“We’re working on some things,” Paulson said. “What do you think we should do?”
“You have to approach what you’re doing from the perspective of being a sheriff in a western town where things are out of control,” Schwarzman replied, “and you have to do the equivalent of just walking onto Main Street and shooting your gun up in the air a few times to establish that you’re in charge because right now no one is in charge!”
Paulson just listened, trying to picture himself in that role. “What do you recommend?”
“Well, the first thing you could do is stop short-selling of financial institutions—forget whether it’s effective in removing the pressure, although it might be. What will be accomplished is that you will scare the participants in the market, and they will recognize that things are going to change and they can’t continue to invest in the exact same way, and that will force people to pause,” Schwarzman said.
“Okay. That’s not a bad idea,” Paulson agreed. “We’ve been talking about that. I could do that. What else do you got?”
“I would stop the ability of people to withdraw, you know, transfer their brokerage accounts,” Schwarzman continued. “Nobody really wants to transfer their account out of Goldman or Morgan. They just feel they have to do it so they’re not the last person on a sinking ship.”
“I don’t have the powers to do that,” Paulson replied.
“You could get rid of the ability for people to write credit default swaps on financial institutions,” Schwarzman offered as an alternative, “which is putting enormous pressure on financial institutions.”
“I don’t have the powers to do that either,” Paulson protested.
Schwarzman, concerned that he wasn’t getting through to Paulson, replied, “Look, you’re going to have to announce something very big to rescue the system, some huge amount of money that gets utilized to address the problems of the system.”
“Well, we’re not ready to do that yet,” Paulson told him. “We’ve got some ideas,” he said.
“I don’t think that it’s relevant if you haven’t fully baked everything,” Schwarzman said, “You need an announcement tomorrow to stop the collapse and you’ve got to figure something out that will grab people’s attention.”
“What’s wrong?” John Mack asked in alarm as his CFO, Colm Kelleher, walked into his office late Wednesday, his face ashen.
“John,” Kelleher said in his staccato British inflections, “we’re going to be out of money on Friday.” He had been nervously watching the firm’s tank—its liquid assets—shrink, the way an airline pilot might stare at the fuel gauge while circling an airport, waiting for landing clearance.
“That can’t be,” Mack said anxiously. “Do me a favor, go back to the financing desk, go through it again.”
Every hour was bringing a new problem. The internal memo he had sent out earlier decrying short-sellers had started leaking out, and now several prominent hedge fund clients that used shorting strategies—some simply to hedge their exposures to other securities—were closing their Morgan Stanley accounts in protest.
“It’s one thing to complain, but another to put out a memo blaming your clients,” railed Jim Chanos, the short-seller who famously unearthed the problems at Enron. He had been a Morgan Stanley client for twenty years, but now he was making his displeasure known by pulling $1 billion from his account at the firm. Julian H. Robertson Jr., the founder of Tiger Management, one of the first and most successful hedge funds, called the firm apoplectically, though he stopped short of redeeming the money he kept with Morgan Stanley.
As annoyed as they might have been by the attack on shorts, the firm’s clients were about to become a good deal angrier. Mack was reviewing draft language for the statement he would publish the following day in support of Cuomo’s investigation into short selling. Though he knew full well that his language would infuriate his clients and send even more of them packing, Mack didn’t believe he had a choice but to lend his support:
Morgan Stanley applauds Attorney General Cuomo for taking strong action to root out improper short selling of financial stocks. By initiating a wide-ranging investigation of this manipulative and fraudulent conduct, Attorney General Cuomo is showing decisive leadership in trying to help stabilize the financial markets. We also support his call for the SEC to impose a temporary freeze on short selling of financial stocks, given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks.
Kelleher returned to Mack’s office thirty minutes after having been sent to review the firm’s balances again, slightly less shaken, but only slightly. After finding some additional money trapped in the system between trades that hadn’t yet settled, he revised his prognosis: “Maybe we’ll make it through early next week.”
Paulson was hunched over his telephone, straining to hear Bernanke and Geithner on the speakerphone. It was late Wednesday, and the Treasury staff was already girding for another all-nighter.
Bernanke was making his frustration clear; he didn’t believe the crisis could be solved by individual deals or some one-off solution. “We can’t keep doing this,” he insisted to Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”
Paulson agreed in theory but was concerned that Bernanke was underestimating the political calculus. “I understand that you guys don’t want to be fighting this fire alone, but the worst outcome would be if I go ask, and they tell me to screw off,” Paulson said. “We will then show that we’re vulnerable and we don’t have the armaments we need.”
“There are no atheists in foxholes and no ideologues in financial crises,” Bernanke, trotting out a phrase he had tried out on some Fed colleagues a day earlier, told Paulson, trying to persuade him that intervention was necessary.
Paulson agreed but said if they were going to proceed, he wanted to promote his plan to have the government buy toxic assets, a solution that he thought would be the most politically palatable, because it would be comparable to the Resolution Trust Corporation of the late 1980s. Congress created the RTC in 1989 to handle the more than $400 billion in loans and other assets held by 747 failed savings and loans as part of the S&L crisis. The RTC had been the recipient of a wide range of loans, properties, and bonds from the failed thrifts. Like the predicament Paulson currently faced, some of the assets were good but most were bad, and some, including construction and development loans, had no discernible market. The task was daunting: L. William Seidman, the RTC chairman, initially estimated that even if the agency sold $1 million of assets a day, it would take three hundred years to dispose of everything. By the time the RTC completed its job in 1995, a year ahead of its deadline, the cost to the taxpayers was nearly $200 billion (in 2008 dollars)—a much lower tab than what many had feared at the time the agency had been created.
Paulson thought the idea had merit and was buoyed by an op-ed in the Wall Street Journal that morning touting a similar plan by Paul A. Volcker, the former chairman of the Federal Reserve; Nicholas F. Brady, a former U.S. Treasury secretary; and Eugene A. Ludwig, a former U.S. comptroller of the currency.
“This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management,” they wrote. “The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link.”