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

The bad news mounted. Bank after bank announced multi-billion-dollar write-downs, losses, or drastically shrunken profits as they reported wretched results for the third quarter and made dire forecasts for the fourth. In the U.S., Merrill Lynch was the first big bank to be rocked. On October 24, it announced the biggest quarterly loss in its history—$2.3 billion—and CEO Stan O’Neal resigned less than a week later. Then Citi blew up. In early November, it announced it faced a possible $11 billion in write-downs on top of $5.9 billion it had taken the previous month, and Chuck Prince was out. (By year-end, John Thain had replaced O’Neal, and Vikram Pandit had been chosen to succeed Prince.)

The next day, November 5, Fitch Ratings said it was reviewing the financial strength of triple-A-rated monoline insurers. This raised the prospect of a wave of downgrades on the more than $2 trillion worth of securities they insured, many of them mortgage backed. Banks would be obligated to take losses as they wrote down the value of the assets on which these insurance guarantees were no longer reliable. With traders betting that the Fed would further slash interest rates, the U.S. dollar slid, and the euro and pound hit new highs.

From the onset of the crisis, I had leaned on the banks to raise capital to fortify themselves in a difficult period, and many of them took my advice, issuing stock and seeking overseas investors. In October, Bear Stearns reached an agreement with Citic Securities, the state-owned Chinese investment company, in which each firm would invest $1 billion in the other. This would give Citic a 6 percent stake in Bear, with an option to buy 3.9 percent more. In December, Morgan Stanley sold a 9.9 percent stake to state-owned China Investment Corporation for $5 billion, and Merrill Lynch announced that it would sell a $4.4 billion stake, along with an option to buy another $600 million in stock, to Singapore’s state-run Temasek Holdings.

But not everyone was pulling in their horns. In October, Lehman and Bank of America committed a whopping $17.1 billion of debt and $4.6 billion of bridge equity to finance the acquisition of the Archstone-Smith Trust, a nationwide owner and manager of residential apartment buildings.

Even as this frothy deal closed, the economy as a whole was coming under increasing stress. Energy costs skyrocketed, with a barrel of oil approaching the $100 mark, and consumer confidence declined along with new-home sales and housing prices. The United States, long the engine of worldwide economic growth, was running out of steam. Volatility wracked the markets: between November 1 and November 7, the Dow dropped 362 points one day, rose 117 points five days later, then plunged 361 points the day after that, partly because of the weak dollar. By mid-November the dollar had dropped 14 percent over the preceding year against the euro, to the $1.46 level.

Many people around the world blamed the U.S. for the crisis—specifically, Anglo-American-style capitalism. Federal Reserve chairman Ben Bernanke and I flew separately to the G-20 gathering in Cape Town, South Africa, that month with one intention: to buttress confidence in the United States. The timing was fortuitous. The G-20 was an increasingly important group because it included both developed economies and such emerging-markets powerhouses as China, India, and Brazil. We were able to reach out directly and reassure the representatives of these countries, which accounted for just under 75 percent of global gross domestic product (GDP).

At the meeting Ben and I took pains to reassure our fellow finance ministers and central bankers of our commitment to a strong U.S. economy and currency. At the same time, we tried to make clear that the main problem was not the dollar but the financial system in general—under strain from the rapid global deleveraging and the threat it posed to our economy. We emphasized how focused we were on that problem.

Before I left Cape Town, I was fortunate to have a private breakfast in my hotel room with China’s central bank governor, Zhou Xiaochuan, a charming, straightforward old friend and committed reformer. Our group was staying at a beautiful resort, Hôtel Le Vendôme, outside of Cape Town, and my room overlooked the sea and a golf course, where I’d stolen a few moments to go birding the previous day. At one point, Zhou and I stepped out on the balcony to take in the splendor of a South African summer morning.

I had been pressing the Chinese to move ahead with the liberalization of their financial markets by opening them more to foreign competition, but now Zhou told me that with the U.S. markets in disarray, China was not prepared to give us the capital markets opening we wanted. Zhou did tell me he was confident there would be progress in other important areas.

Not long after the G-20 meeting, I went to Beijing for the Third China-U.S. Strategic Economic Dialogue, and my deputy chief of staff, Taiya Smith, and I met with my Chinese counterpart, Vice Premier Wu Yi, ahead of the formal sessions. After months of negotiations with the Chinese, Taiya had arranged this special meeting so I could make one last push for raising the equity caps that limited the percentage of ownership that foreigners could hold in Chinese financial institutions. The Chinese had been under pressure from the U.S. and other countries to no longer maintain an artificially weak currency that prevented market forces from helping China rebalance its economy, which was overly reliant on cheap exports. Popular opinion attributed China’s large trade imbalances and huge capital reserves to its currency policy, but this was only part of the story. The bigger factor, in my view, was the lack of savings by Americans, which translated into our massive levels of imports and overreliance on foreign capital flows. And because the Chinese managed their currency to move in sync with the dollar, other trading partners, particularly Canada and European countries, had begun to complain about swelling imbalances. I explained, as I often had, that a currency that reflected market reality was a key to China’s continued economic reform and progress. It would alleviate mounting inflationary pressure in China, spurring the development of its domestic market and reducing its dependence on exports.

Wu Yi looked at me directly and said she could do nothing to change the equity caps at that point. However, she quickly followed up by saying that my arguments on the currency were more persuasive.

She said no more on the subject, but I knew that I would not be going home to Washington empty-handed. We had made great progress on food and product safety and on an effort to combat illegal logging. But most important, over the next six months I watched the yuan, which was trading at 7.43 to the dollar in December, strengthen to about 6.81 by mid-July. China’s sudden flexibility not only benefited that country but would help forestall protectionist sentiment in the U.S. Congress.

On the financial side, however, the bad news piled up day by day. In mid-November, Bank of America and Legg Mason said they would spend hundreds of millions of dollars to prop up their faltering money market funds, which had gotten burned buying debt from SIVs. Although the public considered money market funds among the safest investments, some funds had loaded up on asset-backed commercial paper in hopes of raising returns.

Meantime, the credit markets relentlessly tightened as banks grew increasingly reluctant to lend to one another. One key measure of the confidence banks had in one another, the LIBOR-OIS spread—which measures the rate they charge each other for funds—had begun to widen dramatically. Traditionally this rate had stood at about 10 basis points, or 0.10 percent. The spread jumped to 40 basis points on August 9, and climbed to 95.4 basis points in mid-September, before easing to just under 43 basis points on October 31. But then the markets sharply tightened, anticipating big losses at major banks, which would force them to sell assets to increase their liquidity. By the end of November, the LIBOR-OIS spread had topped 100 basis points.