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

A year ago Jackson Hole had been a more trying experience for Bernanke. As the credit crisis escalated that summer, Bernanke and a core group of advisers—Geithner; Warsh; Donald Kohn, the Fed vice chairman; Bill Dudley, the New York Fed’s markets desk chief; and Brian Madigan, director of the division of monetary affairs—huddled inside the Jackson Lake Lodge, trying to figure out how the Fed should respond to the credit crisis.

The group roughed out a two-pronged approach that some would later call “the Bernanke Doctrine.” The first part involved using the best-known weapon in the Fed’s arsenal: cutting interest rates. To address the crisis of confidence in the markets, the policy makers wanted to offer support, but not at the expense of encouraging recklessness in the future. In his address at the 2007 conference, Bernanke had said, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” Yet his very next sentence—“But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy”—bolstered what had been perceived as the central bank’s policy since the hasty, Fed-organized, Wall Street-financed bailout of the hedge fund Long-Term Capital Management in 1998: If those consequences were serious enough to impact the entire financial system, the Fed might indeed have broader obligations that might require intervention. It was precisely this view that influenced his thinking in protecting Bear Stearns.

By this year’s conference the Bernanke Doctrine had come under attack. As Bernanke, looking exhausted, sat slumped at a long table in the lodge’s wood-paneled conference room, speaker after speaker stood up to criticize the Fed’s approach to the financial crisis as essentially ad hoc and ineffective, and as promoting moral hazard. Only Alan Blinder, once a Fed vice chairman and a former Princeton colleague of Bernanke’s, defended the Fed. Blinder told this tale:

One day a little Dutch boy was walking home when he noticed a small leak in the dike that protected the people in the surrounding town. He started to stick his finger in the hole. But then he remembered the moral hazard lesson he had learned in school… . “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout, and doing so would just encourage more shoddy construction. Besides, the foolish people who live here should never have built their homes on a floodplain.” So the boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned—including the little Dutch boy.

Perhaps you’ve heard the Fed’s alternative version of this story. In this kinder, gentler version, the little Dutch boy, somewhat desperate and worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. It was painful and not guaranteed to work—and the little boy would rather have been doing other things. But he did it anyway. And all the people who lived behind the dike were saved from the error of their ways.

The previous day, Bernanke, in his address to the symposium, had made a plea to move beyond a finger-in-the-dike strategy by urging Congress to create a “statutory resolution regime for nonbanks.”

“A stronger infrastructure would help to reduce systemic risk,” Bernanke noted.

It would also mitigate moral hazard and the problem of “too big to fail” by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention.

A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.

Bernanke did not mention Fannie or Freddie, but their fate was on the minds of many at Jackson Hole. That Friday Moody’s cut its ratings on the preferred shares of both companies to just below the level of non-investment grade, or junk. Expectations increased that Treasury would have to pull the trigger and put capital in Fannie and Freddie.

Jackson Hole also had, of course, long been a popular destination for the very wealthy. James Wolfensohn, the former Schroder’s and Salomon Brothers banker who became president of the World Bank, was one of Jackson Hole’s celebrity residents, and during the 2008 symposium he held a dinner at his home. In addition to Bernanke the guest list included two former Treasury officials, Larry Summers and Roger Altman, as well as Austan Goolsbee, an economic adviser to Barack Obama, who was about to be officially nominated as the Democratic candidate for president.

That night Wolfensohn posed two questions to his guests: Would the credit crisis be a chapter or a footnote in the history books? As he went around the table and surveyed opinions, everyone agreed that it would probably be a footnote.

Then, Wolfensohn asked: “Is it more likely that we’ll have another Great Depression? Or will it be more of a lost decade, like Japan’s?” The consensus answer among the dinner guests to that question was that the U.S. economy would probably have a prolonged, Japan-like slump. Bernanke, however, surprising the table, said that neither scenario was a real possibility. “We’ve learned so much from the Great Depression and Japan that we won’t have either,” he said assuredly.

“We’ve made a decision,” Paulson announced to his team and advisers in a conference room at Treasury the last week of August about the fate of Fannie and Freddie. “They can’t survive. We have to fix this if we are going to fix the mortgage market.”

Upon his return to Washington from Beijing, Paulson had spent a day listening to presentations from Morgan Stanley and others and had decided that they had no choice but to take action, especially as he watched the shares of both companies continue to slide. To Paulson, unless he solved Fannie and Freddie, the entire economy would be in jeopardy.

Morgan Stanley had spent the past three weeks working on what was internally called “Project Foundation.” Some forty employees had been assigned to the task, working nights and weekends. “It’s easier in jail,” complained Jimmy Page, an associate. “At least you get three meals a day and conjugal visits.”

The firm had undertaken a loan-by-loan analysis of the portfolios of the two mortgage giants, shipping reams of mortgage data from Fannie and Freddie off to India, where some thirteen hundred employees in Morgan’s analytic center went through the numbers on every single loan—nearly half the mortgages in the entire United States.

The Morgan Stanley bankers had also conducted a series of phone calls with investors to get a better sense of the market’s expectations. The outcome was, as Dan Simkowitz described it to the Treasury team: “The market cares what the Paulsons think. John Paulson and Hank Paulson. They want to know what John Paulson thinks is enough and they want to know what Hank Paulson is going to do.” (John Paulson was the most successful hedge fund investor of the past two years, having shorted subprime before anyone else, making some $15 billion for his investors and personally taking home more than $3.7 billion.)

The Morgan Stanley bankers estimated that the two mortgage companies would need some $50 billion in a cash infusion, just to meet their capital requirement, which should be equal to 2.5 percent of their assets; banks, at a minimum, had to have at least 4 percent. With the housing market deteriorating it was clear that the GSEs’ thin capital cushion was in danger.