On the Brink (14 page)

For all that, I also knew Bear as a scrappy firm that liked to do things its own way: alone on Wall Street it had refused to help rescue Long-Term Capital Management in 1998. Bear’s people were survivors. They had always seemed to find a way out of trouble.

For months, Steel and I had been pushing Bear, and many other investment banks and commercial banks, to raise capital and to improve their liquidity positions. Some, including Merrill Lynch and Morgan Stanley, had raised billions from big investors such as foreign governments’ sovereign wealth funds. Bear had talked with several parties but had only managed to make an agreement with China’s Citic Securities under which each would invest $1 billion in the other. The deal was not the answer to Bear’s needs and in any case hadn’t yet closed.

Investment banks were more vulnerable to market pressures than commercial banks. For most of this country’s history, there had been no practical differences between them. But the Crash of 1929 changed that. Congress passed a series of reforms to protect bank depositors and investors by controlling speculation and curbing conflicts of interest. The Glass-Steagall Banking Act of 1933 prohibited depository institutions from engaging in what was seen as the risky business of underwriting securities. For many years, commercial banks, viewed as more conservative, took deposits and made loans, while investment banks, their more adventurous cousins, concentrated on underwriting, selling, and trading securities. But over time the dividing lines blurred, until in 1999 Congress allowed each side to jump fully into the other’s businesses. This gave rise to a wave of mergers that created the giant financial services companies that dominated the landscape in 2008.

But regulation had not kept pace with these changes. Oversight bodies were too fragmented and lacked adequate powers and authorities. That was one reason Treasury was working hard to complete our blueprint for a new regulatory structure.

Commercial banks enjoyed a greater safety net than investment banks did: When in trouble, commercial banks could turn to the Federal Reserve as their lender of last resort. If that failed, the government could step in, take the bank over, and put it in receivership. Seizing control of the bank’s assets, and standing behind its obligations, the FDIC could carefully wind down the bank, or sell it, to protect the financial system.

Though the more highly leveraged investment banks were regulated by the SEC and followed stricter accounting standards than the commercial banks did, the government had no power to intervene if one failed—even if that failure posed a systemic threat. The Fed had no facility through which investment banks could borrow, and the SEC was not a lender and did not inspire market confidence. In a world of large, global, intertwined financial institutions, the failure of one investment house, like Bear Stearns, could wreak havoc.

As soon as Bob Steel left my office that Thursday morning, I made a flurry of calls, beginning with the White House. Then I phoned a very concerned Tim Geithner, who assured me he was all over Bear. He asked if I had talked with SEC chairman Chris Cox.

I tracked Chris down in Atlanta. Though Bear’s name had been tarnished, Cox thought it had a good business and would make a perfect acquisition candidate, and that it ought to be able to find a buyer within 30 days. He’d spoken with Bear’s CEO, Alan Schwartz, who said he had unencumbered collateral—all he needed was for someone to loan against it.

President Bush soon called, and I explained the Bear Stearns situation and the consequences I saw for the markets, and the broader economy, if Bear failed. The president quickly grasped the seriousness of the problem and asked if there was a buyer for the stricken firm. I told him I didn’t yet know, but that we were thinking through all our options.

“This is the real thing,” I summed up. “We’re in danger of having a firm go down. We’re going to have to go into overdrive.”

Later that afternoon, Steel caught up with me and we agreed that he should go ahead and fly to New York for his daughter’s 21st birthday dinner. He could work from there and we might need him in the city, anyway. It was a stroke of luck that Bob went. He arrived at 6:00 p.m. or so and then found himself so caught on calls with officials at the New York Fed, the SEC, and Bear that he spent two hours on the phone in a conference room at the Westchester County Airport. He barely made it to his daughter’s party for dessert.

By the time I got home I was filled with foreboding. It was Thursday night, so the new
Sports Illustrated
had arrived. Wendy always left it for me on our bed, and I was flipping through the pages, trying to unwind, when the phone rang. It was Bob calling in from the airport in Westchester; he told me the situation was bad and that I would be hooked into a conference call around 8:00 p.m. with Ben Bernanke, Chris Cox, Tim Geithner, and key members of their staffs.

It had been an ugly day for Bear Stearns. Lenders and prime brokerage customers were fleeing so quickly that the company had told the SEC that without a solution, it would file for bankruptcy in the morning. We had limited options. A Bear bankruptcy could cause a domino effect, with other troubled banks unable to meet their obligations and failing. But it was unclear what we could do to stop that disaster. This was a dangerous situation and there weren’t any obvious answers.

We discussed taking preventive measures. The Fed was exploring options for flooding the market with liquidity, or, as Tim said, “putting foam on the runway.” But with conditions as fragile as they were, I questioned whether there was much we could do to stabilize the markets if Bear went down suddenly.

We agreed to confer again first thing in the morning. Tim said, “We’ll have our teams working all night.” His staff would drill down on what a Bear failure might mean to the infrastructure—the markets for secured loans, derivatives, and such that constituted the unseen but vital plumbing of finance. It would be the first of many nights during the crisis when teams at the Fed—or Treasury—would work through the night against excruciating deadlines to try to save the system.

I couldn’t sleep. I was hot and agitated. I tossed and turned. I couldn’t stop thinking about the consequences of a Bear failure. I worried about the soundness of balance sheets, the lack of transparency in the CDS market, and the interconnectedness among institutions that lent each other billions each day and how easily the system could unravel if they got spooked. My mind raced through dire scenarios.

All financial institutions depended on borrowed money—and on the confidence of their lenders. If lenders got nervous about a bank’s ability to pay, they could refuse to lend or demand more collateral for their loans. If everyone did that at once, the financial system would shut down and there would be no credit available for companies or consumers. Economic activity would contract, even collapse.

In recent years banks had borrowed more than ever—without increasing their capital enough. Much of the borrowing to support this increase in leverage was done in the market for repurchase agreements, or repos, where banks sold securities to counter-parties for cash and agreed to buy them back later at the same price, plus interest.

While many commercial banks had big pools of federally insured retail deposits to rely on for part of their funding, the investment banks were more heavily dependent on this kind of financing. Dealers used repos to finance their positions in Treasuries, federal agency debt, and mortgage-backed securities, among other things.Financial institutions could arrange the repos directly with one another or through a third-party intermediary, which acted as administrator and custodian of the securities being loaned. Two banks, JPMorgan and Bank of New York Mellon, dominated this triparty repo business.

The market had become enormous—with perhaps $2.75 trillion outstanding in just the triparty repo market at its peak. Most of this money was lent overnight. That meant giant balance sheets filled with all kinds of complex, often illiquid assets were poised on the back of funding that could be pulled at a moment’s notice.

This hadn’t seemed like a problem to most bankers during the good times that we’d enjoyed until the previous year. Repos were considered safe. Technically purchase and sale transactions, they acted just like secured loans. That is to say, repos were considered safe until the times turned tough and market participants lost faith in the collateral or in the creditworthiness of their counterparties—or both. Secured or not, no one wanted to deal with a firm they feared might disappear the next day. But deciding not to deal with a firm could turn that fear into a self-fulfilling prophecy.

A Bear Stearns failure wouldn’t just hurt the owners of its shares and its bonds. Bear had hundreds, maybe thousands, of counterparties—firms that lent it money or with which it traded stocks, bonds, mortgages, and other securities. These firms—other banks and brokerage houses, insurance companies, mutual funds, hedge funds, the pension funds of states, cities, and big companies—all in turn had myriad counterparties of their own. If Bear fell, all these counterparties would be scrambling to collect their loans and collateral. To meet demands for payment, first Bear and then other firms would be forced to sell whatever they could, in any market they could—driving prices down, causing more losses, and triggering more margin and collateral calls.

The firms that had already started to pull their money from Bear were simply trying to get out first. That was how bank runs started these days.

Investment banks understood that if any questions arose about their ability to pay, creditors would flee at wildfire speed. This is why a bank’s liquidity was so critical. At Goldman we had absolutely obsessed over our liquidity position. We didn’t define it just in the traditional sense as the amount of cash on hand plus unencumbered assets that could be sold quickly. We asked how much money, under the most adverse conditions, could disappear on any given day; if everyone who could legally request their money back did so, how short would we be and could we meet our obligations? To be on the safe side, we kept a lockbox at the Bank of New York filled with bonds that we never invested or lent out. When I was CEO at Goldman, we had amassed $60 billion in these cash reserves alone. Knowing we had that cushion helped me fall asleep at night.

Bear had started the week out with something like $18 billion in cash on hand. It now had closer to $2 billion. It couldn’t possibly meet demands for withdrawals. And in the morning, when the markets opened, no counterparties were going to lend to Bear: they’d all be pulling their money out. This would be bad news indeed, not just for Bear Stearns, but for every institution dealing with them.

No wonder I slept no more than a couple of hours that night. I had never had trouble before, but this night was the beginning of a prolonged bout of sleeplessness that would haunt me throughout the crisis, and particularly after September. On tough days, I would fall asleep exhausted around 9:30 p.m. or 10:00 p.m., then wake up several hours later and lie awake for much of the rest of the night. Sometimes I did my clearest thinking during these hours, occasionally getting up to write things down. By the time the newspapers were delivered at 6:00 a.m., I would have already been up for an hour or two, often turning on cable TV to check on overseas markets.

Friday, March 14, 2008

On Friday morning I had just shaved and was about to get in the shower when the phone rang. It was Bob Steel telling me that a conference call would start around 5:00 a.m. Still wearing the boxer shorts and T-shirt I slept in, I jogged up to the third-floor study of our house so I wouldn’t wake Wendy. On the line were Tim Geithner, Ben Bernanke, Kevin Warsh, and Don Kohn from the Fed; Tony Ryan and Bob Steel from Treasury; and Erik Sirri from the SEC. We waited at first for Chris Cox, who was standing by in his office but never came on because of a communications mix-up. For a few minutes, we plugged in Jamie Dimon, CEO of JPMorgan, Bear’s clearing bank. He painted a dark picture, emphasizing that a Bear Stearns failure would be disastrous for the markets, and that the key was to get Bear to the weekend.

Once Jamie got off, Tim reviewed a creative way he and his team had devised to buy time. The Fed would lend money to JPMorgan, which in turn would lend the money to the beleaguered brokerage firm. To make this work, the Fed’s loan would have to be non-recourse: it would be backed by collateral from Bear, but neither JPMorgan nor Bear would be liable for repayment.

By law the Federal Reserve can lend against assets only when the loan is secured to its satisfaction, meaning in practical terms that there is a minimal chance of the Fed’s losing money. But if this loan could not be repaid, for whatever reason, and the Fed had to sell the collateral for less than the value of the loan, the central bank would incur a loss. It would be a bold, unprecedented action for the Fed to make such a deal.

So Ben threw in a crucial caveat: “I’m prepared to go ahead here only if Treasury is supportive and prepared to protect us from any losses.”

To be honest, I wasn’t sure what, if any, legal authority Treasury might have had to indemnify the Federal Reserve, but I was determined to make it to the weekend. The repo markets would open shortly—around 7:30 a.m.—and I wasn’t about to drag in a lot of lawyers and debate any legal fine points now.

“I’m prepared to do anything,” I said. “If there’s any chance of avoiding this failure, we need to take it.”

First, though, I had to get off the line and speak with President Bush to confirm that he would sign off on the plan. Yes, he said, we had his support. But now he had to scramble. That day he not only had the speech in New York at the Economic Club but also a meeting with the editorial board of the
Wall Street Journal
, which was renowned for its free-market views and its opposition to government interference in the economy.

I told him not to worry; Steel was on top of the Bear situation in New York and could meet him on his arrival. I reiterated, with a touch of black humor: “Mr. President, you can take out that line in your speech about ‘no bailouts.’”