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

CHAPTER SEVENTEEN

When Tim Geithner began his run on Wednesday morning along the southern tip of Manhattan and up the East River just after 6:00, the sun had yet to come up. He was tired and stressed, having slept only several hours in one of the three tiny, grubby bedrooms in the New York Fed’s headquarters.

As he stared at the Statue of Liberty and the first of the morning’s commuter ferries from Staten Island gliding across the harbor, he tried desperately to clear his mind. For five days his brain had been trapped in a maze of numbers—huge, inconceivable, abstract numbers, ranging in the span of twenty-four hours from zero for Lehman to $85 billion for AIG. Eighty-five billion dollars was more than the annual budgets of Singapore and Taiwan combined; who could even begin to understand a figure of that size? Geithner hoped the sum was sufficient—and that the crisis would finally be over.

Those ferries, freighted with office workers, gave him pause. This is what it is all about, he thought to himself, the people who rise at dawn to get in to their jobs, all of whom rely to some extent on the financial industry to help power the economy. Never mind the staggering numbers. Never mind the ruthless complexity of structured finance and derivatives, nor the million-dollar bonuses of those who made bad bets. This is what saving the financial industry is really about, he reminded himself, protecting ordinary people with ordinary jobs.

But as he passed the South Street Seaport and then under the Brooklyn Bridge, he had inadvertently begun thinking about what fresh hell the day would bring. He was most anxious about the latest shocking development: A giant money market fund, Reserve Primary Fund, had broken the buck a day earlier (which meant that the value of the fund’s assets had fallen to below a dollar per share—in this case, 97 cents). Money market funds were never supposed to do that; they were one of the least risky investments available, providing investors with minuscule returns in exchange for total security. But the Reserve Primary Fund had chased a higher yield—a 4.04 percent annual return, the highest in the industry—by making risky bets, including $785 million in Lehman paper. Investors had started liquidating their accounts, which in turn forced managers to impose a seven-day moratorium on redemptions. Nobody, Geithner worried, knew just how extensive the damage could end up being.

Between the money-market funds being under pressure, Geithner thought, and billions of dollars of investors’ money locked up inside the now-bankrupt Lehman Brothers, that means only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

The panic was already palpable in John Mack’s office at Morgan Stanley’s Times Square headquarters. Sitting on his sofa with his lieutenants, Chammah and Gorman, drinking coffee from paper cups, he was railing: The major news on Wednesday morning, he thought, should have been the strength of Morgan Stanley’s earnings report, which he had released the afternoon before, a day early, to stem any fears of panic about the firm following the Lehman debacle. His stock had fallen 28 percent in a matter of hours on Tuesday, and he decided he needed to do something to turn it around. The quarterly earnings report had been a good one—better than that of Goldman Sachs, which had announced their earnings Tuesday morning and also had suffered, but not nearly as much. Morgan had reported $1.43 billion in profits, down a mere 3 percent from the quarter a year earlier. But the headline on the Wall Street Journal was gnawing at him: “Goldman, Morgan Now Stand Alone; Fight On or Fold?” And as the futures markets were already indicating, his attempt to show strength and vitality had largely failed to impress.

Apart from the new anxiety about money market funds and general nervousness about investment banks, he was facing a more serious problem than anyone on the outside realized: At the beginning of the week, Morgan Stanley had had $178 billion in the tank—money available to fund operations and to lend to their major hedge fund clients. But in the past twenty-four hours, more than $20 billion of it had been withdrawn, as hedge fund clients demanded it back, in some cases closing their prime brokerage accounts entirely.

“The money’s walking out of the door,” Chammah told Mack.

“Nobody gives a shit about loyalty,” Mack railed. He had wanted to cut off the flow of funds, but up until now had been persuaded by Chammah to keep wiring the balances. “To put the gates up,” Chammah warned, “would be a sign of weakness.”

The question was, how much more could they afford to let go? “We can’t do this forever,” Chammah said.

While Mack was beginning to believe the hedge funds were conspiring against the firm—“This is what they did to Dick!” he roared—there was fresh evidence that some of them actually did need the cash. Funds that had accounts at Lehman’s London office couldn’t get at them and came begging to Morgan Stanley and Goldman.

As far as Mack was concerned, they needed to keep paying out money. He had spent years building their prime brokerage business into a major profit center—eighty-nine of the top one hundred hedge funds in the world traded through Morgan Stanley. It was essential in the midst of a crisis that the firm not display even the slightest sign of panic, or the entire franchise would be lost.

“We are confident,” he said. “We cannot be weak, and we cannot be confused.”

Under normal circumstances, John Mack could be unflappable. The previous day he’d even been out on the floor, as was his habit, chatting with traders and eating a slice of pizza. But in his office that morning, he was starting to come unwound. There was just too much to do, too many options to explore, too many things to worry about.

The night before, he’d received a call from his old friend Steven R. Volk, a vice chairman at Citigroup and former lawyer who years earlier had helped Mack engineer the merger with Dean Witter. Now Volk, ostensibly calling to offer congratulations on the earnings reports, quietly planted the seed of another merger—with Citi.

“Look, John, we’re here for you. We’re not aggressive. And if you want to do something strategically to put us together, we would like to talk to you,” Volk said.

It was potentially explosive news. A merger between Morgan Stanley and Citigroup would be like combining Microsoft and Intel.

Mack, Chammah, and Gorman batted around the idea. Given the pressure on the broker-dealer model, merging with Citigroup would give it a stable base of deposits. JP Morgan and Citigroup were the only two left of the big, strong banks.

They had all heard about Bank of America’s conference call on Monday regarding its deal with Merrill Lynch and couldn’t ignore Ken Lewis’s comments all but declaring the broker-dealer model officially dead.

“For seven years, I’ve said that the commercial banks would eventually own the investment banks because of funding issues,” Lewis said. “I still think that. The Golden Era of investment banking is over.”

Gorman, at least for the moment, was thinking that he might well be right. “Do you think we should call Citigroup back?” he asked.

Mack nodded and asked his assistant to phone Vikram Pandit’s office. The two men knew each other well—Pandit, then at Morgan Stanley, had been given a big promotion by Mack in 2000—but had never been particularly close.

“Steve tells me you want to do a deal,” Mack said when Pandit got on the line. “It’s tough out there,” Mack continued. “We’re looking at our options.”

“Well, we’d like to be helpful,” Pandit said, “and this could be the time to do something.”

But before he got too far he said, “I’ll come back to you. I need to talk to my board.”

The black and orange screen flickered as Hank Paulson skimmed the updates about the Reserve Primary Fund on his Bloomberg terminal. With $62.6 billion in assets, the fund was a major player, and as a result of its troubles, doubt, he could see right in front of him, was starting to spread throughout the rest of the field.

“We’ve got an emergency,” Ken Wilson said, coming into Paulson’s office and ticking off a list of panicked CEOs who had begun phoning him that morning at 6:30: Larry Fink of BlackRock, Bob Kelly of Bank of New York Mellon, Rick Waddell of Northern Trust, and Jim Cracchiolo at Ameriprise.

“They’re telling me people are clamoring for redemptions. Hundreds of billions of dollars where people want out!” Wilson said. “People are concerned about anyone who has any exposure to Lehman paper.”

Paulson fidgeted nervously. The Lehman-induced panic was spreading like a plague, the black death of Wall Street. The money market industry needed to be shored up. Wilson also told him that he was hearing that Morgan Stanley was coming under pressure from hedge funds seeking redemptions as well. And if Morgan Stanley were to go, Goldman, the firm where both had spent their entire careers, would likely be next in line.

“Another day, another crisis,” Paulson said with a nervous laugh that betrayed an uneasy sense that he was truly beginning to panic himself.

Paulson’s instinctive response had been serial deal making—the private sector’s solution to systemic problems. Firms consolidated, covered one another’s weaknesses.

But this situation didn’t feel normal, in that respect; behind every problem lurked another problem. He may have been praised for not bailing out Lehman, but he could see now that the unintended consequences had been devastating. The confidence that had supported the financial system had been upended. No one knew the rules of engagement anymore. “They pretended they were drawing a line in the sand with Lehman Brothers, but now two days later they’re doing another bailout,” Nouriel Roubini, a professor at New York University’s Stern School of Business, complained that morning.

And now he could understand it: commercial paper and money markets—that was his bread and butter, Goldman’s specialty. The crisis was hitting close to home.

Across town, Kevin Warsh, a thirty-eight-year-old governor at the Federal Reserve, whose office was a few doors down from Bernanke’s, was having his own worries.

He was just finishing up a conference call with Bernanke and central bankers in Europe and Asia in which they explained what they had just done with AIG. Jean-Claude Trichet, the president of the European Central Bank, had been furious with them for their decision to “let Lehman fail” and was lobbying Bernanke to go to Congress to implement a large government bailout for the entire industry, to restore confidence.

But Warsh was nervous about a different issue: Morgan Stanley, where he had worked as an M&A banker before leaving seven years earlier to become special assistant to the president for economic policy. He could tell that his former firm was quickly losing confidence in the marketplace. To him, there was an obvious solution to its problems: Morgan Stanley needed to buy a large bank with deposits. His top choice? Wachovia, a commercial bank with a large deposit base that itself was struggling. Wachovia’s 2006 acquisition of Golden West, the California-based mortgage originator, was turning into a catastrophe, saddling the bank with a giant pile of bad debt that was beginning to reveal itself.

Given that no one at Treasury was allowed to talk to Bob Steel now that he had become CEO of Wachovia, worrying about that firm had become Warsh’s responsibility. And he increasingly had more to worry about: as a former deal maker himself, he knew that Wachovia, too, needed a partner desperately and he just might have to play the role of matchmaker. There is no way the bank will make it on its own, he thought.

But like Paulson with Goldman, Warsh had his own conflict-of-interest problem with Morgan Stanley, so he sought out Scott Alvarez, the Fed’s general counsel, and requested a letter clearing him to make contact with his former employer, based on an “overwhelming public interest.”

Warsh contacted Steel and instructed him to call Mack in twenty minutes, which left him enough time to give Mack a heads-up.

Warsh then called Geithner and asked, “Do you want me to call John? Or do you want to call John?”

They decided to call him together.

Despite its terminal illness, Lehman Brothers was bustling with activity. Legions of sleep-deprived, depressed traders, lawyers, and other employees were still working the phones and doing what they had to do before closing up the shop. Fresh in their minds was the memo that Dick Fuld had sent out the previous night: “The past several months have been extraordinarily challenging, culminating in our bankruptcy filing,” he wrote. “This has been very painful on all of you, both personally and financially. For this, I feel horrible.” To some angry employees, it was an extraordinary understatement that called to mind Emperor Hirohito’s famous surrender broadcast on August 15, 1945, when he told a stunned nation that “the war situation has developed not necessarily to Japan’s advantage.”

But later that day, Bart McDade, Skip McGee, and Mark Shafir, working off of four hours’ sleep in three days, were able to announce a welcome bit of good news: Though it was far too late to save the entire firm, Lehman had an agreement to sell its U.S. operations for $1.75 billion. The buyer was Barclays, Lehman’s onetime would-be savior, which ended up getting the part it wanted without having to acquire the whole firm. The deal would allow at least some of Lehman’s ten thousand employees in the United States to keep their jobs.

As McDade, McGee, and Shafir walked the floors, some employees stood up to applaud.

Mack knew what Bob Steel was calling about, and he was happy to speak with him. Both men were graduates of Duke and members of the university board, and not long after Steel had taken over at Wachovia, Mack had gone down to see him in Charlotte, to pitch Morgan Stanley as an adviser. No business had come out of the meeting—the bank had Goldman to help them sort through the Golden West quagmire—but the men realized they spoke the same language and agreed to stay in touch.

“Very interesting times,” Steel now said. “I imagine you’ve already heard from Kevin. He told me he thought we should connect.”

Steel went on, intentionally keeping the discussion vague until he gauged Mack’s intentions. “There might be an opportunity for us. We’re thinking about a lot of things. I think this could be the right time to talk. But we’d need to move fast.”

“I could see something,” Mack replied, intrigued but noncommittal. “What’s your timing?”

“We’re moving in real time,” Steel said.

Considering the meltdown in the markets, Mack thought it was at least worth talking. For Steel, a Morgan Stanley deal happened to be both commercially and personally attractive. All the tumult within the firm had left Mack without a clear successor. While he may not have wanted Mack’s job immediately, their mutual friend Roy Bostock, a Morgan Stanley board member, had privately hinted to Steel that a deal between Morgan Stanley and Wachovia could present an elegant solution to Morgan’s succession problems down the road. This could be Steel’s big opportunity to finally run a top Wall Street firm.

After speaking with Steel, Mack called Robert Scully, his top deal maker, and told him about the conversation. Scully had his doubts; he didn’t know much about Wachovia’s books, but what he did know alarmed him. He agreed, however, that at this point, no options could be automatically ruled out. Besides, Wachovia had one of the biggest, most solid deposit bases in the country, an extremely attractive feature as Morgan Stanley was watching its cash fly out the door.

Scully in turn called Rob Kindler, a vice chairman, to tell him that Dave Carroll, Wachovia’s head of business development, was coming to meet them on Thursday and get things started.

In the relatively straitlaced banker culture of Morgan Stanley, Kindler was an outlier—loud, indiscreetly blunt, and predisposed to threadbare old suits. In the 1990s, he had been a star lawyer at Cravath, Swaine & Moore, but he always preferred banking. He left law and originally joined JP Morgan. (A constant prankster, he soon had hats made with the slogan, “One Firm, One Team, Bribe a Leader,” mocking JP Morgan’s slogan of “One Firm. One Team. Be a Leader.”) Despite his idiosyncrasies, when it came to deal making, his advice was highly valued. Kindler didn’t initially like the notion of a Wachovia merger either, he told Scully, and took a reflexively cynical view: “Let’s put this in context for a moment: Bob Steel comes from Goldman; Wachovia’s investment bankers are Goldman; Paulson is obviously from Goldman. The only reason we’re having this meeting with Wachovia is because Goldman won’t do the deal!”

Scully had been thinking much the same thing but hadn’t been willing to say so. “I don’t know,” he said. “Seems like a bad idea.”

But Kindler couldn’t help himself and soon began to wrap his brain around the possibilities of the deal. “It could be good for us,” he told Scully. “It brings us a deposit base; a regional banking franchise. Let’s see how it plays out.”

Scully and Kindler got Jonathan Pruzan, co-head of Morgan Stanley’s financial institutions practice, to start running the numbers on Wachovia. The obvious concern was its gargantuan subprime exposure, some $120 billion worth. As the Wachovia due diligence got under way, Mack got a call back from Vikram Pandit, delivering what amounted to a soft no on the merger talks. “The answer is no. The timing isn’t right, but at some point we’d like to do something.”

Mack clicked off, exasperated. Wachovia was nobody’s idea of a dream date, but at the moment, it was the only girl at the dance.

“This is an economic 9/11.”

There was chilling silence in Hank Paulson’s office as he spoke. Nearly two dozen Treasury staffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge of Paulson’s desk, scribbling on legal pads. Looming over them was a portrait of Alexander Hamilton, a copy of a portrait painted in 1792, when the young nation endured its first financial panic. A Treasury associate, William Duer, who also happened to be a personal friend of Hamilton’s, had used inside information to build up a huge position in government securities. When bond prices slid, Duer could not cover his debts, setting off a panic. Hamilton decided against bailing out his friend but did direct the Treasury to buy government securities, steadying the market—a long-forgotten but potentially instructive model of government intervention.

Paulson was seated in a chair in the corner, slouching, nervously tapping his stomach. He had a pained look on his face as he explained to his inner circle at Treasury that in the past four hours, the crisis had reached a new height, one he could only compare with the calamity seven years earlier, almost to the week. While no lives may have been at stake, companies with century-long histories and hundreds of thousands of jobs lay in the balance.

The entire economy, he said, was on the verge of collapsing. He had been on the phone that morning with Jamie Dimon, who had expressed his own anxiety. Paulson was no longer worried just about investment banks; he was worried about General Electric, the world’s largest company and an icon of American innovation. Jeffrey Immelt, GE’s CEO, had told him directly that the conglomerate’s commercial paper, which it used to fund its day-to-day operations, could stop rolling. He had heard murmurs that JP Morgan had stopped lending to Citigroup; that Bank of America had stopped making loans to McDonald’s franchisees; that Treasury bills were trading for under 1 percent interest, as if government-backed bonds were the only thing that investors could still trust.

Paulson knew this was his financial panic and perhaps was the most important moment of his tenure at Treasury, and possibly of his entire career. The night before, Bernanke and Paulson had agreed that the time had come for a systemic solution; deciding the fate of each financial firm one at a time wasn’t working. It had been six months between Bear and Lehman, but if Morgan Stanley went down, probably no more than six hours would pass before Goldman did, too. The big banks would follow, and God only knew what might happen after that.

And so Paulson stood in front of his staff in search of a holistic solution, a solution that would require intervention. He still hated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment.

“Nothing is breaking our way,” Paulson declared. “We can’t solve the problems of today; we need to think of tomorrow. We need to get ahead of this. It’s deepening, moving too quickly. This is the financial equivalent of war, and we’re going to need wartime powers.” They needed to start thinking about what kind of program they could put together, he said, and while he wasn’t sure that that approach would even be politically feasible, it had to be explored.

He told the staff that he knew and accepted that he would be subjected to an enormous amount of political flak; he had already been criticized for the bailout of AIG, with Barney Frank mockingly declaring that he was going to propose a resolution to call September 15—the day Lehman filed for bankruptcy—as “Free Market Day.” “The national commitment to the free market lasted one day,” Frank said. “It was Monday.”

Senator Jim Bunning, Republican from Kentucky, was decrying that “once again the Fed has put the taxpayers on the hook for billions of dollars to bail out an institution that put greed ahead of responsibility.” Richard Shelby, Republican from Alabama, added that he “profoundly disagrees with the decision to use taxpayer dollars to bail out a private company.”

The first order of business, Paulson said, was addressing the money market crisis. Steve Shafran, a former Goldman banker, suggested that the Treasury could simply step in and guarantee the funds. “We have the authority,” he said, citing the Gold Reserve Act of 1934, which set aside a fund, now totaling $50 billion, to stabilize essential markets. The key, Shafran said, was that all they needed to access it was presidential approval, bypassing Congress.

“Do it!” Paulson said, and Shafran slipped out of the room to put the process in motion.

There was, however, no such easy solution to begin stabilizing the banks. Phil Swagel, the wonky assistant secretary for economic policy, emphasized the necessity of being bold and not avoiding addressing the problems for fear of political fallout. “You don’t want to be running Japan,” he said.

Swagel and Neel Kashkari dusted off the ten-page “Break the Glass” paper they had prepared the previous spring: In the event of a liquidity crisis, the plan called for the government to step in and buy toxic assets directly from the lenders, thereby putting right their balance sheets and enabling them to keep extending credit. The authors knew that executing their plan would be complicated—the banks would fight furiously over the pricing of the assets—but it would keep the government’s involvement in the day-to-day businesses as minimal as possible, something conservatives strongly desired.

“This is what we should do,” Kashkari told Paulson. He had been involved in HOPE NOW, one of the government’s early efforts at helping distressed homeowners, and had learned firsthand how difficult it would be to get the banks making new loans as long as they were carrying bad loans on their balance sheets. On the speakerphone from New York, where he still was embroiled in the AIG situation, Paulson’s adviser Dan Jester argued that the purchasing of assets was too cumbersome and recommended instead that capital be injected directly into the institutions. “The more bang for your buck is to put capital in,” he said, explaining that even if the market continued to fall, it would help the banks manage the downturn.

The difficulty with that approach, countered Assistant Secretary David Nason, was the specter of nationalization. If the government put money into firms, it became a de facto owner, which is precisely what most of the people in the room wanted to avoid. “Are people going to think we’re going to AIG them?” he asked, already using the government’s investment less than twenty-four hours earlier as a verb. Paulson had liked the “Break the Glass” idea when it had first been presented to him and was now leaning to move in that direction. AIG was a disaster they couldn’t afford to repeat, and buying the assets maintained a clear border between government and the private sector. The job now was to begin preparing the outlines of legislation for Congress. They were going to need a ton of money, and they were going to need it immediately.

He assigned Kashkari and a team of staffers the task of fleshing out the idea; “Break the Glass” might have been an interesting document in theory, but it lacked details and was far from executable. He gave them twenty-four hours to fill them in.

Before ending the meeting, Paulson asked, “How much is this going to cost?”

Kashkari, who had originally estimated the expense at $500 billion back in the spring, said gravely, “It’s going to be more. I don’t know, maybe even double.”

Dismissing everyone with a warning that their conversation had been confidential, Paulson then called Geithner to compare notes. “You cannot go out and talk about big numbers with regard to capital needs for banks without inviting a run,” Geithner told him. “If you don’t get the authority, I’m certain you’ll spark a freaking panic. You have to be careful about not going public until you know you’re going to get it.”

By midafternoon Wednesday, Morgan Stanley’s stock had fallen 42 percent. The rumors were flying: The latest gossip had the company as a trading partner with AIG, with more than $200 billion at risk. The gossip was inaccurate, but it didn’t matter; hedge funds continued to seek nearly $50 billion in redemptions. Hoping to poach Morgan Stanley’s hedge fund clients, Deutsche Bank was sending out fliers with the headline: “DB: A Solid Counterparty.”

John Mack was meeting with his brain trust, already anticipating what had become a grim end-of-day ritual. At 2:45 p.m., hedge funds would start pulling money out of their prime brokerage accounts, asking for all the credit and margin balances. At 3:00, the Fed window would close, leaving the firm without access to additional capital until the following morning. Then, at 3:02, the spread on Morgan Stanley’s credit default swaps—the cost of buying insurance against the firm’s defaulting—would soar. Finally, its clearing bank, JP Morgan, would call and ask for more collateral to protect it.

“It’s outrageous what’s going on here,” Mack almost shouted, arguing that a raid on Morgan Stanley’s stock was “immoral if not illegal.” Intellectually he understood the benefit that shorts provide in the market—after all, many were his own clients—but at risk now was his own survival.

Colm Kelleher, Morgan Stanley’s CFO, was more fatalistic—the short-sellers couldn’t be stopped, he believed, or even necessarily blamed. They were market creatures, doing what they had to do to survive. “They are cold-blooded reptiles,” he told Mack. “They eat what’s in front of them.”

Mack had just gotten off the phone with one of his closest friends, Arthur J. Samberg, the founder of Pequot Capital Management, who had called about withdrawing some money.

“Look, if you want to take some money out, take money out,” Mack told him, frustrated.

“John, I really don’t want to do it, but my fund-to-funds accounts are saying I have too much exposure to Morgan Stanley,” he said, citing the rumors about its health.

“Take your money,” Mack told him, “and you can tell all your peers to take their credit balances out.”

Mack believed negative speculation was purposely being spread by his rivals and repeated uncritically on CNBC. He was so furious with the “bullshit coverage” that he called to complain to Jeff Immelt, the CEO of GE, which owned CNBC as part of its NBC Universal unit.

“There’s not a lot we can do about it,” Immelt could only say apologetically.

Tom Nides, Mack’s chief administrative officer, thought they needed to go on the offensive. Nides, a former CEO of Burson-Marsteller, the public relations giant, had been one of Mack’s closest advisers for several years, his influence so great that he had persuaded the lifelong Republican to support Hillary Clinton. He now encouraged Mack to start working the phones in Washington and impress upon them the need to instate a ban against short selling. “We’ve got to shut down these assholes!” he told Mack.

Gary Lynch, Morgan Stanley’s chief legal officer and a former enforcement chief at the SEC, volunteered to call Richard Ketchum, the head of regulation of the New York Stock Exchange, and put a bug in his ear about suspicious trading. “I’m in favor of free markets—and I’m in favor of free streets too, but when you have people walking down the streets with bats, maybe it’s time for a curfew,” he said.

Nides set up a series of phone calls for Mack, who also contacted Chuck Schumer and Hillary Clinton, pleading with them to call the SEC to press the case on his behalf. “This is about jobs, real people,” he told them.

After speaking with Christopher Cox, the head of the SEC, however, he was in an even fouler mood. Cox, a free-market zealot, seemed to Mack to be almost intentionally ineffectual, as if that were the proper role of government regulators. There was nothing he was going to do about the shorts, or about anything at all, for that matter.

Paulson, who was next on his call list, was clearly sympathetic to Mack’s cause to ban the short-sellers, but it was unclear whether he could do anything to help him. “I know it, John. I know it,” he said, trying to pacify him. “But this is for Cox to decide. I’ll see what I can do.”

Mack then contacted his most serious rival, Lloyd Blankfein of Goldman, desperate for an ally. “These guys are taking a run at my stock, they’re driving my CDS out,” Mack said frantically. “Lloyd, you guys are in the same boat as I am.” He then made a request of Blankfein: to appear on CNBC with him, as a show of force.

While Blankfein kept a television in his office, he was so disgusted with what he called Charlie Gasparino’s “rumormongering” that he turned it off in protest. “That’s not my thing,” he told Mack. “I don’t do TV.”

As Goldman wasn’t in total crisis mode, Blankfein explained, he was disinclined to join Mack in a war on the shorts until he absolutely needed to.

Making little progress, Nides had another, perhaps shrewder, angle to play. He could call Andrew Cuomo, the New York State attorney general, who badly needed a cause to resurrect his political fortunes. Nides had a hunch that he might be willing to put a scare into the shorts. It was an easy populist message to get behind: Rich hedge fund managers were betting against teetering banks amid a financial crisis. Everybody remembered what Eliot Spitzer had managed to do to Wall Street from the same platform.

When Nides reached Cuomo, he pitched on announcing an investigation of the shorts. Cuomo had voiced concerns about short-selling before, but this would be a shot across the bow. “If you do this,” Nides said, “we’ll come out and praise you.” Nides knew Mack would be reluctant—he’d be assailing his own clients—but this was a matter of survival.

Before the market closed, Mack sent the following e-mail to the entire staff.

To: All Employees

From: John Mack

I know all of you are watching our stock price today, and so am I. After the strong earnings and $179 billion in liquidity we announced yesterday—which virtually every equity analyst highlighted in their notes this morning—there is no rational basis for the movements in our stock or credit default spreads.

What’s happening out there? It’s very clear to me—we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down. You should know that the Management Committee and I are taking every step possible to stop this irresponsible action in the market. We have talked to Secretary Paulson and the Treasury. We have talked to Chairman Cox and the SEC. We also are communicating aggressively with our long-term shareholders, our counterparties and our clients. I would encourage all of you to communicate with your clients as well—and make sure they know about our strong performance and strong capital position.

“It’s ridiculous that I can’t deal with Goldman at a time like this!” Paulson complained to his general counsel, Bob Hoyt. He was supposed to take part in a 3:00 p.m. call with Bernanke, Geithner, and Cox to discuss Goldman Sachs and Morgan Stanley, but unless he could get a waiver, he would be unable to participate.

With Morgan Stanley on the ropes, Paulson had been growing increasingly worried about Goldman, and if Goldman were to topple, it would, he believed, represent a complete destruction of the system. He’d had enough of recusing himself. Part of him regretted signing the original ethics letter agreeing not to get involved in any matter related to Goldman for his entire tenure. At the time it had seemed a good-faith gesture to go above and beyond the typical one-year moratorium on dealing with former employers, but now, he thought, it had come back to bite him.

Geithner had raised this very issue back in March after the Bear Stearns deal. “You know, Hank, if another one of these banks goes,” he said, “I don’t know who would have the ability to take them over other than Goldman, and we have to do something about your waiver-recusal situation because I don’t know how we can do one of these without you.”

Given the extreme situation in the market, Hoyt told Paulson he thought it was only fair that he try to seek a waiver; Hoyt had, in fact, already even drafted the material needed to request one. As Paulson had sold all of his Goldman stock before he took office, Hoyt thought he could easily tell the Office of Government Ethics that Paulson had no conflict, apart from his remaining stake in Goldman’s pension plan, but that constituted only a small part of his overall wealth. After he turned sixty-five years old, Goldman would pay him $10,533 a year.

Paulson appreciated that the “optics” of receiving a waiver to engage with his former employer would only feed the continuing conspiracy theories about his efforts to help Goldman, but he felt he had no other choice. And he hoped it would remain a secret: He and Hoyt discussed keeping the existence of a waiver confidential.

Hoyt reached out to Fred F. Fielding, counsel to the White House and a longtime Washington hand who knew his way around the system, and to Bernard J. Knight Jr., the DAEO, or designated agency ethics official, at Treasury, who was attending a conference in Florida with another colleague from the White House ethics office. With virtually no pushback, given the gravity of the situation, they quickly accepted Hoyt’s recommendation.

“I have determined that the magnitude of the government’s interest in your participation in matters that might affect or involve Goldman Sachs clearly outweighs the concern that your participation may cause a reasonable person to question the integrity of the government’s programs and operations,” Knight wrote in an e-mail.

Fielding’s office made it official by having a copy of the formal waiver walked over to the Treasury Building. On White House letterhead, it began, “This memorandum provides a waiver… .

In your position as Secretary of the United States Department of the Treasury, you are responsible for serving the American people and strengthening national security by managing the U.S. Government’s finances effectively, promoting economic growth and stability, and ensuring the safety, soundness, and security of the United States and international financial systems.

You currently have an interest in a defined benefit pension plan through your former employers, the Goldman Sachs Group, Inc. Your total investment in this plan represents only a small fraction of your overall investment portfolio. For this reason, your financial interest in the plan is not so substantial as to be likely to affect the integrity of your services to the Government. With this waiver, you may participate personally and substantially in the particular matters affecting this defined benefit pension plan, including the ability or willingness of the Goldman Sachs Group, Inc. to honor its obligations to you under this plan.

Unknown to the public, Paulson was now officially free to help Goldman Sachs.

“Stop the insanity—we need a time out” was the subject line of Glenn Schorr’s e-mail. An analyst at UBS who covered the banking industry, Schorr had sent the missive to accompany his latest report to his clients on Wednesday afternoon. But by the time the market closed—with Morgan Stanley’s shares plummeting 24 percent, to $21.75, after dropping to $16.08 earlier in the day, and Goldman plunging 14 percent, to $114.50, after hitting a low of $97.78—Schorr’s e-mail was being forwarded all around town.

“We think investors should be focused on risk management and performance and not just whether you have retail deposits (banks go out of business, too, last we checked—and at this rate, following money fund redemptions, deposits could be around the corner). In our view, a lack of confidence and forced consolidation into firms that are ‘too big to fail’ can’t be the final solution,” he wrote. “The world should really be concerned about this because if we continue to squeeze the financial system’s balance sheet and see fewer players in the business, the available credit to corporations and hedge funds will shrivel up and the cost of capital will continue to skyrocket across the board.”

The e-mail eventually found its way to the Treasury Building, where Paulson was returning phone calls from a long list, trying to get a realistic view of what was taking place on Wall Street. Among the people he spoke with was Steve Schwarzman, the chairman of Blackstone Group, the private-equity giant.

“Hank, how’s your day going?” Schwarzman jibed when the call was connected.

“Not well. What do you see out there?” Paulson asked.

The conversation quickly turned serious. “I have to tell you, the system’s going to collapse in the next few days. I doubt you’re going to be able to open the banks on Monday,” Schwarzman said, deeply spooked by what he was seeing.

“People are shorting financial institutions, they’re withdrawing money from brokerage firms because they don’t want to be the last people in—like in Lehman—which is going to lead to the collapse of Goldman and Morgan Stanley. Everybody is just pursuing his self-interest,” Schwarzman told him. “You have to do something.”

“We’re working on some things,” Paulson said. “What do you think we should do?”

“You have to approach what you’re doing from the perspective of being a sheriff in a western town where things are out of control,” Schwarzman replied, “and you have to do the equivalent of just walking onto Main Street and shooting your gun up in the air a few times to establish that you’re in charge because right now no one is in charge!”

Paulson just listened, trying to picture himself in that role. “What do you recommend?”

“Well, the first thing you could do is stop short-selling of financial institutions—forget whether it’s effective in removing the pressure, although it might be. What will be accomplished is that you will scare the participants in the market, and they will recognize that things are going to change and they can’t continue to invest in the exact same way, and that will force people to pause,” Schwarzman said.

“Okay. That’s not a bad idea,” Paulson agreed. “We’ve been talking about that. I could do that. What else do you got?”

“I would stop the ability of people to withdraw, you know, transfer their brokerage accounts,” Schwarzman continued. “Nobody really wants to transfer their account out of Goldman or Morgan. They just feel they have to do it so they’re not the last person on a sinking ship.”

“I don’t have the powers to do that,” Paulson replied.

“You could get rid of the ability for people to write credit default swaps on financial institutions,” Schwarzman offered as an alternative, “which is putting enormous pressure on financial institutions.”

“I don’t have the powers to do that either,” Paulson protested.

Schwarzman, concerned that he wasn’t getting through to Paulson, replied, “Look, you’re going to have to announce something very big to rescue the system, some huge amount of money that gets utilized to address the problems of the system.”

“Well, we’re not ready to do that yet,” Paulson told him. “We’ve got some ideas,” he said.

“I don’t think that it’s relevant if you haven’t fully baked everything,” Schwarzman said, “You need an announcement tomorrow to stop the collapse and you’ve got to figure something out that will grab people’s attention.”

“What’s wrong?” John Mack asked in alarm as his CFO, Colm Kelleher, walked into his office late Wednesday, his face ashen.

“John,” Kelleher said in his staccato British inflections, “we’re going to be out of money on Friday.” He had been nervously watching the firm’s tank—its liquid assets—shrink, the way an airline pilot might stare at the fuel gauge while circling an airport, waiting for landing clearance.

“That can’t be,” Mack said anxiously. “Do me a favor, go back to the financing desk, go through it again.”

Every hour was bringing a new problem. The internal memo he had sent out earlier decrying short-sellers had started leaking out, and now several prominent hedge fund clients that used shorting strategies—some simply to hedge their exposures to other securities—were closing their Morgan Stanley accounts in protest.

“It’s one thing to complain, but another to put out a memo blaming your clients,” railed Jim Chanos, the short-seller who famously unearthed the problems at Enron. He had been a Morgan Stanley client for twenty years, but now he was making his displeasure known by pulling $1 billion from his account at the firm. Julian H. Robertson Jr., the founder of Tiger Management, one of the first and most successful hedge funds, called the firm apoplectically, though he stopped short of redeeming the money he kept with Morgan Stanley.

As annoyed as they might have been by the attack on shorts, the firm’s clients were about to become a good deal angrier. Mack was reviewing draft language for the statement he would publish the following day in support of Cuomo’s investigation into short selling. Though he knew full well that his language would infuriate his clients and send even more of them packing, Mack didn’t believe he had a choice but to lend his support:

Morgan Stanley applauds Attorney General Cuomo for taking strong action to root out improper short selling of financial stocks. By initiating a wide-ranging investigation of this manipulative and fraudulent conduct, Attorney General Cuomo is showing decisive leadership in trying to help stabilize the financial markets. We also support his call for the SEC to impose a temporary freeze on short selling of financial stocks, given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks.

Kelleher returned to Mack’s office thirty minutes after having been sent to review the firm’s balances again, slightly less shaken, but only slightly. After finding some additional money trapped in the system between trades that hadn’t yet settled, he revised his prognosis: “Maybe we’ll make it through early next week.”

Paulson was hunched over his telephone, straining to hear Bernanke and Geithner on the speakerphone. It was late Wednesday, and the Treasury staff was already girding for another all-nighter.

Bernanke was making his frustration clear; he didn’t believe the crisis could be solved by individual deals or some one-off solution. “We can’t keep doing this,” he insisted to Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”

Paulson agreed in theory but was concerned that Bernanke was underestimating the political calculus. “I understand that you guys don’t want to be fighting this fire alone, but the worst outcome would be if I go ask, and they tell me to screw off,” Paulson said. “We will then show that we’re vulnerable and we don’t have the armaments we need.”

“There are no atheists in foxholes and no ideologues in financial crises,” Bernanke, trotting out a phrase he had tried out on some Fed colleagues a day earlier, told Paulson, trying to persuade him that intervention was necessary.

Paulson agreed but said if they were going to proceed, he wanted to promote his plan to have the government buy toxic assets, a solution that he thought would be the most politically palatable, because it would be comparable to the Resolution Trust Corporation of the late 1980s. Congress created the RTC in 1989 to handle the more than $400 billion in loans and other assets held by 747 failed savings and loans as part of the S&L crisis. The RTC had been the recipient of a wide range of loans, properties, and bonds from the failed thrifts. Like the predicament Paulson currently faced, some of the assets were good but most were bad, and some, including construction and development loans, had no discernible market. The task was daunting: L. William Seidman, the RTC chairman, initially estimated that even if the agency sold $1 million of assets a day, it would take three hundred years to dispose of everything. By the time the RTC completed its job in 1995, a year ahead of its deadline, the cost to the taxpayers was nearly $200 billion (in 2008 dollars)—a much lower tab than what many had feared at the time the agency had been created.

Paulson thought the idea had merit and was buoyed by an op-ed in the Wall Street Journal that morning touting a similar plan by Paul A. Volcker, the former chairman of the Federal Reserve; Nicholas F. Brady, a former U.S. Treasury secretary; and Eugene A. Ludwig, a former U.S. comptroller of the currency.

“This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management,” they wrote. “The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link.”

On Thursday morning, Tom Nides, who lived in Washington and commuted every week to New York, woke up early at the Regency Hotel and went to the gym. As he read the New York Times on an elliptical machine, he nearly fell off when he came upon the front-page story, which ran under the headline: “As Fears Grow, Wall St. Titans See Shares Fall.”

Directly in the middle of the story was a quote, citing two people who had been briefed on merger talks between Morgan Stanley and Citigroup, saying that John Mack had told Vikram Pandit, “We need a merger or we’re not going to make it.”

Nides couldn’t believe Mack even said that. He had been in the room for one of the calls with Pandit and it didn’t go like that, he thought. Morgan Stanley, Nides knew, could not afford that sort of coverage, whether or not it was true. The more people who knew it, the truer it would become.

“Did you see this irresponsible piece of shit in the Times?” Nides asked when he got Mack on the phone. Mack, however, only read the Wall Street Journal, the Financial Times, and the New York Post, having canceled his Times subscription in protest after the Sulzberger family pulled its money from Morgan Stanley because one of its asset managers had decided to run a proxy contest against the Times ownership.

Now Mack had reason to be upset at the Times all over again. And he and his colleagues were furious with Pandit, who they were convinced must have leaked it.

“You didn’t say this, did you?” Nides asked.

“No, no,” Mack insisted. “I never said that; I definitely didn’t use those words.”

Nides knew he needed to challenge the veracity of the quote immediately. He was already getting calls from other news organizations.

“What fucking kind of reporter are you?” he berated one of the article’s authors, Eric Dash, when he reached him on his cell phone. “You have to rescind the story!”

Mack, meanwhile, prepared to address his employees for the second time in four days, eager to offer them reassurance, especially after the Times story. He had invited Eugene A. Ludwig, chairman of Promontory Financial Group and one of the authors of the editorial in the previous day’s Wall Street Journal advocating for an RTC-like structure, to join him this morning as his adviser.

Battling a cold, his glasses slipping down his nose, Mack stood on Morgan Stanley’s main trading floor, his speech piped in to its employees around the world. He spoke in a plain, unscripted manner, his North Carolina accent perhaps more pronounced than usual.

“You know you’ve seen the cash position, you’ve seen our earnings, ah, all that stuff, unlike what people said about other firms, ah, those numbers are real numbers,” he told them. “We’re clean, we’re making money. We made a lot of money the last eight days also. But it doesn’t make any difference. We deal in a market today that financial chicanery, rumor, and innuendo are much more powerful than real results.”

He related a phone conversation with a “a good friend,” a hedge fund manager who confided his fears about Morgan Stanley. Mack reassured the man, only to receive another call four hours later from the same fund manager about still another market rumor. “My point being, no matter what we say, there’s another rumor that pops up.”

Mack acknowledged that the firm was examining all its options, while expressing bewilderment at how the industry had been turned upside down.

“What I find remarkable is not too long ago, two months ago, four months ago, people said the Citibank model was broken—ah, complicated, big, global, unmanageable. And now our model’s broken. Is our model—and I include Goldman Sachs—is our model broken because we are not part of a bank? Is our model broken, because we’ve consistently in the last three quarters delivered good earnings? Is our model broken because we could not have regulators who stepped in and took strong stands? That might be the issue here.

“I think the issues are: How do you get through chaos? This is chaos. It pains me to go on the floor and see how you guys look.”

Mack then addressed the most sensitive issue for his employees—the selling of stock. According to SEC regulations, employees could sell only during certain designated periods, such as immediately following an earnings report—which meant at the present.

“I know this is a window period,” Mack said, “and I know some of you are very scared—well, maybe all of us are very scared. You want to sell stock, sell your stock. I’m not going to look at it and I don’t care. I’m not selling, and there, well, John, you’ve got a lot of it, you don’t have to worry about it … ah, you know, I do have a lot and I do worry about it, but I really care much more about your getting peace of mind. So if you want to sell, sell. Do it.”

When the time came for questions from the staff, Stephen Roach, Morgan Stanley’s unfailingly bearish economist, asked a pointed question about the shorts: “Short-sellers, John. Many, if not most of them, are clients of the firm. Put yourself in the room with one of these, quote, clients, unquote. What do you say to them?”

Mack drew a deep breath. “Well, um, I’ve thought long and hard about that, and my gut reaction is that I’m angry and I want to tell them what I think. And I don’t want to do business with you and all that other stuff. Then on my second breath, I say, you know, they have their job to do, that’s what they’re doing. I am not going to get pulled into that kind of discussion.

“And this is what I wanted to say, I put a note here about being angry. We can be angry, we are angry, we are upset, and we just have to deal with it. We are not here to beat up on clients and tell them how they deserted us and all of that stuff. We’re here to run this firm, work with our clients as best we can. Some don’t want to do business, we’ll deal with that later, let them go. Let’s stay focused on things that are productive. And venting and telling people what you think and calling them all the names you want to call them is not going to help us,” he said, punctuating the point by adding, “I love beating the shit out of people when they screwed us. But I’m not going there. And I don’t want you to go there.”

The panic at Goldman Sachs could no longer be denied. Perhaps the greatest sign of anxiety was the fact that Gary Cohn, Goldman’s co-president, who usually remained perched in his thirtieth-floor office, had relocated himself to the office of Harvey M. Schwartz, head of global securities division sales, who had a glass wall looking out to the trading floor. The door was left open; he wanted to see and hear exactly what was going on.

The Federal Reserve, along with the other central banks, had just announced plans to pump $180 billion to stimulate the financial system, but the scheme did not seem to be having any appreciable effect. Goldman’s shares opened down 7.4 percent. CNBC, which was airing on flat-screen TVs hanging from the walls of Goldman’s trading floor, had introduced a new “bug” on the bottom left-hand side of the screen that provocatively asked, “Is Your Money Safe?”

It was a question that Goldman clients were beginning to ask themselves. The firm’s own CDS spreads had blown out in a way the firm had never seen before, indicating that investors were quickly beginning to believe the unthinkable: that Goldman, too, could falter. In two days, Goldman’s stock had dropped from $133 to $108.

Every five minutes a salesman would tear into Schwartz’s office with news of another hedge fund announcing its plan to move its money out of Goldman and would hand Cohn a piece of paper with the hedge fund’s phone number so he could talk some sense into them. With Morgan Stanley slowing down its payouts, some investors were now testing Goldman, asking for $100 million just to see if they could afford to pay. In every case, Cohn would wire the money immediately, concerned that if he didn’t, the client would abandon the firm entirely.

The good news for Goldman was that withdrawals were only slightly outpacing inflows. To some extent it had been able to capitalize on the distress of others, as hedge funds needed to execute their trades somewhere. When Steve Cohen of SAC Capital transferred several billion over to Goldman, traders began to whoop it up on the floor.

On the other hand, Stanley Druckenmiller, a George Soros acolyte worth more than $3.5 billion, had taken most of his money out earlier that week, concerned about the firm’s solvency. If word got around that a hedge fund manager of Druckenmiller’s reputation had lost confidence in Goldman, it alone could cause a run. Cohn called him and tried to convince him to return the money to the firm. “I have a long memory,” Cohn, who was taking this personally, told Druckenmiller, for whom he had even hosted a charity cocktail party in Druckenmiller’s honor in his own apartment. “Look, the one thing I’m doing is I’m learning who my friends are and who my enemies are, and I’m making lists.”

Druckenmiller, however, was unmoved. “I don’t really give a shit; it’s my money,” he shot back. Unlike most hedge funds, Druckenmiller’s did consist primarily of his own money. “It’s my livelihood,” he said. “I’ve got to protect myself and I don’t really give a shit what you have to say.”

“You can do whatever you want,” Cohn said in carefully measured tones. But, he added, “this will change our relationship for a long time.”

Half an hour before David Carroll and the Wachovia team were due to arrive at Morgan Stanley, Kindler called down to Scully. Kindler was in his office, peering out his window down at the camera crews camped outside the building.

“Why are we having him meet us here, of all places?” Kindler asked. “There’s reporters outside.”

“Don’t worry. It’ll be fine,” Scully, who took the precaution of sneaking Carroll in via the employee entrance on Forty-eighth Street, assured him.

Kindler’s sole objective was to get his hands on Wachovia’s mortgage book so that he could crack the tape—Wall Street-speak for examining the mortgages individually. That was the only way he could really understand Wachovia’s real value. This was no small undertaking: The tape contained $125 billion of loans, including all manner of bespoke adjustable rates, like “pick a pay,” which gave borrowers a variety of choices each month on how—and even how much—to pay. Among the options was a payment that covered only the interest on the loan.

Morgan Stanley also insisted on seeing Wachovia’s business plan, but Carroll balked at that request. “Our general counsel says it’s a real problem,” he said.

Kindler, convinced that Wachovia was trying to hide something, called Morgan’s general counsel, Gary Lynch, in a rage and told him to put the screws to his counterpart at Wachovia, Jane Sherburne.

“It’s a big legal issue,” she explained. “We can’t give over the data without disclosing it in the merger agreement if we do the deal.”

Lynch, too, was starting to suspect a problem. Are Wachovia’s numbers worse than anyone knows? he wondered to himself. “Well, we can’t do the deal without seeing the data,” he told her.

Sherburne relented.

Lloyd Blankfein, his top shirt button undone and tie slightly askew, looked at his computer screen and saw in dismay that his stock price had dropped 22 percent to $89.29. Blankfein, who up until now had resisted pushing back against short-sellers, was becoming convinced that the pressure his stock was under was not an accident. He had just ended a call with Christopher Cox in which he had told the SEC chairman, “This is getting to be intentional. You know, you may need to do something here.”

In his e-mail in-box was another message from one of his traders saying that JP Morgan was trying to steal his hedge fund clients by telling everyone that Goldman was going under. It was becoming a vicious circle.

Blank fein had been hearing these rumors for the past twenty-four hours, but he had finally had enough. He was furious. The rumormongering, he felt, had gotten out of control. And he couldn’t believe JP Morgan was trashing his firm to his own clients. He could feel himself becoming as anxious as Mack had sounded when they spoke the day before.

He called Dimon. “We’ve got to talk,” Blankfein began as he tried to calmly explain his problem. “I’m not saying you’re doing it, but there are a lot of footprints here.”

“Well, people may be doing something that I don’t know about,” Dimon replied. “But they know what I’ve said, which is that we’re not going after our competitors in the middle of all this.”

Blankfein, however, wasn’t buying his explanation. “But, Jamie, if they’re still doing it, you can’t be telling them not to!” Trying to get his point across, Blankfein, a movie buff, started doing his own rendition of A Few Good Men: “Did you order the Code Red? Did you say your guys would never do anything?” Dimon just listened patiently, eager not to get Blankfein even more wound up.

“Jamie, the point is, I don’t think you’re telling them to do this, but if you wanted to stop them in your organization, you could scare them into not doing it,” Blankfein said.

Even in its panicked state, Goldman was still Goldman, and Dimon didn’t want a war. Within half an hour he had Steve Black and Bill Winters, co-chief executives of JP Morgan’s investment bank, send out a companywide e-mail:

We do not want anyone at JP Morgan capitalizing on the irrational behavior that’s going on in the market toward some of the U.S. broker-dealers. We are operating as business as usual with Morgan Stanley and Goldman Sachs as counterparties. While they are both formidable competitors, during this period, we do not want anyone approaching their clients or employees in a predatory way. We want to do everything possible to remain supportive of their business and not do anything that would impact them negatively.

We do not believe anyone has engaged in any inappropriate behavior, but we want to underscore how important it is to be constructive during this time. What is happening to the broker-dealer model is not rational, and not good for JP Morgan, the global financial system or the country.

Around midday, Hank Paulson reviewed the latest term sheet that his staff had drafted overnight on the issue of dealing with toxic assets, hoping it would be acceptable to present to Congress. His inner circle had assembled in his office, pulling up chairs around a corner sofa.

“It looks much better,” he said, turning the pages. “It’s very simple.” He paused and scanned the bleary-eyed faces in the room. “I want to reiterate that we have to get this up to the Hill quickly,” he said. “We need to keep this simple, very simple. And we have to do it in a way that we encourage, ah, banks and financial institutions to want to participate. We don’t want to have punitive measures with this. This is about recapitalizing our banks and financial institutions setting a price for assets.”

There was just one more issue to deal with, perhaps the most important of all: the price tag.

While the toxic-asset program made sense in theory, for it actually to work, for it to be effective, Paulson knew they’d need to buy large swaths of toxic securities from the nation’s largest banks. The cost was going to be enormous, and it would be perceived, both within and outside of the Washington Beltway, as another bailout.

Paulson looked to Kashkari, who sat on the sofa to his left, for guidance.

The key concern at that moment was whether spending so much money would require them to have to ask Congress to increase the debt ceiling—a political flashpoint that would require Congress to vote to raise the amount of debt the country could take on. It had just increased that amount to $10.615 trillion in July.

As the group discussed the outlines of the proposed legislation, Kashkari’s view was that they ought to try to skirt the issue entirely. “I don’t know if that’s workable, not having a reference to the debt ceiling. Or why don’t we just say it’s not subject to a debt ceiling?”

“You can’t do that,” Paulson pointed out and then added, “I don’t want to go for the debt ceiling and fail. That’s the issue, and then people start focusing on it.”

“I did the analysis,” Phillip Swagel offered, reading from his notes. He had determined that they would need only $500 billion, but only if the situation didn’t grow any worse.

To Paulson, who thought of himself as fiscally conservative, the answer was obvious. “Okay, so I think the responsible thing is to go for the debt ceiling,” he said, instructing Kevin I. Fromer, assistant secretary for legislative affairs, whose job it was to work the Hill, to construct some new language.

“You can go after it but you don’t have to put it in this document,” Fromer replied, resisting Paulson’s request. “We never go up and propose legislation to do the debt ceiling. We just simply arrive at the fact that we have to do it and literally tell Congress they have to do it. They do it because they’re too scared not to do it. It’s just a question of optics.”

They decided that, for the time being, they wouldn’t mention the debt ceiling in the document itself but would address it later, ideally when Congress had already bought into the plan and it was too late to make a change.

Before wrapping up the meeting, Paulson raised one last problem: Wachovia, he said, might falter. He was getting back-channel messages from Kevin Warsh that the bank’s finances were in much worse shape than they believed. Everyone understood the significance of his statement. After all, Bob Steel, their former colleague, was its CEO.

“If Wachovia fails, I’m going to be trotting up to Congress again. So I’m hoping it happens after January!” he said to a roomful of laughs.

“Listen, Jamie just called me fishing around for something,” Colm Kelleher told John Mack midday Thursday as he marched into his office. “He said he was calling to see if he could be of help,” Kelleher added. “It was strange.”

James Gorman, the firm’s co-president, had just reported receiving a similar call, Mack replied, and Geithner had phoned earlier to suggest that he talk to Dimon as a possible merger partner too.

“It’s clear that for him to be calling us, he wants to do a deal,” Kelleher said. “Jamie is always hanging around the hoop. You know Jamie’s saying, ‘Let’s make friends with these guys before I eat them.’”

Mack was irritated by these suggestions; he didn’t particularly want to do a deal with Dimon, as he believed it would involve far too much overlap. But he decided to stop guessing what Dimon might be up to and ask him directly.

“Jamie, Geithner says I should call you,” Mack said abruptly when he reached Dimon on the phone a few minutes later. “Let’s get this out in the open: Do you want to do a deal?”

“No, I don’t want to do a deal,” Dimon said flatly, frustrated that this was the second call he had gotten that day from a competitor who was annoyed with him.

“Well, that’s interesting,” Mack retorted. “You’re calling my CFO and you’re calling my president, why would you do that?”

“I was trying to be helpful,” Dimon repeated.

“If you want to be helpful, then talk to me. I don’t want you calling my guys,” Mack said, hanging up the phone.

The fiftieth floor of Goldman’s fixed-income trading unit was in near meltdown by lunchtime on Thursday. No trading was taking place, and the traders themselves were glued to their terminals, staring at the GS ticker as the market continued its swoon. Goldman’s stock dropped to $85.88, its lowest level in nearly six years; the Dow had fallen 150 points. “The market is trading under the assumption that every financial institution is going under,” Michael Petroff, portfolio manager for Heartland Advisors, told Agence France-Presse that morning. “It’s now emotional.”

Jon Winkelried, Goldman’s co-president, had been walking the floors, trying to calm everyone’s nerves. “We could raise $5 billion in an hour if we wanted to,” he told a group of traders as if to suggest nothing was amiss.

But just then, at 1:00 p.m., the market—and Goldman’s stock—suddenly turned around, with Goldman rising to $87 a share, and then $89. Traders raced through their screens trying to determine what had been responsible for the lift and discovered that the Financial Services Authority in the U.K. had announced a thirty-day ban on short selling twenty-nine financial stocks, including Goldman Sachs. It was exactly what Blankfein and Mack had tried to persuade the SEC’s Christopher Cox to do.

The squawk boxes on Goldman’s trading floor soon crackled to attention. A young trader found a copy of “The Star-Spangled Banner” on the Internet and broadcast it over the speakers to commemorate the moment. About three dozen traders stood up from their desks, placed their hands over their hearts, and sang aloud, accompanied by rounds of high fives and cheers. The market was turning around, and our flag was still there.

Nine minutes later word began to spread that Paulson, too, was working on something big. “Treasury, Fed Weighing Wider Plan to Ease Crisis, Schumer Says” a Bloomberg headline read, buoying the market further.

At exactly 3:01 p.m. the market took off. Traders all over Wall Street turned up the volume when Charlie Gasparino of CNBC reported what he was hearing from his sources on Wall Street: The federal government was preparing “some sort of RTC-like plan” that would “get some or all of the toxic waste off the balance sheets of the banks and brokerages.” Taking “RTC” as code for “everything’s going to be all right,” traders pushed stocks higher immediately. Between the time Gasparino began his report and the segment ended, the market jumped 108 points, a brief respite from the steady downward spiral.

At the Treasury, Paulson and Kashkari had been on a conference call with Geithner and Bernanke for the past hour, trying to decide on a path of least political resistance for shoring up the banks. Bernanke, who seemed bothered by the plan, was arguing in favor of direct capital injections, a measure that had worked in other countries.

Geithner, who had been railing about the need for “decisive action,” all of a sudden started talking about the possibility of opening up the Fed window to virtually any financial institution with any kind of assets. It would be a bold act that would likely be applauded by investors.

“I don’t understand, what do you mean?” Kashkari piped up. “If the Fed really wanted to interpret its authorities creatively, it could do all this without legislation?”

Paulson shot Kashkari an angry look, as it was precisely what he had been hoping that Geithner might convince Bernanke to do—and thus save Paulson a trip to Congress.

“We can’t do that,” Bernanke admonished Geithner.

The call had to end quickly because Paulson and Bernanke were scheduled to brief President Bush in the West Wing on their plan at 3:30 p.m., and Bernanke still needed to drive over from the Fed.

As Paulson and Kashkari began the three-minute walk across the parking lot to the White House, Paulson received a call from Nancy Pelosi.

“Mr. Secretary,” she announced sternly, “we would like to meet with you tomorrow morning because of some of the chaos we see in the markets.”

Knowing that he would need to start building congressional support for his plan as soon as possible, he replied, “Madam Speaker, it cannot wait until tomorrow morning. We have to come today.”

Upon reaching the Oval Office the Treasury officials took their places on the pair of sofas in the middle of the room. Vice President Cheney; Josh Bolten, Bush’s chief of staff—and Paulson’s old friend from Goldman—and several other White House staffers soon joined them, along with Bernanke and Warsh.

Paulson told Bush in no uncertain terms that the financial system was collapsing. “If we don’t act boldly, Mr. President,” he said, “we could be in a depression deeper than the Great Depression,” an assessment with which Bernanke concurred.

Bush was struggling to wrap his mind around the precise course of events. “How,” he questioned, “did we get here?”

Paulson disregarded the question, knowing that the answer would be way too long and lay in a heady mix of nearly a decade of overly lax regulation—some of which he had pushed for himself—overzealous bankers, and home owners living beyond their means. Instead he pressed ahead and told the president that he planned to seek at least $500 billion from Congress to buy toxic assets, explaining that he hoped the program would stabilize the system.

He hastened to point out the political ramifications, suggesting that buying toxic assets was overall a more palatable option than buying stakes in banks themselves.

Bush nodded in agreement but, still confounded by the $500 billion figure, asked, “Is that enough?”

“It’s a lot. It will make a difference,” Paulson assured him. Even if he did want to seek a higher number, Paulson told the president, “I don’t think we can get more.”

They all knew it was going to be a highly politicized issue, but Paulson insisted, “We absolutely need to go to Congress. Treasury doesn’t have the authority.”

For a moment, Paulson paused and then added, “In theory, Ben could always do it.”

Paulson, unexpectedly playing politics himself, appeared to be trying to see how far he could push Bernanke, who, as far as Paulson was concerned, had virtually unlimited powers as long as he was willing to use them.

“Ben, you can do this?” President Bush asked, sensing an opportunity.

Bernanke, however, did not appreciate being put on the spot and tried to sidestep the question. “That is really fiscal policy, not monetary policy,” he said in his professorial tone.

Bush understood. “We need to do what it takes to solve this problem,” he agreed, but given his low approval ratings, he knew he could be of little help on the Hill. “You guys should go up,” he told Paulson and Bernanke. The implication was clear: You’re on your own. But he insisted that the two men sell Congress on the idea quickly.

As they left the White House, Kashkari turned to Paulson and remarked, “I couldn’t believe the kind of pressure you were putting on Ben.”

Paulson just smiled. “Maybe Ben will get there.”

Lloyd Blankfein had not been mollified by the market’s late turnaround, with Goldman’s stock ending the day up at $108, which was still better from its low of $86.31. In his office were Gary Cohn; David Viniar, the firm’s CFO; Jon Winkelried, the co-president; John Rogers; and David Solomon. He knew that until Morgan Stanley fell, Goldman was probably safe, though that was hardly a comfort.

Gary Cohn had been on the phone earlier in the day with Kevin Warsh of the Federal Reserve, brainstorming a way to get in front of the financial tsunami. Warsh threw out the idea that perhaps Goldman should be looking to merge with Citigroup, a fit that could solve major problems for both parties. Goldman could get a huge deposit base, while Citigroup would acquire a management team that investors could support.

Cohn had expressed his doubts about the suggestions. “It probably doesn’t work because I could never buy their balance sheet,” he explained. “And the social issues would be enormous.” The expression “social issues” was yet another Wall Street code for who would run the firm. Goldman’s management didn’t exactly have high regard for Pandit and his team.

“Don’t worry about the social issues,” Warsh told him. “We’ll take care of them.”

That was a not so subtle hint that if a deal was struck, Pandit might be out of a job.

But Blankfein wasn’t particularly interested in either alternative. Rodgin Cohen had been encouraging Goldman to think about transforming the firm into a regulated bank holding company, which JP Morgan and Citigroup were, giving them unlimited access to the Fed’s discount window. It was the same idea that Cohen had unsuccessfully pressed Geithner to consider for Lehman Brothers over the summer, and while Geithner had turned that proposal down, Cohen had become convinced that he might now rule differently given the grave state of the markets.

The notion of becoming a bank holding company had arisen at Goldman from time to time over the years, most recently at their board summer meeting in Russia, where they had discussed the necessity of holding more deposits. Blankfein appreciated that Goldman’s dependence on even a modicum of short-term financing made investors, in this highly charged environment, anxious, and that a deposit base provided a more stable source of capital. Blankfein had always resisted the idea, however, because it came with a hefty price tag in the form of increased regulatory oversight. But these were extraordinary circumstances, to say the least, and the CEO sensed that the world might be moving inexorably in that direction. Given that the bank already had temporary access to the Fed discount window, and that the Fed had literally placed several staffers inside Goldman to monitor the firm, Blankfein started to believe that the prospect of a little extra government regulation didn’t seem particularly onerous.

“This is only going to work if you scare the shit out of them.”

That had been Jim Wilkinson’s advice to Paulson before he and Bernanke left to meet with the congressional leadership at Nancy Pelosi’s office that evening. By Wilkinson’s reckoning, unless they could convince Congress that the world was literally going to come to an end, they would never receive approval for a $500 billion bailout package for Wall Street. Republicans would complain it was socialism; Democrats would carp about rescuing white-collar fat cats.

At a burled wood table just off Pelosi’s office, two dozen congressmen gathered to meet with Paulson, Bernanke, and Christopher Cox, who had been invited more as a courtesy than anything else.

Pelosi began the meeting by welcoming them and thanking them for coming “on such short notice.”

Bernanke, who was known never to exaggerate, began by saying gravely, “I spent my career as an academic studying great depressions. I can tell you from history that if we don’t act in a big way, you can expect another great depression, and this time it is going to be far, far worse.”

Senator Charles Schumer, sitting at the end of the table, noticeably gulped.

Paulson, with a deep sense of intensity, went on to explain the mechanics of his proposal: The government would buy the toxic assets to get them off the banks’ books, which in turn would raise the value of the assets by establishing a price and make the banks healthier, which in turn would help the economy and, as Paulson repeatedly said, “help Main Street.”

Barney Frank, sitting next to Bernanke, thought Paulson’s reference to “Main Street” was a disingenuous ploy to line the pockets of Wall Street and provided no direct help for average Americans saddled with mortgages they can’t afford, foisted on them by the big banks being rescued. “What about the home owner?” he asked. “You aren’t selling this plan to a Wall Street boardroom,” he said derisively. “That’s right,” Christopher Dodd chimed in. Richard Shelby disapprovingly characterized the proposed program as a “blank check.”

Paulson said he understood their concerns. But he continued to play his “scare the shit out of them” card, insisting that it was absolutely necessary: “I don’t want to think about what will happen if we don’t do this.” He said he hoped that Congress could pass the legislation within days and promised to get a full proposal to them literally within hours.

“If it doesn’t pass, then heaven help us all,” Paulson said.

Harry Reid, sitting across from Bernanke, looked at Paulson with a sense of bemusement about the prospect that Congress would pass a bill of this magnitude that quickly. “Do you know what you are asking me to do?” he said. “It takes me forty-eight hours to get the Republicans to agree to flush the toilets around here.”

“Harry,” Mitch McConnell (R-Kentucky), who was deeply frightened by Paulson and Bernanke’s presentation, interjected, “I think we need to do this, we should try to do this, and we can do this.”

John Mack was still at his office in Times Square when Tom Nides, his chief administrative officer, told him the good news: His sources at the SEC had confirmed that the agency was preparing to finally put in place a ban on shorting financial stocks, affecting some 799 different companies. The measure would likely be announced the following morning.

Rumors of the pending action were already moving on the wires. James Chanos, perhaps the best known of the short-sellers, who had pulled his money from Morgan Stanley because of Mack’s support for the ban, was already on the warpath. “While this is all politically pleasing to the regulatory powers that be, the fact of the matter is that there has been no evidence presented of short-sellers circulating false market rumors to drive down the price of stocks,” he said.

That day, Morgan Stanley’s stock had fallen 46 percent, only to turn around in the last hours of trading, ending up 3.7 percent, or 80 cents. Between word of the government’s intervention and the short-selling ban, Mack was hoping that he’d finally have some breathing room.

He knew, though, that beneath the surface the firm was hurting. Hedge funds continued to seek redemptions. Other banks were buying insurance against Morgan Stanley’s going under, covering more than $1 billion. Within the past two days, Merrill Lynch had bought insurance covering $150 million in Morgan debt. Citigroup, Deutsche Bank, UBS, Alliance-Bernstein, and Royal Bank of Canada had all made similar moves to protect themselves from a collapse.

Mack knew that what the firm needed most was an investor to step up and take a big stake in the company to shore it up. “I don’t know how this happened,” he confided in Nides, searching himself. Morgan Stanley had been considered too conservative and Mack pushed the firm to take on more risk at exactly the wrong moment. And now here they were, in the perfect storm, on the cusp of insolvency.

Mack could think of only one investor who might be seriously interested in making a sizable investment in the firm: China Investment Corporation, China’s first sovereign wealth fund. Wei Sun Christianson, CEO of Morgan Stanley China and a fifty-one-year-old dynamo with close relationships throughout the government, had initiated discussions with Gao Xiqing, president of CIC, within the past twenty-four hours. She happened to be in Aspen at a conference with him hosted by Teddy Forstmann, the leveraged buyout king who coined the phrase “Barbarians at the Gate” in the late 1980s, during the bidding war for RJR Nabisco. CIC already held a 9.9 percent stake in Morgan Stanley, and Gao indicated to Christianson that he’d be interested in buying up to 49 percent of the firm. Gao had a major incentive to keep Morgan Stanley alive: He had invested $5 billion in the firm in December 2007, which was now worth half that. Another one of his major investments, in Blackstone Group’s IPO, was down more than 70 percent. If Morgan Stanley filed for bankruptcy, he might lose his job.

Mack and Nides discussed the deal, and while neither man was particularly interested, given their choices, they knew it might prove to be the only solution. Gao, whom Mack had come to know as a fellow Duke trustee, was planning to fly to New York Friday night to meet with them.

Earlier in the day, Mack had spoken with Paulson, who prided himself on his extensive Chinese contacts, trying to persuade him to make a call to the Chinese government to encourage them to pursue the deal. It was a tad unusual to ask the government to serve as a broker, but Mack was desperate. “The Chinese need to feel as if they are being invited in,” Mack explained. Paulson said he’d work on it and see if President Bush would be willing to call China’s president, Hu Jintao. “We need an independent Morgan Stanley,” he affirmed.

Nides, however, had a more cynical view of Paulson’s desire to protect Morgan Stanley. “He’ll keep us alive,” Nides told Mack, “because if he doesn’t, then Goldman will go.”