All The Devils Are Here: Unmasking the Men Who Bankrupted the World (66 page)

But $13 billion was a drop in the ocean for Fannie and Freddie. By 2008, the two companies held a total $84 billion in capital—less than 2 percent of what was, by that point, a combined $5.3 trillion in mortgages they owned or guaranteed. Even more than the banks, Fannie and Freddie could not afford major write-downs. There was absolutely no margin for error.

Yet Fannie and Freddie
were
taking write-downs. In February 2008, the GSEs announced their 2007 earnings: both lost money—$2.1 billion in the case of Fannie Mae, while Freddie Mac lost $3.1 billion, its first annual loss ever. The reason was deteriorating mortgages. Yet at the same time, they were taking on more and more risk—because nobody else could, or would. By
early 2008, Fannie and Freddie were buying four out of every five U.S. mortgages, double their market share from two years earlier. In mid-February, President Bush signed a law that included a provision to raise the size of the jumbo mortgages Fannie and Freddie could buy, from $417,000 to $729,750 in high-cost areas—a stunning, unnecessary increase that was supported by both Democratic Speaker of the House Nancy Pelosi and Republican John Boehner, the House minority leader. (Paulson opposed the increase.)
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It was insanity. Jim Lockhart, a Yale fraternity buddy of Bush’s who had become the chairman of OFHEO, told Congress, “The GSEs have become the dominant funding mechanism for the entire mortgage system in these troubling times. In doing so, they have been reducing risks in the market, but concentrating mortgage risks on themselves.”

It was Bear Stearns that went first, in March of 2008.

If the failure of the two Bear Stearns hedge funds in July 2007 served as a kind of prologue to the financial crisis—a taste of what was to come—then the collapse of Bear Stearns itself was a rousing act one. There wasn’t much substantive difference between the two failures except in scale. Bear Stearns was awash in mortgage-backed securities of all sorts. It used them as collateral for its repo transactions. It had them on its balance sheet. It traded in CDOs and CDOs squared. Because it was both the smallest of the five major American investment banks and the most obviously exposed to mortgage risk, the market started asking questions about the value of its collateral. The answers didn’t really matter; the questions were all it took to kill the firm.

“The interdependent relationships between banks and brokerages and institutional investors strike most laymen as impenetrably complex, but a simple ingredient lubricates the engine: trust,” wrote Alan “Ace” Greenberg, former Bear Stearns chairman, in a memoir co-authored by Mark Singer. “Without reciprocal trust between the parties to any securities transaction, the money stops. Doubt fills the vacuum, and credit and liquidity are the chief casualties.
Bad news, whether it derives from false rumor or verifiable fact, then has an alarming capacity to become contagious and self-perpetuating.”

Which is exactly what happened. On Monday, March 10—the beginning of its last week as an independent firm—Bear Stearns’s stock stood at around $70 a share. It had bank financing of about $120 billion and $18 billion in cash. But, recalled Greenberg, “some of our counterparties were expressing skepticism about our liquidity and were wary of dealing with us.” On Tuesday, Christopher Cox, the chairman of the SEC, told the press, “We have a good deal of comfort about the capital cushions at these firms.” It didn’t help. Bear’s cash fell to $15 billion as hedge funds began pulling their money out. One hedge fund withdrew all the securities it kept at Bear—“tens of billions of dollars’ worth,” wrote Greenberg. “Before the trading day closed, the Dutch bank Rabobank Group had told us that they weren’t renewing a $500 million loan due to mature at the end of the week and probably wouldn’t renew a $2 billion line of credit the following week.” On Wednesday, CEO Alan Schwartz went on CNBC, where he denied that Bear Stearns was having liquidity problems. If anything, that only made matters worse: going on TV to deny liquidity problems was likely to
create
liquidity problems, because it would spook lenders. Sure enough, repo lenders started refusing to roll over Bear’s commercial paper. By Thursday night, Bear was down to $5 billion in cash—though, notes Greenberg, “in light of the obligations that came due Friday morning, for all intents and purposes the figure was zero.” By Friday, the stock had dropped to around $30 a share. Bush was scheduled to give a speech at the Economic Club in New York that day. Already nervous at the beginning of the week, Paulson pressed Bush not to say there would be “no bailouts.”

And by Monday morning, March 17, Bear Stearns had been sold to J.P. Morgan for $2 a share. Paulson, who had urged J.P. Morgan to make the deal so that Bear wouldn’t go bankrupt—and wreak havoc on the financial system—had insisted on that punitive price. Later, facing a revolt by Bear shareholders, J.P. Morgan raised the price to $10 a share. In his book, Paulson describes the new price as “an unseemly precedent to reward the shareholders of a firm that had been bailed out by the government.” And it had, because J.P. Morgan would not have done the deal if the Fed hadn’t agreed to provide a $30 billion loan to a stand-alone entity that would buy a pool of Bear’s mortgages that J.P. Morgan didn’t want.

The banks’ dirty little secret was now out in the open. It wasn’t just Fannie and Freddie that had been creating moral hazard all these years. So had
the nation’s big banks. They had taken on terrible risks, built up immense leverage, and created such tight interconnections with their derivatives books that the failure of any one of them could bring down all the others. When things got bad, they assumed they had an “implicit government guarantee,” just like Fannie and Freddie. In
On the Brink
, Paulson recalls a phone call he received from his former number two at Goldman, Lloyd Blankfein. It was the Saturday that Treasury and the Fed were negotiating with J.P. Morgan to take over Bear. “I could hear the fear in his voice,” writes Paulson. The Goldman CEO told him that “the market expected a Bear rescue. If there wasn’t one, all hell would break loose.

At Fannie Mae and Freddie Mac, the losses continued to grow. Fannie was about to slide under OFHEO’s capital requirements, which executives referred to as “the line of death.” Even though they were convinced they could survive the losses, they worried that if they slid below even by a dollar, OFHEO would punish them in some way.

Some in the government were starting to freak out about the GSEs. In an e-mail on March 16 to others at Treasury, Bob Steel, the undersecretary for domestic finance and Paulson’s point man on Fannie and Freddie, wrote, “I was leaned on very hard by Bill Dudley”—an executive vice president at the New York Fed—“to harden substantially the gty.” That meant that the New York Fed wanted the U.S. government to explicitly stand behind the GSE’s debt. It was an expression of the fear officials were starting to feel about the GSEs. And yet, on March 19, four days after Bear was rescued, OFHEO, backed by Treasury, issued a press release announcing that it had agreed to
reduce
Fannie and Freddie’s capital cushion, which, claimed OFHEO, was “expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market.” A month earlier, OFHEO had loosened the portfolio caps the GSEs had agreed to after the accounting scandals. The two changes together “should allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year,” OFHEO reported. “These companies are safe and sound, and … they continue to be safe and sound,” said Lockhart.

Lockhart should have known better. What OFHEO had really done was reduce Fannie and Freddie’s protection against insolvency—even though the companies were edging closer to it every day. Because if it didn’t, no one in America would be able to buy a house.

Later that day, Josh Rosner released a report entitled “OFHEO Got Rolled.” “We view any reduction as a comment not on the current safety and soundness of the GSEs but on the burgeoning panic in Washington,” he wrote. “While many are viewing these actions as a positive sign, we continue to believe that they highlight that the building is shaking from the top to bottom.”

“From March to September,” says a former Treasury official, “the big question was, how would we attempt to deal with the next shoe dropping?” Nobody doubted another shoe was coming.

With his antennae so attuned to Wall Street, Paulson had long thought the next shoe could be Lehman Brothers, the second smallest of the big five. When Bear Stearns started its downward spiral, Paulson had called Lehman CEO Dick Fuld, who was on a business trip in India. “You better get back here,” Paulson told him, according to
Too Big to Fail
, Andrew Ross Sorkin’s book about Wall Street during the financial crisis.

Fuld was an aloof, stubborn executive who had run Lehman since 1994 and had seen his firm through crises before. He felt certain he could do it again. But he was playing a dangerous game. Instead of getting “closer to home,” like Goldman Sachs, Lehman had decided to double down, in large part by financing and investing in big commercial real estate deals at the very height of the real estate bubble. Between the fourth quarter of 2006 and the first quarter of 2008, Lehman’s assets had increased by almost 50 percent, to some $400 billion. Its leverage ratio was 30 to 1. “Pedal to the metal,” is how David Goldfarb, Lehman’s chief strategy officer, described the firm’s growth, according to Lehman’s bankruptcy examiner.

All that risk on its books was taking a toll, however. The market was starting to ask questions, just as it had with Bear. The stock was declining. And starting in 2007, according to one well-placed observer, Lehman had begun to lose access to unsecured funding, so it was increasingly dependent on the repo market. But repo lenders had begun to steadily increase the “haircut” they demanded from Lehman. On March 26, Eric Felder, Lehman’s U.S. head of global credit products, sent an e-mail to Bart McDade, the head of Lehman’s equity capital markets group. “I’m scared that our repo is going to pull away … We need to be set up for [commercial paper] going to zero and a meaningful portion of our secured repo fading (not because it makes sense
but just because)…. The reality of our problem lies in our dependence on repo and the scale of the real estate related positions….”
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Ian Lowitt, who was then Lehman’s co–chief administrative officer, wrote back, “People are on it. Agree there will be another run, but believe it will be industry wide not Lehman specific. You are not Cassandra, cursed by Apollo to be able to see the future but have no one believe you!!!”

That the government knew Lehman Brothers was playing with fire—and did nothing about it—would become clear in the aftermath of the crisis. The SEC, for instance, would later tell the Lehman bankruptcy examiner that it was well aware that the bank had repeatedly violated its own internal risk limits. But, the agency added, it “did not second-guess Lehman’s business decisions so long as the limit excesses were properly escalated within Lehman’s management.”