Andrew Sorkin - Too Big to Fail - The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

For the past seventy-two hours the government had been insisting that it would not bail out any financial institution. Now, with that one sentence, Geithner had turned everything on its head. Even if it was just a hypothetical, the rules of engagement had evidently just changed.

Geithner continued, throwing out a series of questions. “How would this work? How would you structure the terms? How will the capital markets respond? How will the debt markets react?”

Goldman’s Winkelried could not hide a slight smile. Scully of Morgan Stanley, realizing the night before that he needed a Plan B, had already roughed out a term sheet based on the numbers that JP Morgan and Goldman Sachs had put together. If it was good enough for them—and by Morgan Stanley’s estimation, they were going to be stealing the company—it should be good enough for the Federal Reserve.

“Work on it,” Geithner said, and then left the room.

“Braunstein isn’t picking up his fucking phone,” Willumstad railed after dialing his cell several times, worried that he was being kept in the dark.

John Studzinski, his adviser from Blackstone, had just heard from one of his colleagues who was down at the NY Fed that he had seen Goldman and JP Morgan executives high-fiving one another—even while another team from the two banks was still camped out at AIG, rifling through its books.

Studzinski finally managed to reach Porat by text-messaging her. However, she was purposely being vague, and would only offer, “The deal is changing. Stop sharing information with JPM and GS.”

A few minutes later, Willumstad’s assistant announced that Tim Geithner, whom Willumstad had frantically attempted to reach several times that morning, was on the phone.

“Hi, Tim,” Willumstad said, somewhat impatiently.

“Give me a progress report,” Geithner instructed, rather than offering the progress report that Willumstad had been waiting for desperately.

“I just want you to know that we’re preparing for bankruptcy,” Willumstad told him steadily. “I’ve called the backup lines. I just think you should know that.”

Geithner seemed anxious and quickly cut him off with, “Don’t do that.”

“You have to give me a reason not to,” he said, mystified by the odd reply. “I have an obligation and responsibility. I can get $15 billion and keep me going for a couple of days. I have to protect the shareholders here.”

“Well, I’ll tell you something confidential,” Geithner finally said. “We’re working on some help for you, but there’s no guarantees, it has to be approved by Washington.”

Willumstad, still dubious, replied, “Well, unless you can assure me that there’s going to be some help, we’re going to go ahead with the backup.”

“You should try and undo whatever you’ve done,” Geithner ordered and hung up.

When he got off the phone, Willumstad immediately informed his lawyers, Jamie Gamble and Michael Wiseman, and, none of them quite knowing what to do next, tried Braunstein’s phone again, with no success.

“Screw it,” Wiseman said. “I know we’re not invited, but let’s just go over there ourselves.”

Hank Paulson was in his office at Treasury when Lloyd Blankfein called him at 9:40 a.m. in a panic. Blankfein, anxious by nature, was even more so now, and Paulson could sense it.

Blankfein told Paulson about a new problem he was seeing in the market: Hedge funds that had traded through Lehman’s London unit were suddenly being cut off, sucking billions of dollars out of the market. While the Fed had kept Lehman’s broker-dealer in the United States open in order to wind down the trades, Lehman’s European and Asian operations were forced by law to file for bankruptcy immediately.

Blankfein explained that through an arcane process called rehypothecation, Lehman had reloaned the hedge funds’ collateral to others through its London unit, and sorting out who owned what had become a logistical nightmare. To stay liquid, many hedge funds were forced to sell assets, which pushed the market even lower. Some hedge funds, fearing that Lehman was on the brink, had already dropped it as a prime broker before the bankruptcy. But for those who stuck by it, the results were painful, as was the case with Ramius Capital, whose founder, Peter A. Cohen, was once the chairman of Lehman’s predecessor, Shearson Lehman. In the week before the bankruptcy he had declared on CNBC that his firm wouldn’t pull its business from Lehman. Now he had to tell his investors that their money had become trapped in a mysterious bankruptcy process in London.

Pleading with his former boss to do something to calm the markets, Blankfein told Paulson that his biggest worry was that so much money was clogged up inside Lehman that investors would panic and start pulling their money out of Goldman Sachs and Morgan Stanley, too.

Bernanke was clearly distracted as he presided over the FOMC meeting at the Federal Reserve in Washington, passing notes back and forth with Kevin Warsh as they tried to come up with a game plan for AIG. They had agreed to another conference call with Geithner at 10:45 a.m. to get an update.

Geithner reiterated that “a private-market solution is dead” and told them, “We need to think about using our balance sheet. We need to act with force and determination,” suggesting that if the Fed made a big, bold deal to backstop AIG, it could help restore confidence in the markets. He proposed using the Federal Reserve Act, Section 13, point 3, a unique provision that permitted the Fed to lend to institutions other than banks under “unusual and exigent” circumstances.

As Paulson and Bernanke both knew, AIG had effectively become a linchpin of the global financial system. Under European banking regulations, financial institutions had been allowed to meet capital requirements by entering into credit default swap agreements with AIG’s financial products unit. Using the swaps, the banks had essentially wrapped AIG’s triple-A credit rating around riskier assets, such as corporate loans and residential mortgages, allowing the banks to take on more leverage.

If AIG were to fail, however, those protective wrappers would vanish, forcing the banks to mark down assets and raise billions of dollars—a frightening prospect in the current markets. And the numbers were staggering: Halfway though 2008, AIG had reported more than $300 billion in credit default swaps involved in this wrapping procedure, which it politely called “regulatory capital relief.”

Then, of course, there was the matter of AIG’s vast insurance empire, which included about 81 million life insurance policies around the world with a face value of $1.9 trillion. While that part of the business was highly regulated and the policies generally protected, there was a risk that panicky customers would cash in their policies in droves and create instability at other major insurers.

Bernanke listened patiently as Geithner made his case, but Warsh made his reluctance known, as he had been promoting a “buying time” plan. His view was that the Fed should open its checkbook, but only for thirty days—enough time to really examine AIG seriously.