As the Suburban raced to Bernanke’s office, Kashkari, who was unflappable by nature, remained calm. After a brief stint as a satellite engineer, he had gone to work as an investment banker for Goldman Sachs in San Francisco, where no one had ever needed to tell him that he was good at his job. He loved meeting with clients and putting his salesmanship to the test; like Paulson, he was an aggressive, get-it-done guy. And like Paulson, he occasionally ruffled feathers with his shoot-first-and-ask-questions-later approach, though few ever doubted his intellectual firepower.
Kashkari had always wanted to work in government, and though he’d met Paulson only once previously, he left him a congratulatory voice-mail when Paulson was named Treasury secretary. To his surprise, Paulson responded the next day: “Thanks. I’d love for you to join me at Treasury.”
Kashkari immediately booked a flight to Washington, during which he carefully rehearsed the pitch he would make to Paulson. They met at the Old Executive Office Building, where Paulson was camped out until the Senate could confirm him, and Kashkari had scarcely begun his presentation when he noticed a distracted, slightly irritated look come over Paulson’s face. Kashkari stopped in midsentence.
“Look, here is what I’m trying to do here,” Paulson told him. “I want to put together a small team that will be working on policy issues, all kinds of issues, really, just doing whatever it takes to get things done. How does that sound?”
An astonished Kashkari realized, He’s offering me a job!
As the two men shook hands on the deal, Paulson suddenly remembered an important detail and asked, “Oh, yeah, there’s just one other thing. Are you a Republican?” As luck would have it, he was. Paulson saw him out and directed him to the White House Personnel Office a few blocks away. Kashkari was soon on the team, and now he was about to lead the biggest sales pitch of his career—to the single most influential person in the entire world’s economy.
Four words had dogged Ben Bernanke from the moment he assumed the job of chairman of the Federal Reserve on February 10, 2006: “Hard Act to Follow.” It was, perhaps, an inevitable epithet for the man whom the renowned Washington Post investigative reporter Bob Woodward had also dubbed “The Maestro”—Alan Greenspan, who was to fiscal policy what Warren Buffett was to investing. Greenspan had overseen the Federal Reserve during a period of unprecedented prosperity, a spectacular bull market that had begun during the Reagan administration and had run for over twenty years. Not that anyone outside the economics profession had a clue what Greenspan was doing or even saying most of the time. His obfuscation in public pronouncements was legendary, which only added to his mystique as a great intellect.
Bernanke, by contrast, had been a college professor for most of his career, and at the time of his appointment to replace the then-eighty-year-old Greenspan, his area of specialization—the Great Depression and what the Federal Reserve had done wrong in the 1920s and 1930s—seemed quaint. Trying to identify the causes of the Great Depression may be the Holy Grail of macroeconomics, but to the larger public, it seemed to have little practical application in a key government position. Any economic crisis of that magnitude seemed safely in the past.
By the summer of 2007, however, America’s second Gilded Age had come shockingly to an end, and Greenspan’s reputation lay in tatters. His faith that the market was self-correcting suddenly seemed fatally shortsighted; his cryptic remarks were judged in hindsight as the confused ramblings of a misguided ideologue.
As a scholar of the Depression, Bernanke was cut from a different cloth, though he shared Greenspan’s belief in the free market. In his analysis of the crisis, Bernanke advanced the views of the economists Milton Friedman and Anna J. Schwartz, whose A Monetary History of the United States, 1867–1960 (first published in 1963) had argued that the Federal Reserve had caused the Great Depression by not immediately flushing the system with cheap cash to stimulate the economy. And subsequent efforts proved too little, too late. Under Herbert Hoover, the Fed had done exactly the opposite: tightening the money supply and choking off the economy.
Bernanke’s entrenched views led many observers to be optimistic that he would be an independent Fed chairman, one who would not let politics prevent him from doing what he thought was the right thing. The credit crisis proved to be his first real test, but to what degree would his understanding of economic missteps eighty years earlier help him grapple with the current crisis? This was not history; this was happening in real time.
Ben Shalom Bernanke was born in 1953 and grew up in Dillon, South Carolina, a small town permeated by the stench of tobacco warehouses. As an eleven-year-old, he traveled to Washington to compete in the national spelling championship in 1965, falling in the second round when he misspelled “Edelweiss.” From that day forward he would wonder what might have been had the movie The Sound of Music, which featured a well-known song with that word for a title, only made its way to tiny Dillon.
The Bernankes were observant Jews in a conservative Christian evangelical town just emerging from the segregation era. His grandfather Jonas Bernanke, an Austrian immigrant who moved to Dillon in the early 1940s, owned the local drugstore, which Ben’s father helped him run; his mother was a teacher. As a young man, Ben waited tables six days a week at South of Border, a tourist stop off Interstate 95.
In high school, Bernanke taught himself calculus because his school did not offer a class in the subject. As a junior, he achieved a near-perfect score on the SATs (1590), and the following year he was offered a National Merit Scholarship to Harvard. Graduating with a degree in economics summa cum laude, he was accepted to the prestigious graduate program in economics at the Massachusetts Institute of Technology. There he wrote a dense dissertation about the business cycle, dedicating it to his parents and to his wife, Anna Friedmann, a Wellesley College student whom he married the weekend after she graduated in 1978.
The young couple moved to California, where Bernanke taught at Stan-ford’s business school and his wife entered the university’s master’s program in Spanish. Six years later, Bernanke was granted a tenured position in the economics department at Princeton. He was thirty-one and a rising star, admired for “econometrics” research that used statistical techniques and computer models to analyze economic problems.
Bernanke also demonstrated political skills as his intellectual reputation grew. As chairman of the Princeton economics department, he proved effective at mediating disputes and handling big egos. He also created a series of new programs and recruited promising young economists such as Paul Krugman (who happened to be his ideological opposite). Six years later Bernanke was recruited to succeed Greenspan.
Up until early August 2007, Bernanke had been enjoying his tenure at the Fed, so much so that he and Anna had planned to take a vacation that month and drive to Charlotte, North Carolina, and then on to Myrtle Beach, South Carolina, to spend time with friends and family. Before heading south, he had to see to one final business matter: the Federal Open Market Committee, the Fed’s powerful policy-making panel, which among its other responsibilities sets interest rates, was scheduled to meet on August 7. On that day, Bernanke and his colleagues acknowledged for the first time in recent memory the presence of “downside risks to growth,” but decided nonetheless to keep the Fed’s benchmark interest rate unchanged at 5.25 percent for the ninth consecutive meeting. Rather than try to boost economic activity by lowering rates, the committee decided to stand pat. “The committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected,” the Fed announced in a subsequent statement.
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 acknow
ledge 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 5.75 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.
After a few minutes of chat, Swagel reached into a folder and gingerly handed Bernanke the ten-page outline of the “Break the Glass” paper. Kashkari glanced at his colleagues for reassurance and then began to speak.
“I think we all understand the political calculus here, the limits of what we can legally do. How do you get the authority to prevent a collapse?” Bernanke nodded in agreement, and Kashkari continued. “So, as you know, we in Treasury, in consultation with staffers at the Fed, have been exploring a set of options for the last few months, and I think we have come up with the basic framework. This is meant to be something that if we’re ever on the verge of mayhem, we can pull off the shelf in the event of an emergency and present to Congress and say, ‘Here is our plan.’”
Kashkari looked over at Bernanke, who, having been intently studying the text, had immediately zeroed in on the key of the plan: “Treasury purchases $500 billion from financial institutions via an auction mechanism. Determining what prices to pay for heterogeneous securities would be a key challenge. Treasury would compensate bidder with newly issued Treasury securities, rather than cash. Such an asset-swap would eliminate the need for steriliza
tion by the Fed. Treasury would hire private asset managers to manage the portfolios to maximize value for taxpayers and unwind the positions over time (potentially up to 10 years).”
Bernanke, weighing his words carefully, asked how they had come up with the $500 billion figure.
“We are talking a ballpark estimate of, what, say, $1 trillion in toxic assets?” explained Kashkari. “But we wouldn’t have to buy all of the bad stuff to make a meaningful dent. So, let’s say half. But maybe it’s more like $600 billion.”
As Bernanke continued to study their paper, Kashkari and Swagel took a second to savor the moment: They were briefing the keeper of The Temple—as the Federal Reserve is often called—on what might be a historic bailout of the banking system. Government intervention on this scale hadn’t been contemplated in at least fifty years; the savings and loan rescue of the late 1980s was a minor blip by comparison.
If the “Break the Glass” plan did get past Congress—a problem they’d concern themselves with later—they had already detailed how Treasury would designate the New York Fed to run the auctions of Wall Street’s toxic assets. Together they would solicit qualified investors in the private sector to manage the assets purchased by the government. The New York Fed would then hold the first of ten weekly auctions, buying $50 billion worth of mortgage-related assets. The auctions would, it was hoped, fetch the best possible price for the government. Ten selected asset managers would each manage $50 billion for up to ten years.