• HIGHLIGHTS
• Paulson didn't use all the tools in his toolbox
• The looming crisis wasn't a surprise
• Where did the TARP money go?
• Banks find themselves in "the realm of the puppet master"
• Her disappointment with Secretary Geithner

So it's Sept. 15, [2008]. Lehman Brothers is gone on the weekend, on Sunday night. [Merrill Lynch CEO] John Thain and [Bank of America CEO] Ken Lewis are shaking hands. And, the way our story goes, it's a kind of bulwark by [then-Treasury Secretary Henry] Paulson. He's hoping that the merger of these two institutions will somehow soften the blow of what's happened to Lehman and what may or may not be inevitable. … You're teaching at the time?

I'm teaching bankruptcy.

And what are you thinking when all of this is transpiring?

So I walk into class on Monday morning, and we have the day's lessons laid out. Everyone's done their reading. ... Everyone's sitting forward. And clearly the designated questioner has a hand up. And he says: "Just say something about Lehman. Tell us just something about what's going on." ...

I said, "OK, five minutes." We spent the next hour talking about Lehman in the context of Bear Stearns and what it is that Henry Paulson was trying to tell the rest of the country, and particularly how we're going to be OK on the economy, and what he was trying to signal, in effect, to the other financial institutions: "We're not here to bail you out. We're going to make this work."

Moral hazard is the rule of the day.

That's right: "You're on your own. Make it happen. We're not here to be the insurer of last resort, ... the sugar daddy to provide all the assets to make this happen." ...

How big a mistake was that?

You know, here's the hard question. When things started falling apart, everyone's like, "Whoa, big mistake." But let's keep in mind, we reverse course within two days. ...

So the big mistake is to say, "North 90 miles an hour," and then go south 140 miles an hour. Confidence that these guys have a clue drops to zero. So the way I measure this is not what happens in the 48 hours between [the collapse of] Lehman and AIG. It's how it is that Treasury and Fed articulates two of the most diametrically opposed policies within literally hours of each other, and then the kind of chaos we end up in. ... You can't go north and south at the same time without destroying everyone's confidence.

And you've got Bear, and Paulson preaches moral hazard on the weekend back in March. But Sunday morning, he's on the talk shows saying: "Moral hazard. We're not going to do this again." Then he's got Fannie [Mae (Federal National Mortgage Association)] and Freddie [Mac (Federal Home Loan Mortgage Corp.)] in August, conservatorship. So I guess he's still going north 90 miles an hour.

That's the problem. His words don't match his deeds. So he's already with Bear Stearns, in effect, gone a little south by having arranged the deals and tried to make it all work out. Fannie and Freddie, you can always say, "Oh, but that's exceptional, because they were already quasigovernmental entities." So that's there.

And indeed, on that Monday in September, the lesson I was teaching my bankruptcy class about what this meant was that Lehman was his way to say: "I really mean it when I say no moral hazard. This is it: private profit, private losses. We just have to take our licks, and the reality is what the reality is. It is not the taxpayer's role to bail out any of you." I thought on Monday that I understood where he was and that he had charted a course, and we were in it now for the ride to see how it would work. ...

Then he says: "I had no idea about the interconnectivity of Lehman and how bad it was all over the place. I had no sense of AIG's exposure and what that might have meant. And the credit market starts to freeze, and the [commercial] paper market's gone, and I have to do something." But maybe he didn't. Is that what you're saying?

The question is, what's the something? It's not as if the only tool in his toolbox is to say, "Let's shovel in $700 billion of taxpayer money and eventually maybe a trillion or two of Treasury guarantees."

There are a lot of other tools that might have been used, and let me just suggest one. He could look around at Lehman and say, "You know, the mistake in Lehman is that there was no way to prevent a run on Lehman's assets once it had filed for bankruptcy." The bankruptcy laws had been changed quite significantly in the early 2000s and again in 2005 in order to say when a financial institution goes into bankruptcy, in effect, people who have credit default swaps and other kinds of fancy financial instruments with them can keep on collecting, but they don't have to pay immediately, even if they're in offset positions; that is, "You owe me some money, and I owe you some money." That meant that there was a feasting instantly on Lehman, that they fell on Lehman the way that depositors fell on banks in the 1930s before we had the bank holiday.

Another option available to Paulson would have been to say, "Look, what Lehman teaches us is that a disorganized liquidation in which people beat on the doors and clamor and grab the first assets they can and race out was a really terrible way to do this." And in fact, there are a lot of folks who now estimate we just basically wasted $50 billion in assets out of Lehman, that Lehman went from a little bit insolvent to wildly insolvent just literally in hours because of the run-on-the-bank sort of mentality.

So Paulson might have said: "The first line of defense is not taxpayer dollars. The first line of defense is a controlled way to liquidate out these businesses and preserve as much value as we can to be distributed to the individual parties."

In other words, we have to back out of these positions. These businesses have to back out of their swaps and their guarantees and all the things they're involved in, but we're going do it in a way to maximize value to all of those involved. That's a very different position. ...

You know what's remarkable about this? Of all the people I've talked to over the last few months, this thing keeps bubbling away in me, which is, when we fight a war, we war-game in advance; we figure stuff out, right? Here we are in this problem that we kind of know is coming in about '06. [Then-President and CEO of the Federal Reserve Bank of New York Tim] Geithner is making speeches. Others are making speeches. [Former Federal Reserve Board Chair Paul] Volcker has spoken, and lots of other people. We certainly know by August of '07. And after Bear, you'd think we'd know that something big is happening right --

It's spring of '08. If we don't know that there's a problem, then it's because we've got our fingers stuffed in our ears, our eyes taped shut, and we're singing, "La, la, la, la, la, I can't hear you."

Well, exactly. ... We've talked to people from the Treasury who were on Paulson's staff who say: "We were writing plans. We thought we had ideas that we were cooking up." ... Have you heard since then that there were big plans that Paulson sort of shoved aside, or is he just kind of flying by the seat of his pants?

As I understand it, there were no plans. ... Every erg of energy went to keeping the punch bowl full, the noisemakers going, the music playing loud, right? What we were doing with the interest rates, monetary policy, I mean, it's just fancy ways of doing the same thing.

But let's party, party, party, keep this boom economy going, and what happens tomorrow is what happens tomorrow, as long as it doesn't happen on my watch. So I think these were people who, right down at the heart of it, said: "I can only plan for a party mentality. And I'm just not going to plan for the alternative that something else is going on."

Well, thank you. That's depressing.

But, you know, it's important. And it's important to unpack this ... so we can think about how we put together better regulatory structures that don't fail us so miserably. If we don't know what went wrong, then we don't know what to change to make sure that it doesn't happen to us again in another 10 to 15 years. So yeah, it's a depressing conversation, but it's a conversation we absolutely, positively must have.

[On Sept. 18, Paulson and Fed Chairman Ben Bernanke tell the congressional leadership] that if they didn't do something incredibly fast … that the economy would melt down by Monday. … Are you aware that these conversations are taking place in Washington, and the dire scenarios are being painted?

Well, so once there's been this whiplash between Lehman and AIG -- "It's all on you," and "We'll totally bail you out" -- this back-and-forth movement, there follows this period of great uncertainty where everyone's asking, "So what's the long-term strategy?" And we sort of go into a holding period, because no one understands where this is going to go.

And you keep mapping out alternatives: What are the possible tools? Which direction could this take? And then the announcement is this vague announcement -- it's supposed to be reassuring that the federal government is going to stand behind it; no one's going to fail. "We're here. We're going to throw everything we have to into this." … And the question for me at this moment is, what does that mean? We're going to stand behind what? ...

And you remember the first description was, "We'll buy troubled assets at a price far above what any sensible person would pay for them." Well, that's just a way of subsidizing those who took incredible risks. And in fact, it subsidizes those who took the biggest risks the most. I thought that was what the whole conversation about moral hazard was supposed to say was not going to happen.

So this first description of how we're going to be saved is -- you ever ring a bell that's got a crack in it? You know how a bell can look perfect, but you ring it and it doesn't sound right? Even a small crack, it doesn't sound right. It doesn't quite add up. It's not coherent.

And that's where we get started. So Congress, having had a gun held to its head by the nation's top economic chief, the secretary of the Treasury, [who] says, in effect, "Give me $700 billion or the economy gets it," you know, "This is what I need to save it," but he describes this plan that no one is sure makes any sense. So we engage in a big conversation about moral hazard, which is appropriate.

But the underlying part has to be, buying assets doesn't make any sense at this point. Are we sure $700 billion does it? What about all the things that have been inflated