Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

By contrast with the European experience it is not hard to see how this self-congratulatory American narrative gained purchase. But its economic merits are not so obvious as its proponents presume.

Gone were the days when economic policy was about shrinking the state to set free the spontaneous order of market liberty. No longer did wisdom lie in devising predictable rules to curtail the arbitrary discretion of policy makers. Economic policy modeled on warfare was a matter of will, vigilance, tactical nous and firepower. And despite the populist appeal of the military rhetoric, there was a political price to pay.

Though bankers detested government intervention, they also wanted to avoid the stigma of joining a cartel of ailing firms, especially one including Citigroup, whose balance sheet was particularly toxic.10 When major global competitor HSBC announced that it would absorb the full amount of $45 billion in losses suffered by its SIVs onto its balance sheets, its largest American rivals could not be seen to be settling for a second-best option.

In Britain in 2008, the Scottish conglomerate HBOS would be sold off to Lloyds Bank with encouragement from Downing Street.12 Germany’s number two bank, Dresdner, would be amalgamated with Commerzbank, the number three.13 As both deals would reveal, the risk was that the bank that was in trouble would pull its rescuer down with it.

To the relief of the Treasury and the Fed, J.P. Morgan was interested in buying out Bear. Its hard-charging CEO, Jamie Dimon, was confident that his robust balance sheet put him in a position to safely pick over the carcass. But to finalize the deal, Dimon needed the right inducement. Under the emergency powers provided by section 13(3) of the Fed’s statutes, $30 billion in the most toxic assets were taken off Bear’s books by a SIV funded by the New York Fed.

Strict advocates of moral hazard logic would forever after argue that it was the Bear rescue that set up the Lehman disaster.17 With one investment bank having been rescued, Lehman’s management felt safe. A solution for their problems would be found too. They could afford to take their time finding the best possible deal, an attitude that would cost them dearly.

As the indispensable government-sponsored backdrop to the American housing market, they were at the center of one of the most formidable political networks in Washington. By the summer of 2008, with private securitization stalled, they were also responsible for backstopping 75 percent of new mortgages in the United States.

The vast bulk of the Fannie Mae and Freddie Mac balance sheet consisted of top-quality conforming mortgages. If they had had conventional balance sheets, they ought to have been able to ride out the storm. The problem was they did not. In June 2008 Fannie Mae and Freddie Mac held MBS valued at $1.8 trillion and guaranteed another $3.7 trillion on the basis of shareholder equity, which in the case of Fannie Mae came to only $41.2 billion, and in the case of Freddie Mac, to $12.9 billion.

Allowing for only minimal losses, the capital of both Fannie Mae and Freddie Mac would be completely wiped out. If they folded they would take down the last remaining lenders in the mortgage market and put in doubt the credit of the United States.

The Treasury favored an authorization limited only by the federal government’s borrowing ceiling, putting the full financial clout of the American state behind the GSE. As Paulson famously put it to the Senate Banking Committee, “[I]f you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”

The Chinese might be excused their confusion. The political theater being played in Washington, DC, was new and strange. A conservative, free-market administration led by businessmen was proposing unlimited state spending to nationalize a large part of the housing finance system.

Paulson was registering a basic rift within American conservatism. The right wing of the party could not be counted on to give support to measures that were unpopular and distasteful, but were clearly necessary to save “the system.”

Paulson’s extraordinary plenipotentiary authorization to rescue Fannie Mae and Freddie Mac passed Congress on July 26, with three quarters of House Republicans voting against. It was signed into law on July 30. The White House thought it best to forgo the usual festive Oval Office ceremony. There was no reason to goad the Republicans and no time to lose.

The results were dispiriting. Both of the GSEs were insolvent. Liquidity support would not be enough. On Sunday, September 7, 2008, Fannie Mae and Freddie Mac were placed under conservatorship. It was nationalization in all but name.

The crucial effect of this intervention was to reassure bondholders, especially those abroad, that Fannie Mae and Freddie Mac would not fail. Despite the machinations of Russia, the breakdown of America’s government-sponsored mortgage machine did not spill over into a global crisis.

On the right wing of the Republican Party, fully mobilized for the hotly contested presidential election, the nationalization of Fannie Mae and Freddie Mac unleashed a firestorm.27 The Treasury did its best to ward off allegations of cronyism by imposing a punitive dividend for the capital it contributed, wiping out the GSEs’ existing shareholders. The American Bankers Association rallied to the administration, calling on Republicans to support the rescue effort. But it was immediately countered by the conservative Club for Growth, a key right-wing lobby group funded by the Koch brothers.

Palin did not have coherent views on the GSEs or the financial crisis.

You don't say

What made the Republican brush fire so worrying was that by early September it was clear that the rescue of Fannie Mae and Freddie Mac was only the first round, and that the next phase of the battle would be decided not in Washington but on Wall Street.

Merrill was bigger than Lehman. It too was heavily exposed to the real estate bust. Like Lehman it was an investment bank that could not function without access to the repo market. After Lehman it would certainly have been the next to fail.28 But unlike Lehman, Merrill’s management was nimble and saved its bank by pushing for direct talks with Bank of America.

On the desperate weekend of September 13–14, 2008, Bank of America’s hundreds of billions of retail deposits guaranteed by the FDIC were one part of the financial system that was not running. That funding base gave Bank of America the platform to buy out Merrill Lynch. But on what terms?

After Bank of America took Merrill, for Lehman, the last remaining hope was a transatlantic deal with the British bank Barclays, where the expat American Bob Diamond, formerly of Morgan Stanley and Credit Suisse, was calling the shots. But Prime Minister Gordon Brown and Chancellor Alistair Darling refused to loosen regulations to allow the takeover to go ahead without full shareholder approval and without commitments of support from the US Treasury.

The problem was not that the Treasury and the Fed lacked the will, but that they lacked the means. The Lehman collapse was not the result of a deliberate intention on the part of the authorities. “We hadn’t done it on purpose,” Geithner insisted. “We had run up against the limits of our authority and the fears of the British regulators.”

For Geithner at the New York Fed, this was no comfort: “We hadn’t chosen to draw a line. We had been powerless, not fearless. We had tried but failed to prevent a catastrophic default.”37 On this interpretation of the crisis, Geithner would go on to base an entire program of state building. If in 2008 what had been missing were adequate state powers of intervention, the answer was to equip the Fed and the Treasury with the right tools. What Geithner could not admit is the possibility that “Hank and Ben” had, in fact, made a mistake.

The best available contemporary evidence, rather than the self-justifications that the actors fashioned for themselves after the catastrophic consequences of Lehman’s failure became apparent, suggests that the basic constraint on the Lehman rescue was Paulson’s refusal, from the outset, to consider another bailout.

It was a judgment that would be borne out two weeks later in the desperate battle to pass the Troubled Asset Relief Program (TARP). Though it was Paulson who took the lead in the Lehman talks in New York, from Washington Bernanke was fully in agreement. The Fed was notably uncooperative in the desperate efforts of Lehman’s management to buy time.

The argument made at the time was that ending uncertainty by means of bankruptcy would help to calm the markets. It is easy to say with hindsight, but it was a spectacular error of judgment.

When the bailout team had reached a similar conclusion about Lehman twenty-four hours earlier, they had started preparing for bankruptcy. This time, the conclusion was the opposite. The financial markets would not withstand a second shock, and AIG’s level of interconnectedness through derivatives, repo and securities lending was even greater than that of Lehman. Letting AIG fail would, in the words of one Wall Street player, have been an “extinction-level” event.

The Fed backstopped AIG’s credit default swap portfolio and its securities lending business. In exchange it would take stock in AIG and its subsidiaries that would give the US government a 79.9 percent equity stake in AIG’s global insurance business. Following the template established with the Fannie Mae and Freddie Mac nationalization, the deal inflicted a huge loss on AIG’s existing shareholders. The securities lending business was unwound, with the New York Fed purchasing from AIG its depreciated portfolio of MBS, enabling it to pay off its securities-lending counterparties.

In effect, together with the collateral they had already claimed from AIG, the counterparties received payment at 100 percent of par on $62.2 billion in toxic mortgage-backed securities, the market value of which was closer to $27.2 billion.

In the course of the bailout, the Fed made sure to leave in place the insurance contracts that AIG had offered to European banks to provide “regulatory relief.” If they had been voided, the Americans estimated that the European banks would have faced calls for at least $16 billion in additional capital.

Having realized the scale of what they were up against, Bernanke and Paulson decided on September 17 that they must appeal to Congress for additional resources and the authority to use them.41 Paulson knew it was a serious political risk. But they were now faced with the collapse of the entire Wall Street system, and the resources at their disposal to meet it were stretched to the limit.

One week after Lehman, they were rescued by the transparent expedient of redesignating them as commercial bank holding companies so that they might benefit from the protection of FDIC deposit insurance. But that only increased the burden on the FDIC, which had problems of its own.

With $244 billion in mortgages on the balance sheet, WaMu was the largest commercial bank in American history to fail. J.P. Morgan promptly snapped up WaMu’s network of 2,239 retail branches and their deposits.42 Nor was J.P. Morgan the only buyer that could see the prizes on offer in the giant fire sale.

After the unlimited bailout authorization for the GSEs, the Treasury was now asking to spend the equivalent of the entire US defense budget on bad mortgage securities. But what was truly audacious about Paulson’s bill was the nature of the power he was asking for.

Paulson was asking for legal carte blanche. Sketchy though it was, the proposal did not come out of the blue. Already in mid-April 2008 Paulson and a Treasury team had met with Bernanke and his staff to discuss what they called a “Break the Glass” memo outlining different options for emergency action.

Every dollar of bank capital was leveraged. So a dollar of government capital would support ten, twenty or thirty times as much in lending. But recapitalization was rejected on political grounds. Paulson had no desire to go down in history as the Treasury secretary who nationalized America’s banking system.

Buying debts did not involve ownership of banks. It did not raise issues of control or corporate governance. It could all be done through “the market.” An auction mechanism could be used to determine the price. It was also, admittedly, slow moving and expensive: $700 billion would cover barely more than half the outstanding subprime securitization. It wasn’t the perfect solution. But after Lehman, AIG and WaMu, the Treasury and the Fed were desperate. They needed something that might pass, and pass quickly.

The left-wing filmmaker Michael Moore weighed in with an incendiary e-mail to his mass following, entitled “The Rich Are Staging a Coup This Morning.”

Faaaaaaart

As the British journalist Paul Mason remarked, Paulson’s cack-handed proposal triggered an “accidental synergy between the right-wing populist opposition to the bailout and the left-liberal stance.”53 History would prove it to be more than accidental.

If McCain threw in his lot with the rebel Republicans, it would not only threaten the proposed legislation, it would force the Democratic presidential campaign into a devastatingly unpopular choice. House Republican leader John Boehner was not helpful. One third of the Republican congressional party was so ideologically opposed to any more bailouts that there was no hope of their support. Another third were in tight races and could not risk alienating their base.

Rising stars from the right wing of the Republican Party, like Paul Ryan of Wisconsin and Eric Cantor of Virginia, rallied around the resistance to the Bush administration’s “sellout.”

Lol where are they now

In the end it took interventions by the White House chief of staff and major Republican donors, including Henry Kravis, the private equity billionaire, J.P. Morgan vice chair James Lee and John Thain of Merrill Lynch, to hold McCain in line.57 But this left McCain tongue-tied, torn between the demands of “the system” and the populist groundswell that Palin was rallying to his cause.

In the climactic meeting of the two candidates with the Bush administration on September 25, a meeting called at McCain’s request, the Republican candidate literally had nothing to say.

To speed TARP along it was tacked on to House Resolution 3997, also known as the Defenders of Freedom Tax Relief Act, providing tax breaks for members of the armed services, volunteer firefighters and peace corps members.

The scene in the House of Representatives was not reassuring. After a morning of polemical speeches, voting started after lunchtime. On screens around the world one could see the grinding process of congressional democracy in action.

Tellingly, of the 205 votes in favor of Hank Paulson’s TARP plan, 140 came from the Democrats and only 65 from the Republicans. Of those opposed, 133 were Republicans and 95 Democrats.

The Dow Jones index plummeted by 778 points, wiping $1.2 trillion off the value of American businesses in a matter of hours. It was the biggest loss on record, worse than on 9/11, when the index had plunged by 684 points.60 The shock to global confidence was devastating. It produced a terrifying synchronization of the crisis on both sides of the Atlantic.

As the Americans were trying and failing to patch together the first TARP deal, in London Gordon Brown’s government was frantically trying to persuade Spain’s Santander to buy out the branch network of mortgage lender Bradford & Bingley and its £22 billion in deposits. That would leave the UK Treasury holding £41 billion in mortgages that no one wanted to touch.

The Europeans were putting out one fire after another, bank by bank. But on the night of September 29, with the failure of TARP roiling the markets, Dublin cracked.

After a panic-stricken night of discussion, early in the morning of September 30 the Dublin government announced that for fear of dying it would commit suicide. As Europe turned on the morning news it learned that the Irish government was fully guaranteeing not just the deposits but all the liabilities of six major Irish banks for a period of two years. No other government had been advised in advance, nor had the ECB, nor had the Irish taxpayers.66 It stopped the run, but it left Ireland, with a population half the size of New York City, guaranteeing 440 billion euros in bank liabilities.