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

As Treasury secretary, I often turned to Dick for his market insights. A former bond trader, he was shrewd, willing to share information, and very responsive. I could tell that Bear’s demise had shaken Dick. How far he was willing to go to protect his firm was another question.

For some time, I had been encouraging a number of commercial and investment banks to recognize their losses, raise equity, and strengthen their liquidity positions. I said that I had never, over the course of my career, seen a financial CEO who had gotten into trouble by having too much capital.

I emphasized this point to Fuld in late March. He maintained he had enough capital but knew he needed to restore confidence in Lehman. Shortly after, Dick called to say that he was thinking of approaching General Electric CEO Jeff Immelt and Berkshire Hathaway CEO Warren Buffett as possible investors. Dick said he served on the New York Fed board with Immelt and could tell that the GE chief liked and respected him. And he thought Berkshire Hathaway would be a good owner. I told Dick that GE was unlikely to be interested but that calling Warren Buffett was worth a try.

A few days later, on March 28, I was lying on my couch at home, watching ESPN on my birthday, when the phone rang. Dick was calling to say he had talked to Buffett. He wanted me to call Warren and put in a good word. I declined, but Dick persisted. Buffett, he said, was waiting for my call.

It was a measure of my concern for Lehman that I decided to see just how interested Warren was. I picked up the phone and called him at his office in Omaha. I considered Warren a friend, and I trusted his wisdom and invariably sound advice. On this call, however, I had to be careful about what I said. I pointed out that I wasn’t Lehman’s regulator and didn’t know any more than he did about the firm’s financial condition—but I did know that the light was focused on Lehman as the weakest link, and that an investment by Warren Buffett would send a strong signal to the credit markets.

“I recognize that,” Buffett said. “I’ve got their 10-K, and I’m sitting here reading it.”

Truth is, he didn’t sound very interested at all.

I learned later that Fuld had wanted Buffett to buy preferred stock at terms the Omaha investor considered unattractive.

The following week, Lehman raised $4 billion in convertible preferred shares, insisting it was raising the capital not because it needed to, but to end any questions about the strength of its balance sheet. Investors greeted the action heartily: Lehman’s shares rose 18 percent, to above $44, and its credit default spreads dropped sharply, to 238 basis points from 294 basis points.

It was April 1—April Fools’ Day.

Bear Stearns’s failure in March had highlighted many of the flaws in the regulatory structure of the U.S. financial system. Over the years, banks, investment banks, savings institutions, and insurance companies, to name just some of the many kinds of financial companies active in our markets, had all gotten into one another’s businesses. The products they designed and sold had become infinitely more complex, and big financial institutions had become inextricably intertwined, stitched tightly together by complex credit arrangements.

The regulatory structure, organized around traditional business lines, had not begun to keep up with the evolution of the markets. As a result, the country had a patchwork system of state and federal supervisors dating back 75 years. This might have been fine for the world of the Great Depression, but it had led to counterproductive competition among regulators, wasteful duplication in some areas, and gaping holes in others.

I had aimed my sights at this cumbersome and inefficient arrangement from my first days in office. In March 2007, at a U.S. Capital Markets Competitiveness Conference at Washington’s Georgetown University, participants from a wide spectrum of the markets had agreed that our outmoded regulatory structure could not handle the needs of the modern financial system. Over the following year, Treasury staff, under the direction of David Nason, with strong support from Bob Steel, had devised a comprehensive plan for sweeping changes, meeting with a wide variety of experts and soliciting public comment. On March 31, 2008, we unveiled the final product, called the Blueprint for a Modernized Financial Regulatory System, to a standing-room-only crowd of about 200. There must have been 50 reporters there amid the marble and chandeliers of the 19th-century Cash Room.

Calling for the modernization of our financial regulatory system, I emphasized, however, that no major regulatory changes should be enacted while the financial system was under strain. I hoped the Blueprint would start a discussion that would move the reform process ahead. And I stressed that our proposals were meant to fashion a new regulatory structure, not new regulations—though we clearly needed some.

“We should and can have a structure that is designed for the world we live in, one that is more flexible, one that can better adapt to change, one that will allow us to more effectively deal with inevitable market disruptions, and one that will better protect investors and consumers,” I said.

Long-term, we proposed creating three new regulators. One, a business conduct regulator, would focus solely on consumer protection. A second, “prudential” regulator would oversee the safety and soundness of financial firms operating with explicit government guarantees or support, such as banks, which offer deposit insurance; for this role we envisioned an expanded Office of the Comptroller of the Currency. The third regulator would be given broad powers and authorities to deal with any situation that posed a threat to our financial stability. The Federal Reserve could eventually serve as this macrostability regulator.

Until this ultimate structure was in place, the Blueprint recommended significant shorter-term steps that included merging the Securities and Exchange Commission with the Commodity Futures Trading Commission; eliminating the federal thrift charter and combining the Office of Thrift Supervision with the Office of the Comptroller of the Currency; creating stricter uniform standards for mortgage lenders; enhancing oversight of payment and settlement systems; and regulating insurance at the federal level.

Though our team worked closely with other agencies in crafting the Blueprint, we had run into some disagreements with the Federal Reserve. It wanted to retain its role as a bank regulator, particularly its umbrella supervision over bank holding companies; without this it felt it couldn’t effectively oversee systemically important firms. We saw no reason to highlight our differences. We all agreed that it would not be wise for the Fed to relinquish these responsibilities in the short run because it was the bank regulator with the most credibility—and resources. Ben Bernanke supported the Fed’s taking on the new macro responsibilities from the beginning. But he and Tim Geithner wanted to be sure, and rightly so, that we gave the Fed the necessary authorities and access to information to do the thankless job of super-regulator. (I was pleased to see that the Obama administration, in its program of reforms, echoed the Blueprint’s call for a macrostability regulator.)

The Blueprint did not focus much on government-sponsored enterprises like Fannie Mae and Freddie Mac. We did note that a separate regulator for the GSEs should be considered, and we also recommended that they fall under the purview of the Fed as market stability overseer.

Meantime, I was determined to push forward on the reform of the two mortgage giants. As credit dried up, their combined share of new mortgage activity had grown from 46 percent before the crisis to 76 percent. We needed them to provide low-cost mortgage funds to support the housing market. Hence the importance of their March 19 announcement that they would be making up to $200 billion in new funds available to the markets, in conjunction with planned new capital raising.