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

That, however, was not what Wall Street wanted to hear, for concerns about the sputtering economy had investors clamoring for a rate cut. Four days earlier financial commentator Jim Cramer had exploded on an afternoon segment of CNBC, declaring that the Fed was “asleep” for not taking aggressive action. “They’re nuts! They know nothing!” he bellowed.

What the Fed’s policy makers recognized but didn’t acknowledge publicly was that credit markets were beginning to suffer as the air had begun gradually seeping out of the housing bubble. Cheap credit had been the economy’s rocket fuel, encouraging consumers to pile on debt—whether to pay for second homes, new cars, home renovations, or vacations. It had also sparked a deal-making frenzy the likes of which had never been seen: Leveraged buyouts got larger and larger as private-equity firms funded takeovers with mountains of loans; as a result, transactions became ever riskier. Traditionally conservative institutional investors, such as endowments and pension funds, came under pressure to chase higher returns by investing in hedge funds and private-equity funds. The Fed resisted calls to cut interest rates, which would only have thrown gasoline onto the fire.

Two days later, however, the world changed. Early on the morning of August 9, in the first major indication that the financial world was in serious peril, France’s biggest bank, BNP Paribas, announced that it was halting investors from withdrawing their money from three money market funds with assets of some $2 billion. The problem? The market for certain assets, especially those backed by American mortgage loans, had essentially dried up, making it difficult to determine what they were actually worth. “The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating,” the bank explained.

It was a chilling sign that traders were now treating mortgage-related assets as radioactive—unfit to buy at any price. The European Central Bank responded quickly, pumping nearly 95 billion euros, or $130 billion, into euro money markets—a bigger cash infusion than the one that had followed the September 11 attacks. Meanwhile, in the United States, Countrywide Financial, the nation’s biggest mortgage lender, warned that “unprecedented disruptions” in the markets threatened its financial condition.

The rates that banks were charging to lend money to one another quickly spiked in response, far surpassing the central bank’s official rates. To Bernanke what was happening was obvious: It was a panic. Banks and investors, fearful of being contaminated by these toxic assets, were hoarding cash and refusing to make loans of almost any kind. It wasn’t clear which banks had the most subprime exposure, so banks were assumed guilty until proven innocent. It had all the hallmarks of the early 1930s—confidence in the global financial system was rapidly eroding, and liquidity was evaporating. The famous nineteenth-century dictum of Walter Bagehot came to mind: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

After Bernanke told his wife their trip had to be canceled, he summoned his advisers to his office; those who were away called in. Fed officials began working the phones, trying to find out what was happening in the markets and who might need help. Bernanke was in his office every morning by 7:00 a.m.

Only two days later came the next shock. It was becoming a daily scramble for the Fed to keep up with the dramatically changing conditions. The following day Bernanke held a conference call with Fed policy makers to discuss lowering the discount rate. (A symbolic figure in normal times, the discount rate is what the Fed charges banks that borrow directly from it.) In the end, the Fed issued a statement announcing that it was providing liquidity by allowing banks to pledge an expanded set of collateral in exchange for cash—although not on the scale that the Europeans had—to help the markets function as normally as possible. It also again reminded the banks that the “discount window” was available. Less than a week later, Bernanke, faced with continued turmoil in the markets, reversed his earlier decision and went ahead with a half-point cut in the discount rate, to 4.75 percent, and hinted that cuts in the benchmark rate—the Fed’s most powerful tool for stimulating the economy—might be coming as well. Despite these reassurances, markets remained tense and volatile.

By now it was clear even to Bernanke that he had failed to gauge the severity of the situation. As late as June 5, he had declared in a speech that “at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.” The housing problem, he had thought, was limited to the increase in subprime loans to borrowers with poor credit. Although the subprime market had mushroomed to $2 trillion, it was still just a fraction of the overall $14 trillion U.S. mortgage market.

But that analysis did not take into account a number of other critical factors, such as the fact that the link between the housing market and the financial system was further complicated by the growing use of exotic derivatives. Securities whose income and value came from a pool of residential mortgages were being amalgamated, sliced up, and reconfigured again, and soon became the underpinnings of new investment products marketed as collateralized debt obligations (CDOs).

The way that firms like a JP Morgan or a Lehman Brothers now operated bore little resemblance to the way banks had traditionally done business. No longer would a bank simply make a loan and keep it on its books. Now lending was about origination—establishing the first link in a chain of securitization that spread risk of the loan among dozens if not hundreds and thousands of parties. Although securitization supposedly reduced risk and increased liquidity, what it meant in reality was that many institutions and investors were now interconnected, for better and for worse. A municipal pension fund in Norway might have subprime mortgages from California in its portfolio and not even realize it. Making matters worse, many financial firms had borrowed heavily against these securities, using what is known as leverage to amplify their returns. This only increased the pain when they began to lose value.

Regulators around the world were having trouble understanding how the pieces all fit together. Greenspan would later admit that even he hadn’t comprehended exactly what was happening. “I’ve got some fairly heavy background in mathematics,” he stated two years after he stepped down from the Fed. “But some of the complexities of some of the instruments that were going into CDOs bewilders me. I didn’t understand what they were doing or how they actually got the types of returns out of the mezzanines and the various tranches of the CDO that they did. And I figured if I didn’t understand it and I had access to a couple hundred PhDs, how the rest of the world is going to understand it sort of bewildered me.”

He was not alone. Even the CEOs of the firms that sold these products had no better comprehension of it all.

The door of the chairman’s office swung open, and Bernanke warmly greeted the group from Treasury. Like Swagel, he still had the halting manner of an academic, but for an economist, he was unusually adept at small talk. He showed Paulson and his team into his office, where they settled around a small coffee table. Beside the expected Bloomberg terminal, Bernanke had a Washington Nationals cap prominently displayed on his desk.