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

After some back and forth, Buffett made a quick proposal: He indicated he might be interested in investing in preferred shares with a dividend of 9 percent and warrants to buy shares of Lehman at $40. Lehman’s stock had closed at $37.87 that Friday. It was an aggressive offer by the Oracle of Omaha. A 9 percent dividend was a very expensive proposition—if Buffett made a $4 billion investment, for example, he’d be due $360 million a year—but that was the cost of “renting” Buffett’s name.

In Omaha, Buffett had already begun doing a little soul searching, uncertain if he could even bring himself to put his money into an investment bank again. In 1991 he had rescued Salomon Brothers when the storied New York investment house was on the brink, but he quickly realized then that he couldn’t bear the culture of Wall Street. If he now came to Lehman’s assistance, the world would be scrutinizing his participation, and he was well aware that not only would his money be on the line, but his reputation as well. Even though Buffett had often traded in the market using hedges and derivatives, he despised the trader ethos and the lucrative paydays that enriched people he thought were neither particularly intelligent nor created much value.

The investment bankers didn’t make any money, but they felt they were the aristocracy. And they hated the traders, partly because the traders made the money and therefore had more muscle.”

After getting himself another Diet Cherry Coke, he began to read Lehman’s 10-K, its annual report,

Buffett returned to his examination of Lehman’s 10-K. Whenever he had a concern about a particular figure or issue, he noted the page number on the front of the report. Less than an hour into his reading, the cover of the report was filled with dozens of scribbled page citations. Here was an obvious red flag, for Buffett had a simple rule: He couldn’t invest in a firm about which he had so many questions, even if there were purported answers. He called it a night, resolved that he was unlikely to invest.

Although he never brought the subject up, Buffett found it curious that Fuld never mentioned what he imagined was an important piece of news that had crossed the tape over the weekend: “Lehman hit by $355 million fraud.” Lehman had been swindled out of $355 million by two employees at Marubeni Bank in Japan, who had apparently used forged documents and imposters to carry out their crimes.

You just can’t trust people like that.

As unpopular as it might be to state aloud, he intended to stress the fact that 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,” he wrote. “This is not theoretical risk, and it is not something that the market can solve on its own.”

The Federal Reserve had never before made such an enormous loan to the private sector. Why, exactly, had it been necessary to intervene in this case? After all, these weren’t innocent blue-collar workers on the line; they were highly paid bankers who had taken heedless risks. Had Geithner, and by extension the American people, been taken for suckers?

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?

Geithner landed a job at Henry Kissinger’s consulting firm, researching a book for Kissinger and making a very favorable impression on the former secretary of State. Geithner learned quickly how to operate effectively within the realm of powerful men while not becoming a mere sycophant; he intuitively understood how to reflect back to them an acknowledgment of their own importance.

During the Asian financial and Russian ruble crises of 1997 and 1998, Geithner played a behind-the-scenes role as part of what Time magazine called “The Committee to Save the World,” helping to arrange more than $100 billion of bailouts for developing countries.

The presidency of the New York Fed is the second most prominent job in the nation’s central banking system, and it carries enormous responsibilities. The New York bank is the government’s eyes and ears in the nation’s financial capital, in addition to being responsible for managing much of the Treasury’s debt.

He also worked diligently to fill in gaps in his own knowledge, educating himself on the derivatives markets and eventually becoming something of a skeptic on the notion of risk dispersion. To his way of thinking, the spreading of risk could actually exacerbate the consequences of otherwise isolated problems—a view not shared by his original boss at the Fed, Alan Greenspan.

Those circumstances, Geithner told the committee, were not unlike those of 1907, or the Great Depression, and he went on to draw a straight line between panic on Wall Street and the economic health of the country: “Absent a forceful policy response, the consequences would be lower incomes for working families; higher borrowing costs for housing, education, and the expenses of everyday life; lower value of retirement savings; and rising unemployment.” So they’d done what they had to do for the good of the entire country, if not the world, as Steel explained. And thanks to their efforts, he confidently told the lawmakers, the hole in the dike had been plugged.

Despite his public show of humility, Dimon was well aware of what a coup the deal had been for him. From the perspective of the financial media, at least, the Bear acquisition was viewed as a home run.

won’t pay you as much,” Weill told the twenty-five-year-old, “but you’re going to learn a lot and we’re going to have a lot of fun.” Dimon was sold.

Dimon was at a point in his life where many in the same position might have opted for security; his wife had just given birth to their first child. But he decided to stick with Weill, even though Weill hadn’t yet settled on his next project and had taken space in a small office. As the months wore on and Dimon found himself watching Weill sleep off his martini lunches on their office couch, he wondered if he had made a bad bet. Weill couldn’t seem to get anything off the ground, and Dimon had asked himself whether his mentor had played his last hand.

Dimon’s reputation rose alongside Weill’s. They were a team: Weill, the strategist and deal maker; Dimon, more than twenty years his junior, the numbers cruncher and operations whiz.

A more injurious slight came after the $83 billion merger with Citicorp, the deal that rewrote the rules of the U.S. financial system as the last Depression-era barriers between commercial and investment banking—passed as the Glass-Steagall Act of 1933—were removed

When Weill learned of the incident, he judged it inappropriate. A week later, he and his co-CEO, John Reed, summoned Dimon to the corporate compound in Armonk, New York, where they asked him to resign. It proved to be both the worst and best thing that ever happened to Dimon. Just as Weill had done after leaving American Express, he took his time finding a new job, turning down a number of suitors—including, reportedly, the Internet retailer Amazon. Dimon knew little else outside of banking, and he waited for an opportunity in his field, finally accepting the top job at Bank One, a second-tier, hodgepodge operation based in Chicago. It was the launchpad he had been looking for, and he set out to streamline its operations and repair its balance sheet, to the point where he could engineer a deal with JP Morgan in 2004 that would put him in line to succeed William Harrison as CEO.

Once the proudest of Wall Street institutions, JP Morgan had fallen into the middle of the pack as its competitors had begun to outdo it.

Executives visibly tensed when Dimon pulled out of his breast pocket a handwritten piece of paper that served as his daily to-do list.

Dimon, who was paranoid by his very nature, understood the intricacies of virtually every aspect of banking (unlike many of his CEO peers) and also reduced risk; profits were literally squeezed out of each part of the company. Most important, as the credit crisis began to spread, Dimon showed himself to be infinitely more prudent than his competitors. The bank used less leverage to boost returns and didn’t engage in anywhere near the same amount of off-balance-sheet gimmickry. So while other banks began to stumble severely after the market for subprime mortgages imploded, JP Morgan stayed strong and steady.

By Sunday morning, Dimon had seen enough. He told Geithner that JP Morgan was going to pull out; the problems with Bear’s balance sheet ran so deep as to be practically unknowable. Geithner, however, would not accept his withdrawal and pressed him for terms that would make the deal palatable. They finally arrived at an agreement for a $30 billion loan against Bear’s dubious collateral, leaving JP Morgan on the hook for the first $1 billion in losses.

“One thing I can say with confidence,” he told the committee members. “If the private and public parties before you today had not acted in a remarkable collaboration to prevent the fall of Bear Stearns, we would all be facing a far more dire set of challenges.”

“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. The numbers in that area were indeed worrisome. Lehman Brothers was leveraged 30.7 to 1; Merrill Lynch was only slightly better, at 26.9 to 1. Paulson knew intuitively that Wall Street’s leverage problem could not end well.

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.”

Kashkari had always wanted to work in government, and though he’d met Paulson only once previously, he left him a congratulatory voice mail when Paulson was named Treasury secretary. To his surprise, Paulson responded the next day: “Thanks. I’d love for you to join me at Treasury.”

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.

decided nonetheless to keep the Fed’s benchmark interest rate unchanged at 5.25 percent for the ninth consecutive meeting. Rather than try to boost economic activity by lowering rates, the committee decided to stand pat. “The committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected,” the Fed announced in a subsequent statement. That, however, was not what Wall Street wanted to hear, for concerns about the sputtering economy had investors clamoring for a rate cut. Four days earlier financial commentator Jim Cramer had exploded on an afternoon segment of CNBC, declaring that the Fed was “asleep” for not taking aggressive action. “They’re nuts! They know nothing!” he bellowed.

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 rates that banks were charging to lend money to one another quickly spiked in response, far surpassing the central bank’s official rates. To Bernanke what was happening was obvious: 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.

“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 discount rate is what the Fed charges banks that borrow directly from it.)

benchmark rate—the Fed’s most powerful tool for stimulating the economy—might

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.

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. Regulators around the world were having trouble understanding how the pieces all fit together. Greenspan would later admit that even he hadn’t comprehended exactly what was happening. “I’ve got some fairly heavy background in mathematics,” he stated two years after he stepped down from the Fed. “But some of the complexities of some of the instruments that were going into CDOs bewilders me. I didn’t understand what they were doing or how they actually got the types of returns out of the mezzanines and the various tranches of the CDO that they did. And I figured if I didn’t understand...

Then Kashkari summarized what he and his colleagues at Treasury viewed as the pros and cons of their proposal. The first and most important point was that if the government acted, banks would continue lending—but not, it was hoped, in the irresponsible way that gave rise to the crisis in the first place. The primary argument against the proposal was that, to the extent that the plan worked, it would create “moral hazard.” In other words, the people who made the reckless bets that initially caused the problems would be spared any financial pain.

Steel took a deep breath and then asked his question: “Is there a price at which you’d be interested in Lehman? And if so, what would you need from us?” Diamond was momentarily speechless; Treasury, he realized, was clearly trying to formulate strategic solutions in the event that Lehman found itself in a Bear Stearns–like situation. From long acquaintance he knew Steel to be a no-nonsense pragmatist, not someone who idly floated trial balloons.

Lehman was a logical merger candidate if Diamond—and, of course, his boss and the board in London—wanted Barclays to become an overnight investment banking powerhouse in New York. But he knew it would be an expensive purchase so long as Dick Fuld was running it. Still, an opportunity like this hardly came up often.

the uptick rule—a regulation that had been introduced by the Securities and Exchange Commission in 1938 to prevent investors from continually shorting a stock that was falling.

But in 2007 the commission had abolished the rule, and to critics like Cramer, its decision had been influenced by free-market ideologues who were eager to remove even the most benign speed bumps from the system. Ever since, Cramer had been warning anyone who’d listen that without this check, hedge funds were free to blitzkrieg good companies and drive down their stock.

Einhorn’s analysts spent their days studying 10-Ks in conference areas with wonky names like “The Nonrecurring Room,” a reference to the accounting term for any gain or loss not likely to occur again—a categorization sometimes used by companies to beef up their statements. For Einhorn, it was a red flag, and one that he used to spot businesses he could short. Among the companies he had identified from recent research was Lehman Brothers, which he thought might be an ideal topic for his speech. While questioning Lehman’s solidity may have become the most popular recent topic of Wall Street gossip, Einhorn had been quietly worried about the firm since the previous summer.

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.

More important, Einhorn thought Lehman was not being forthcoming about a dubious accounting maneuver that had enabled it to record revenue when the value of its own debt fell, arguing that theoretically it could buy that debt back at a lower price and pocket the difference.

“This is crazy accounting. I don’t know why they put it in,” Einhorn told his staff. “It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”

What Einhorn now wanted to know was whether Lehman reassessed the value of its illiquid assets—including some $9 billion in mortgages—every day, every week, or every quarter.

“from a balance sheet and business mix perspective, Lehman is not that materially different from Bear Stearns.”

As investor events go—and there are many—this was one that genuinely mattered. The hedge fund industry is famously reclusive, but today the key players in the field were in attendance, the auditorium packed with industry titans such as Carl Icahn, Bill Miller, and Bill Ackman. By some estimates, the guests in the audience that day had more than $500 billion under management.