Too Big To Fail

In early June, Jamie Dimon was meeting with Robert Willumstad, who ran private-equity fund Brysam Global Partners and was chairman of the board of insurer AIG, one of the largest financial companies in the world. In 2004, AIG Financial Products Corp. (FP) had been put “on probation” after settling “criminal and civil charges that it had allowed PNC Financial Services to shift $762 million in bad loans off its books” (157). Later, FP “became Ground Zero for the financial shenanigans that would nearly destroy the company” (157).

In late 1997, JP Morgan had begun pitching a “new kind of credit derivative product called the broad index secured trust offering,” or “BISTRO” (158-59). AIG came up with its own version of this credit default swap, and it became a “big player in the area” (159) by 2005. It was thought that these would be “foolproof” unless there was “another Great Depression” (159).

The mistake AIG and others made was to believe that pieces of debt with “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” (159). Toward the end of 2005, AIG stopped underwriting insurance on CDOs that were tied to subprime mortgage-backed securities, so they thought they had “dodged a bullet” (159). With very little debt and about $40 billion in cash, AIG was thought to be “too big to fail” (160). But by 2007, “how AIG saw itself and how everyone had come to view it were rapidly diverging” (160).

In January 2008, Willumstad realized AIG could “soon be forced to pay out astronomical sums of money” (162). He immediately contacted AIG’s outside auditor, PricewaterhouseCoopers, and discovered a “material weakness” (162), as it was euphemistically called, in its accounting methods. It had to revise its estimated losses from $1 billion to over $5 billion.

Because AIG employees were paid a percentage of profits and AIG didn’t want its team to leave because it would not get paid in light of the firm’s huge losses, AIG approved a retention plan that would pay out $165 million in 2009 and $235 million in 2010—a plan that gave rise to a “political nightmare that would result in censure, death threats, and a mad scramble on Capitol Hill to undo the bonuses” (163-64).

In May 2008, AIG lost its AAA rating; Standard & Poor’s cut its rating to AA minus. Meanwhile, JP Morgan and Citigroup were “spearheading a push for AIG to take additional write-downs and disclose them (165). AIG had to cave to JP Morgan because it needed to raise money and “could not afford to have a battle with its main banker become public” (166).

Lloyd Blankfein of Goldman Sachs was in Russia in 2008 for a Goldman board meeting. Goldman also had a meeting scheduled with Vladimir Putin during the trip. The meeting was held in Russia as one of the economies to which “wealth and power was now shifting” (168), along with Brazil, India, and China. Russia had sent the world markets “into a tailspin” (168) back in 1998 when it suddenly defaulted on its debt, to the point that Goldman had to postpone plans to go public. This was Goldman’s third foray into dealing with Russia.

At the meeting, the firm’s senior strategy officer, Tim O’Neill, made the case that Bear “was not just a one-off event” (171). Goldman had “steered clear of the most noxious” (169) assets—those backed by subprime mortgages, but O’Neill was there to serve as the “fire marshal”: “Nothing was burning yet, but it was his responsibility to identify all the emergency exits” (170). The problem was that, unlike commercial banks, Goldman did not have its own assets. It relied on the “short-term repo market—repurchase agreements that enabled firms to use financial securities as collateral to borrow funds” (170). Goldman tended to have longer term debt agreements, but it was still “susceptible to the vagaries of the market” (171).

One of O’Neill’s suggestions was for Goldman to buy an insurance company, one “large enough to put more than a dent in Goldman’s already hefty balance sheet” (175). AIG was at the top of the list of contenders. The one person on the board with experience in the insurance industry was Edward Liddy of Allstate, and he was not enthusiastic about the idea.

At the same time, Goldman was disputing AIG’s valuation of the securities it put up as collateral for its trades through Goldman as overinflated. But no one at the board meeting raised this as “evidence of a potential fatal flaw in Goldman’s consideration to merge with AIG—that the company itself was in serious trouble and had resorted to overvaluing its securities as a stopgap” (176). PricewaterhouseCoopers (PWC) was also seen as having a conflict, as it represented both Goldman and AIG.   

Henry Paulson was in Russia at the same time and had organized an informal meeting with Goldman’s board while he was there, but Jim Wilkinson, who had been asked to arrange the meeting, had concerns about the “optics” (179). He obtained approval from Treasury’s general counsel, as long as it was a “social event” (179), but Wilkinson still wanted to keep it quiet. At the event, Paulson said he thought they might “come out of this by year’s end,” which puzzled Blankfein, who thought it could “only get worse” (180).

In late June, the new president of Lehman, Bart McDade, asked Dick Fuld to hire back Michael Gelband and Alex Kirk, two senior traders who had been fired by Joe Gregory who had been “among the most vocal opponents of the firm’s escalation of risk over the years” (181). Gelband agreed to come back only because he was a longtime friend of McDade, having attended the University of Michigan Business School together.

In July, Paulson was still having “deep misgivings about the economy in the near term,” and his “immediate worry” (183) was about Lehman. He was also losing his deputy, Bob Steel, who was leaving to be the CEO of Wachovia, having been in charge of Fannie Mae and Freddie Mac, the “government-sponsored enterprises (GSE) that had been the engine of the real estate boom and were now coming undone” (183). Paulson and his team had already been discussing “ways to unwind Fannie and Freddie should a real crisis hit” (184), but anything involving these companies was a political football. Paulson had “called the debate over Fannie and Freddie ‘the closest thing I’ve seen to a holy war’” (185).

At their height, Fannie and Freddie “owned or guaranteed some 55 percent of the $11 trillion US mortgage market” (185). And they were also “important conduits for the business of mortgage-backed securities” (185). But by 1999, “under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages,” an “inherently risky business” (186). Ultimately, the “success of the two companies in both the financial and political arena inevitably fostered a culture of arrogance” (186). Their “overconfidence led both companies eventually to move into derivatives and to employ aggressive accounting measures” (186). They were later forced to restate years of results when they were found to have manipulated their earnings.

In March 2008, the Bush administration “lowered the amount of capital the two companies were required to have as a cushion against losses,” in exchange for their promise to “help bolster the economy by stepping up their purchases of mortgages” (186-87). But by July 2008, “it was all coming undone” (187).

Paulson appeared in front of the House Financial Services Committee to “start laying the groundwork for obtaining authority from Congress to wind down” (189) Fannie and Freddie. Paulson ended up calling former Fed chairman Alan Greenspan for advice, and Greenspan “suggested that there was too much housing supply and that the only real way to really fix the problem would be for the government to buy up vacant homes and burn them” (190). Paulson was furious when someone leaked the story about Fannie and Freddie to the New York Times, a move that was “bound to undermine confidence even further” (191). Sure enough, it created a panic. Paulson decided to “ask for the authority to put money into Fannie and Freddie, in the hopes that he’d never actually have to use it” (192).

Paulson was furious when he saw a draft of the proposal to petition Congress, which asked for only “temporary” (196) authority over Fannie and Freddie. However, he saw that asking for only temporary authority was more politically palatable. He hoped that “simply having the authority” would “be enough to calm the markets” (200), but his announcement that he would be seeking that authority led to more confusion in the market.

At the hearing itself, his plan was met with opposition, including accusations from Senator Jim Bunning that this would be “socialism here in the United States of America” and that the Fed purchase of Bear Stearns was “amateur socialism” (202) compared to this. Senator Bunning also forced Paulson to admit that the money, if needed, would come from the taxpayers. Paulson felt he was being “branded as little less than an enemy of the people, if not an enemy to the American way of life” (202). Hedge funds were also angry with him for convincing the SEC to crack down on short-sellers. He felt he needed more firepower, so he contacted Dan Jester, a retired Goldman Sachs banker, and Ken Wilson, an old college friend who was Goldman’s top adviser to other banks. After getting a call directly from President Bush, Wilson agreed.

Meanwhile, Dick Fuld believed that Goldman Sachs was behind the “whisper campaign” (187) against Lehman and called Lloyd Blankfein about it, but Blankfein did not take kindly to the accusation. Fuld later heard that Credit Suisse was spreading rumors. The “constant stream of bad news” was “hampering Fuld’s efforts to raise more capital” (187). Fuld ended up contacting his old friend John Mack, of Morgan Stanley, to see if Morgan Stanley might be interested in buying Lehman, but an awkward meeting with Morgan Stanley “ended with no agreement and what seemed like no incentive to keep talking” (194).

Fuld had also been talking for several months with his outside lawyer, Rodgin Cohen of Sullivan & Cromwell, who had suggested that Lehman “voluntarily turn itself into a bank holding company” (194). Fuld ran this by Timothy Geithner, who “was apprehensive that Fuld might be moving too hastily” (195). Fuld felt “deflated” (196) at the end of the call. Cohen ended up approaching Bank of America (BofA) about potentially buying Lehman. Fuld and Cohen met with Greg Curl, Bank of America’s top deal banker. Curl was “dumbfounded” by Fuld’s pitch, seemed less like a “plea for help” and more like a “reverse takeover: Bank of America would be paying Fuld to run its investment banking franchise for it” (199). Curl said he would run it by the CEO of Bank of America, Ken Lewis.

As of July 21, Fuld had been asking Paulson for weeks to call Bank of America on his behalf. After a dinner that night in Paulson’s honor at the New York Fed, Paulson and Geithner had arranged a private meeting between Fuld and Lewis. Lewis ended up thinking that Fuld was asking for an amount per share that was “far too high” (206), and he ended up bowing out of a deal, while leaving the possibility open to talk about it again. That left only a deal with the Koreans as a possibility.

At a board meeting in July, Fuld had invited Gary Parr, a banker at Lazard, to give a presentation, but Fuld ended up angrily cutting him off and accusing him of “trying to scare” the board and “shamelessly plugging” (205) his own services. Fuld ended up trying to repair the relationship, realizing that the stress was getting to him.

On July 29, Robert Willumstad of AIG was meeting with Tim Geithner to “sound him out about getting some help if the markets turned against him” (209). About a month earlier, his head of strategy, Brian Schreiber, had made a “startling discovery” that AIG might actually have a “liquidity problem, not a capital problem” (209). In other words, AIG could find itself struggling to sell its securities “fast enough or at high enough prices to meet its obligations” (209) given the current credit crisis. If a ratings agency downgraded AIG’s debt, that would make the situation even worse, triggering “covenants in its debt agreements to post even more collateral” (209). However, Geithner did not seem persuaded by Willumstad’s request and said that he thought it would “exacerbate” what Willumstad was “trying to avoid” (211), by causing others to have greater concerns.

A month later, Willumstad and Schreiber met with Jamie Dimon and others at JP Morgan. Schreiber was already not a fan of JP Morgan, and one of its representatives, Tim Main, made matters worse by pointing out that the bank expects its clients to “recognize their own problems and shortcomings” (228). Dimon cut him off and the meeting continued, but the damage was done. Dimon saw AIG as having a “short-term liquidity problem,” but Willumstad pointed out that it was “not that simple,” because most of AIG’s assets were held by “state-regulated insurance subsidiaries, which could not be sold easily by the parent company” (228).

The same day, Fuld was heading back from meeting with Min Euoo Sung of the Korea Development Bank, which he felt had gone well and which had been kept out of the press. These talks continued in August, when it became clear that Min “wanted nothing to do with Lehman’s commercial real estate holdings” (215). He said he would consider buying a majority stake in Lehman if it spun off its commercial and residential real estate assets into a separate company. They appeared close to a deal, but Fuld unexpectedly showed up when they reconvened and tried to pressure Min into taking the real estate holdings and paying a higher price. The talks nearly ended, but as Min studied the term sheet, he saw a red flag: The Korean bank was being asked to “provide credit to Lehman to help support it” (217). Based on how the meeting had been conducted, he saw a “credibility problem” (217) and decided not to do the deal.

On August 6, a team from Morgan Stanley was meeting at Treasury, having been called in by Paulson to help with Fannie and Freddie. Morgan Stanley stood to lose tens of millions because it would not be able to conduct any business with Fannie and Freddie for the next six months, but John Mack decided it was the “patriotic thing to do” (212). A week earlier, Treasury had been given “temporary authority to backstop Fannie and Freddie” (212). Paulson was looking to Morgan Stanley to help figure out what to do with that authority. He told them he didn’t want to just “kick the can down the road” (213). He had “three objectives: market stability, mortgage availability, taxpayer protection” (213).

The Morgan Stanley bankers came up with “Project Foundation” (224), the result of a loan-by-loan analysis of the portfolios of Fannie and Freddie and other research. They estimated that each would “need some $50 billion in a cash infusion, just to meet their capital requirement” (224). Paulson “laid out his plan to mount the equivalent of a financial invasion on Fannie and Freddie” (226) for President Bush, who gave him the go-ahead.

The same month, Paulson called Steve Shafran, one of his special advisers, for an update on Lehman. Shafran said he believed the Fed and the SEC recognized the risks within Lehman: “its repo book, or portfolio of repurchase agreements; its derivative book; its broker dealer; and its illiquid assets, such as real estate and private equity investment” (219). Paulson was less confident other agencies would step in. The SEC, for example, could “try to maintain Lehman’s US broker-dealer unit, but the holding company and all of its international subsidiaries would have to file for bankruptcy” (220) because the SEC doesn’t have jurisdiction over them. They also wouldn’t be able to ask Congress to use taxpayer money to guarantee obligations outside of the United States.

Just before the government planned to take over Fannie and Freddie, Ken Wilson called Herb Allison, formerly of Merrill Lynch and TIAA-CREF, to hire him as the CEO of Fannie. When Paulson told the management teams of Fannie and Freddie what the government planned to do, with or without their cooperation, Freddie’s team capitulated quickly, but Fannie’s CEO, Daniel Mudd, did not. When Fannie executives tried to drum up support from lawmakers, they found out that Treasury “had already secretly lobbied them on the wisdom of a takeover” (231). Fannie gave its consent, too, and there was “palpable relief” (231) among Treasury staffers when the takeover was announced.

Paulson, however, was still worried about Lehman. When the Freddie and Fannie news broke, Fuld called Ken Wilson to say he hoped that would calm the markets, but he pointed out that he still didn’t seem to have any deals available. Wilson suggested he might have to accept a price that seemed low “to keep the organization intact” (233).