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

“Recently, we had the CEO of a financial institution in our office. His firm held some mortgage bonds on its books at cost. The CEO gave me the usual story: The bonds are still rated triple A, they don’t believe that they will have any permanent loss, and there is no liquid market to value these bonds. “I responded, ‘Liar! Liar! Pants on fire!’ and proceeded to say that there was a liquid market for these bonds and they were probably worth sixty to seventy percent of face value at the time, and that only time will tell whether there will be a permanent loss. “He surprised me by saying that I was right. He observed that if he said otherwise, the accountants would make them write the bonds down.”

“For the last several weeks, Lehman has been complaining about short-sellers. Academic research and our experience indicate that when management teams do that, it is a sign that management is attempting to distract investors from serious problems.”

What the public did not know—nor did some of Lehman’s top executives, including Fuld—was that Lehman had been artificially lowering its quarterly leverage ratio by using an accounting sleight of hand.

“You’re a wonderful leader, but when the books are written, your Achilles’ heel will be that you have a blind spot for weak people who are sycophants.”

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.

While the firm did employ a well-regarded chief risk officer, Madelyn Antoncic, who had a PhD in economics and had worked at Goldman Sachs, her input was virtually nil. She was often asked to leave the room when issues concerning risk came up at executive committee meetings, and in late 2007, she was removed from the committee altogether.

Through hard work and support from powerful mentors, O’Neal rose rapidly through the ranks.

In 2007, Merrill kept its foot firmly on the gas pedal, underwriting more than $30 billion worth of CDOs in the first seven months of the year alone. With his bets paying off so incredibly well, though, O’Neal had overlooked one critical factor—he hadn’t made any preparations for an inevitable downturn, having never paid much attention to risk management until it was too late.

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.

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 pyramidlike structure of a collateralized debt obligation is a beautiful thing—if you are fascinated by the intricacies of financial engineering. A banker creates a CDO by assembling pieces of debt according to their credit ratings and their yields. The mistake made by AIG and others who were lured by them was believing that the ones with the higher credit ratings were such a sure bet that the companies did not bother to set aside much capital against them in the unlikely event that the CDO would generate losses.

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 early February, the auditor had instructed AIG to revalue every last one of its credit default swaps in light of recent market setbacks. Days later the company embarrassingly disclosed that it had found a “material weakness”—a rather innocuous euphemism for a host of problems—in its accounting methods. At the same time, a humiliated AIG had to revise its estimate of losses in November and December, an adjustment that raised the figure from $1 billion to more than $5 billion.

In May, AIG reported dismal results for the first quarter, a $9.1 billion write-down on credit derivatives and a $7.8 billion loss—its largest ever. Standard & Poor’s responded by cutting its rating on the company by one notch, to AA minus.

Many foreign investors feared that Russia’s commitment to open and free markets was quickly fading, particularly in light of the power grabs in the energy industry.

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.”

Apart from his general systemic concerns, though, Paulson’s immediate worry was Lehman Brothers. He had spoken to Fuld from his cabin on the island earlier in the day, and it was becoming clearer to him that the firm was unlikely to find a buyer.

Harting, an analyst at Lehman Brothers, wrote that revised accounting rules might require Fannie and Freddie to raise an additional $75 billion in combined new capital. The report revived all the fears about the two mortgage giants, reminding investors of how thin a cushion they had if the housing slump deepened. If confidence was eroding in the government-sponsored enterprises—businesses that the market believed had the implicit backing of taxpayers—the entire U.S. economy could be threatened.

Credit default swaps on the debt sold by Fannie and Freddie—essentially, insurance—were trading at levels reserved for companies with credit ratings five levels below their own triple-A ratings, the highest a company could have. Those ratings were, in fact, more a reflection of the government’s implicit backing than the companies’ own fundamentals.

Fannie Mae (originally the Federal National Mortgage Association) in 1938, it was politically divisive. 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.

But in 1999, under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages. The move was presented in the press as a way to put homes within the reach of countless Americans, but providing loans to people who wouldn’t ordinarily qualify for them was an inherently risky business, as telegraphed by the New York Times the day the program was announced: “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”

A socialist. Mr. Bailout. Hank Paulson believed he was fighting the good fight, a critical fight to save the economic system, but for his efforts he was being branded as little less than an enemy of the people, if not an enemy to the American way of life. He couldn’t understand why no one could see how bad the situation had really become.

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.

Fuld interjected. “I think you’re making a big mistake,” he told Min. “You’re going to miss a great opportunity. There’s a lot of value in these real estate assets,” pressing Min to buy at least some of them. As the conversation continued, Fuld suggested that Min’s plan to pay 1.25 times book value was “too low,” instead recommending they negotiate on the basis of 1.5 times book value. McDade and McGee couldn’t believe what they were witnessing. They had spent the past two days orchestrating a deal based on spinning off the real estate assets, and now Fuld was trying to retrade on their work. Worse, a look of horror crossed Min’s face. Min pulled Barancik aside and whispered, “I’m not comfortable with this,” and in response, Barancik spoke up on behalf of KDB. He said they would only negotiate on the basis of 1.25 times the book value valuation, and then, as his aggravation mounted, started questioning Lehman’s accounting.

Nason had raised the possibility that they might have no choice in an emergency but to go to Congress and seek permission to guarantee all of Lehman’s trades. But as quickly as he raised the idea, he shot himself down. “To guarantee all the obligations of the holding company, we would have to ask Congress to use taxpayer money to guarantee obligations that are outside the U.S.,” he announced to the room. “How the hell would we ask for that?”

Bernanke had said, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” Yet his very next sentence—“But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy”—bolstered what had been perceived as the central bank’s policy since the hasty, Fed-organized, Wall Street–financed bailout of the hedge fund Long-Term Capital Management in 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.

Bernanke, however, surprising the table, said that neither scenario was a real possibility. “We’ve learned so much from the Great Depression and Japan that we won’t have either,” he said assuredly.

To Paulson, unless he solved Fannie and Freddie, the entire economy would be in jeopardy.

“The market cares what the Paulsons think. John Paulson and Hank Paulson. They want to know what John Paulson thinks is enough and they want to know what Hank Paulson is going to do.” (John Paulson was the most successful hedge fund investor of the past two years, having shorted subprime before anyone else, making some $15 billion for his investors and personally taking home more than $3.7 billion.)

The Morgan Stanley bankers estimated that the two mortgage companies would need some $50 billion in a cash infusion, just to meet their capital requirement, which should be equal to 2.5 percent of their assets; banks, at a minimum, had to have at least 4 percent. With the housing market deteriorating it was clear that the GSEs’ thin capital cushion was in danger.

“If your stock price continues to slide, something might come out of the woodwork here with a price that doesn’t look that compelling. But you might have to take it to keep the organization intact.” “What do you mean, low price?” “It could be low single digits.” “No fuckin’ way,” Fuld said heatedly. “Bear Stearns got $10 a share, there’s no fuckin’ way I will sell this firm for less!”

“I’ve been trying to encourage opening up the lines of communication between Wall Street and Capitol Hill,” he now told the bankers, explaining that when he ran Goldman, he hadn’t “appreciated how important it was to establish the right relationships in Washington.”

About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.” You didn’t have to be a Harvard MBA to instantly comprehend the significance of that figure: If AIG went under, it could take the entire financial system along with it.

Black had long been bearish on Lehman. At an internal leadership forum at JP Morgan in January 2007, he had predicted: “Dick Fuld will end up selling that company when he has to sell instead of when he should have sold it.” Reminding the group of his earlier prognostication, he announced: “I told you they would be fucked!”

“The key thing you have to understand is it’s not in anyone’s interest for Lehman to fail,” replied Bove, who, oddly enough, had a buy on the stock and a $20 price target. “It’s not in the interest of its competitors—Goldman Sachs, Morgan, Citigroup, JP Morgan—because if Lehman were to fail, then the pressure moves to Merrill Lynch and then it moves to who knows who else?

If all that weren’t enough to deal with, McDade had just had a baffling conversation with Fuld, who informed him that Paulson had called him directly to suggest that the firm open up its books to Goldman Sachs. The way Fuld described it, Goldman was effectively advising Treasury. Paulson was also demanding a thorough review of Lehman’s confidential numbers, courtesy of Goldman Sachs.

Lewis’s biggest concern about a potential deal, as he told Paulson, was Fuld, who Lewis worried would be unrealistic about his asking price. He recounted to Paulson how badly their meeting had gone back in July. “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.

From his days as a merger banker focusing on financial services, he knew that if Lehman was on the auction block, Bank of America would be the likely buyer. But if Lehman was sold to Bank of America, the implications for his own firm, Merrill Lynch, would be enormous. He had long believed that Bank of America was the natural buyer for Merrill; at a Merrill board meeting just a month earlier, Bank of America had been listed in a presentation as just one of a handful of compatible merger partners.

Finally, the time came for the dreaded meeting with Moody’s. Steve Black from JP Morgan had come downtown to lend some credibility to the affair and to help answer questions about AIG’s plans to raise capital. It was one thing for Willumstad to state that he had every intention of raising capital and quite another entirely to have the president of JP Morgan affirm that he intended to support the company in that effort. The stakes were high: If the agency cut AIG’s credit rating by even one notch, it could trigger a collateral call of $10.5 billion. If Standard & Poor’s followed suit, which was likely—“the blind leading the blind,” Willumstad said of them—the figure would rise to $13.3 billion. Should that happen, and AIG be unable to come up with the extra capital, it would be a virtual death sentence.

“We’ve looked at it and we can’t do it—we can’t do it without government assistance,” Lewis said levelly. “We just can’t do it because we can’t get there.” Like many of Lehman’s critics at the time, including the anxious shareholders who were flooding the market with sell orders, Lewis said that the valuations that Lehman had placed on its assets were far too high. Buying them could expose Bank of America to huge risks.

Paulson joined a strategy call with Geithner, Bernanke, and Cox. He felt they were about to go into crisis mode and feared another Bear Stearns–like weekend. This time, however, he was determined that it end differently. He believed they needed to prepare what he called a “LTCM-like solution”—in other words, he was committed to the idea of encouraging firms in the private sector to band together and put their own money up to somehow save Lehman Brothers.

Flowers’s eyes widened as he studied the numbers. “You guys have a real problem here.” “Yes. But we should be okay if we can make the capital raise work,” Willumstad said. “Have you guys thought about Chapter 11?” Flowers blurted out. It was as if he had touched the third rail. “Why are you using words like that?” Bensinger asked, clearly upset.

He also walked through the company’s various divisions and the amount of cash that each had on hand. Before Schreiber could continue with his inventory, Dimon cut him off. “You’re a smart guy but you’re running a fucked-up process.” 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.”

In times of crisis—when a big check had to be written almost immediately—Buffett was the obvious man to turn to.

Buffett, however, wasn’t especially interested in getting mixed up in such a mess. “You know, I don’t have as much money as I used to,” he said with a laugh. “I’m kind of low on cash.”

Willumstad, who had never met Buffett, called and began his pitch, but before he could get very far into it, Buffett stopped him. “I’ve looked over the 10-K,” he said. “The company is too complicated. I don’t have enough confidence to do that. Look, nothing is going to work with us, so don’t waste your time. You’ve got plenty to do.”

With the stock trading down another 9.7 percent to $3.71 a share, the possibility was being discussed openly not only throughout the office but in the media as well. By now the anger was also becoming increasingly palpable on the trading floor among the firm’s staff. Lehman’s employees were unique on Wall Street in that they owned a quarter of the company’s shares.

And as of Friday, those shares had lost 93 percent of their value since January 31; $10 billion had disappeared. (Fuld, who owned 1.4 percent of the company—some 10.9 million shares—had lost $649.2 million.)

Deep below the limestone and sandstone building, which was modeled after the Strozzi Palace of Florence, lies a three-level vault built into the bedrock of Manhattan, fifty feet below sea level. It holds more than $60 billion of gold. Real hard assets, with real value.