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

EPILOGUE

In the span of just a few months, the shape of Wall Street and the global financial system changed almost beyond recognition. Each of the former Big Five investment banks failed, was sold, or was converted into a bank holding company. Two mortgage-lending giants and the world’s largest insurer were placed under government control. And in early October, with a stroke of the president’s pen, the Treasury—and, by extension, American taxpayers—became part owners in what were once the nation’s proudest financial institutions, a rescue that would have seemed unthinkable only months earlier.

Wiring tens of billions of dollars from Washington to Wall Street, however, did not immediately bring an end to the chaos in the markets. Instead of restoring confidence, the bailout had, perversely, the opposite effect: Investors’ emotions and imaginations—the forces that John Maynard Keynes famously described as “animal spirits”—ran wild. Even after President Bush signed TARP into law, the Dow Jones Industrial Average went on to lose as much as 37 percent of its value.

But there was another kind of fallout, too—one that had a far more profound effect on the American psyche than did the immediate consequences of the dramas being played out daily on Wall Street. In the days and weeks that followed the first payouts under the bailout bill, a national debate emerged about what the tumult in the financial industry meant for the future of capitalism, and about the government’s role in the economy, and whether that role had changed permanently.

A year later such concerns remain very much at the forefront of the national conversation. As this book was going to press, a raucous public outcry, complete with warnings about creeping socialism, questioned the government’s role not just in Wall Street, but in Detroit (since the bank rescue, the government also supplied billions of dollars in aid to two automotive giants, General Motors and Chrysler, to restructure in bankruptcy court) and in the health care system. Washington has also named an overseer, popularly known as a “pay czar,” to review compensation at the nation’s bailed-out banks.

One unexpected result of this new federal activism was that traditional political beliefs had been turned on their head, with a Republican president finding himself in the unaccustomed position of having to defend a hands-on approach. “The government intervention is not a government takeover,” President Bush asserted on October 17, 2008, as he sought to counter his critics. “Its purpose is not to weaken the free market. It is to preserve the free market.”

Bush’s statement seemed to sum up the paradox of the bailout, in which his administration and the one that followed decided that the free market needed to be a little less free—at least temporarily.

In some respects, Hank Paulson’s TARP was initially a victim of his own aggressive sales pitch. While the program was fundamentally an attempt to stabilize the financial system and keep conditions from growing worse, in order to win over lawmakers and voters it had been presented as a turnaround plan. From the vantage point of consumers and small-business owners, however, the credit markets were still malfunctioning. After hundreds of billions of dollars had been set aside to rescue banks, many Americans still couldn’t obtain a mortgage or a line of credit. For them the turnaround that had been promised didn’t come soon enough.

Even with the help of cash infusions some of the country’s major banks continued to falter. Citigroup, the largest American financial institution before the crisis, devolved into what Treasury officials began referring to as “the Death Star.” In November 2008 they had to put another $20 billion into the financial behemoth, on top of the original $25 billion TARP investment, and agreed to insure hundreds of billions of dollars of Citi’s assets. In February 2009 the government increased its stake in the bank from 8 percent to 36 percent. The bank that only a decade earlier had spearheaded a push toward deregulation was now more than one third owned by taxpayers.

Even among those who continued to believe in the bailout concept, there were lingering questions about how well Washington had acquitted itself, with the loudest debate focusing on one deal in particular.

In early 2009 the Bank of America-Merrill Lynch merger became the subject of national controversy when BofA announced that it needed a new $20 billion bailout from the government, becoming what Paulson declared “the turd in the punchbowl.” When it later emerged that Merrill had paid its employees billions of dollars in bonuses just before the deal closed, the public outrage led to a series of investigations and hearings that embarrassingly pulled back the curtain on the private negotiations that took place between the government and the nation’s financial institutions.

The September sale of Merrill Lynch to Bank of America had been presented as a way to save Merrill. But in the several months that it took the deal to close, Merrill’s trading losses ballooned, its asset management business weakened, and the firm had to take additional write-downs on its deteriorating assets. The public wasn’t informed about these mounting problems, however, and on December 5, shareholders of both companies voted to approve the deal at separate meetings.

Behind the scenes, Ken Lewis threatened to withdraw from the deal, but Paulson and Bernanke pressed him to complete it or risk losing his job.

As details of the drama leaked out John Thain became a quick casualty, with Ken Lewis firing him in his own office. He was soon recast from the hero who had saved Merrill into the source of its troubles, despite indications that Bank of America was aware of the firm’s problems and chose not to disclose them. Additional criticism was leveled at Thain when it emerged that he had asked the outgoing Merrill board for as much as a $40 million bonus. “That’s ludicrous!” shouted John Finnegan, the Merrill director who was on its compensation committee, when a human resources representative made the request. Thain has said that he knew nothing about it, and by the time a discussion about his compensation reached the full board, he had withdrawn any request for a bonus.

Nowhere was the public backlash more severe, however, than it was against American International Group. AIG had become an even greater burden than anyone expected, as its initial $85 billion lifeline from taxpayers eventually grew to include more than $180 billion in government aid. Geithner’s original loan to AIG, which he had said was fully collateralized, quickly looked to be no sounder an investment than a mortgage lender’s loan to a family with bad credit and no ability to ever pay it back.

Now that taxpayers were owners of AIG, lawmakers complained loudly about a $440,000 retreat for their independent insurance agents at the St. Regis Monarch Beach resort in Dana Point, California, and an $86,000 partridge-hunting trip in the English countryside. But the greatest ire was reserved for reports of millions of dollars in bonuses being awarded to AIG executives, as protesters swarmed its headquarters and its officials’ homes. President Obama asked, “How do they justify this outrage to the taxpayers who are keeping the company afloat?” while on his television program Jim Cramer ranted, “We should hound them in the supermarket, we should hound them in the ballpark, we should hound them everywhere they are.”

The widespread criticism gave rise to considerations about how to continue operating the business: Should decisions about how the company spent its money be made in reaction to popular opinion or with the goal of achieving profits? Edward Liddy, AIG’s new CEO, so frustrated with trying to serve two masters, left the company within eleven months of joining it.

There was also the issue of exactly how the AIG bailout money was used. More than a quarter of the bailout funds left AIG immediately and went directly into the accounts of global financial institutions like Goldman Sachs, Merrill Lynch, and Deutsche Bank, which were owed the money under the credit default swaps that AIG had sold them and through their participation in its securities lending program. To some extent this disbursement only bolstered the argument of critics who decried Paulson’s rescue as a bailout by Wall Street for Wall Street. (It didn’t help that foreign banks received some of the indirect aid, even though foreign governments hadn’t contributed to the rescue plan.)

Because Goldman Sachs was the largest single recipient of the AIG payments, receiving $12.9 billion, much of the anger quickly settled on it, as theories proliferated about what strings the firm might have pulled behind the scenes given its ties to Paulson and Treasury’s cast of Goldman alumni. In particular, the Goldman connection to AIG suggested to some that it was the reason that Treasury—or what people had started calling “Government Sachs”—had chosen to rescue the insurance giant and not Lehman. Goldman disputed claims that it benefited from the AIG rescue, contending that it had been “always fully collateralized and hedged ” in its exposure to the insurance company. (In fairness, it does appear that the firm had been so, despite a lingering whisper campaign to the contrary. And the $12.9 billion headline number is somewhat misleading; $4.8 billion of the amount transferred to Goldman was in exchange for securities that it had been holding.) That’s not to say Goldman did not have a vested interest in seeing AIG rescued, but the facts are slightly more complex than have often been presented by the media.

The news reports, however, kept feeding off one another and therefore missed the underlying truth: Paulson himself had had very little to do with the rescue of AIG; it was, rather, orchestrated by Geithner (and executed, in part, by Treasury’s Dan Jester). While the fact has often been overlooked, Geithner, by his very nature—as has been demonstrated throughout this book and in his subsequent policies as Treasury secretary—is as much a proactive deal maker as Paulson, if not more so.

Still, the conspiracy theories kept coming, and the narratives grew more elaborate. “Is Goldman Sachs Evil?” asked the cover of New York magazine. The writer Matt Taibbi created a new popular metaphor for the firm, describing Goldman in a Rolling Stone article as a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

Months after the TARP infusion, Goldman reported a profit of $5.2 billion for the first half of 2009. In June the firm paid back the $10 billion of TARP money, and in July paid $1.1 billion to redeem the warrants that were issued to the government as part of the TARP infusion. For Goldman, even as a bank holding company, it was back to business as usual.

The real question about Goldman’s success, which could be asked about other firms as well, is this: How should regulators respond to continued risk taking—which generates enormous profits—when the government and taxpayers provide an implicit, if not explicit, guarantee of its business? Indeed, in Goldman’s second quarter of 2009, its VaR, or value at risk, on any given day had risen to an all-time high of $245 million. (A year earlier that figure had been $184 million.) Goldman’s trades have so far paid off, but what if it had bet the wrong way? For better or worse, Goldman, like so many of the nation’s largest financial institutions, remains too big to fail.

Could the financial crisis have been avoided? That is the $1.1 trillion question—the price tag of the bailout thus far.

The answer to that question is “perhaps.” But the preemptive strike would probably have had to come long before Henry Paulson was sworn in as secretary of the Treasury in the spring of 2006. The seeds of disaster had been planted years earlier with such measures as: the deregulation of the banks in the late 1990s; the push to increase home ownership, which encouraged lax mortgage standards; historically low interest rates, which created a liquidity bubble; and the system of Wall Street compensation that rewarded short-term risk taking. They all came together to create the perfect storm.

By the time the first signs of the credit crisis surfaced, it was probably already too late to prevent a crash, for by then a massive correction was inevitable. Still, it is reasonable to ask whether steps could have been taken even at that late stage to minimize the damage. Hank Paulson had, after all, been predicting a problem in the markets since the first summer he joined the Bush administration. Likewise, as chairman of the New York Fed, Tim Geithner had also warned for years that the interconnectedness of the global financial markets may well have made them more vulnerable to a panic, not less. Should these men have done more to prepare for an actual crisis?

To his credit, Paulson did speak openly for months about formalizing the government’s authority to “wind down” a failing investment bank. He never made that request directly to Congress, however, and even if he had, it’s doubtful he could have gotten it passed. The sad reality is that Washington typically tends not to notice much until an actual crisis is at hand.

That, of course, raises a more pointed question: Once the crisis was unavoidable, did the government’s response mitigate it or make it worse?

To be sure, if the government had stood aside and done nothing as a parade of financial giants filed for bankruptcy, the result would have been a market cataclysm far worse than the one that actually took place. On the other hand, it cannot be denied that federal officials—including Paulson, Bernanke, and Geithner—contributed to the market turmoil through a series of inconsistent decisions. They offered a safety net to Bear Stearns and backstopped Fannie Mae and Freddie Mac but allowed Lehman to fall into Chapter 11, only to rescue AIG soon after. What was the pattern? What were the rules? There didn’t appear to be any, and when investors grew confused—wondering whether a given firm might be saved, allowed to fail, or even nationalized—they not surprisingly began to panic.

Tim Geithner admitted as much in February 2009, acknowledging that “emergency actions meant to provide confidence and reassurance too often added to public anxiety and to investor uncertainty.”

Of course, there are many people on Wall Street and elsewhere who argue to this day that it was the government’s decision to let Lehman fail that was its fundamental error. “On the day that Lehman went into Chapter 11,” Alan Blinder, an economist and former vice chairman of the Federal Reserve, said, “everything just fell apart.”

It is, by any account, a tragedy that Lehman was not saved—not because the firm deserved saving but because of the damage its failure ultimately wreaked on the market and the world economy. Perhaps the economy would have crumbled anyway, but Lehman’s failure clearly hastened its collapse.

CEO Richard Fuld did make errors, to be sure—some out of loyalty, some out of hubris, and even some, possibly, out of naïveté. But unlike many of the characters in this drama, whose primary motive was clearly to save themselves, Fuld seems to have been driven less by greed than by an overpowering desire to preserve the firm he loved. As a former trader whose career was filled with any number of near-death experiences and comebacks, he remained confident until the end that he could face down this crisis, too.

Despite claims to the contrary by Paulson, it seems undeniable that the fear of a public outcry over another Wall Street rescue was at least a factor in how he approached Lehman’s dilemma. One person involved in the government’s deliberations that weekend, in a remarkably candid moment, told me that the fact that the UK government indicated that it would face a major struggle to approve a deal with Barclays was “actually a strange coincidence,” because “we would have been impeached if we bailed out Lehman.”

While hindsight suggests that the federal government should have taken some action to prop up Lehman—given the assistance it was prepared to offer the rest of the industry once it began to face calamity—it is also true that the federal government did lack an established system for winding down an investment bank that was threatened with failure. Paulson, Geithner, and Bernanke were forced to resort to what MIT professor Simon Johnson has called “policy by deal.”

But deals, unlike rules, have to be improvised—and the hastier ones tend by their very nature to be imperfect. The deals hatched in sleepless sessions at the Federal Reserve Bank of New York or at Treasury were no different. They were products of their moment.

In truth, while unnoticed, it wasn’t the fate of the U.S. operations of Lehman Brothers that caused the white-knuckled panic that quickly spread throughout the world. To its credit, the Fed wisely decided to permit Lehman’s broker-dealer to remain open after the parent company filed for bankruptcy, which allowed for a fairly orderly unwinding of trades in the United States. Outside the country, however, there was pandemonium. Rules in the United Kingdom and Japan forced Lehman’s brokerage units there to shut down completely, freezing billions of dollars of assets held by investors not just abroad, but perhaps more important, here in the United States. Many hedge funds were suddenly left short of cash, forcing them to sell assets to meet margin calls. That pushed down asset prices, which only sparked more selling as the cycle fed on itself.

Washington was totally unprepared for these secondary effects, as policy makers had seemingly neglected to consider the international impact of their actions—an oversight that offers a strong argument for more effective global coordination of financial regulations.

Subsequently, Paulson, in trying to defend his decisions, managed to muddy the waters by periodically revising his reasons for not having saved Lehman. In a January 4, 2009, op-ed piece in the New York Times, Michael Lewis and David Einhorn wrote: “At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.”

Once the Barclays deal failed, it appears that the United States government truly did lack the regulatory tools to save Lehman. Unlike the Bear Stearns situation, in which JP Morgan was used as a vehicle to funnel emergency loans to Bear, there was no financial institution available to act as conduit for government loans to Lehman. Because the Fed had already determined that Lehman didn’t have sufficient collateral to borrow against as a stand-alone firm, there were effectively no options left.

Still, these explanations don’t address the question of why Paulson and the U.S. government didn’t do more to keep Barclays at the table during negotiations. In the series of hectic phone calls with British regulators on the morning of Sunday, September 14, 2008, neither Paulson nor Geithner ever offered to have the government subsidize Barclays’ bid, helping reduce the risk for the firm and possibly easing the concerns of wary politicians in Britain.

In Paulson’s view, Barclays’ regulators in the UK would never have approved a deal for Lehman within the twelve-hour period in which he believed a transaction would have had to be completed. From that perspective, further negotiations would only have been a waste of precious time. Paulson may be correct in his conclusions, but it is legitimate to ask whether he pulled the plug too early.

It will likely be endlessly debated whether Paulson’s decisiveness throughout the crisis was a benefit or a detriment, but the argument can also be made that any other individual in Paulson’s position—in a lame-duck administration with low and dwindling popular support—might have simply frozen and done nothing. It is impossible to argue he didn’t work hard enough. And a year later, it appears that many of the steps he took in the midst of the crisis laid the groundwork for the market’s stabilization, with the Obama administration, Geithner, and Bernanke often taking credit for the reversal. Thus far, many of the biggest banks that accepted TARP funds have returned it, taxpayers have made $4 billion in profit. However, that does not account for the hundreds of millions of dollars directed at firms like AIG, Citigroup, and elsewhere that may never get paid back.

Barney Frank perfectly articulated the dilemma that will likely haunt Paulson as historians seek to judge his performance. “The problem in politics is this: You don’t get any credit for disaster averted,” he said. “Going to the voters and saying, ‘Boy, things really suck, but you know what? If it wasn’t for me, they would suck worse.’ That is not a platform on which anybody has ever gotten elected in the history of the world.”

To attempt to understand how the events of September 2008 occurred is, of course, an important exercise, but only if its lessons are used to help strengthen the system and protect it from future crises. Washington now has a rare opportunity to examine and introduce reforms to the fundamental regulatory structure, but it appears there is a danger that this once-in-a-generation opportunity will be squandered.

Unless those regulations are changed radically—to include such measures as stricter limits on leverage at large financial institutions, curbs on pay structures that encourage irresponsible risks, and a crackdown on rumormongers and the manipulation of stock and derivative markets—there will continue to be firms that are too big to fail. And when the next, inevitable bubble bursts, the cycle will only repeat itself.

The financial industry had always been intended to be something of an unseen backroom support for the broader economy, helping new businesses get off the ground and mature companies adapt and expand. Yet in the years leading up to the crisis, the finance sector itself became the front room. The goal on Wall Street became to generate fees for themselves as opposed to for their clients. As this book went to press, the handful of proposals that have been introduced to put the financial system back in its right place and rein in risk have seemed tepid and halfhearted, at best. Relieved that the worst is supposedly behind us, the Obama administration seems to have moved on to other priorities.

Meanwhile, Wall Street, bent but not broken, rumbles on in search of new profits. Risk is being reintroduced into the system. Vulture investing is back in vogue again, with everyone raising money in anticipation of the collapse of commercial real estate and the once-in-a-lifetime bargains that might be available as a result. Perhaps most disturbing of all, ego is still very much a central part of the Wall Street machine. While the financial crisis destroyed careers and reputations, and left many more bruised and battered, it also left the survivors with a genuine sense of invulnerability at having made it back from the brink. Still missing in the current environment is a genuine sense of humility.

As this behind-the-scenes tale has, I hope, illustrated, in the end, whether an institution—or the entire system—is too big to fail has as much to do with the people that run these firms and those that regulate them as it does any policy or written rules. What happened during this period will be studied for years to come, perhaps even by a new generation of bankers and regulators facing similar challenges.

When the post-bailout debate was still at its highest pitch, Jamie Dimon sent Hank Paulson a note with a quote from a speech that President Theodore Roosevelt delivered at the Sorbonne in April 1910 entitled “Citizenship in a Republic.” It reads:

It is not the critic who counts: not the man who points out how the strong man stumbles or where the doer of deeds could have done better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming, but who knows the great enthusiasms, the great devotions, who spends himself for a worthy cause; who, at the best, knows, in the end, the triumph of high achievement, and who, at the worst, if he fails, at least he fails while daring greatly, so that his place shall never be with those cold and timid souls who knew neither victory nor defeat.

It was a remarkable quote for Dimon to have chosen. While Roosevelt’s words described a hero, they were deeply ambiguous about whether that hero succeeded or failed. And so it is with Paulson, Geithner, Bernanke, and the dozens of public-and private-sector figures who populate this drama. It will be left to history to judge how they fared during their own time “in the arena.”