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

To his credit, Paulson did speak openly for months about formalizing the government’s authority to “wind down” a failing investment bank. He never made that request directly to Congress, however, and even if he had, it’s doubtful he could have gotten it passed. The sad reality is that Washington typically tends not to notice much until an actual crisis is at hand.

That, of course, raises a more pointed question: Once the crisis was unavoidable, did the government’s response mitigate it or make it worse?

To be sure, if the government had stood aside and done nothing as a parade of financial giants filed for bankruptcy, the result would have been a market cataclysm far worse than the one that actually took place. On the other hand, it cannot be denied that federal officials—including Paulson, Bernanke, and Geithner—contributed to the market turmoil through a series of inconsistent decisions. They offered a safety net to Bear Stearns and backstopped Fannie Mae and Freddie Mac but allowed Lehman to fall into Chapter 11, only to rescue AIG soon after. What was the pattern? What were the rules? There didn’t appear to be any, and when investors grew confused—wondering whether a given firm might be saved, allowed to fail, or even nationalized—they not surprisingly began to panic.

Tim Geithner admitted as much in February 2009, acknowledging that “emergency actions meant to provide confidence and reassurance too often added to public anxiety and to investor uncertainty.”

Of course, there are many people on Wall Street and elsewhere who argue to this day that it was the government’s decision to let Lehman fail that was its fundamental error. “On the day that Lehman went into Chapter 11,” Alan Blinder, an economist and former vice chairman of the Federal Reserve, said, “everything just fell apart.”

It is, by any account, a tragedy that Lehman was not saved—not because the firm deserved saving but because of the damage its failure ultimately wreaked on the market and the world economy. Perhaps the economy would have crumbled anyway, but Lehman’s failure clearly hastened its collapse.

CEO Richard Fuld did make errors, to be sure—some out of loyalty, some out of hubris, and even some, possibly, out of naïveté. But unlike many of the characters in this drama, whose primary motive was clearly to save themselves, Fuld seems to have been driven less by greed than by an overpowering desire to preserve the firm he loved. As a former trader whose career was filled with any number of near-death experiences and comebacks, he remained confident until the end that he could face down this crisis, too.

Despite claims to the contrary by Paulson, it seems undeniable that the fear of a public outcry over another Wall Street rescue was at least a factor in how he approached Lehman’s dilemma. One person involved in the government’s deliberations that weekend, in a remarkably candid moment, told me that the fact that the UK government indicated that it would face a major struggle to approve a deal with Barclays was “actually a strange coincidence,” because “we would have been impeached if we bailed out Lehman.”

While hindsight suggests that the federal government should have taken some action to prop up Lehman—given the assistance it was prepared to offer the rest of the industry once it began to face calamity—it is also true that the federal government did lack an established system for winding down an investment bank that was threatened with failure. Paulson, Geithner, and Bernanke were forced to resort to what MIT professor Simon Johnson has called “policy by deal.”

But deals, unlike rules, have to be improvised—and the hastier ones tend by their very nature to be imperfect. The deals hatched in sleepless sessions at the Federal Reserve Bank of New York or at Treasury were no different. They were products of their moment.

In truth, while unnoticed, it wasn’t the fate of the U.S. operations of Lehman Brothers that caused the white-knuckled panic that quickly spread throughout the world. To its credit, the Fed wisely decided to permit Lehman’s broker-dealer to remain open after the parent company filed for bankruptcy, which allowed for a fairly orderly unwinding of trades in the United States. Outside the country, however, there was pandemonium. Rules in the United Kingdom and Japan forced Lehman’s brokerage units there to shut down completely, freezing billions of dollars of assets held by investors not just abroad, but perhaps more important, here in the United States. Many hedge funds were suddenly left short of cash, forcing them to sell assets to meet margin calls. That pushed down asset prices, which only sparked more selling as the cycle fed on itself.

Washington was totally unprepared for these secondary effects, as policy makers had seemingly neglected to consider the international impact of their actions—an oversight that offers a strong argument for more effective global coordination of financial regulations.

Subsequently, Paulson, in trying to defend his decisions, managed to muddy the waters by periodically revising his reasons for not having saved Lehman. In a January 4, 2009, op-ed piece in the New York Times, Michael Lewis and David Einhorn wrote: “At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.”

Once the Barclays deal failed, it appears that the United States government truly did lack the regulatory tools to save Lehman. Unlike the Bear Stearns situation, in which JP Morgan was used as a vehicle to funnel emergency loans to Bear, there was no financial institution available to act as conduit for government loans to Lehman. Because the Fed had already determined that Lehman didn’t have sufficient collateral to borrow against as a stand-alone firm, there were effectively no options left.

Still, these explanations don’t address the question of why Paulson and the U.S. government didn’t do more to keep Barclays at the table during negotiations. In the series of hectic phone calls with British regulators on the morning of Sunday, September 14, 2008, neither Paulson nor Geithner ever offered to have the government subsidize Barclays’ bid, helping reduce the risk for the firm and possibly easing the concerns of wary politicians in Britain.

In Paulson’s view, Barclays’ regulators in the UK would never have approved a deal for Lehman within the twelve-hour period in which he believed a transaction would have had to be completed. From that perspective, further negotiations would only have been a waste of precious time. Paulson may be correct in his conclusions, but it is legitimate to ask whether he pulled the plug too early.

It will likely be endlessly debated whether Paulson’s decisiveness throughout the crisis was a benefit or a detriment, but the argument can also be made that any other individual in Paulson’s position—in a lame-duck administration with low and dwindling popular support—might have simply frozen and done nothing. It is impossible to argue he didn’t work hard enough. And a year later, it appears that many of the steps he took in the midst of the crisis laid the groundwork for the market’s stabilization, with the Obama administration, Geithner, and Bernanke often taking credit for the reversal. Thus far, many of the biggest banks that accepted TARP funds have returned it, taxpayers have made $4 billion in profit. However, that does not account for the hundreds of millions of dollars directed at firms like AIG, Citigroup, and elsewhere that may never get paid back.