Henry Paulson - On the Brink - Inside the Race to Stop the Collapse of the Global Financial System

In the year I’d been in government, Ben and I had developed a special bond. Though we shared some common interests, such as a love of baseball, our relationship was 95 percent business. What made it special was our complete candor—laying all the cards on the table, determining where we had differences, and talking very directly about them. I kept Ben abreast of what I saw happening, passing along to him any market color I picked up from my conversations with senior bankers in the U.S. and around the world, including difficulties we’d begun to see in July with funding based on the London Interbank Offered Rate (LIBOR).

By law, the Federal Reserve operates independently of the Treasury Department. Though we took care to observe this separation, Ben, Tim Geithner, and I developed a spirit of teamwork that allowed us to talk continually throughout the oncoming crisis without compromising the Fed’s independence.

Ben was always willing to cooperate and a pleasure to work with. He is, easily, one of the most brilliant people I’ve ever known, astonishingly articulate in his spoken word and in his writing. I read carefully his speeches—on a wide range of subjects, from income inequality to globalization. And he was kind enough to look over some of my speeches before I gave them. He explained complex issues clearly; a chat with him was like a graduate school seminar.

Ben shared my concern with the developments in Europe. We agreed to keep our staffs in close contact, while I would talk directly to bankers and relay to Ben what they thought of the problem. That morning the Fed loaned $24 billion to banks via the New York Fed; on Friday it followed with an additional $38 billion even as the ECB lent out another 61 billion euros, or $83.4 billion.

When I returned to my office, I found Treasury on full alert. Bob Steel, the undersecretary for domestic finance, briefed me on the markets and possible responses. Keith Hennessey phoned from the White House to find out what was going on. I immediately started making calls to see how Wall Street was responding: Dick Fuld at Lehman, Stan O’Neal at Merrill Lynch, Steve Schwarzman at Blackstone, and Lloyd Blankfein at Goldman Sachs. All these CEOs were on edge. I also called Tim Geithner and Chris Cox, chairman of the Securities and Exchange Commission.

Throughout the crisis, in fact, I would keep in constant touch with Wall Street CEOs, while Bob Steel and other members of my team talked with traders, investors, and bankers around the world. To know what was really going on, we had to get behind the numbers we monitored on Bloomberg screens. We knew, of course, that we were dealing with self-interested parties, but getting this practical market knowledge was absolutely essential.

Beginning that morning, we went into high gear. Bob Hoyt, our general counsel, asked his team in the legal department to begin examining the statutes and historical precedents to see what authorities the Treasury—or other agencies—might have to deal with market emergencies. Earlier in the summer I’d asked Bob Steel to begin developing solutions for our mortgage problems, though at the time we didn’t realize how far-reaching those problems would become. Now I asked him to speed up his efforts. On Monday, after a long weekend of work, Bob and I would lay out the problem in detail to the president, agreeing to roll out a plan of action by Labor Day.

It was pretty clear from what I gleaned from my conversations that the market was in for a bad patch. That Friday, the Dow Jones Industrial Average, which had passed 14,000 for the first time in mid-July, fell nearly 400 points, its second-biggest one-day drop in five years. I could sense a big storm coming.

In retrospect, the crisis that struck in August 2007 had been building for years. Structural differences in the economies of the world had led to what analysts call “imbalances” that created massive and destabilizing cross-border capital flows. In short, we were living beyond our means—on borrowed money and borrowed time.

The dangers for the U.S. economy had been obscured by an unprecedented housing boom, fed in part by the low interest rates that helped us recover from the downturn that followed the bursting of the late-’90s technology bubble and the impact of the 9/11 attacks. The housing bubble was driven by a big increase in loans to less creditworthy, or subprime, borrowers that lifted homeownership rates to historic levels. By the time I took office in July 2006, fully 69 percent of U.S. households owned their own homes, up from 64 percent in 1994. Subprime loans had soared from 5 percent of total mortgage originations in 1994 to roughly 20 percent by July 2006.

Encouraging high rates of homeownership had long been a cornerstone of U.S. domestic policy—for Democrats and Republicans alike. Homeownership, it’s commonly believed, helps families build wealth, stabilizes neighborhoods, creates jobs, and promotes economic growth.

But it’s also essential to match the right person to the right house: people should have the means to pay for the homes they buy, and lenders should ensure that they do. As the boom turned into a bubble, this disciplined approach fell away. Far too many houses were bought with little or no money down, often for speculative purposes or on the hope that property values would keep rising. Far too many loans were made or entered into fraudulently. Predatory lenders and unscrupulous brokers pushed increasingly complex mortgages on unsuspecting buyers even as unqualified applicants lied to get homes they couldn’t afford. Regulators failed to see, or stop, the worst excesses. All bubbles involve speculation, excessive borrowing and risk taking, negligence, a lack of transparency, and outright fraud, but few bubbles ever burst as spectacularly as this one would.

By the fourth quarter of 2006, the housing market was turning down. Delinquencies on U.S. subprime mortgages jumped, leading to a wave of foreclosures and big losses at subprime lenders. On February 7, 2007, London-based HSBC Holdings, the world’s third-largest bank, announced that it was setting aside $10.6 billion to cover bad debts in U.S. subprime lending portfolios. The same day, New Century Financial Corporation, the second-biggest U.S. subprime lender, said it expected to show losses for fourth-quarter 2006. By April 2, 2007, it was bankrupt. Two weeks after that, Washington Mutual, the biggest savings and loan in the U.S., disclosed that 9.5 percent of its $217 billion loan portfolio consisted of subprime loans and that its 2007 first-quarter profits had dropped by 21 percent.

The housing market, especially in the subprime sector, was clearly in a sharp correction. But how widespread would the damage be? Bob Steel had organized a series of meetings across government agencies to get on top of the problem, scrutinizing housing starts, home sales, and foreclosure rates. Treasury and Fed economists concluded that the foreclosure problem would continue to get worse before peaking in 2008. Of perhaps 55 million mortgages totaling about $13 trillion, about 13 percent, or 7 million mortgages, accounting for perhaps $1.3 trillion, were subprime loans. In a worst-case scenario we thought perhaps a quarter, or roughly $300 billion, might go bad. Actual losses would be much less, after recoveries from sales of foreclosed homes. They would, unfortunately, cause great pain to those affected, but in a $14 trillion diverse and healthy economy, we thought we could probably weather the losses.

All of this led me in late April 2007 to say in a speech before the Committee of 100, a group promoting better Chinese-American relations, that subprime mortgage problems were “largely contained.” I repeated that line of thinking publicly for another couple of months.

Today, of course, I could kick myself. We were just plain wrong. We had plenty of company: In mid-July, in testimony before Congress, Ben Bernanke cited estimates of subprime losses reaching $50 billion to $100 billion. (By early 2008 losses from subprime lending had reached an estimated $250 billion and counting.)