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

Nervously, Goldman started buying up protection in the form of credit default swaps—insurance—against the possibility that AIG would fail. Given that no one at the time seriously thought that would ever happen, the insurance was relatively cheap: For $150 million, Goldman could insure some $2.5 billion worth of debt.

“To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large, complex financial institution,” he planned to say. “As former Federal Reserve chairman Greenspan often noted, the real issue is not that an institution is too big or too interconnected to fail, but that it is too big or interconnected to liquidate quickly. Today our tools are limited.”

For months Paulson and his team had been discussing ways to unwind Fannie and Freddie should a real crisis hit—he considered their situation far more important to the long-term health of the economy than Lehman’s or the other investment banks’. But he knew it was all too easy to get bogged down in the political fighting over the controversial companies that had made home ownership a near right during the boom. With its critics insisting that Fannie and Freddie were neck-deep in the subprime mess, Paulson had a year earlier called the debate over Fannie and Freddie “the closest thing I’ve seen to a holy war.”

A product of the housing slump of the Great Depression and Franklin Delano Roosevelt’s New Deal, the company was formed to buy loans from banks, savings banks, and other lenders in order to promote home lending by reducing lenders’ risk and to increase the amount of capital available for housing.

By the 1990s, Fannie’s chief executive could boast, without much exaggeration, that “we are the equivalent of a Federal Reserve system for housing.” At their pinnacle the two mortgage giants—neither of them an originator of loans—owned or guaranteed some 55 percent of the $11 trillion U.S. mortgage market. Beginning in the 1980s, the two companies also became important conduits for the business of mortgage-backed securities. Wall Street loved the fees it collected from securitizing all kinds of debt, from car loans to credit card receivables, and Fannie’s and Freddie’s portfolios of mortgages were the biggest honeypot around.

But in 1999, under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages.

The success of the two companies in both the financial and political arena inevitably fostered a culture of arrogance. “[We] always won, we took no prisoners and we faced little organized political opposition,” Daniel Mudd, then the president of Fannie Mae, wrote in a 2004 memo to his boss. That overconfidence led both companies eventually to move into derivatives and to employ aggressive accounting measures. They were later found by regulators to have manipulated their earnings, and both were forced to restate years of results. The CEOs of both companies were ousted.

Fannie and Freddie were still reeling from the accounting scandals when in March 2008, just days after the rescue of Bear Stearns, the Bush administration lowered the amount of capital the two companies were required to have as a cushion against losses. In exchange, the companies pledged to help bolster the economy by stepping up their purchases of mortgages.

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

available to the broker-dealers,” he continued.

1998: If those consequences were serious enough to impact the entire financial system, the Fed might indeed have broader obligations that might require intervention. It was precisely this view that influenced his thinking in protecting Bear Stearns.

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

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

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

If Treasury was planning a government-led hostile takeover—the first in history—then

As the company had warned in an SEC filing several weeks earlier, a downgrade would be very expensive. If either Standard & Poor’s or Moody’s lowered its rating by one notch, AIG would be required to post $10.5 billion in additional collateral; if both agencies lowered their ratings, the damage would soar to $13.3 billion. As part of its contract to sell credit default swaps, AIG was required to maintain certain credit ratings—or add new collateral to compensate—as insurance against its potential inability to pay out any claims on the swaps. AIG was now a AA-minus company, and it was facing a tab that was growing quickly. Its executives were estimating that the firm could soon be hit with demands for as much as $18 billion in additional collateral.

There is no federal regulation or supervision of the insurance business.

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

“This is out of Dick’s hands,” Paulson assured him. It was a powerful statement that could be interpreted only one way: You can negotiate directly with me.

You’re on your own. None of the banks volunteered to offer any new credit lines.

No more than fifteen minutes into the meeting, the Moody’s analyst made it clear that the agency would downgrade AIG by at least one notch and possibly two. By Willumstad’s calculations, if they did so on Monday, the company would have at least three days before it would have to post the collateral. That meant he had until Wednesday, or at the latest, Thursday, to come up with an astronomical amount of money.

The mood in Washington was not hard to discern: There was no desire whatsoever for any further Wall Street rescues. All punditry could talk about was moral hazard, as if it were some sort of emerging disease that had just reached pandemic proportions. Bail out Lehman, the thinking went, and you will make bailouts the default solution at a time when no firm seems safe.

The worst-case scenario that Schreiber was describing wasn’t anywhere near bad enough, Dimon insisted, and scoffed, “You guys have no idea what you’re doing. This is amateurish, it’s pathetic.”

For all the complaints about Wall Street being short-term oriented, most Lehman employees had a five-year vesting period, which meant huge sums of their own wealth were tied up in the firm without the ability to sell their shares. And as of Friday, those shares had lost 93 percent of their value since January 31;

This is it, Blankfein thought. The big one. Paulson was going to have “the families” meet to try to save Lehman.

The problem was evident: Lehman had virtually no cash left. If there was no solution by Monday, the risk was that investors would demand what little money was left and put the firm out of business within minutes of the opening bell. That in turn would put the financial system as a whole at risk, as counterparties—investors on the other side of a trade with Lehman— wouldn’t be able to settle their trades, creating a cascading problem that could soon turn into a catastrophe. As sophisticated as the world’s markets have become, the glue that holds the entire arrangement together remains old-fashioned trust. Once that vanishes, things can unravel very quickly.

He said that they had identified at least $70 billion in problem assets that Bank of America would need guaranteed—the figure had grown from the $40 billion of a day earlier—and that it might be even larger. Given that, they were going to put their pencils down unless Paulson was willing to “step up.”

Del Missier began to explain to Buffett why the guarantee was so important. “If Lehman trades dollars for yen with somebody, that bank needs to know that Lehman is going to deliver the dollars before they deliver the yen,” he told Buffett. “If there are worries that they’re going to be able to settle that trade, the whole thing is going to unravel.”

While commercial banks like JP Morgan had large, stable deposit bases, they still funded part of their business the same way the broker-dealers did: by regularly rolling over short-term commercial paper contracts that had become subject to the same erosion of confidence that had brought down Bear Stearns—and now Lehman Brothers.

“Paulson said it’s over. The U.K. government won’t allow Barclays to do the deal. Nobody’s saving us.”

“If Lehman goes into bankruptcy, totally unprepared, there’s going to be Armageddon,” Miller warned. “I’ve been a trustee of broker-dealers, little cases, and the effect of their bankruptcies on the market was significant. Here, you want to take one of the largest financial companies, one of the biggest issuers of commercial paper, and put it in bankruptcy in a situation where this has never happened before. What you’re going to do now is take liquidity out of the market. The markets are going to collapse.” Miller waved his finger and repeated, “This will be Armageddon!”

Merrill Lynch, with a history of nearly one hundred years as one of the most storied names on Wall Street, would be sold to Bank of America for the biggest premium in the history of banking mergers. It was, as one newspaper later put it, as if Wal-Mart were buying Tiffany’s.

“This is a day of disgrace! How could the government have allowed this to happen?” Kaufman thundered. “Where were the regulators?”

Incredibly tone-deaf

What went unspoken was the fact that all three banks, and virtually all of Wall Street, were huge counterparties to AIG. If the company were to fail, they would all face serious consequences. Therefore, there was a huge incentive to keep the insurer alive for everyone at the table. On the surface, Goldman looked like one of AIG’s biggest counterparties, but earlier that morning, Goldman’s Gary Cohn had boasted internally that the firm had hedged so much of its exposure to AIG that it might actually make $50 million if the company collapsed. The firm’s decision to buy insurance in the form of credit default swaps against AIG beginning in late 2007 was starting to seem like a smart investment. The firm had conducted what it internally called a “WOW analysis”—a worst-of-the-worst case scenario—and it was quickly coming true. Even though Goldman had hedged its direct exposure to AIG, Blankfein appreciated the larger problem: The collateral damage to its other counterparties and the rest of the market could expose the firm to untold billions in crippling losses.

For the first time in weeks, on Tuesday morning the editorial pages of the major newspapers were heralding Hank Paulson. They applauded his decision to not use taxpayer money to bail out Lehman Brothers.

Given the conversation he’d had with Dan Jester at 6:00 that morning, however, it was looking increasingly likely that AIG and the global financial system were now in such peril that the government would have no choice but to intervene. Paulson had seen the panic gripping the markets in the past twenty-four hours, which was duly reflected in the headlines on every newsstand. That morning’s Washington Post was typical of the tone of the coverage: “Stocks Plunge as Crisis Intensifies; AIG at Risk; $700 Billion in Shareholder Value Vanishes.”

“What would it look like if we said the Fed was going to do this?” For the past seventy-two hours the government had been insisting that it would not bail out any financial institution. Now, with that one sentence, Geithner had turned everything on its head. Even if it was just a hypothetical, the rules of engagement had evidently just changed.

As Paulson and Bernanke both knew, AIG had effectively become a linchpin of the global financial system. Under European banking regulations, financial institutions had been allowed to meet capital requirements by entering into credit default swap agreements with AIG’s financial products unit. Using the swaps, the banks had essentially wrapped AIG’s triple-A credit rating around riskier assets, such as corporate loans and residential mortgages, allowing the banks to take on more leverage. If AIG were to fail, however, those protective wrappers would vanish, forcing the banks to mark down assets and raise billions of dollars—a frightening prospect in the current markets. And the numbers were staggering: Halfway though 2008, AIG had reported more than $300 billion in credit default swaps involved in this wrapping procedure, which it politely called “regulatory capital relief.”

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.

“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.”

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.

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.

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.”

morning of Friday, September 19, 2008, to formally announce and clarify what he had dubbed earlier that morning the Troubled Asset Relief Program, soon known as TARP, a vast series of guarantees and outright purchases of “the illiquid assets that are weighing down our financial system and threatening our economy.”

“The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy,” he explained, his tie slightly askew and looking paler and more tired than he ever had before. “When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans, and investments that create jobs. As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy. . . .

“There’s around $11 trillion of residential mortgages, there’s around $3 trillion of commercial mortgages, that leads to $14 trillion, roughly five percent of that is $700 billion.” As he plucked numbers from thin air even Kashkari laughed at the absurdity of it all.

One of Immelt’s primary concerns, however, was what would happen if its adviser, Goldman Sachs, went out of business. General Electric was more about manufacturing than financial engineering, but roughly half of its profits in recent years had come from a finance company unit called GE Capital. Like most Wall Street firms, GE Capital relied on the short-term paper market and the confidence of investors worldwide, and Immelt was worried about how the fate of Goldman and Morgan Stanley might affect it.

But then he wound up for his big pitch: To complete the deal, he said, Goldman would need the government to guarantee, or ring-fence, Wachovia’s entire portfolio of ARM option mortgages—all $120 billion worth.

He suggested that if they structured it so that Goldman would take a first loss on the deal—in the same way that JP Morgan had agreed to accept the first $1 billion of losses at Bear Stearns before the Federal Reserve would step in and guarantee the next $29 billion—the government might well consider acting as a backstop.

Goldman Sachs and Morgan Stanley would become bank holding companies. It was a watershed event: The two biggest investment banks in the nation had essentially declared their business model dead to save themselves. The New York Times described it as “a move that fundamentally reshapes an era of high finance that defined the modern Gilded Age” and “a blunt acknowledgment that their model of finance and investing had become too risky.”