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

Financing illiquid assets like real estate with short-term borrowings has long been a recipe for disaster, as the savings and loan crisis of the 1980s and early 1990s demonstrated. But by 2007, several dozen SIVs owned some $400 billion in assets, bought with funds that could disappear virtually overnight. And disappear these funds did—as investors refused to roll loans over even when they appeared fully collateralized. The banks like Citi that stood behind the SIVs now faced a huge potential drain on their capital at just the moment they had to contend with a liquidity crunch.

SIVs weren’t the only issuers of asset-backed commercial paper. Other entities that invested in debt securities relied on that market—as did a number of specialized mortgage lenders, which lacked access to the retail deposits of their commercial bank rivals. They were all part of a shadow banking market that had grown quickly and out of the sight of regulators. By 2007, some $1.2 trillion in asset-backed commercial paper was outstanding.

These issuers had found willing buyers in pension funds, money market funds, and other institutional investors eager to pick up a little yield over, say, U.S. Treasuries on what they considered a perfectly safe investment. But after the Bear Stearns hedge funds blew up, and with mortgage securities being downgraded by the rating agencies, the assets backing up the ABCP no longer seemed so safe. Investors stopped buying, a disaster for investment funds that owned longer-term hard-to-sell securities.

IKB Deutsche Industriebank, a German lender that specialized in lending to midsize industrial firms, discovered this in late July 2007 when an SIV it ran was having difficulty rolling over its commercial paper. The German government stepped in and organized a bank-led 3.5 billion-euro ($4.8 billion) rescue. As we watched LIBOR-based funding tighten, we began to wonder if European banks were in as good a shape as they had been claiming.

Then on August 6, attention switched back to the U.S. when American Home Mortgage Investment Corporation, a midsize mortgage lender, filed for bankruptcy, unable to sell its commercial paper. The market was becoming increasingly unsettled. With mortgage-related paper plunging in value—the triple-A portion of the ABX index hit 45 percent of face value in late July—and, with no buyers for asset-backed commercial paper, the securitization business ground to a halt, even as banks began to shy away from lending to one another, driving LIBOR lending rates up.

Part of the problem was in the nature of these shadow banking markets: their lack of transparency made it impossible for investors to judge the value of what they were invested in, whether an SIV or a CDO or a CDO-squared. Perhaps only one-third of the $400 billion in SIV assets were mortgage-related, but investors had no way of knowing precisely what was owned by the SIV they were lending to or had purchased a piece of.

It was, as Bob Steel memorably described it, the financial version of mad cow disease: only a small portion of the available beef supply may be affected, but the infection is so deadly that consumers avoid all beef. Just so, investors shunned anything they thought might be infected with toxic mortgage paper. In practical terms this meant that very solid borrowers—from the Children’s Hospital of Pittsburgh to the New Jersey Turnpike Authority—could see their normal funding sources evaporate.

Despite the actions of the ECB and the Fed, markets relentlessly tightened. By August 15, Countrywide Financial Corporation, the biggest U.S. mortgage originator, had run into trouble. It had funded its loans in an obscure market known as the repurchase, or repo, market, where it could essentially borrow on a secured basis. Suddenly its counterparties were shunning it. On the following day, it announced that it was drawing down on $11.5 billion in backup lines with banks, unnerving the market. A week later, Bank of America Corporation invested $2 billion in the company in return for convertible preferred shares potentially worth 16 percent of the company. (It would agree to buy Countrywide in January 2008.)

On August 17, the Fed responded to market difficulties by cutting its discount rate by half a percentage point, to 5.75 percent, citing downside risks to growth from tightening credit. The central bank announced a temporary change to allow banks to borrow for up to 30 days, versus its normal one-day term, until the Fed determined that market liquidity had improved.

Investors ran away from securities that made them nervous—driving the current yield of 30-day ABCP up to 6 percent (from 5.28 percent in mid-July)—and began to accumulate Treasury bonds and notes, long the safest securities on the planet. This classic flight-to-quality nearly resulted in a failed auction of four-week bills on August 21, when massive demand for government paper so muddied the price discovery process that, ironically, some dealers pulled back from bidding to avoid potential losses. As a result, there were barely enough bids to cover the auction, so yields shot up despite the strong real demand. Karthik Ramanathan, head of Treasury’s Office of Debt Management, had to reassure global investors that the problems stemmed from too much demand, not too little. In the end, the Treasury auctioned off $32 billion in four-week bills at a discount rate of 4.75 percent, nearly 2 percentage points higher than the prior day’s closing yield.

The next morning, Ben and I briefed Senate Banking Committee chair Chris Dodd on the markets. Dodd had interrupted his presidential campaign for what appeared to be a publicity event. I was new enough to Washington to be put off by this request, and I was also frustrated that GSE reform had been held up during the year.

Ben and I met with Dodd in his office at the Russell Senate Office Building, discussing the markets and the housing crisis. The affable Dodd was friendly but criticized me to reporters afterward, questioning whether I understood the importance of the subprime mortgage problem.

In fact, I was watching the mortgage market more closely than the senator realized. It was becoming increasingly clear that the housing problems had crossed into the financial system, producing the makings of a much more ominous crisis. The sooner the housing correction ran its course, the sooner the credit markets would also stabilize.

The president had encouraged me to put together a foreclosure initiative that we could launch before Congress returned after Labor Day. On August 31, I stood beside President Bush as he tasked me, along with Housing and Urban Development secretary Alphonso Jackson, to spearhead an effort to identify struggling home-owners and help them keep their primary residences. We began by announcing an expansion of a Federal Housing Administration program and a proposed tax change to make it easier to restructure mortgages.

The administration’s goal was to minimize as much as possible the pain of foreclosure for Americans, without rewarding speculators or those who walked away from their obligations when their mortgages were underwater. We knew we couldn’t stop all foreclosures—in an average year 600,000 homes were foreclosed on. But we sought to avoid what we called preventable foreclosures by helping those who wanted to stay put in their homes and who, with some loan modifications, had the basic financial ability to do so. In practice this meant working with homeowners who held subprime adjustable-rate mortgages and who could afford the low initial rate before the first reset kicked their monthly payments up to more than they could afford.

Complicating matters, we learned that many foreclosures occurred for the simple, if appalling, reason that borrowers frequently didn’t communicate with their lenders. Indeed, after mortgage loans were made and securitized, the only communication borrowers had was with the mortgage servicers, the institutions that collected and processed the payments. Fearful of foreclosure, only 2 to 5 percent of delinquent borrowers, on average, responded to servicers’ letters about their mortgages, and those who did had trouble reaching the right person to help them. The servicers were not prepared for the tidal wave of borrowers who needed to modify their loans.