In FED We Trust, page 23
AIG’s difficulties grew more intense by the hour. With its debt downgraded and its stock price plummeting, the insurance giant’s trading partners were refusing to do business with it. Over the weekend, AIG executives had told the Fed and the Treasury it had enough money to make it until Thursday. By Tuesday morning, AIG said they could make it till the next day. By Tuesday afternoon, they were saying they might need $4 billion by the end of the day — and even that proved optimistic.
“I JUST CHANGED MY MIND”
Just as with Bear Stearns, the intense deathwatch on Wall Street inconveniently preceded a scheduled FOMC meeting in Washington. Bernanke and Kohn tried to call the regional bank presidents in advance so they wouldn’t arrive in Washington angry that they knew no more than had been in the newspapers. Geithner stayed in New York to tend to AIG, missing the meeting entirely. Around 8 A.M. he dialed into a conference call and told Bernanke, Paulson, and Kevin Warsh that Wall Street wasn’t going to rescue AIG. The update made Bernanke uncharacteristically late for the 8:30 A.M. start to the FOMC meeting, akin to a priest showing up late for morning mass.
The FOMC discussion of the economy and interest rates was straightforward and dull. The Fed hadn’t cut rates since April and agreed to keep rates unchanged in September, as markets had anticipated. Bernanke briefed his colleagues on the ugliness of the Lehman weekend and explained vaguely about the condition of the next patient in the emergency room: AIG. Warsh chimed in with a few details from the weekend, but they didn’t tell the full committee that the Fed was on the verge of swallowing AIG.
The meeting broke up around 12:30 P.M. The plan was for the governors and presidents to grab food from the buffet in the adjacent room, as was the routine, and then bring the food back to the boardroom to hear from Laricke Blanchard, the Fed’s congressional lobbyist.
But before lunch began, Geithner telephoned with an urgent plea to Bernanke: convene a meeting of the governors. It was time for the Federal Reserve Board to consider another “unusual and exigent” loan, a move Geithner had considered unimaginable just two days earlier. “I just changed my mind, and I wasn’t alone in changing my mind,” Geithner later explained.
So Bernanke, Kohn, Warsh, Kroszner, and Betsy Duke — a banker whom Bush had appointed to the Fed board in August — huddled around the coffee table in Bernanke’s office so they could hear Geithner on the Polycom speakerphone. Lunch with the rest of the FOMC never happened. Eventually, the bank presidents realized they had been abandoned, and wandered off to cars and airports with little idea of what was going on in Bernanke’s office just a few steps away.
The other Fed officials didn’t know much about AIG. Geithner described what had caused him to change his mind: the realization that AIG had become more than a big insurance company; it was now a company that had made financial promises on which hundreds of financial firms around the world depended. AIG, he told them, was a sprawling set of profitable insurance businesses trapped beneath a parent company that had become a giant hedge fund that had massive losses. Options for saving the company were limited: recapitalizing AIG in the midst of a financial panic was impossible. Yet in the wake of the messy Lehman bankruptcy, Geithner added, the system couldn’t withstand another disorderly disintegration of a major financial institution. Only later did the public learn the specifics of what Geithner already knew: nearly every major financial institution in the world had bought financial insurance of some sort or placed huge bets with AIG. (AIG disclosed in early 2009, for instance, that Société Générale, the big French bank, had $4.1 billion at stake, and Goldman Sachs had nearly $6 billion.)
And unlike Lehman’s and Bear Stearns’s largely wholesale businesses — trading with other financial institutions — AIG’s businesses also touched hundreds of millions of American companies and households. In addition to its foundering hedge fund, AIG sold insurance to more than 100,000 big and small companies, pension plans, and municipalities, and sold insurance or managed retirement plans for thirty million Americans.
In his relentless, disciplined manner, Geithner posed these questions: Was there an alternative to the Fed lending money? Was there some way for the Fed to rally Wall Street to avoid an AIG default? Was the Fed confident it could contain the damage if AIG went under? Was there some way the Fed could buy AIG a few weeks with a short-term loan? To each, Geithner answered: “No.”
Warsh pushed back, asking if there was any way to lend AIG money for thirty days, send in SWAT teams of regulators, and find some way out. Geithner accused him of “temporizing,” by which he meant avoiding a tough decision to do the uncomfortable but inevitable. Warsh backed off. Bernanke mostly listened, looking more grave than usual.
“LET’S DO THIS ONE”
After Geithner’s stark briefing, the Fed began looking for someone else’s money. Geithner and Treasury’s Dan Jester had kept Paulson in the loop; now the Fed started pressing the Treasury to kick in, especially since putting money into AIG would go far beyond conventional Fed lending to banks. There was talk of tapping the $50 billion in the Treasury’s Exchange Stabilization Fund, a war chest created by Congress in 1934 so the Treasury could intervene in foreign exchange markets. The statute gives the secretary and the president the power to use it to “deal in gold, foreign exchange, and other instruments of credit and securities,” broad enough for almost anything. But Treasury lawyers said the link between AIG and the dollar was too tenuous. Paulson knew that when Bernanke saw the system at risk, he would find a way to make a loan. Tapping the FDIC insurance fund was floated, even though AIG wasn’t a bank that the FDIC had insured. That didn’t work either.
BERNANKE’S DASHBOARD
September 15, 2008
Change from
August 7, 2007
Dow Jones Industrial Average: 10,918 down 19.1%
Market Cap of Citigroup: $83.0 billion down 65.6%
Price of Oil (per barrel): $95.71 up 32.1%
Unemployment Rate: 6.2% up 1.50 pp
Fed Funds Interest Rate: 2.0% down 3.25 pp
Financial Stress Indicator: 1.06 pp up 0.84 pp
Soon the question became the same as in the earlier crescendos of the Great Panic: Was there some way the Fed could come up with the money? The answer, eventually, was yes. The Fed general counsel in Washington, Scott Alvarez, and the New York Fed general counsel, Tom Baxter, found a justification for doing with AIG what the Fed hadn’t done for Lehman: lend enough to keep it out of bankruptcy. Lehman’s only collateral, they reasoned, was the franchise of an investment bank that no one wanted to buy, and that wasn’t worth much. AIG had businesses that the Fed believed had substantial value and could be sold; they would be collateral for the Fed loan.
Bernanke and Geithner got Paulson on the phone. All of the alternatives were ugly, but Paulson was no longer shouting about “no taxpayer money.”
Bernanke called the question: “Let’s do this one.”
“We did this very unhappily,” Bernanke later remembered. “AIG came to us on the brink of a default. They had not found a private-sector solution, and we were the last, the only chance. The company shouldn’t have been saved in terms of its own quality and management, etcetera. But we thought that on top of Lehman, this would be just a complete disaster for the markets and the banking system.”
“If there’s a single episode in this entire eighteen months that has made me more angry, I can’t think of one, than AIG,” Bernanke told a congressional committee in March 2009, echoing what he had said inside the Fed each time the price tag of the AIG operation grew — and grow it did. By March 2009, the Fed and the Treasury, which chipped in after it got money from Congress, had $183 billion sunk into the company.
“AIG exploited a huge gap in the regulatory system,” Bernanke complained. “There was no oversight of the financial products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses. There was no regulatory oversight because there was a gap in the system,” he said.
He said the Fed “really had no choice” but to sink billions into the company to try to stabilize it because the failure of what had become such a major financial operation in the midst of a crisis could be “disastrous for the economy.” With millions of policyholders and thousands of derivatives and credit-Insurance counterparties, Bernanke said AIG’s downfall would have been “devastating to the stability of the world financial system.” In an obvious reference to those who had criticized the Fed’s emergency rescue of Bear Stearns, he added, “If there’s been any doubt about the power of financial stress to affect the real economy, I hope that it’s been removed at this point.”
The unanswered, and perhaps unanswerable, question was whether AIG would have survived without a Fed rescue if Lehman hadn’t gone into bankruptcy. The shock waves from Lehman clearly made AIG’s problems worse. The bankruptcy gave all its creditors and counterparties good reason to protect themselves in ways that threatened the stability of the financial system. But AIG was in trouble before Lehman’s collapse — and the weight of its debts and bad bets was so heavy that it might have gone under even had Lehman been sold to Barclays or rescued by the government.
In part so they wouldn’t be seen as soft touches, the Fed and the Treasury decided to offer AIG the same, tough interest rate that AIG’s investment bankers had been discussing with Wall Street. There was talk about whether it would be too onerous, and there was a debate: Should the government make a loan to AIG on terms more generous than the commercial market had been discussing? The answer, at least in retrospect, was that the government was not just another investor: it was trying to save the system, not make a profit. The terms of the deal would be relaxed later, when it became clear that the company couldn’t survive them.
To move quickly, the government arranged for a law firm that had been working on the deal for AIG’s bankers, Davis Polk & Wardwell, to switch teams and represent the Treasury and the Fed. In the end, the Fed offered AIG up to $85 billion at 8.5 percentage points above the rates banks were charging one another, and said the government would take a 79.9 percent interest in the company in exchange. This wasn’t a loan; this was a takeover. And it was a take-it-or-leave-it offer.
Geithner was told to give AIG until 8 P.M. to accept or decline the terms. The terms were tough — too tough, AIG and some others argued later. But Bernanke and Paulson had a signal to send: if you have to crawl to the government to recapitalize yourself, it’s not going to be on easy terms.
Around 3:15 P.M., Bernanke, Paulson, and Warsh cut off the conference call and rushed to the White House for a previously scheduled meeting of the President’s Working Group on Financial Markets — a coordinating committee that the Treasury secretary chaired that was created after the 1987 stock market crash. The markets were so fragile that the White House canceled plans to let reporters and photographers record the beginning of the meeting; it feared a stray comment from the president or someone else would make a bad day worse.
Bernanke and Paulson focused on AIG and the reasons they were trying so hard to keep it from following Lehman into bankruptcy court. They didn’t tell the president that they probably were going to need a lot of money from Congress. But White House aides at the meeting noticed a change in tone. The one-company-at-a-time rescue wasn’t working. Bush did as he did at almost every stage of the Great Panic: he delegated. “If you are comfortable with this, then I am comfortable with it,” he told Bernanke and Paulson.
More than a year into a financial panic that had become the biggest threat to American prosperity in a generation, the president of the United States remained largely a spectator as the Treasury secretary and Fed chairman he had appointed made and executed the plays. One presidential adviser explained that Bush, aware how unpopular he had become, figured he would make Paulson’s job tougher if he appeared to be calling the shots. Others said the White House, stumbling through its last few months, was simply exhausted and understaffed.
“THE ONLY PROPOSAL YOU’RE GOING TO GET”
Around 4 P.M. on September 16, the government’s three-page offer was delivered to AIG in New York. Robert Willumstad, the former Citigroup executive who had been chairman of the AIG board for a couple of years and became its CEO in June 2008, called a board meeting for 5 P.M.
At 4:50 P.M., Paulson and Geithner called. “This is the only proposal you’re going to get,” said Geithner, making it clear that there wasn’t going to be any bargaining.
“And there’s one condition,” Geithner added. “We’ll replace you as CEO.”
At least one AIG director objected. Marty Feldstein, the Harvard economist who had been among Bernanke’s rivals for the Fed job, said it wasn’t the government’s role to forcibly buy private companies. “We are faced with two bad choices,” Willumstad told the board. “File for bankruptcy tomorrow morning or take the Fed’s deal tonight.”
At 7:50 P.M., Willumstad told the Fed that AIG accepted the terms. Fed-wire, the Fed-maintained network for moving large sums among banks, was kept open past its usual 6 P.M. closing so AIG could get its cash transfusion. AIG had said that afternoon that it anticipated needing $4 billion; Fed officials were stunned when AIG drew $14 billion that night and another $23 billion over the next few days.
“WE’RE ALL IN THIS MESS TOGETHER”
While the AIG board was meeting in New York, Paulson called Senate majority leader Harry Reid of Nevada and said he and Bernanke wanted to come to the Capitol around 6:30 P.M. The crisis had overwhelmed the call-one-congressman-at-a-time approach.
Bernanke and Paulson entered Reid’s office on the second floor of the Capitol, looking like two exhausted surgeons about to deliver grim news to relatives. Most of the senior congressional leadership from both parties had rushed to be there. Senator Judd Gregg, the New Hampshire Republican, showed up in a tuxedo but no tie.
Bernanke and Paulson explained the outlines of the AIG deal and why they had decided that allowing AIG to follow Lehman into bankruptcy was unwise. They emphasized how interconnected everything was. They didn’t seek the blessing of the congressional leaders, and none was offered. Instead, Harry Reid told them: We’ve listened, but don’t go out and tell people that we’ve approved this. This is your responsibility. Both Bernanke and Paulson acknowledged as much.
At one point, Barney Frank recalled, he asked Bernanke: “Do you have $80 billion?” And Bernanke replied: “Well, we have $800 billion,” a reference to the value — then — of the Fed’s assets. “And that’s when many of us, for the first time, understood the full scope of this [“unusual and exigent circumstances”] statute.”
For many members of Congress, the Fed’s ability to come up with $85 billion overnight led to the realization that the Fed increasingly was acting like a fourth branch of government. Most politicians, indeed, most American citizens, had a vague idea that the Fed could move some interest rates up or down. But they had no idea that the Fed could — with the push of a button on a computer keyboard — create that much money from nothing and without seeking the approval of Congress or the president.
The meeting lasted nearly an hour. The members of Congress left one at a time, most ducking reporters waiting outside. Representative Spencer Bachus of Alabama, senior Republican on the House Financial Services Committee, offered a promise of unity: “We’re all in this mess together.”
Frank, the committee’s chairman, came out later and growled, with substantial accuracy: “We’ve had a series of ad hoc interventions. This is one more ad hoc intervention.”
Bernanke and Paulson rebuffed reporters. Bernanke went back to his office and called Geithner to settle last-minute details on the AIG deal. Around 10 P.M., after AIG had agreed to the terms, Bernanke convened a conference call to brief the Fed bank presidents, several of whom were disgruntled because they had been told so little even though they were in Washington while the AIG drama unfolded.
Paulson allowed himself a little hope — “not an expectation,” he emphasized, just hope — that perhaps the markets would stabilize. “Fannie and Freddie were off the table. Lehman was off the table. Merrill Lynch was off the table,” he said. One big West Coast bank was teetering, Washington Mutual, or WaMu. But he already was talking to JPMorgan Chase’s chief executive, Jamie Dimon, about that one. “WaMu was about to be off the table. Maybe the situation would get better,” he said. He was wrong.
ANAPHYLACTIC SHOCK
As the markets opened Wednesday morning, September 17, Bernanke — with Kohn and Warsh sitting beside him — called his counterparts in Europe, the U.K., and Japan to explain the AIG deal. Jean-Claude Trichet, who had been privately critical of letting Lehman sink, was relieved that the United States had come to its senses and dismissed any suggestion that this had been a tough call for Bernanke.
An hour later, the Four Musketeers assembled by phone to hear the New York Fed’s Bill Dudley give his daily report on the markets. It was ugly. The Dow Jones Industrial Average fell 449.36 points, or 4.1 percent, to 10609.66, its lowest close in nearly three years. Trading was so heavy it nearly matched the record — which had been set just two days earlier. European and Asian stocks were down. General Electric, usually considered so creditable that it borrowed close to the Fed funds rate target — then 2 percent — was forced to pay 3.5 percent for overnight money. And yields on the safest securities of all, short-term U.S. Treasury bills, fell nearly to 0 percent because so many investors wanted to park their money there.
“It was becoming clear that the markets were going into anaphylactic shock, and that we needed to do something,” Bernanke said. The Fed could no longer cope with the Great Panic by itself.
