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

running the numbers on Wachovia. The obvious concern was its gargantuan subprime exposure, some $120 billion worth.

Wachovia was nobody’s idea of a dream date, but at the moment, it was the only girl at the dance.

Paulson was no longer worried just about investment banks; he was worried about General Electric, the world’s largest company and an icon of American innovation. Jeffrey Immelt, GE’s CEO, had told him directly that the conglomerate’s commercial paper, which it used to fund its day-to-day operations, could stop rolling.

Paulson knew this was his financial panic and perhaps was the most important moment of his tenure at Treasury, and possibly of his entire career. 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.

He still hated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment.

The first order of business, Paulson said, was addressing the money market crisis. Steve Shafran, a former Goldman banker, suggested that the Treasury could simply step in and guarantee the funds. “We have the authority,” he said, citing the Gold Reserve Act of 1934, which set aside a fund, now totaling $50 billion, to stabilize essential markets. The key, Shafran said, was that all they needed to access it was presidential approval, bypassing Congress. “Do it!” Paulson said,

“You cannot go out and talk about big numbers with regard to capital needs for banks without inviting a run,” Geithner told him. “If you don’t get the authority, I’m certain you’ll spark a freaking panic. You have to be careful about not going public until you know you’re going to get it.”

By midafternoon Wednesday, Morgan Stanley’s stock had fallen 42 percent. The rumors were flying: The latest gossip had the company as a trading partner with AIG, with more than $200 billion at risk. The gossip was inaccurate, but it didn’t matter; hedge funds continued to seek nearly $50 billion in redemptions.

John Mack was meeting with his brain trust, already anticipating what had become a grim end-of-day ritual. At 2:45 p.m., hedge funds would start pulling money out of their prime brokerage accounts, asking for all the credit and margin balances. At 3:00, the Fed window would close, leaving the firm without access to additional capital until the following morning. Then, at 3:02, the spread on Morgan Stanley’s credit default swaps—the cost of buying insurance against the firm’s defaulting—would soar. Finally, its clearing bank, JP Morgan, would call and ask for more collateral to protect it.

Unknown to the public, Paulson was now officially free to help Goldman Sachs. —

The conversation quickly turned serious. “I have to tell you, the system’s going to collapse in the next few days. I doubt you’re going to be able to open the banks on Monday,” Schwarzman said, deeply spooked by what he was seeing. “People are shorting financial institutions, they’re withdrawing money from brokerage firms because they don’t want to be the last people in—like in Lehman—which is going to lead to the collapse of Goldman and Morgan Stanley. Everybody is just pursuing his self-interest,” Schwarzman told him. “You have to do something.” “We’re working on some things,” Paulson said. “What do you think we should do?” “You have to approach what you’re doing from the perspective of being a sheriff in a western town where things are out of control,” Schwarzman replied, “and you have to do the equivalent of just walking onto Main Street and shooting your gun up in the air a few times to establish that you’re in charge because right now no one is in charge!”

“John,” Kelleher said in his staccato British inflections, “we’re going to be out of money on Friday.” He had been nervously watching the firm’s tank—its liquid assets—shrink, the way an airline pilot might stare at the fuel gauge while circling an airport, waiting for landing clearance.

“It’s one thing to complain, but another to put out a memo blaming your clients,” railed Jim Chanos, the short-seller who famously unearthed the problems at Enron. He had been a Morgan Stanley client for twenty years, but now he was making his displeasure known by pulling $1 billion from his account at the firm.

Morgan Stanley applauds Attorney General Cuomo for taking strong action to root out improper short selling of financial stocks. By initiating a wide-ranging investigation of this manipulative and fraudulent conduct, Attorney General Cuomo is showing decisive leadership in trying to help stabilize the financial markets. We also support his call for the SEC to impose a temporary freeze on short selling of financial stocks, given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks.

Bernanke was making his frustration clear; he didn’t believe the crisis could be solved by individual deals or some one-off solution. “We can’t keep doing this,” he insisted to Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”

Congress created the RTC in 1989 to handle the more than $400 billion in loans and other assets held by 747 failed savings and loans as part of the S&L crisis. The RTC had been the recipient of a wide range of loans, properties, and bonds from the failed thrifts. Like the predicament Paulson currently faced, some of the assets were good but most were bad, and some, including construction and development loans, had no discernible market. The task was daunting: L. William Seidman, the RTC chairman, initially estimated that even if the agency sold $1 million of assets a day, it would take three hundred years to dispose of everything. By the time the RTC completed its job in 1995, a year ahead of its deadline, the cost to the taxpayers was nearly $200 billion (in 2008 dollars)—a much lower tab than what many had feared at the time the agency had been created.

“The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link.”

Directly in the middle of the story was a quote, citing two people who had been briefed on merger talks between Morgan Stanley and Citigroup, saying that John Mack had told Vikram Pandit, “We need a merger or we’re not going to make it.” Nides couldn’t believe Mack even said that. He had been in the room for one of the calls with Pandit and it didn’t go like that, he thought. Morgan Stanley, Nides knew, could not afford that sort of coverage, whether or not it was true. The more people who knew it, the truer it would become. “Did you see this irresponsible piece of shit in the Times?” Nides asked when he got Mack on the phone. Mack, however, only read the Wall Street Journal, the Financial Times, and the New York Post, having canceled his Times subscription in protest after the Sulzberger family pulled its money from Morgan Stanley because one of its asset managers had decided to run a proxy contest against the Times ownership.

“We’re clean, we’re making money. We made a lot of money the last eight days also. But it doesn’t make any difference. We deal in a market today that financial chicanery, rumor, and innuendo are much more powerful than real results.”

The Federal Reserve, along with the other central banks, had just announced plans to pump $180 billion to stimulate the financial system, but the scheme did not seem to be having any appreciable effect. Goldman’s shares opened down 7.4 percent.

The firm’s own CDS spreads had blown out in a way the firm had never seen before, indicating that investors were quickly beginning to believe the unthinkable: that Goldman, too, could falter.

“Look, the one thing I’m doing is I’m learning who my friends are and who my enemies are, and I’m making lists.” Druckenmiller, however, was unmoved. “I don’t really give a shit; it’s my money,” he shot back. Unlike most hedge funds, Druckenmiller’s did consist primarily of his own money. “It’s my livelihood,” he said. “I’ve got to protect myself and I don’t really give a shit what you have to say.”

Lynch, too, was starting to suspect a problem. Are Wachovia’s numbers worse than anyone knows? he wondered to himself. “Well, we can’t do the deal without seeing the data,” he told her. Sherburne relented.

Even in its panicked state, Goldman was still Goldman, and Dimon didn’t want a war. Within half an hour he had Steve Black and Bill Winters, co–chief executives of JP Morgan’s investment bank, send out a companywide e-mail: We do not want anyone at JP Morgan capitalizing on the irrational behavior that’s going on in the market toward some of the U.S. broker-dealers. We are operating as business as usual with Morgan Stanley and Goldman Sachs as counterparties. While they are both formidable competitors, during this period, we do not want anyone approaching their clients or employees in a predatory way. We want to do everything possible to remain supportive of their business and not do anything that would impact them negatively. We do not believe anyone has engaged in any inappropriate behavior, but we want to underscore how important it is to be constructive during this time. What is happening to the broker-dealer model is not rational, and not good for JP Morgan, the global financial system or the country. —

While the toxic-asset program made sense in theory, for it actually to work, for it to be effective, Paulson knew they’d need to buy large swaths of toxic securities from the nation’s largest banks. The cost was going to be enormous, and it would be perceived, both within and outside of the Washington Beltway, as another bailout.

The key concern at that moment was whether spending so much money would require them to have to ask Congress to increase the debt ceiling—a political flashpoint that would require Congress to vote to raise the amount of debt the country could take on. It had just increased that amount to $10.615 trillion in July.

Paulson raised one last problem: Wachovia, he said, might falter. He was getting back-channel messages from Kevin Warsh that the bank’s finances were in much worse shape than they believed. Everyone understood the significance of his statement. After all, Bob Steel, their former colleague, was its CEO.

“Well, that’s interesting,” Mack retorted. “You’re calling my CFO and you’re calling my president, why would you do that?” “I was trying to be helpful,” Dimon repeated. “If you want to be helpful, then talk to me. I don’t want you calling my guys,” Mack said, hanging up the phone.

“The market is trading under the assumption that every financial institution is going under,” Michael Petroff, portfolio manager for Heartland Advisors, told Agence France-Presse that morning. “It’s now emotional.”

But just then, at 1:00 p.m., the market—and Goldman’s stock—suddenly turned around, with Goldman rising to $87 a share, and then $89. Traders raced through their screens trying to determine what had been responsible for the lift and discovered that the Financial Services Authority in the U.K. had announced a thirty-day ban on short selling twenty-nine financial stocks, including Goldman Sachs. It was exactly what Blankfein and Mack had tried to persuade the SEC’s Christopher Cox to do.

Paulson told Bush in no uncertain terms that the financial system was collapsing. “If we don’t act boldly, Mr. President,” he said, “we could be in a depression deeper than the Great Depression,” an assessment with which Bernanke concurred. Bush was struggling to wrap his mind around the precise course of events. “How,” he questioned, “did we get here?” Paulson disregarded the question, knowing that the answer would be way too long and lay in a heady mix of nearly a decade of overly lax regulation—some of which he had pushed for himself—overzealous bankers, and home owners living beyond their means.

“This is only going to work if you scare the shit out of them.” That had been Jim Wilkinson’s advice to Paulson before he and Bernanke left to meet with the congressional leadership at Nancy Pelosi’s office that evening. By Wilkinson’s reckoning, unless they could convince Congress that the world was literally going to come to an end, they would never receive approval for a $500 billion bailout package for Wall Street. Republicans would complain it was socialism; Democrats would carp about rescuing white-collar fat cats.

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.”

He said he hoped that Congress could pass the legislation within days and promised to get a full proposal to them literally within hours. “If it doesn’t pass, then heaven help us all,” Paulson said. Harry Reid, sitting across from Bernanke, looked at Paulson with a sense of bemusement about the prospect that Congress would pass a bill of this magnitude that quickly. “Do you know what you are asking me to do?” he said. “It takes me forty-eight hours to get the Republicans to agree to flush the toilets around here.” “Harry,” Mitch McConnell (R-Kentucky), who was deeply frightened by Paulson and Bernanke’s presentation, interjected, “I think we need to do this, we should try to do this, and we can do this.”

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.” He also announced an expansive plan to guarantee all money market funds in the nation for the next year, hoping that that move would keep investors from fleeing them.

Evidently confident that Washington had finally brought the financial crisis under control—between Paulson’s TARP and Cox’s ban on short-sellers—the stock market had risen 300 points at the open and continued to hold its ground as Paulson spoke.

Whatever that sum turned out to be, they knew they could count on Kashkari to perform some sort of mathematical voodoo to justify it: “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.

“What do you think of becoming a bank holding company?” Blankfein asked Mack when he picked up the receiver. Mack hadn’t really studied the issue and asked, “Would that help us?” Blankfein said that Goldman had been investigating the possibility and explained to him the benefits—namely, that if they allowed themselves to be regulated by the Federal Reserve, they’d have unlimited access to the discount window and would have an easier time raising capital, among other things.

“You’ve got to be fucking kidding me,” Scully exclaimed. “We obviously can’t do this deal.” To make it work, Morgan Stanley would have to raise some $20 billion to $24 billion of equity to capitalize the combined firm, a virtual impossibility under the current market conditions. Even so, the Morgan bankers decided not to cancel the all-day diligence session, as they figured they had nothing to lose. Morgan Stanley might well be able to take advantage of Paulson’s new plan to buy toxic assets from Wachovia and, indeed, investors had already bid up Wachovia’s shares that morning on precisely that expectation.

“These guys are clearly disengaged,” Kindler told him. Scully described Wachovia’s mortgage book as “a $40 to 50 billion problem. It’s huge.

Kelleher, who had been keeping a careful watch over the firm’s dwindling cash pile, had just taken a look at Wachovia’s numbers for himself and observed, “That’s a shit sandwich even I can’t get my big mouth around.”

Jonathan Kindred, president of Morgan Stanley’s securities business in Tokyo, greeted him and said excitedly, “This is interesting. I just got a call from Mitsubishi. They want to do the deal.” Mitsubishi UFJ, Japan’s biggest bank, was interested in buying a stake in Morgan Stanley.

Kindred said he thought Mitsubishi was prepared to move quickly. But Kelleher, rolling his eyes, was skeptical. He had worked with other Japanese banks before and, in his experience, they had always lived up to their reputation as being slow, risk-averse, and deeply bureaucratic.

He suggested to Warsh that the government attempt a shotgun wedding between Goldman and Wachovia. He knew it was a long shot—the “optics,” he acknowledged, would be problematic, given Paulson had worked at Goldman for thirty years and been its CEO from 1999 to 2006 and that Wachovia’s CEO, Bob Steel, was a former Goldman man and Paulson’s former deputy at Treasury too—but it would solve everyone’s problems: Goldman would get the deposit base it had been seeking, and Wachovia would have its death sentence stayed.

Over dinner, ordered in from Mack’s favorite restaurant, San Pietro—again—they discussed a possible transaction. Alternating between standing up and lying down, Gao reiterated his interest in buying 49 percent of Morgan Stanley. As he had told Christianson on the flight over, he now indicated that he was prepared to provide the firm with a credit line of as much as $50 billion and a nominal equity investment—no more than $5 billion, maybe less. Mack was stunned. He had known the price that would be offered might be low, but to him this was absurdly so—it was effectively merely a loan.

However insulting Gao’s proposal, Mack recognized that his situation was desperate. Despite the market rally, the firm had continued to bleed cash. Kelleher had given him the cash balances and they were not good—about $40 billion in the tank. A few bad days could wipe them out, and most days lately had been bad ones.

The urgency of getting the sale approved was growing more and more evident as with each passing hour the markets chipped away at the value of Lehman’s assets. Not only was the bankruptcy of Lehman, which had filed for Chapter 11 with $639 billion in assets, by far the largest in the nation’s history, but an unwinding of so complex a financial institution had never before been attempted.

Miller, even under these circumstances dapper in a gray suit, red tie, and blue shirt, outlined the deal: Barclays would pay $1.75 billion for Lehman’s North American operations. “This is a tragedy, Your Honor,” Miller said of what had happened to Lehman Brothers. “And maybe we missed the RTC by a week,” he added, referencing the development of the new TARP program. “That’s the real tragedy, Your Honor.” “That occurred to me as well,” Judge Peck said sympathetically.

With a heavy heart, he went on to offer a eulogy: “Lehman Brothers became a victim. In effect, the only true icon to fall in the tsunami that has befallen the credit markets. And it saddens me. I feel that I have a responsibility to all the creditors, to all of the employees, to all of the customers and to all of you.” It was 12:41 a.m. when Judge Peck ended the hearing. As he stepped down from the bench, the courtroom, with at least several people moved to tears, erupted in a wave of applause.

On a pad that morning, Geithner started writing out various merger permutations: Morgan Stanley and Citigroup. Morgan Stanley and JP Morgan Chase. Morgan Stanley and Mitsubishi. Morgan Stanley and CIC. Morgan Stanley and Outside Investor. Goldman Sachs and Citigroup. Goldman Sachs and Wachovia. Goldman Sachs and Outside Investor. Fortress Goldman. Fortress Morgan Stanley. It was the ultimate Wall Street chessboard.