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

My audience included former Treasury secretary Larry Summers, who told me before the speech that he’d been looking into the GSEs. “This is a huge problem,” he said. Working off public numbers, he had done some analysis that led him to believe they were likely to need a lot of capital. “They are a disaster waiting to happen,” he said.

While I shared Larry’s concerns about the GSEs, in my mind the monoline insurers presented a more immediate problem. They had become the latest segment of finance hurt by the spiraling credit crisis, and their troubles imperiled a vast range of debt.

Fitch Ratings had downgraded Ambac Financial Group, the second-largest bond insurer, to AA in January. The move raised concerns that rival rating agencies would follow suit, causing other insurers to lose their high ratings. That meant that the paper they insured faced downgrades, including the low-risk debt that local governments issued to pay for their operations. Forced to pay more to borrow, U.S. cities might have to reduce services and postpone needed projects.

The monoline troubles had spilled over into yet another market sector—that of auction-rate notes, which were longer-term, variable-rate securities whose interest rates were set at periodic auctions. The market was sizable—slightly more than $300 billion—and was used chiefly by municipalities and other public bodies to raise debt, as well as by closed-end mutual funds, which issued preferred equity.

The vast majority of the auction-rate notes had bond insurance or some other form of credit enhancement. But with the monolines shaky, investors shunned the auction-rate market, which completely froze in February, as hundreds of auctions failed for lack of buyers. The brokerage firms that sold the securities had typically stepped in to buy them when demand lagged. But faced with their own problems they were no longer doing so.

Although the monolines did not have a federal-level regulator, I had asked Tony Ryan and Bob Steel to look for ways to be helpful to Eric Dinallo, the superintendent of insurance for New York State, who regulated most of the big monolines and had begun work on a rescue plan. New York governor Eliot Spitzer also got involved, testifying on the insurers’ troubles before a House Financial Services subcommittee on February 14.

I knew the governor from his days as New York State attorney general, and he called me on February 19 and 20 to discuss potential solutions. I saw him at the Gridiron Club’s annual dinner, held at the Renaissance Washington DC Hotel on March 8.

This good-natured roast of the capital’s political elite drew more than 600 people, including Condi Rice and a number of other Cabinet members. President Bush supplemented his white tie and tails with a cowboy hat and sang a song about “the brown, brown grass of home” to mark his last Gridiron dinner as president.

Wendy and I were glad to have a chance to chat with Eliot, whom Wendy knew from her environmental work, when he came up to the dais to speak to us. He was friendly and relaxed, and he looked like a million bucks as he talked to me about the monolines and thanked me for Bob Steel’s help.

Looking back now, I realize that Spitzer must have known that he would be named within days as the customer of a call-girl service, and that his world would come crashing down. But that night he looked like he didn’t have a care in the world.

I can’t remember many speeches I looked forward to less than the one I was scheduled to deliver Thursday morning, March 13, at the National Press Club.

My purpose was to announce the results of a study of the financial crisis by the President’s Working Group and to unveil policy recommendations affecting areas ranging from mortgage origination and securitization to credit rating agencies and over-the-counter derivatives like credit default swaps. We had worked hard on these proposals since August, coordinating closely with the Financial Stability Forum in Basel, which planned to release its response in April at the upcoming G-7 Finance Ministers meeting.

But our timing was dreadful. It seemed premature to suggest steps to avoid a future crisis with no end in sight to this one. As much as I wanted to cancel the speech, I felt that if I did, the market would have smelled blood.

I hurried through my brief remarks, preoccupied and impatient to get back to the office. It had been a rough week. The markets had taken a sharp turn for the worse, as sinking home prices continued to pull down the value of mortgage securities, triggering more losses and widespread margin calls. Financial stocks were staggering, while CDS spreads—the cost to insure the investment banks’ bonds against default or downgrade—hit new highs. Banks were reluctant to lend to one another. The previous weekend there had been a banking conference in Basel, and Tim Geithner had told me that European officials were worried that the crisis was worsening. It was an unsettling confirmation of conversations I had had with a number of European bankers.

The firm under the most intense pressure was Bear Stearns. Between Monday, March 3, and Monday, March 10, its shares had fallen from $77.32 to $62.30, while the cost to insure $10 million of its bonds had nearly doubled from $316,000 to $619,000. Other investment banks also felt the heat. The next-smallest firm, Lehman Brothers, which was also heavily overweighted in mortgages and real estate, had seen the price of CDS on its bonds jump from $228,000 to $398,000 in the same time. A year before, CDS rates on both banks had been a fraction of that—about $35,000.

On the Tuesday before my speech, the Fed had unveiled one of its strongest measures yet, the Term Securities Lending Facility (TSLF). This program was designed to lend as much as $200 billion in Treasury securities to banks, taking federal agency debt and triple-A mortgage-backed securities as collateral. The banks could then use the Treasuries to secure financing. Crucially, the Fed extended the length of the loans from one day to 28 days and made the program available not just to commercial banks but to all primary government dealers—including the major investment banks that underwrote Treasury debt issues.

I was pleased with the Fed’s decision, which let banks and investment banks borrow against securities no one wanted to buy. And I had hoped that this bold action would calm the markets. But just the opposite happened. It was an indication of the markets’ jitters that some took the move as a confirmation of their worst fears: things must be very serious indeed for the Fed to take such unprecedented action.

On Wednesday, most of America found itself temporarily diverted from the markets’ tremors when Eliot Spitzer announced he was resigning as New York’s governor following a two-day riot of news coverage after he was named as a client of a prostitution ring. I know many on the Street took pleasure in his troubles, but I just felt shock and sadness. The Gridiron dinner where he had seemed so carefree just days before seemed an eternity ago.

I was too preoccupied to dwell on Spitzer’s misfortunes. Not only did I have to prepare my own speech, but I’d also been advising President Bush on an upcoming address of his own. It was scheduled for Friday at the Economic Club in New York. The president hoped to reassure the country with a firm statement on the administration’s resolve. We were agreed on just about everything except for one key point. I advised him to avoid saying that there would be “no bailouts.”

The president said, “We’re not going to do a bailout, are we?”

I told him I wasn’t predicting one and it was the last thing in the world I wanted.

But, I added, “Mr. President, the fact is, the whole system is so fragile we don’t know what we might have to do if a financial institution is about to go down.”