.)

The Morgan Stanley bankers estimated that the two mortgage companies would need some $50 billion in a cash infusion, just to meet their capital requirement, which should be equal to 2.5 percent of their assets; banks, at a minimum, had to have at least 4 percent. With the housing market deteriorating it was clear that the GSEs’ thin capital cushion was in danger.

Worse, Paulson had heard rumors when he was in China that Russia had approached some Chinese officials to suggest that both countries start selling large amounts of Freddie and Fannie debt to force the United States to prop them up. Jamie Dimon had separately called him and encouraged him to take decisive action.

Paulson led a discussion around the table at Treasury about whether it made sense to put Fannie and Freddie in Chapter 11 bankruptcy protection or whether conservatorship—in which the companies would still be publicly traded with the government as a trustee exercising control—was the better option.

Ken Wilson was a bit anxious about pursuing what Paulson was describing as a “hostile takeover” without more professional guidance. “Hank, there is no fucking way we can pursue these kinds of alternatives without getting a first-rate law firm,” Wilson told him.

“Okay,” Paulson agreed. “So what do you think?”

“Let me call Ed Herlihy at Wachtell and see if he’ll do it,” Wilson said. “The idea of putting these guys in Chapter 11 is a joke. These are still privately owned entities with obligations to shareholders and bondholders. It’s going to get ugly.”

Wilson had a compelling reason for having recommended Herlihy: He had been involved in some of the biggest takeover battles in corporate America. Earlier in the year he had helped advise JP Morgan Chase in its acquisition of Bear Stearns. His firm—Wachtell, Lipton, Rosen & Katz—was synonymous with corporate warfare. One of its founding partners, Martin Lipton, had devised among the most famous of antitakeover defenses, the “poison pill.” If Treasury was planning a government-led hostile takeover—the first in history—then Herlihy was certainly the lawyer they wanted.

They began their battle plans on the weekend of August 23. Herlihy and a team of Wachtell, Lipton lawyers came to Washington on a half dozen different Delta and US Airways shuttles in order not to arouse suspicion. Paulson walked them through the game plan, assisted by Dan Jester, the lanky Texan who had joined Treasury less than a month earlier. The hope was that like megamergers that are often completed over the course of a single three-day weekend to protect against a leak impacting the stock market, they could take Fannie and Freddie over during the Labor Day holiday, which was the following weekend.

The lawyers and the Treasury officials spent several hours debating possible tactics, relevant statutes, and the structures of each of the companies. Jester and Jeremiah Norton, another staffer at Treasury, outlined a plan to put capital into Fannie and Freddie, and an actual mechanism to take control of them, via the purchase of preferred stock and warrants.

But Paulson soon realized that the Labor Day target was going to be impossible. One of the lawyers had noticed that Fannie’s and Freddie’s regulator from the Federal Housing Finance Agency, James Lockhart, had written letters to both companies over the summer saying that they were considered adequately capitalized. “You’ve got to be kidding me,” Paulson replied when he heard about the letters. Treasury could face resistance from the GSEs’ supporters in Congress and from the companies themselves if the government were to reverse itself apparently arbitrarily. The companies’ claims that they were well capitalized and the regulator’s endorsement would both have to be challenged.

“That’s intangibles and all the stuff that I would call bullshit capital,” Paulson complained.

“We need to reconstruct the record,” Jester announced about the Federal Housing Finance Agency letters.

“Right, right,” Herlihy chimed in. “We need new letters that are pretty bad—or at least accurate.”

The Federal Reserve was then asked to provide examiners, and they would spend the next two weeks going through the books, desperately trying to document the capital inadequacies at Fannie and Freddie.

As the Treasury team went around the table, one issue kept getting raised about pushing forward with a takeover: What if the boards of the two companies resisted?

“Look, trust me,” Paulson said. “You don’t believe me, but I know boards, and they’re going to acquiesce. When we get done talking with them, they’ll acquiesce.”

On the morning of Tuesday, August 26, Paulson walked over to the White House and was escorted downstairs to the basement of the West Wing, where he was given a seat in the five-thousand-square-foot Situation Room. At 9:30 President Bush was beamed onto one of the large screens from his ranch in Crawford, Texas, for a secured videoconference with Paulson. After some brief pleasantries, Paulson laid out his plan to mount the equivalent of a financial invasion on Fannie and Freddie. Bush told him he could proceed with the preparations.

As Labor Day weekend approached, the Treasury team and its advisers started to plot the actual details of the dual takeover. They knew they would have to move quickly, with military precision, and in secrecy before the GSEs could start rallying their supporters in Congress. They wrote scripts specifying exactly what they would tell the companies and their boards. They wanted to make certain that there could be no compromises, no delays. Internally, Treasury officials talked about offering Fannie and Freddie two doors: “Door 1, you cooperate; Door 2, we’re doing it anyway.”

On Thursday morning, August 28, Bob Willumstad and AIG’s head of strategy, Brian Schreiber, walked into JP Morgan’s headquarters at 270 Park Avenue and, escorted by a security guard, were taken by private elevator to the firm’s executive floor, where they had an appointment with Jamie Dimon.

Passing through the main glass doors into a wood-paneled reception area, Willumstad and Schreiber took in the newly renovated offices on the forty-eighth floor. As the two men sat waiting, Willumstad knew his associate was silently irate. Schreiber had been working throughout August on various plans to raise capital and extend the company’s credit lines to avoid facing a cash crunch if the market were to worsen. As part of his efforts he had held a bakeoff among a number of banks and had been unimpressed with JP Morgan’s pitch—and he was still smarting from the firm’s aggressive attitude when they raised capital for AIG in the spring. He had hoped to use Citigroup and Deutsche Bank, but Willumstad had insisted that they consider JP Morgan. The way things were playing out, if things really did get much worse, Willumstad figured he’d rather be dealing with an ally in Dimon, even if his colleague felt otherwise.

The AIG executives were escorted to Dimon’s office, which actually consists of an office with a desk, a sitting room, and a conference room. In the conference area Dimon, Steve Black, co-head of the investment bank, Ann Kronenberg, and Tim Main took their places around a wood table with a whiteboard behind them.

After some small talk, Dimon thanked them for coming, and Main, who headed the bank’s financial institutions group, launched into his pitch for why AIG should use JP Morgan. Main pointed out his group’s number one ranking in the latest league underwriting tables and noted its work in helping CIT Group issue two equity offerings worth $1 billion.

“That’s a dubious achievement to cite,” Willumstad later commented to Schreiber, “given that shares of CIT were trading below $10 [in August 2008] when they were more than four times that a year ago.” All in all, however, it was a fairly standard pitch from a Wall Street banker, the kind everyone in the room had heard dozens, if not hundreds, of times before: We’re the best suited to help you, we have the most talent, the most resources; we understand your needs better than anyone else.

But then Main concluded with a not-so-subtle dig at AIG and his past experience with the company. He pointed out that JP Morgan had a lot to offer but stressed that it was important that its clients recognize their own problems and shortcomings. Many in the room, including Dimon, were taken aback.

“Forget Mr. Obnoxious,” Dimon said, cutting Main off. But the damage had been done, and the AIG executives were clearly upset, Willumstad finding the performance annoying while Schreiber thought it was offensive. After a few minutes they shrugged the comment off and resumed their talks with Dimon directly, as an embarrassed Main slumped in his chair.

“Jamie, one of my concerns here is that there’s a higher probability now that we’re going to get downgraded,” Willumstad explained. “The rating agencies promised me they would wait until the end of September, but then the Goldman report came out and they got nervous,” he said, referring to an analyst report issued by Goldman Sachs raising questions about the firm. The report was so influential that Willumstad had received a call from Ken Wilson and Tony Ryan at Treasury to check up on the company.

“Maybe you should just take the downgrade. It’s not the end of the world,” Dimon suggested.

“No, this is not just a downgrade,” Willumstad insisted. As the company had warned in an SEC filing several weeks earlier, a downgrade would be very expensive. If either Standard & Poor’s or Moody’s lowered its rating by one notch, AIG would be required to post $10.5 billion in additional collateral; if both agencies lowered their ratings, the damage would soar to $13.3 billion. As part of its contract to sell credit default swaps, AIG was required to maintain certain credit ratings—or add new collateral to compensate—as insurance against its potential inability to pay out any claims on the swaps. AIG was now a AA-minus company, and it was facing a tab that was growing quickly. Its executives were estimating that the firm could soon be hit with demands for as much as $18 billion in additional collateral.

Left unspoken was the fact that if AIG could not come up with the cash, bankruptcy was the only alternative.

As Dimon saw it, this was a short-term liquidity problem. “You have a lot of collateral, you know, you have a trillion-dollar balance sheet, you have plenty of securities,” he told them. Yes, it could get much worse, but for now, it was just a temporary annoyance.

“We do,” Willumstad agreed, “but it’s not that simple. Most of the collateral is in the regulated insurance companies.”

By midyear AIG had $78 billion more in assets than it had in liabilities. But most of those assets were held by its seventy-one state-regulated insurance subsidiaries, which could not be sold easily by the parent company. There is no federal regulation or supervision of the insurance business. Instead, state insurance commissioners and superintendents have substantial powers to regulate and restrict an insurer’s asset sales. The responsibility of the state regulator at all times is to protect the policy-holder. There was virtually no possibility that AIG would be able to raise cash quickly by selling some of these assets.

Now Dimon finally understood the scope of the problem, as did everyone else in the room.

Just as they were walking out, Dimon pulled Willumstad aside. “Listen, you don’t have the luxury of time,” he told him. “If it’s not us, get someone else, but you need to get on this.”

The next day, Willumstad followed up on the meeting.

“Jamie, this is only going to work if there is chemistry on both sides,” Willumstad began. “With all due respect, I know you guys have a lot of confidence in Tim Main, but the reality is, you saw what I saw.”

Dimon knew exactly what Willumstad was about to say and interrupted him with, “Steve Black will handle it.”

“Good,” Willumstad replied.

“You got to plan on packing your clothes and coming up,” Ken Wilson told Herb Allison, the former Merrill Lynch and TIAA-CREF executive whom he located on a beach in the Virgin Islands on Thursday night and let in on the big secret: The government planned to take over Fannie and Freddie that coming weekend, September 6.

It wasn’t just a social call, however; Wilson had phoned Allison to hire him as the CEO of Fannie. After all, if they were going to take over the company, they wanted to install their own management.

“Look, Ken,” Allison told him. “I would like to. For reasons of public service, I’m interested in this job. I want to help you guys, and so you have to let me know what to do. I don’t have any clothes. All I have is shorts and flip-flops.” Wilson promised to buy him some clothes when he arrived in Washington.

Paulson had decided to execute the takeover plan earlier in the week after a visit by Richard Syron, the chief executive of Freddie Mac. Syron, whom Paulson detested, told him that he had gone to Goldman Sachs’ headquarters to pitch potential investors but several days of meetings proved to be in vain: No one was willing to make a significant investment in the company. Paulson’s conversation with Dan Mudd, Fannie Mae’s CEO, whom Paulson liked better, still wasn’t inspiring.

And so on the night of Thursday, September 4, Treasury began its battle plan.

Like clockwork, the chief executives of Fannie and Freddie were instructed to attend meetings on Friday afternoon with Paulson and Bernanke at the offices of the Federal Housing Finance Agency. Mudd’s meeting would start at 3:00; Syron’s at 4:00. They were each advised to bring their lead director, but told nothing else. Paulson figured that by the time any of this could leak, the markets would be closed and he’d have forty-eight hours to execute his plan.

That afternoon, dark rain clouds massed over the capital as Tropical Storm Hanna approached. In an upstairs conference room Bernanke took a seat on one side of James Lockhart while Paulson took his place on the other. At each meeting, James Lockhart began by telling the Fannie and Freddie executives and their lawyers that their companies faced such potentially great losses that they could not function and fulfill their mission. The FHFA, he said, reading from his prepared script, was acting “rather than letting these conditions fester.”

The businesses would be put into conservatorship, he explained, and while they would still be private companies with their shares listed, control over them would be in the hands of the FHFA. Existing management would be replaced. There would be no golden parachutes.

“I want to be fair, open, and honest,” Paulson told them. “We’d like your cooperation. We want you to consent.” But then he added, “We have the grounds to do this on an involuntary basis, and we will go that course if needed.” Syron capitulated quickly, calling his board and breaking the bad news to them.

Fannie’s CEO, Daniel Mudd, wasn’t so easy. He and his lawyers retreated to Sullivan & Cromwell’s Washington office. The attorneys were furious, and Rodgin Cohen, usually an entirely self-possessed man, called Ken Wilson at Treasury directly and shouted, “Ken, what is going on here? This is bullshit!”

When Fannie executives began calling around for support from lawmakers on the Hill they discovered that Paulson and Treasury had already secretly lobbied them on the wisdom of a takeover. For Democrats, the pitch was that the step had to be taken to keep the system of mortgage financing functioning, while for Republicans the emphasis was on the systemic risk that Fannie and Freddie posed.

Fannie’s lawyers summoned all the members of the board to Washington for a meeting at the FHFA the following day. Treasury had made it clear that it wanted only board members present—Fannie could not bring its banking adviser, Goldman Sachs, to the gathering.

At noon on Saturday the lawyers—Beth Wilkinson, Rodgin Cohen, and Robert Joffe of Cravath, Swaine & Moore, who were advising Fannie’s board—accompanied the entire thirteen-member board, who crowded into the same small room at FHFA as had been used the day before when Treasury presented its terms: It would acquire $1 billion of new preferred senior shares in each company, which would give it 79.9 percent of the common shares of each. The government would contribute as much as $200 billion into both companies if necessary. The terms were nonnegotiable.

The meeting ended quickly, and the Fannie directors left to deliberate. Wilkinson realized that she would have to cancel a birthday dinner she had planned for her husband, David Gregory of NBC News. Late that Saturday night the board of Fannie Mae finally voted to give its assent. Paulson was awoken at 10:30 that night by a call from Barack Obama, the Democratic presidential candidate. Earlier that day, on a campaign stop in Indiana, Obama had said about the Fannie and Freddie situation that “any action we take must be focused not on the whims of lobbyists and special interests worried about their bonuses and hourly fees, but on whether it will strengthen our economy and help struggling homeowners.” Obama and Paulson spoke for nearly an hour.

After the takeover was announced on Sunday, there was palpable relief among the Treasury staffers who had been working on it for weeks. They had accomplished something that they were convinced would go a long way toward stabilizing the financial system. The markets would steady now that a major source of uncertainty had been removed. They had hit a home run.

Paulson, however, still had one pressing concern: Lehman Brothers.

Ken Wilson, with a free afternoon on his hands for the first time since he had started working for Paulson, left Treasury and walked to his apartment, and then to a pub in Georgetown to have dinner while watching a football game.

That night he checked his voice mail to find several messages from Dick Fuld.

When he returned the call, Fuld told him how thrilled he was about the Fannie and Freddie news, hoping it would calm the markets. But he was distraught over the lack of deals available to him. The Korean situation seemed doomed. Bank of America was nowhere. Fuld said that the firm was planning to pursue a good bank-bad bank strategy, in which he hoped to spin off the firm’s toxic real estate assets into a separate company. Stephen Schwarzman, the co-founder of Blackstone Group and a former Lehman banker, had just had a blunt conversation with Fuld. “Dick, this is like cancer. You’ve got to lop off the bad stuff. You need to get back to the old Lehman,” he told him.

Wilson, getting nervous that the spin-off plan wouldn’t be enough, told Fuld, “You have to really think about doing what’s right for the firm,” trying politely to suggest that he needed to sell the firm without actually using the word.

“What do you mean?” Fuld asked.

“If your stock price continues to slide, something might come out of the woodwork here with a price that doesn’t look that compelling. But you might have to take it to keep the organization intact.”

“What do you mean, low price?”

“It could be low single digits.”

“No fuckin’ way,” Fuld said heatedly. “Bear Stearns got $10 a share, there’s no fuckin’ way I will sell this firm for less!”