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

Faced with spiking interbank lending rates, the Fed on November 15 pumped $47.25 billion in temporary reserves into the banking system—its biggest such injection since 9/11. The Fed continued to take extraordinary steps in December to ease liquidity in the markets. On the 11th it cut both the discount rate and Fed funds rate by 25 basis points, to 4.75 percent and 4.25 percent, respectively. On the 12th it announced that it had established $24 billion in “swap lines” with the European Central Bank and the Swiss National Bank to increase the supply of dollars to overseas credit markets.

The following day the Fed unveiled the Term Auction Facility (TAF), which was designed to lend funds to depository institutions for terms of between 28 and 84 days against a wide range of collateral. Launched in conjunction with similar programs undertaken by central banks of other countries, TAF was created to give banks an alternative to the Fed discount window, whose use had long carried a stigma; banks feared that if they borrowed directly from the Fed, their creditors and clients would assume that they were in trouble.

The first TAF, on December 17, 2007, auctioned $20 billion in 28-day credit; the second, three days later, provided an additional $20 billion in 35-day credit. Banks hungrily lapped up the funds, and on December 21 the Fed said it would continue the auctions as long as necessary.

While helpful to the financial system, such measures could not halt the broader economy’s ongoing slide. When the White House first began to consider a tax stimulus, right after Thanksgiving, I hated the idea. For me, a stimulus program was the equivalent of dropping money out of the sky—a highly scattershot and short-term solution. But by mid-December 2007 it was clear that the economy had hit a brick wall.

I’m no economist, but I’m good at talking to people and figuring out what’s happening. After speaking with a variety of business executives, I knew that the problems from financial services had spilled over into the broader economy. In mid-December, after I’d returned from China, I traveled around the country to promote HOPE Now. I talked with local officials, large and small businesses, and citizens in places hard-hit by foreclosures, including Orlando, Florida; Kansas City, Missouri; and Stockton, California. I called Josh Bolten from the road and told him to tell the president that the economy had slowed down very noticeably. Clearly, we needed to do something, for economic—and political—reasons.

On January 2, 2008, I met with the president, and he asked me to consult with Congress, investors, and business leaders so we could make a decision when he returned from an eight-day overseas trip. I’d had enough conversations with the president to know that he was prepared to move quickly and in a bipartisan way as long as the program was designed to have an immediate impact, which almost certainly meant transfer payments to those with low incomes. This was a touchy point for Republicans, but the president was not an ideologue: he wanted to see quick results.

During the first half of January, I made a number of outreach calls to both Republicans and Democrats on the Hill, consistently arguing that each side needed to compromise to create a program that would be timely, temporary, and simple, yet big enough to make a difference. The legislation, I stressed, shouldn’t be used to further the longer-term policy goals of either party. The Republicans were reluctantly willing to go along with a stimulus plan if we didn’t add things like increased unemployment insurance, but Democratic leaders believed that we had to address needs that could only be handled through traditional programs like unemployment insurance and food stamps. Still, I thought we could hold the line; House Speaker Nancy Pelosi wanted a deal badly enough to control the most liberal members of her caucus.

On Friday, January 18, President Bush called for a spending package of 1 percent of GDP, or about $150 billion, designed to give the economy a “shot in the arm” with one-time tax rebates and tax breaks to encourage businesses to buy equipment. I gave interviews all day to reinforce the president’s decision. The weekend and following week, I knew, would be filled with negotiations with lawmakers.

On the following Tuesday I went to Nancy Pelosi’s conference room to meet with the Speaker, Senate Majority Leader Harry Reid, Senate Minority Leader Mitch McConnell, House Majority Leader Steny Hoyer, and House Minority Leader John Boehner. Reid and McConnell agreed to let the House take the lead on the stimulus, and Pelosi—clearly hungry for a bipartisan achievement after a slow first year as Speaker—worked her tail off. She dropped demands for unemployment and food stamp benefits in exchange for tax rebates for virtually everyone, regardless of whether they paid income tax or not.

The combination of slumping financial markets and the growing macroeconomic concerns gave us a powerful impetus. Economic conditions had become so worrisome that the Fed, on January 22, slashed the Fed funds rate by 75 basis points, to 3.5 percent, in a rare move made between scheduled Federal Open Market Committee meetings. (On January 30, it would cut the funds rate by another 50 basis points at its regular meeting.)

On January 24—just two days after I first went to the Hill—Pelosi, Boehner, and I announced a tentative agreement for a $150 billion stimulus plan centering on $100 billion in tax rebates for an estimated 117 million American families. Depending on income level, the stimulus would give as much as $1,200 to certain households, with an additional $300 for each child.

Because the stimulus was a bipartisan effort, I had to swallow a few things I didn’t like, including an increase in Fannie and Freddie’s loan limit for high-cost areas, to $729,750 from $417,000. Nonetheless, the stimulus represented a huge political and legislative accomplishment, and President Bush signed it into law on February 13, after a remarkably quick two-week passage through the House and the Senate. And the Internal Revenue Service and Treasury’s Financial Management Service did something that initially seemed impossible: they got all the rebate checks out by July. Some were sent out as early as late April, despite the crunch of tax season.

I hoped the stimulus would solve many of the economic problems. We believed we were looking at a V-shaped recession and assumed that the economy would bottom out in the middle of 2008.

The market difficulties had a decidedly global cast. At the G-7’s fall meeting in Washington, I had begun questioning the strength of European banks; they used a more liberal accounting method than U.S. banks, one that in my opinion covered up weaknesses. In January 2008, a group of Treasury officials, including Acting Undersecretary for International Affairs Clay Lowery, traveled to Europe to get a better handle on what was happening in its financial sector. After visiting a number of countries, including the U.K., France, Switzerland, and Germany, they concluded that Treasury’s suspicions were correct: European banking was weaker than officials were letting on.

On February 17, just a few days after President Bush signed the stimulus bill, U.K. chancellor of the Exchequer Alistair Darling announced that the British government would nationalize Northern Rock. The credit crisis had pushed the big mortgage lender to the brink of failure.

In the U.S., the markets continued to slip, troubled by oil prices, a weakening dollar, and ongoing concerns about credit. Over the week of March 3–7, the Dow lost almost 373 points, ending at 11,894—far below the 14,000 of the preceding October. That Thursday I traveled to California for a round of appearances in the San Francisco Bay Area, including a speech on March 7 at the Stanford Institute for Economic Policy Research. My talk centered on the U.S. housing situation, and I outlined our continuing efforts with HOPE Now and fast-track modifications, pointing out that more than 1 million mortgages, 680,000 of them subprime, had been reworked. In the question-and-answer period that followed, I fielded a query about whether I would consider guaranteeing mortgage-backed bonds issued by Freddie and Fannie. I sidestepped this, saying that the institutions needed reform and a strong regulator.