It was by its very nature a secret undertaking, given that he wasn’t allowed to let anyone—least of all Lehman Brothers—know that the government was even thinking about the possibility, no matter how improbable it might be. If the stock market caught even a whiff of it, Lehman’s shares would plunge. But Paulson, who had been speaking to Fuld almost every day, had become convinced that Lehman was going to face a struggle in its attempts to raise capital, and they needed to prepare for the very worst.
Indeed, Paulson had become so frustrated with Fuld’s various plans that he had assigned Ken Wilson to be Fuld’s personal liaison. “I’m going to tell Dick that he’s talking to you,” Paulson told Wilson. “It’s just a waste of time. I’ll talk with him when he’s got something really important to say to me.”
Paulson wasn’t the only one worried about Lehman. Shafran’s assignment followed a series of e-mail exchanges within the Federal Reserve back in June between Bernanke and his colleague, Donald Kohn, the Fed’s vice chairman. Kohn had written to Bernkane to say that he had spent time “thinking about options” for Lehman “ in the event the slow erosion of confidence turns into a rout and liquidity fled quickly. None are good, given the lack of interest by a purchaser.” He followed up with second e-mail: “One of the hedge fund types on Cape Cod told me that his colleagues think Lehman can’t survive—the question is when and how they go out of buinsess not whether.”
For Shafran, dealing with other government agencies was something of a novelty. He had moved himself and his children to Washington only a year earlier, after his wife of twenty-four years, Janet, was killed in a plane accident. They had been living in Sun Valley, where he had gone after retiring from Goldman Sachs. Shafran had worked at the firm for fifteen years, serving as Paulson’s point person in Hong Kong, helping him in his efforts to gain entree to China. He had come to Washington to start over.
For Shafran the Lehman project was even more awkward than it would be for other Treasury staffers because he was a casual friend of Fuld’s. They knew each other from Sun Valley, where Shafran had become a city councilman in Ketchum and Fuld owned ninety-seven acres in the area (worth some $27 million), with a main home on a private road across the Big Wood River and a cabin on the shore of Pettit Lake, right near Shafran’s. They played golf together at the Valley Club and socialized occasionally. Shafran liked Fuld and admired his intensity.
But now, as Shafran was sitting in the gas station parking lot on the phone, he gave Paulson a progress report. He said he had held some conference calls with the Fed and SEC, and while they thought it was impossible to truly estimate the systemic risk, he felt that they were finally at least paying attention to the challenge. “They are on it,” he said. “I’m comfortable.” He explained that they had identified four risks within Lehman: its repo book, or portfolio of repurchase agreements; its derivative book; its broker dealer; and its illiquid assets, such as real estate and private equity investment.
Paulson knew he couldn’t do much for Lehman himself. Treasury itself did not have any powers to regulate Lehman, so it would be left to the other agencies to help manage a failure. But that made him anxious.
Earlier in the summer, David Nason had held a meeting with the SEC and told Paulson they were not on top of the situation. With streams of spreadsheets of Lehman’s derivative positions splayed before them in the Grant conference room, he had questioned Michael A. Macchiaroli, an associate director at the SEC, about what they would do if Lehman failed.
“There are a lot of positions,” Macchiaroli said. “I’m not sure what we’d do with the positions, but we’d try to net them out, and we’d go in there, and SIPC would come in,” he added, referring to Securities Investor Protection Corporation, which acts in a quasi-FDIC capacity but on a much smaller scale.
“That can’t be the answer,” Nason replied. “That would be a mess.”
“The problem is that half their book is the U.K.,” Macchiaroli said, explaining that many of Lehman’s trades went through its unit in London.
“And their counterparties are outside the United States, and we don’t have jurisdiction over them.” In the event of a disaster, all the SEC could do was try to maintain Lehman’s U.S. broker-dealer unit, but the holding company and all of its international subsidiaries would have to file for bankruptcy.
There were no good answers. Nason had raised the possibility that they might have no choice in an emergency but to go to Congress and seek permission to guarantee all of Lehman’s trades.
But as quickly as he raised the idea, he shot himself down.
“To guarantee all the obligations of the holding company, we would have to ask Congress to use taxpayer money to guarantee obligations that are outside the U.S.,” he announced to the room. “How the hell would we ask for that?”
Across a sweeping meadow from the Jackson Lake Lodge, the towering white peaks of the Tetons offered a majestic view, but one that no longer took Ben Bernanke’s breath away the way it once had. As he walked its trails on August 22 he recalled that it was here, at the Federal Reserve Bank of Kansas City’s summer symposium in the Grand Teton National Park, that he had first made his name nearly a decade ago. For the next three days, however, he could expect little more than criticism, questioning of his actions over the past year, and questions about what role the government should play with respect to Fannie and Freddie. In the summer of 1999, when the mania for Internet stocks was in full bloom, Bernanke and Mark Gertler, an economist at New York University, had presented a paper at Jackson Hole that contended that bubbles of that sort need not be a huge concern of the central bank. Pointing to steps taken by the Federal Reserve in the 1920s to pop a stock’s bubble that only created problems when an economic downturn took hold, Bernanke and Gertler argued that the central bank should restrict itself to its primary responsibility: trying to keep inflation stabilized. Rising asset prices should only be a concern for the Fed when they fed inflation. “A bubble, once ‘pricked,’ can easily degenerate into a panic,” they argued in a presentation that had been the talk of the conference and had attracted the favorable notice of Alan Greenspan.
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.
