Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis — and Themselves

by Andrew Ross Sorkin

At the time, Wall Street believed fervently that its new financial products—mortgages that had been sliced and diced, or “securitized”—had diluted, if not removed, the risk. Instead of holding on to a loan on their own, the banks split it up into individual pieces and sold those pieces to investors, collecting enormous fees in the process. But whatever might be said about bankers’ behavior during the housing boom, it can’t be denied that these institutions “ate their own cooking”—in fact, they gorged on it, buying mountains of mortgage-backed assets from one another. But it was the new ultra-interconnectedness among the nation’s financial institutions that posed the biggest risk of all. As a result of the banks owning various slices of these newfangled financial instruments, every firm was now dependent on the others—and many didn’t even know it. If one fell, it could become a series of falling dominoes. There were, of course, Cassandras

Bear Stearns, the smallest but scrappiest of Wall Street’s Big Five investment houses, had agreed to be sold—for $2 a fucking share! And to no less than Jamie Dimon of JP Morgan Chase. On top of that, the Federal Reserve had agreed to take on up to $30 billion of losses from Bear’s worst assets to make the deal palatable to Dimon.

JP Morgan’s deal for Bear Stearns was, he recognized, a lifesaver for the banking industry—and himself. Washington, he thought, was smart to have played matchmaker; the market couldn’t have sustained a blow-up of that scale. The trust—the confidence—that enabled all these banks to pass billions of dollars around to one another would have been shattered. Federal Reserve chairman Ben Bernanke, Fuld also believed, had made a wise decision to open up, for the first time, the Fed’s discount window to firms like his, giving them access to funds at the same cheap rate the government offers to big commercial banks.

broker-dealers, the infelicitous name for firms that trade securities on their own accounts or on behalf of their customers—in

housing prices started to plummet and overextended banks cut back sharply on new lending,

Within an hour, Lehman’s stock had plunged by 48 percent.

Retrospectively, I'm glad I was too young and oblivious to have been paying attention that day.

A bunch of “hedgies,” Wall Street’s disparaging nickname for hedge fund managers, had systematically taken down Bear Stearns by pulling their brokerage accounts, buying insurance against the bank—an instrument called a credit default swap, or CDS—and then shorting its stock. According to Russo’s sources, a story making the rounds was that the group of short-sellers who had destroyed Bear had then assembled for a breakfast at the Four Seasons Hotel in Manhattan on Sunday morning, clinking glasses of mimosas made with $350 bottles of Cristal to celebrate their achievement. Was it true? Who knew?

That remark skirted the catch-22 involved with the Fed’s decision to make cheap loans available to firms like Lehman: Using it would be an admission of weakness, and no bank wanted to risk that. In fact, the Fed’s move was intended more to reassure investors than to shore up banks.

The battle between bankers and traders is the closest thing to class warfare on Wall Street. Investment banking was esteemed as an art, while trading was more like a sport, something that required skill, but not necessarily brains or creativity.

Bear Stearns—with its high leverage, virtually daily reliance on funding from others simply to stay in business, and interlocking trades with hundreds of other institutions—was a symptom of a much larger problem confronting the nation’s financial system.

“The most important risk is systemic: if this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole,”

Geithner had for years warned that the explosive growth in credit derivatives—various forms of insurance that investors could buy to protect themselves against the default of a trading partner—could actually make them ultimately more vulnerable, not less, because of the potential for a domino effect of defaults. The boom on Wall Street could not last, he repeatedly insisted, and the necessary precautions should be taken. He had stressed these ideas time and again in speeches he had delivered, but had anyone listened? The truth was, no one outside the financial world was particularly concerned with what the president of the New York Fed had to say. It was all Greenspan, Greenspan, Greenspan before it became Bernanke, Bernanke, Bernanke.

One of the first causalities of the credit crunch was two Bear Stearns hedge funds that had invested heavily in securities backed by subprime mortgages. It was those mortgages that were now undermining confidence in the housing market—a market that Fannie and Freddie dominated, underwriting more than 40 percent of all mortgages, most of which were quickly losing value. That, in turn, was infecting bank lending everywhere.

the last Depression-era barriers between commercial and investment banking—passed as the Glass-Steagall Act of 1933—were removed by a bill introduced by Republican senator Phil Gramm of Texas and Republican congressman Jim Leach of Iowa.

People continue to not understand what socialism is, apparently.

“I am worried about a lot of things,” Paulson now told Fuld, singling out a new IMF report estimating that mortgage- and real estate–related write-downs could total $945 billion in the next two years. He said he was also anxious about the staggering amount of leverage—the amount of debt to equity—that investment banks were still using to juice their returns. That only added enormous risk to the system, he complained.

Lehman Brothers was leveraged 30.7 to 1; Merrill Lynch was only slightly better, at 26.9 to 1.

The credit crisis wasn’t just a U.S. problem; it had spread globally. Mario Draghi, Italy’s central bank governor and a former partner at Goldman Sachs, spoke candidly of his worries about global money-market funds. Jean-Claude Trichet told the audience that they needed to come up with common requirements for capital ratios—the amount of money a firm needed to keep on hand compared to the amount it could lend—and, more important, leverage and liquidity standards, which he thought were much more telling indicators of a firm’s ability to withstand a “run on the bank.” Mr. King, the governor of the Bank of England, offered perhaps the harshest assessment. “You are all bright people, but you failed. Risk management is hard,” he declared. “So the lesson is, we can’t let you get as big as you were and do the damage that you’ve done or get as complex as you were.”

As a scholar of the Depression, Bernanke was cut from a different cloth, though he shared Greenspan’s belief in the free market. In his analysis of the crisis, Bernanke advanced the views of the economists Milton Friedman and Anna J. Schwartz, whose A Monetary History of the United States, 1867–1960 (first published in 1963) had argued that the Federal Reserve had caused the Great Depression by not immediately flushing the system with cheap cash to stimulate the economy. And subsequent efforts proved too little, too late. Under Herbert Hoover, the Fed had done exactly the opposite: tightening the money supply and choking off the economy.

What the Fed’s policy makers recognized but didn’t acknowledge publicly was that credit markets were beginning to suffer as the air had begun gradually seeping out of the housing bubble. Cheap credit had been the economy’s rocket fuel, encouraging consumers to pile on debt—whether to pay for second homes, new cars, home renovations, or vacations. It had also sparked a deal-making frenzy the likes of which had never been seen: Leveraged buyouts got larger and larger as private-equity firms funded takeovers with mountains of loans; as a result, transactions became ever riskier. Traditionally conservative institutional investors, such as endowments and pension funds, came under pressure to chase higher returns by investing in hedge funds and private-equity funds. The Fed resisted calls to cut interest rates, which would only have thrown gasoline onto the fire. Two days later, however, the world changed. Early on the morning of August 9, in the first major indication that the financial world was in serious peril, France’s biggest bank, BNP Paribas, announced that it was halting investors from withdrawing their money from three money market funds with assets of some $2 billion. The problem? The market for certain assets, especially those backed by American mortgage loans, had essentially dried up, making it difficult to determine what they were actually worth.

It was a panic. Banks and investors, fearful of being contaminated by these toxic assets, were hoarding cash and refusing to make loans of almost any kind. It wasn’t clear which banks had the most subprime exposure, so banks were assumed guilty until proven innocent. It had all the hallmarks of the early 1930s—confidence in the global financial system was rapidly eroding, and liquidity was evaporating. The famous nineteenth-century dictum of Walter Bagehot came to mind: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

The housing problem, he had thought, was limited to the increase in subprime loans to borrowers with poor credit. Although the subprime market had mushroomed to $2 trillion, it was still just a fraction of the overall $14 trillion U.S. mortgage market. But that analysis did not take into account a number of other critical factors, such as the fact that the link between the housing market and the financial system was further complicated by the growing use of exotic derivatives. Securities whose income and value came from a pool of residential mortgages were being amalgamated, sliced up, and reconfigured again, and soon became the underpinnings of new investment products marketed as collateralized debt obligations (CDOs).

The way that firms like a JP Morgan or a Lehman Brothers now operated bore little resemblance to the way banks had traditionally done business. No longer would a bank simply make a loan and keep it on its books. Now lending was about origination—establishing the first link in a chain of securitization that spread risk of the loan among dozens if not hundreds and thousands of parties. Although securitization supposedly reduced risk and increased liquidity, what it meant in reality was that many institutions and investors were now interconnected, for better and for worse. A municipal pension fund in Norway might have subprime mortgages from California in its portfolio and not even realize it. Making matters worse, many financial firms had borrowed heavily against these securities, using what is known as leverage to amplify their returns. This only increased the pain when they began to lose value.

“Treasury purchases $500 billion from financial institutions via an auction mechanism. Determining what prices to pay for heterogeneous securities would be a key challenge. Treasury would compensate bidder with newly issued Treasury securities, rather than cash. Such an asset-swap would eliminate the need for sterilization by the Fed. Treasury would hire private asset managers to manage the portfolios to maximize value for taxpayers and unwind the positions over time (potentially up to 10 years).”

Maybe the key point of the entire pre-eruption buildup

Realistic?

Key political consideration

On Thursday, August 9, 2007, seven months before Bear went down, Einhorn had rolled out of bed in Rye, New York, a few hours before dawn to read reports and write e-mails. The headlines that day struck him as very odd. All that summer, the implosion in subprime mortgages had been reverberating through the credit markets, and two Bear Stearns hedge funds that had large positions of mortgage-backed securities had already collapsed. Now BNP Paribas, the major French bank, had announced that it was stopping investors from withdrawing their money from three money market funds. Like Bernanke, he stopped everything he was doing that weekend to try to better understand what was really happening. “These people are workers in France, they’ve got a money market account that they’re earning no money on. Their only goal is to have that money available to them whenever they want it; that’s what a money market account is. You can’t freeze the money market,” he told his team. Einhorn e-mailed some of his top analysts to assign a special project: “We’re going to do something we don’t usually do, research-wise,” he announced. Instead of the usual painstaking investigation into a company or a particular idea, they were going to conduct—on both Saturday and Sunday—a crash investigation of financial companies that had big exposure to the world of securitized debt. He knew that this was where the problem had started, but what concerned him now was trying to understand where it might end. Any ba...

As a concept, mark-to-market is simple to understand, but it is a burden to deal with on a daily basis. In the past, most banks had rarely if ever bothered putting a dollar amount on illiquid investments, such as real estate or mortgages, that they planned to keep. Most banks valued their illiquid investments simply at the price they paid for them, rather than venture to estimate what they might be worth on any given day. If they later sold them for more than they paid for them, they made a profit; if they sold them for less, they recorded a loss. But in 2007 that straightforward equation changed when a new accounting rule, FAS 157, was enacted. Now if a bank owned an illiquid asset—the property on which its headquarters was located, for example—it had to account for that asset in the same way as it would a stock. If the market went up for those assets in general, it would have to record that new value in its books and “write it up,” as the traders put it. And if it fell? In that case, it was supposed to “write it down.” Of course, no one ever wanted to write down the value of his assets. While it may have been an interesting theoretical exercise—the gains and losses are not actually “realized” until the asset is sold—mark-to-market had a practical impact: A firm that had a huge write-down has less value.

A lesson worth remembering

Walsh had virtually unlimited use of Lehman’s balance sheet and used it to turn the firm into an all-in, unhedged play on the U.S. real estate market, a giant REIT (real estate investment trust) with a little investment bank attached—a strategy that worked extraordinarily well right up until the moment that it didn’t.

Banks were creating increasingly complex products many levels removed from the underlying asset. This entailed a much greater degree of risk, a reality that neither totally grasped and showed remarkably little interest in learning more about.

The percentage of Americans who owned stock—whether directly or indirectly, through mutual funds and retirement plans—more than doubled from 1983 to 1999, by which point nearly half the country were investors in the market.

Meanwhile, its traditional power base, the retail brokerage business, was being undercut by the rise of discount online brokerage firms like E*Trade and Ameritrade.

As well as by vigorous cost cutting, O’Neal had plans to make Merrill great again through redirecting the firm into riskier but more lucrative strategies. O’Neal’s model for this approach was Goldman, which had begun aggressively making bets using its own account rather than simply trading on behalf of its clients.

securities. In just two years Merrill became the biggest CDO issuer on Wall Street.

Merrill sought to be a full-line producer: issuing mortgages, packaging them into securities, and then slicing and dicing them to CDOs. The firm began buying up mortgage servicers and commercial real estate firms, more than thirty in all, and in December 2006, it acquired one of the biggest subprime mortgage lenders in the nation, First Franklin, for $1.3 billion. But just as Merrill began moving deeper into mortgages, the housing market started to show its first signs of distress. By late 2005, with prices peaking, American International Group, one of the biggest insurers of CDOs through credit default swaps, stopped insuring securities with any subprime tranches.

By the end of 2006, however, the market for subprime mortgages was perceptibly unraveling—prices were falling, and delinquencies were rising.

By 2008, however, the word “modest” was seldom used in connection with AIG. In only a few decades it had grown into one of the world’s largest financial companies, with a market value of just under $80 billion (even after a steep slide in its share price earlier that year) and more than $1 trillion worth of assets on its books. That phenomenal expansion was primarily the result of the cunning and drive of one man: Maurice Raymond Greenberg, known to friends as “Hank,” after the Detroit Tigers slugger Hank Greenberg, and referred to within the company simply as “MRG.”

A great deal of money can be made from derivatives, which are, in simplest terms, financial instruments that are based on some underlying asset, such as residential mortgages, to weather conditions. Like the bomb that ended the film Dr. Strangelove, derivatives could, and did, blow up; Warren Buffett called them weapons of mass destruction.

The key to the success of the business was AIG’s triple-A credit rating from Standard & Poor’s. With it the fund’s cost of capital was significantly lower than that of just about any other firm, enabling it to take more risk at a lower cost. Greenberg had always recognized how valuable the triple-A rating had been to him and guarded it carefully. “You guys up at FP ever do anything to my Triple-A rating, and I’m coming after you with a pitchfork,” he warned them.

With BISTROs, a bank took a basket of hundreds of corporate loans on its books, calculated the risk of the loans defaulting, and then tried to minimize its exposure by creating a special-purpose vehicle and selling slices of it to investors. It was a seamless, if ominous, strategy. These bondlike investments were called insurance: JP Morgan was protected from the risk of the loans going bad, and investors were paid premiums for taking on the risk. Ultimately, Cassano passed on buying BISTROs from JP Morgan, but he was intrigued enough that he ordered his own quants to dissect it. Building computer models based on years of historical data on corporate bonds, they concluded that this new device—a credit default swap—seemed foolproof. The odds of a wave of defaults occurring simultaneously were remote, short of another Great Depression. So, absent a catastrophe of that magnitude, the holders of the swap could expect to receive millions of dollars in premiums a year. It was like free money.

The biggest reason, though, for the confidence within the firm was the unusual nature of AIG itself. It was not an investment bank at the mercy of the short-term financing market. It had very little debt and some $40 billion in cash on hand. With a balance sheet of more than $1 trillion, it was simply too big to fail.

By that point in time, however, how AIG saw itself and how everyone had come to view it were rapidly diverging. The clients who bought super-seniors insured by AIG might still be making their payments, but on paper they saw their values falling. Market confidence in CDOs had collapsed; the credit-rating agencies were lowering their rankings on tens of billions of dollars’ worth of CDOs, even those that had triple-A ratings. In 2007 one of its biggest clients, Goldman Sachs, demanded that AIG put up billions of dollars more in collateral as required under its swaps contracts.

In early March, AIG’s board, after requiring Sullivan to redraft the proposed retention program more than once, approved a plan that would pay out $165 million in 2009 and $235 million in 2010. At the time, it hardly seemed like a decision that anyone outside AIG would care about—let alone give rise to the political nightmare that would result in censure, death threats, and a mad scramble on Capitol Hill to undo the bonuses.

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

The issue facing them was this: Unlike a traditional commercial bank, Goldman didn’t have its own deposits, which by definition were more stable. Instead, like all broker-dealers, it relied at least in part on the short-term repo market—repurchase agreements that enabled firms to use financial securities as collateral to borrow funds. While Goldman tended to have longer term debt agreements—avoiding being reliant on overnight funding like that of Lehman, for example—it still was susceptible to the vagaries of the market. That arrangement was something of a double-edged sword. It could bet its own money utilizing enormous amounts of leverage—putting up $1, for example, and using $30 of debt, a practice common in the industry. Bank holding companies like JP Morgan Chase, which were regulated by the Federal Reserve, faced far more restrictions when it came to debt-fueled bets on the market. The downside was that if confidence in the firm waned, that money would quickly evaporate.

During the Clinton administration’s first term, Congress was working on the legislation that would repeal the Glass-Steagall Act of 1933, tearing down the walls dividing banks, brokers, and other financial businesses.

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

Goldman executives considered AIG was “marking to make-believe,” as Blankfein told the board.