posted September 16, 2018
Anniversary of the 2008 Lehman Brothers: Did the Fed and Treasury Engineer the Banking Crash?

(Excerpt from ‘Epic Recession: Prelude to Global Depression’, by Dr. Jack Rasmus, Pluto books, 2010


Bear Stearns was especially dependent on day to day funding from the big commercial banks like JP Morgan Chase and others. As Bear Stearns’ stock plummeted it had to use up virtually all its capital. As it did, other commercial banks began to refuse to loan it overnight funds in order to keep operating. Other shadow bank investors like Hedge Funds with money in Bear Stearns began pulling out their funds. What this represented was a kind of ‘wholesale’ or institutional run on the bank in the case of Bear Stearns. It was about to go bankrupt. Were Bear Stearns a commercial bank and thus a member of the Federal Reserve system, the Fed could have provided funds to it through its recent TAF auction or by other direct means. But at this time the shadow investment banks like Bear were not members of the Fed system and could not join even if they wanted. Bear Stearns also ‘owed’ other banks and financial institutions. Had it simply gone bankrupt, that would have resulted in additional major losses of those other institutions at a time during which their losses were growing rapidly for other reasons. The chain-reaction of losses and bank defaults might have been serious.

The Fed at this point, in mid-March 2008, intervened unilaterally, redefining its own charter to cover the investment bank segment of the shadow banking sector. It ‘arranged’ for the sale of Bear Stearns to JP Morgan Chase at firesale $2 per share prices, or about $236 million, a total value more than a billion less than Bear Stearns’ Manhattan, New York, office building. The Fed gave JP Morgan $29 billion to ensure the deal. Morgan would not even have to put up its own collateral, the Fed allowing it to use Bear Stearns assets instead. In short, JP Morgan Chase was given Bear Stearns virtually free, hand-delivered by the Federal Reserve. In arranging the firesale of Bear Stearns to Chase, the Fed entered new territory as ‘lender of last resort’. It gave the signal that banks, even shadow banks, henceforth would not be allowed to fail. Morale hazard was no longer a factor to the Fed.

The bankruptcy of Bear Stearns set off instability in other areas, including globally. In addition to the $29 billion Bear bailout, the Fed instituted new emergency lending facilities for primary dealers-investment banks-brokers and put up another $300 billion in funding. It also arranged $36 billion in swap loans to European central banks.

With the Bear Stearns bailout, the Fed had used up half of its available $850 billion of resources on hand. Having ‘shot off its big gun’ it retreated temporarily to the sidelines. Bernanke’s public position at this point was that banks and shadow banks still experiencing growing losses should now raise private capital on their own and not expect a bailout. But failing banks tend to have trouble raising capital, to say the least. And the new Fed policy of mass liquidity injection and bailout had now been set in motion. Market speculators were not fooled by talk of banks’ raising capital on their own. and would soon test the limits of the Fed’s new liquidity policy.

For a few months, in April-May 2008, it appeared the financial crisis had somewhat stabilized. The temporary effects from the fiscal stimulus bill passed in February were also entering the economy. That stimulus and continuing expansion in world trade, and thus exports, together appeared to prop up the real economy, which recorded a moderate rise in GDP. But it was a weakest of recoveries, and sustaining it was never a question. It had dissipated in three months. The real economy continued to deteriorate below the surface throughout the spring of 2008 and into the summer. Nearly a year of credit tightening, slowing industrial production, and steadily rising jobless for seven straight months was taking a deeper toll on the real economy.

By June 2008 the decline of the real economy began to reappear. Debt loads were rising for banks, consumers and businesses alike. Prices were beginning to slow and level off. The exports and commodities boom was over. Unemployment was rising faster. Signs were growing the fiscal stimulus package passed in February was beginning to run out of steam. Oil, commodity, and export prices were starting to unwind. Bank lending to non-financial businesses was falling at a 9.1% annual rate—the fastest since 1973. Rates on corporate loans, investment grade bonds, and residential mortgages were rising—a reflection of the growing financial fragility of borrowers. Financial fragility and consumption fragility were both continuing to deteriorate. Meanwhile, short sellers and speculators were sharpening their knives, preparing to go after the next subprime burdened financial institution. By late June 2008 their next target was clear: the quasi government agencies, Fannie Mae and Freddie Mac, who were required by law to buy up bad mortgages and were now becoming overloaded as private sector lenders in effect transferred their debt and falling financial assets to the government quasi agencies, Fannie and Freddie.

In July 2008, the renewed financial instability focused on Fannie/Freddie. A new phase in the financial crisis was about to emerge. In July the lead role as ‘lender of last resort’ shifted from the Fed—now on the sidelines trying to absorb the Bear Stearns bailout and the other emergency auctions initiated in March—to the U.S. Treasury and its Secretary, Henry Paulson.


Former CEO and Chairman of the largest Investment Bank, Goldman Sachs, and billionaire banker, Henry Paulson, was brought into the Bush administration at the end of June 2006. His prime task was to complete the deregulation of the financial sector. Initiated under Reagan, financial deregulation accelerated into high gear under Clinton in 1999-2000 with the repeal of the 1930s Glass-Steagal Act and its replacement with Gramm-Bliley in 1999 and the passage of the Commodities Modernization Act soon after. The federal regulatory structure for banks and shadow banks was largely eviscerated by 1999-2000. Investment banks like Goldman were removed altogether from Securities and Exchange Commission (SEC) oversight. But state-level regulators were still an obstacle and annoyance.

Paulson’s first task was to clear the decks of this remaining obstacle on the road to total and complete financial deregulation. One of his first efforts in office was to form a Committee on Capital Markets Regulation (CCMR) along with other big financial institution players. The CCMR issued its 148 page report in November 2006. At the same time Paulson addressed the Economic Club of New York explaining the objectives of the report was to put in place curbs on state regulators, like New York’s Eliot Spitzer and others. The report came up with 32 specific recommendations for legislation, and called for a basic change in financial regulatory policy that would focus on “the soundness of the financial system” instead of individual institution’s acts of wrongdoing. Regulators at the SEC and elsewhere would henceforth have to do cost benefit analyses for every rule, economists would replace lawyers on the staff, and the federal government would be given power to block indictments by state regulators. Paulson and the Treasury held a conference in early 2007 to push the proposals further toward legislative enactment. It was followed by a recommendation by the Paulson-headed ‘President’s Working Group on Financial Markets’ that the hedge fund industry, now with nearly $2 trillion in assets, should not be regulated. Nor should the government levy taxes on hedge funds and private equity firms, another new form of shadow banking. Such was the mindset of the man who the Bush administration would call on to bring discipline and regulation to the banking system once it began to collapse.

A final ‘coup de grace’ for financial regulation, the Supreme Court added its weight to efforts to silence state regulators who were now increasingly warning of growing financial irregularities and pending crisis. The Court ruled in April 2007 that mortgage subsidiaries of national banks were no longer subject to state regulators. States were thus stripped of the authority they had exercised for thirty-five years.

Once the subprime mortgage bust occurred in early August 2007, Paulson had little to say and did even less, leaving action to the Fed. In October 2007 in another speech he called for better monitoring of mortgage brokers, but added a new ‘regulatory blueprint’ would take years to develop and implement.

Paulson, like Bernanke at the time, was deeply committed to ‘voluntary’ solutions to the crisis, advocating that banks ‘pool’ their remaining assets as a defense to the crisis. Some of the larger banks attempted to do so, forming a ‘superconduit fund’, called the Master Liquidity Enhancement Conduit, or MLEC. As for homeowners, now beginning to default in increasing numbers and foreclose, Paulson’s answer was ‘voluntary action’ by lenders in which they would renegotiate loans. When Sheila Bair, head of the FDIC, proposed to freeze interest rates temporarily on 2 million mortgages, Paulson opposed vigorously. Instead, he led Bush efforts to launch what was called the ‘HOPE NOW Alliance Plan’ for voluntary mortgage relief. The New York Times called the Paulson plan “too little, too late, too voluntary”, designed to create the appearance of action to undercut more aggressive proposals pending U.S. House of Representatives bills introduced in November-December 2007. Outside experts, like Harvard University bankruptcy expert, Elizabeth Warren, called the Paulson proposal “the bank lobby’s dream”.

Paulson continued to sit on the sidelines in early 2008 as the Fed struggled to get ahead of the crisis curve in the weeks leading up to the Bear Stearns collapse in mid-March 2008. In March the Fed originally requested that Paulson and the Treasury bail out Bear Stearns, but Paulson refused, putting forward the excuse the Treasury could do nothing without an Act of Congress.

In a U.S. Chamber of Commerce speech in March after the Fed’s bailout, Paulson continued to argue that Investment banks should not be regulated like commercial banks, adding “recent market conditions are an exception to the norm” and it was premature to attempt a system-wide bank stabilization effort. Instead he referred to his ‘Blueprint’ for a new deregulated system and proposed that oversight of state banks should be reassigned from the FDIC to the Federal Reserve and Bernanke. That blueprint also proposed replacing the Securities and Exchange Commission, SEC, tasked with bank regulation since the 1930s, with a “self regulating organization, an industry group that develops and enforces rules of conduct and business standards…”

In other words, even after the collapse of Bear Stearns—an event which clearly signaled that other Investment banks, many hedge funds, and mortgage lenders were in deep trouble and were already technically insolvent—Paulson kept pushing the Bush party line of financial deregulation as he had from first entering office as Treasury Secretary a year earlier. He pushed for voluntary self-rescue by the banks and voluntary renegotiation of mortgages—neither of which remotely happened. Paulson’s main proposal for dealing with the growing financial crisis was for the banks to ‘raise capital’ on their own to offset the deepening losses on their balance sheets.

Paulson the champion of financial deregulation, of hands off and voluntary solutions, and of the view banks should rescue themselves was, in a matter of days, thrust into the opposite role, in which he would perform even more questionably. It all began with the crisis of the quasi-government mortgage agencies, Fannie Mae and Freddie Mac, in early July 2008. That date marks the beginning of the road to the banking panic of 2008 in September-October and to a subsequent virtual shutdown of the financial system.

By law Fannie and Freddie are required to buy up mortgages. Before the crisis erupted, they were limited to buying no more than 40% of mortgages issued. By June 2008 that had risen to more than 80%. Like private mortgage lenders and financial institutions, Fannie/Freddie resold $1.7 trillion bundled mortgages, but in their case directly as U.S. securities to investors, banks, and central banks around the world. Thus bad subprimes bought by the agencies were recycled globally, tying financial institutions worldwide into the web of bad mortgage debt. By summer 2008 the two agencies found themselves with a total of $5.3 trillion in liabilities, but with only $81 billion in reserves. That meant reserves equal to only 1.6% of the mortgage liabilities they owned or guaranteed. It was a classic case of severe and sharply deteriorating financial fragility.

As it became increasingly apparent Fannie/Freddie were taking on more and more ‘bad’ debt investors became more concerned the two agencies could not cover their multi-trillion dollar liabilities with their miniscule liquid funds on hand. With housing prices continuing to fall and foreclosures rise, in early July analysts estimated losses by Fannie/Freddie over the coming year ranging from $100 to $300 billion. It was a perfect scenario for speculators and short sellers to jump in and repeat the process that drove Bear Stearns into financial oblivion, and which was now eating away at other I-banks like Lehman Brothers, Morgan Stanley and others. The big attack came the week of July 7-11 as speculators began aggressively short selling their stock. The commodities speculation boom was now over; there was even more available liquidity now with which to speculate by short selling. Fannie/Freddie was the target.

In the days immediately leading up to July 11, Paulson repeatedly proclaimed that the two agencies had sufficient capital, were voluntarily raising more, and that no rescue of the agencies was necessary. Of course, Paulson never bothered to explain how companies with such a collapse in stock prices might be able to ‘raise capital’. By the end of the week of July 7-11, Fannie Mae’s stock price was down 76% over the previous year, and Freddie’s had fallen 83%. Nevertheless, as late as July 10 Paulson was publicly stating there was no anticipation of the need for a bailout. As he publicly declared, “For market discipline to effectively constrain risk financial institutions must be allowed to fail.”

Over the weekend of July 12-13, Paulson did an about-face. When markets opened on Monday, July 14, Paulson and Bernanke together announced a plan that guaranteed the government would not allow Fannie/Freddie to fail. The plan required that Congress provide $300 billion of bailout funding. Paulson graphically explained he wouldn’t need to use the $300. It was just his ‘bazooka’, he said, the threat of which would prove sufficient to deter collapse of the agencies. Until Congress passed the funding, the Fed provided interim emergency loans to the two agencies from its ‘discount’ window and the newly established Fed special auction. Paulson also proposed the U.S. Treasury buy the two agencies’ public stock, thus propping up their stock prices, if necessary.

Congress passed an emergency housing industry law in late July. In it were provisions for $100 billion immediately and up to $300 billion later to bailout Fannie/Freddie if needed. Paulson said he wouldn’t need to use it; that the mere option of its availability would prove sufficient to calm the speculators, markets and investors. He was wrong again. Throughout August short sellers were driving the agencies’ stock prices down to record lows. Sometime in August Paulson shifted to bailout. At the end of the first week of September, he shot off his bazooka and bailed out Fannie/Freddie. The shot was heard ‘round the financial world. Now it was crystal clear the Fed and Treasury policy was to bail out whatever financial institution was in trouble. Bear Stearns was not an aberration, one time event. It was now all about helicopters and bazookas.

What explains the 180 degree shift by Paulson? One plausible interpretation is that foreign investors, banks, and central banks that had accumulated $1.7 trillion in Fannie/Freddie agency debt began to panic and demand Paulson take action to ensure Fannie/Freddie wouldn’t collapse. As the two agencies’ stock prices fell to single digits, Paulson stepped in to protect foreign bond holders. Failure to placate foreign bond holders could well mean a sharp decline in their purchase of U.S. bonds needed to finance the continually rising U.S. budget deficit, which was about to accelerate by trillions in the next year. But by protecting bondholders in the Fannie/Freddie bailout and allowing preferred and common stockholders to lose everything, Paulson doomed the rest of the investment banks to the short seller wolves. With stockholders seeing the writing on the wall, they were now more than ever willing to sell their stock, creating the perfect situation for short sellers. It also made it virtually impossible for Fannie/Freddie or any investment bank to voluntarily raise equity capital. The manner in which Paulson handled the Fannie/Freddie bailout exacerbated the pressures on the investment banks. Then bailing out just the bondholders worsened the situation. In short, Paulson bungled the process.

By the Fed bailing out Bear Stearns and the Treasury Fannie and Freddie, Bernanke and Paulson thought it would restore confidence in the institutions and the financial system in general. All it did was encourage speculators to go after the remaining I-banks more aggressively. It was now the end of the first week of September and the worse was yet to come.

Between the first and second weeks of September the stock prices of all the remaining investment banks went into freefall. The ‘raise capital voluntarily’ strategy of the preceding three months thus collapsed with the collapse of banks’ stock. In other words, financial fragility was rapidly worsening as a consequence of the bailouts of Bear Stearns and Fannie-Freddie. The remaining large investment banks—Merrill Lynch, Morgan Stanley, Goldman Sachs, Lehman Brothers, and others—were also in big trouble by September. The most serious was Lehman Brothers, an investment bank with $639 billion in assets but with leveraged debt of 30 to 1 and most of that in subprimes, commercial property, and leveraged buyout loans. Of all the investment banks, Lehman was also the most exposed to securitized assets in general. Between 2003-2007, Lehman had securitized $700 billion in assets—85% of which ($600 billion) were residential. 40% of its subprimes were delinquent. And by September Lehman had less than $20 billion in liquid resources on hand and couldn’t raise capital despite multiple attempts to do so. Lehman sought desperately to sell its best assets at firesale prices to raise capital, even seeking buyers in Korea, Japan and China. But all walked away from deals. It then tried to get the Fed to extend it status as a bank holding company (as the Fed did for Bear Stearns) to allow it access to emergency Fed auctions and funding. But the Fed refused.

One might reasonably ask why were short sellers and other speculators intent on driving down stock prices of I-banks like Lehman when it might result in the latter’s collapse? The answer is yet another example of speculation in financial assets running rampant. Investors after 2000 were able to purchase derivatives called ‘Credit Default Swaps’, or CDSs. This was originally conceived as insurance against the collapse of a company. If the collapse occurred, those who bought CDS contracts as insurance would be paid off. But CDSs soon evolved into more than insurance contracts. They became a form of investment gambling. CDS contracts had zoomed to $60 trillion worldwide in less than a decade. Speculators were increasingly buying CDS contracts as a ‘bet’ that a company would in fact fail and they’d receive a payoff. CDS purchases typically totaled even more than a company was worth. CDS betting thus presented an incentive for speculators to drive a company into bankruptcy by short selling. Speculators could make money as the stock price fell, and then again when the company collapsed Short sellers made money on driving down stock prices. But as stock prices fell, CDS prices escalating in value. Speculative profits were thus possible in both directions simultaneously—on stock asset price collapse and CDS asset price inflation—in a dual kind of betting. All this amounted to speculating on speculation—i.e. ‘casino investing’.

The Bush administration for years resisted any effort to regulate CDS trades. There was no public market for CDSs and thus no regulation possible. Trades were conducted privately and no one knew for certain, least so the government, where the trades were made and for how much or how many parties there were to a trade. Nor was the Bush administration willing to do much about the growing number, weight and influence of short sellers. Once the commodities boom ended in the spring of 2008, more short sellers entered the market attacking the investment banks’ stock prices. The Bush SEC had placed token limits on short selling earlier in the year. The SEC then allowed those limits to expire in mid-August, which resulted in even more intensified short selling of Fannie, Freddie, Lehman and other banks’ stock. Lehman stock in particular came under massive short selling pressure between September 8 and 12.

On September 15 the Treasury held an emergency meeting to which 30 top banks globally were invited to try to arrange a buyer for Lehman. At first Bank of America appeared interested. But Merrill Lynch quickly offered itself to B of A on terms the latter could not refuse, and B of A bought Merrill instead of Lehman. There were potential buyers for Lehman and it could have been bought. The lynchpin of the problem was the Treasury refusal to ‘insure’ the deal for any of the buyers—just the opposite of the insured deal JP Morgan Chase got from the Fed with the Bear Stearns bailout. Lehman in contrast was allowed to go bankrupt. But before it was announced the following Monday, the banks were allowed a special four hour trading session to hedge their possible losses with CDSs and other derivatives. Lehman was history that following Monday. Within days the fall of Lehman set off a collapse of a string of financial institutions. Biggest was the insurance giant, AIG, which the government then bailed out quickly for $123 billion (later extended to more than $180 billion).

A key, still unanswered question is why Paulson supported the Fed bailout of Bear Stearns prior to Lehman’s collapse and AIG immediately after, but allowed Lehman itself to collapse? One possible answer is that Bear Stearns and AIG were both heavily involved with CDSs, while Lehman was overexposed to subprime and commercial mortgages and leveraged loans but not particularly exposed to CDSs. Could it be then that the problem wasn’t that AIG and Bear were ‘too big to fail’ but that the CDS derivatives market was ‘too big’?

Another explanation is that Goldman Sachs, Paulson’s old company where he was previously chairman, had heavily invested in Bear and stood to lose billions if it went under, whereas Lehman was Goldman Sachs’ main competitor. But estimates of a Lehman bail out were no more than $85 billion, less than half that spent on AIG a few days later. Then again, AIG was one of the biggest players in CDSs. Arguments by Paulson that bailing out Lehman would have created a ‘bailout culture’ are simply not convincing; that culture had already been created with Bear Stearns and Fannie/Freddie.

The decision to let Lehman collapse was, in the last analysis, Paulson’s. To his bungled handling of the Fannie and Freddie bailouts was thus added his even greater misstep with Lehman. But it would not be his last. Lehman’s mid-September failure set off the banking panic of 2008. Unlike Fannie/Freddie, where stockholders lost everything but bondholders were protected, with Lehman bondholders also lost everything, months later only recovering 8 cents on the dollar. Only those who held derivatives on Lehman were first in line to claim whatever assets were left—i.e. to recall, the big 30 banks that Paulson brought together on the eve of the Lehman collapse whom Paulson allowed 4 hours to buy CDS claims to hedge their losses before the Lehman bankruptcy announcement. They lost little, if anything. In contrast to bonds and stocks, CDS claims delivered 91 cents on the dollar. But of course that’s not ‘insider trading’.

The Lehman collapse and how it was allowed to unwind exacerbated an already deteriorating state of confidence in the banking system’s future. Now no one knew for certain what the government’s policy was—bailout if ‘too big’ or let them fail if too big. Paulson’s handing of it in effect created the worse of both worlds.

In quick succession a series of other banks either folded or were absorbed into others. Washington Mutual, Wachovia, Merrill Lynch, AIG—all quickly imploded. The case of AIG is of particular interest. This time Paulson didn’t call in the CEOs of the leading banks to his office to mutually decide. He brought in only his old alma mater, Goldman Sachs. To recall, AIG was deeply exposed to CDSs. And Goldman Sachs was deeply exposed to AIG. Paulson not only bailed out AIG—he bought them out! AIG was bought by the government, the U.S. Treasury, for 100 cents on the dollar! Full price. No negotiations and no ‘’haircuts’ for those exposed to AIG—one of the most exposed of which was Goldman Sachs, the only bank allowed in the decision with Paulson the weekend before the AIG announcement. Initially the cost of the AIG bailout was $123 billion for taxpayers. Shortly thereafter the terms were adjusted more favorably to AIG and even more money was doled out to them. Still another dose followed. The sharp contrasts between the way Lehman was handled and the way Paulson ‘resolved’ the much larger AIG crisis raise interesting questions—especially given the presence of Goldman as the only bank present in the decision to take over and bail out AIG.

Following the collapse of AIG and the big banks, the run by institutions and ‘wholesalers’ on shadow banks spread rapidly to other financial institutions and markets. Hedge funds were hard hit by the Lehman failure. They held 32% of the entire $60 trillion CDS market. Withdrawals of investors from the funds accelerated, forcing the funds to freeze withdrawals. They would quickly lose $600 billion in withdrawals. Almost immediately hedge funds therefore began selling their assets. The prices for loans for leveraged buyouts also began to collapse. Money Market Funds with their $4 trillion in assets began experiencing withdrawals and one of the largest funds, Primary Reserve, nearly went bust. The Commercial Paper market shut down. Nearly all securitized consumer credit markets collapsed. The stock market plummeted with the Dow Jones experiencing a series of its worst days on record.

In other words, asset price deflation was rapidly spreading to other sectors of the shadow banking system. In contrast, prices of CDSs soared, delivering super-profits to gamblers and speculators that bought. Foreign banks began withdrawing funds from the U.S. banking system as well, as the banking crisis spread rapidly in Europe with failures of British, Belgian and Iceland banks. Registering massive losses, U.S. banks, traditional and shadow, began freezing credit. No longer a credit crunch, the system entered a phase of virtual credit crash after September 19, 2008. The credit crash accelerated the transmission of the financial crisis to the real economy. Mass layoffs quickly followed in November and December, continuing through the first half of 2009. Financial fragility had ‘fractured’ seriously with the events of September-October 2008. Mass layoffs meant consumption fragility was now about to deteriorate further as well, as credit to households collapsed while disposable income fell.

On September 19 Paulson proposed to Congress that it give the Treasury $700 billion to use to buy up bad assets of the banks in order to resolve the crisis. At first Congress balked and rejected the bill. Paulson’s proposal was a simple one page request, saying nothing about how or where the $700 billion was to be spent. It was essentially a blank check for him to sign and spend as he alone determined. After the ‘no vote’, it was revised. Between the first and second votes a massive business lobbying campaign descended on Capitol Hill. Legislators were threatened with a financial Armageddon, for which they would be solely responsible should the bill not pass. The $700 billion was all necessary, Paulson argued, in order to buy the ‘bad assets’ on the balance sheets of banks. Cleaning up the bad assets was necessary, he argued, in order to get the banks to begin lending again—both to homeowners and the mortgage markets and to general business. The government relented and gave him his $700 billion check, with the understanding he would buy the bad assets on banks’ books and thereby end the credit crash.

With the money in hand he set out to purchase the assets. He soon found that $700 billion was far too little. The value of the assets on banks’ balance sheets that had collapsed were worth at least $4 trillion, as was later revealed by IMF and other independent estimates. Worse, the banks themselves didn’t want to sell them! That is, unless Paulson and the government was interested in buying them at the prior, full purchase market value! The banks were keeping the assets on their books at inflated, above market price. They had no incentive to sell them at market prices and register even greater losses in doing so. They wanted Paulson to buy them at above market price.

This of course posed a serious problem for Paulson. If he purchased assets worth 50 cents or even 10 cents on the dollar he would be charged with providing a windfall profit to the banks purchasing the assets well above what they were worth. Besides, the $700 billion would hardly dent the $4 trillion, and the problem would still remain. But the banks wouldn’t sell at the true market value of the assets. If they did, then they would have to write down trillions $ more on their balance sheets, which were already deep in the red. There would be no doubt they were insolvent in that case. So it was a standoff. Banks wouldn’t sell at true market value; Paulson couldn’t buy at their inflated initial purchase value. The bad assets remained on the books—and continued to grow. Bank balance sheets continued to deteriorate as the value of housing prices, mortgage bonds, and other securities continued to collapse in value as housing, stock market, and various securitized asset prices continued to fall.

Congress repeatedly requested information what he was doing with the $700 billion in the weeks following the passage of the $700 billion, now called the Term Asset Relief Program, or TARP for short. Unable to buy the assets and clean up the banks’ balance sheets—which all agreed was the necessary first step to get ‘credit flowing again’ as the bankers’ favorite phrase goes—Paulson instead threw $125 billion at the nine biggest banks. He called their CEOs to his office and told they had to take the money whether they wanted to or not. He followed the disbursement by another roughly $125 billion to scores of regional and smaller banks. None of the $250 billion was used to purchase bad assets. Another $80 billion or so went to AIG in several installments. Tens of billions more to Citigroup and Bank of America in November. Nearly $20 billion to auto companies. By February 2009 less than $190 billion of the $700 remained. Once again, none of it expended to purchase ‘bad assets’.

To sum up his performance, Paulson’s term in office amounted to a series of actions that did nothing to address or correct the crisis, and actually served to exacerbate it. His errors were both strategic and tactical. Right up to August 2007 he continued to push financial deregulation, when it was clear deregulation was contributing to the problem of financial fragility and instability. He then did virtually nothing for nine months after the crisis evolved, deferring to Bernanke and the Fed. His one weak foray into the crisis in 2007 was to push Bush’s plan to get banks and mortgage lenders to voluntarily renegotiate mortgages, announced in December 2007. Reportedly that no more than 50 such mortgages were ever reset under this plan. He stood by and played cheerleader to Bernanke as the Fed bailed out Bear Stearns distributed $400 billion to banks, including those offshore, in March 2008. After March he pushed once again for banks to voluntarily raise capital on their own, even as speculators were hammering their stock prices throughout the summer of 2008. He did nothing to limit short sellers, and in fact opposed measures that would have reduced their impact. When thrust to the fore in the case of Fannie Mae and Freddie Mac in July, he repeatedly denied they needed government bailout, said publicly he would not use the $300 billion allocated by Congress if it were given to him, publicly signaled if he did bail them out, he would protect bondholders only, which accelerated the dumping of their stock and the short selling. He then totally reversed himself and bailed out the agencies in early September. The flip-flopping and dragging out of the bailout decision fueled the speculation in their stock that doomed Fannie/Freddie. It also fueled speculation in the stocks of investment banks like Lehman and others, pushing them past the point of no return in September.

Bailing out Fannie/Freddie after insisting no more bailouts would occur, then switching 180 degrees and refusing to bail out Lehman destroyed whatever confidence might have been restored by consistent Fed-Treasury policy action. After letting Lehman collapse he then reversed a second time and bailed out AIG, in a process that was highly suspect given the presence of only one bank, Goldman Sachs, participating in the decision. Paulson thereafter panicked Congress into providing the $700 billion TARP, which he never put to the use authorized, but instead partially dissipated on a string of piecemeal rescue efforts. As former IMF economist, Simon Johnson, commented in January 2009, “How cold a person with so much market experience be repeatedly at the center of such major misunderstandings regarding the markets…”. Following the TARP fiasco, Paulson steadily slipped into policy oblivion, as Bernanke and the Fed came assumed center stage once again in bailing out the banks.

While Paulson would not spend the full TARP $700b allocated by Congress, and eventually restore $300b of it back to the US Treasury in 2009, the Fed’s Bernanke would expend $6 trillion in Quantitative Easing (QE) Fed direct buying of bad assets from banks and investors (and above their market prices) from 2009 through 2016. The Democrat Party controlled Congress in 2009 would help as well–by allowing banks to suspend normal ‘mark to market’ accounting practices to cover up their then serious losses (to make the banks appear better off than they were in fact in order to get investors to start re-buying collapsed bank stocks). Phony Fed bank ’stress tests’ would serve the same purpose, to encourage bank equity price recovery. Paulson achieved nothing–except ensuring a massive tens of billion of dollars for his former company, Goldman Sachs, by bailing out AIG and ensuring the latter paid off the CDSs it sold to Goldman Sachs.

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