Authors: Gillian Tett
The bankers split into groups and went to different rooms to discuss options. One gaggle explored the question of whether the banks might coordinate a joint rescue plan, comparable to the LTCM deal. Another debated what would happen if Lehman Brothers filed for bankruptcy. Separately, Fed officials hunted for a purchaser. There were two possible candidates: Bank of America and Barclays, which had a large investment banking operation known as Barclays Capital. Barclays Capital CEO Bob Diamond was highly ambitious and eager to bolster his position in the American markets.
By Saturday evening, after hours of debate fueled by deliveries of coffee and doughnuts, the bankers had decided that a joint rescue plan was impossible. Bank of America also signaled that it had lost interest in bidding, but to Geithner’s relief, Barclays still seemed keen. On Sunday morning, though, an entirely unexpected hitch emerged. To make the deal work, the Fed wanted Barclays to honor all the existing trades attached to Lehman Brothers when the markets opened on Monday morning. Without that guarantee, Geithner feared panic would erupt. However, British financial regulations stipulated that Barclays would not be allowed to extend that scale of guarantee without asking its shareholders first. At first, Barclays assumed that the Financial Services Authority, the main UK regulator, would be willing to waive that restriction, given the extraordinary circumstances. On Sunday, though, British regulators indicated that they were not willing to bend the rule.
Officials in the Washington Fed and US Treasury were furious. Henry Paulson called senior UK financial officials and implored them to help, but the British dragged their heels. Some US officials suspected that British regulators secretly feared Barclays was too weak to conduct such
a large deal; others blamed Barclays for playing hardball to win more financial aid.
Frantically, some of the Barclays team asked if the Fed itself could guarantee its trades or extend a loan for a few days. The British officials raised similar questions. They believed it was up to the
Americans,
not them, to be creative and get the deal done. However, Paulson refused to condone any move that might smack of a bailout. He had taken quite a bit of political heat over time for rescuing Bear and for the move to place Fannie and Freddie in “conservatorship.” He now believed a line should be drawn in the sand.
That left Geithner in a terrible fix. He had scurried to make banks tackle the issue of counterparty risk in the derivatives markets during the summer, but most of the proposed reforms weren’t yet in place. The “chain reaction” problem loomed as large as it had during the crisis at Bear. However, the rules that governed the Fed stipulated that the central bank could extend loans only when they were backed by good-quality collateral. In the case of Bear, Geithner’s officials deemed that to be the case because Bear had plenty of assets. At Lehman Brothers, though, the black hole appeared to be so vast that Geithner doubted that the Fed had the legal powers to act without a specific mandate from the Treasury or Congress, and that mandate was not forthcoming.
On Sunday afternoon, Barclays pulled out, leaving a bitter taste on both sides. Geithner was now staring into the face of disaster. The Fed officials made one last-ditch attempt to lessen the shock. They urgently summoned all the senior bankers with connections to the derivatives world who they could find on a Sunday afternoon, placed them in a room, and asked then to come clean about any derivatives deals they had that involved Lehman Brothers. The hope was that banks could then cancel some deals, lessening losses. The initiative failed, though, in part because it was impossible to get enough bankers there on such short notice.
On Sunday evening, Dimon convened a meeting of the JPMorgan Chase board and solemnly told them that the bankruptcy of Lehman loomed. Geithner had run out of time. “We think we are going to be fine, in terms of our bank,” Dimon observed, in uncharacteristically somber
tones. “But it’s going to be very, very ugly for others. Worse than anything that any of us have seen in our lives.”
Dimon was right. The bankruptcy of Lehman was announced in the final hours of Sunday, September 14, New York time. As the markets opened for business in Asia and London, it briefly appeared that investors might take the news in stride, but, as so often in the credit crisis, the initial calm reflected stunned confusion rather than confidence. Market players were trying to assess the logistical complexities created by the collapse and began to panic. Ironically, the biggest source of concern was
not
the issue Geithner had long fretted about, namely, the challenge of untangling credit derivatives trades. Precisely because the Fed already had issued so many warnings on the matter, most banks and hedge funds had put a plan into place to unwind large volumes of trades. The logistical details of that task were extremely daunting, but the problem had at least been recognized and worked on. It was a “
known
unknown,” as some bankers joked, quoting former US Defense Secretary Donald Rumsfeld’s notorious comment about the chaos of the Iraq War.
What was more frightening was that Lehman’s failure had also created “
un
known unknowns,” chain reactions the investment community had not expected. One problem was that in London, dozens of hedge funds suddenly discovered that the failure of Lehman had left their assets frozen. While in New York, hedge fund assets tended to be ring-fenced when they were held by a broker, meaning that they could always be reclaimed by the funds in the event of default, in London such assets were not legally ring-fenced. That left the British funds unable to complete numerous trades, triggering panic.
Another unexpected shock hit the $3 trillion American money-market fund sector. In the months before the Lehman collapse, many of these funds had purchased debt issued by Lehman Brothers, assuming that the US government would never let Lehman collapse. Now those funds were nursing substantial losses. On September 16, the $62 billion Reserve Primary Fund, the country’s oldest money-market fund, posted a somber statement on its website: “The value of the debt securities issued by Leh
man Brothers Holdings (face value $785 million) and held by the Primary Fund has been valued at zero effective as of 4:00 p.m. New York time today.” That threatened to spark more panic. America’s money-market fund industry had prided itself on
never
“breaking the buck,” and the Reserve had just done so. A run on the money-market funds now seemed likely.
Meanwhile, as Steven Black and Vikram Pandit had anticipated, a crisis had been building at AIG. By the summer of 2008, AIG was holding around $560 billion in super-senior risk, such a gargantuan number and so little known outside the group that when some of the former J.P. Morgan team linked to the BISTRO trades later saw it, they assumed it was a typo. “It’s got to be $60 billion, hasn’t it?” one asked.
What was even more alarming was that AIG was ill equipped to handle that risk. Back in the autumn of 2007, when banks had started writing down their holdings of super-senior risk, AIG had initially refused to follow suit. Its executives argued that the swings in the ABX bore no relation to economic reality, and they believed AIG could afford to take a long-term view because it was an insurance group, not a trading house. Then on February 11, 2008, AIG had been forced to admit that its auditors, PricewaterhouseCoopers, had discovered a “material weakness” in its accounts. The problem was that when AIG insured super-senior CDO debt, it often promised to post collateral to back up that insurance. But AIG had not accumulated the reserves it would need to follow through on that commitment in the event of a wave of claims.
By early 2008, AIG was facing an avalanche of claims, forcing the company to announce some $43 billion of write-downs of super-senior assets, even more than at Citi and UBS, blasting a hole in its balance sheet. Like the other banks, AIG had frantically tried to plug that gap by issuing fresh shares, and asked JPMorgan Chase to colead that. But when senior JPMorgan bankers looked at AIG’s books during the summer, they were so shocked that they secretly threatened to resign from the underwriting deal.
By mid-September, AIG faced a new, even more deadly threat. The largest agency ratings warned that they were considering removing the insurance group’s triple-A tag because of the subprime woes. That cre
ated a new squeeze, since AIG would need to post more collateral for its CDS deals if it lost its coveted triple-A. Behind the scenes, some large investment banks quietly demanded that AIG produce more collateral. The insurance group, however, did not appear to have the money at hand. It seemed that another default loomed.
The markets were tipped into free fall. The shock of the Lehman collapse on Sunday night had been devastating by itself. But combined with the money-market panic and the prospect of an AIG default, the three events produced the perfect market storm. Around the world, stock markets collapsed, wiping $600 billion off global equity prices in just thirty-six hours. More devastating still was the pattern unfolding deep inside the debt markets. As investors around the world confronted these triple shocks, many panicked to such an extent that they completely withdrew from the market. Almost overnight, liquidity dried up in a host of different debt markets. Merrill Lynch, Goldman Sachs, and Morgan Stanley suddenly found it impossible to raise funds in the capital markets. So did a host of European banks in Ireland, the UK, Holland, and elsewhere. The implication was brutal: across the Western world, the senior managers of a host of the world’s largest banks and brokers quietly told their central banks that they could collapse within days. The only institutions that appeared safe were the few that funded themselves primarily with retail deposits; almost every other financial institution looked vulnerable in a way that nobody had ever imagined before.
“If this continues, the next logical step is that the cash eventually stops coming out of the ATM machines—if that happens, God help us all,” confessed one senior banker in the City of London on Tuesday. Or as the chief risk officer of one of the world’s largest banks later recalled, “Investors just would not touch any type of debt because nobody knew the value of anything. The system was near collapse.” The issue was no longer a run on one bank or hedge funds, as in the summer of 2007, or a run on “just” the shadow banking world. A run on the entire system had started.
As panic mounted, hedge funds and banks rushed to sell any assets they could. There were no takers. Markets went haywire, as prices of dif
ferent assets spiraled upwards and downwards in a manner that appeared completely irrational based on a fundamental economic analysis.
This blew apart the complex trading strategies banks and hedge funds had devised with derivatives to protect their portfolios from losses—or to “hedge” the risk, in banking jargon. Nothing as brutal had been witnessed in the markets since the Wall Street crash of 1929.
In Europe, regulators and policy makers seethed in fury and shock. Until the very last minute, most European officials—like investors—had assumed that the US government would find a way to save Lehman. Its failure to do so had tipped the system into a global crisis, the Europeans complained. “What was horrendous is the decision of Henry Paulson to let Lehman Brothers go—for the equilibrium of the world financial system, this was a genuine error,” observed French economy minister Christine Lagarde, reflecting a widespread view. Stung, Geithner tried to explain that he had had no choice. “The Fed just did not have the legal authority to act,” he told European counterparts. But that cut little ice with the Europeans; all they wanted to know was what the Americans, or anybody else, could do now to prevent a catastrophic meltdown of the entire system.
The answer came in several stages. On the evening of Tuesday 16, the Fed announced that it would extend an $85 billion loan to AIG, in exchange for taking a 79.9 percent stake in the group. Essentially, that added up to a full-blown nationalization of AIG. It was an extraordinary step, especially given that just forty-eight hours earlier, the Fed and Treasury had refused to extend aid to Lehman Brothers. Gamely, the Fed officials tried to explain away the policy contradictions by pointing out that AIG did have assets to post as collateral to any Fed loan, but that was, at best, a fig leaf covering a major policy shift.
The level of state intervention was steadily cranked up, facilitating many mergers. On Monday 15, even before the AIG deal was finagled, Bank of America announced plans to purchase Merrill Lynch. The deal appeared to have been heavily encouraged by the Fed and Treasury to avert the risk of Merrill collapsing. On Thursday 18, British authorities unveiled a shotgun marriage of their own. Lloyds TSB, one of the stronger British banks, announced it was taking over the operations of ailing
HBOS. The same day, central banks unveiled yet more coordinated liquidity injections, including a deal between the Bank of England and the Fed to pump dollar liquidity into London. British regulators also announced a ban on short selling of bank shares, in an effort to stem the collapse of shore prices. On the other side of the Atlantic, on the same day, the Treasury unveiled a safety net for money-market funds. Once again, this used Fed money to stave off a run. Then, at the end of the week, Henry Paulson announced a bold plan by which the Treasury would earmark up to $700 billion in funds to purchase “troubled assets” from the banks, such as their super-senior holdings. The Troubled Asset Relief Program (TARP) carried echoes of the Treasury’s idea for the ill-fated “superfund.” However, whereas when the superfund had been proposed a year earlier, Paulson had been adamant to downplay any suggestion that the government was bailing out the banking system, by 2008 the word “bailout” was no longer taboo. Crucially, the government had realized that injecting central bank liquidity was no longer enough to prop up the banking system. Since the banks were short of capital as well as liquidity, they needed injections of capital, too, and the only place that could come from was the government itself. The fate of TARP, however, would prove fraught with controversy.