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

By April it was clear that the downturn would be long, and not just in the U.S.—mortgage activity in the U.K., for example, had ground to a near halt. Oil prices continued to rise, the dollar stumbled, and the press was filled with stories of food shortages, and riots, in several countries.

I traveled to Beijing to meet with Wang Qishan, who had replaced Wu Yi as vice premier, to set the table for the next round of the Strategic Economic Dialogue. I had known and worked with Wang, whom I considered a trusted friend, for 15 years. A former mayor of Beijing, with an appetite for bold action and a sly sense of humor, he had guided his country out of the SARS crisis and led the preparation for the 2008 Olympic Games. Though we spent considerable time discussing the vital issues of rising energy prices and the environment, which were to be the focus of our upcoming June meeting, Wang was most interested in the problems in the U.S. capital markets. I was candid about our difficulties but mindful that China was one of the top holders of U.S. debt, including hundreds of billions of GSE debt. I stressed that we understood our responsibilities.

In truth, U.S. markets were weakening again. Banks continued their efforts to raise capital, even as they suffered more big losses. On April 8, Washington Mutual said it would raise $7 billion to cover subprime losses, including a $2 billion infusion from the Texas private-equity group TPG. On April 14, Wachovia Corporation announced plans to raise $7 billion. Merrill Lynch reported first-quarter losses of $1.96 billion on $4.5 billion in write-downs, mostly from subprime mortgages, while Citigroup recorded a $5.1 billion loss, owing to a $12 billion write-down on subprime mortgage loans and other risky assets.

A somber mood prevailed when the G-7 held its ministerial meeting in Washington on April 11. That day, the Dow plunged 257 points, after General Electric’s first-quarter earnings came in lower than expected. Talk of oil prices, which were topping $110 a barrel on their way to a July high of nearly $150, dominated the meeting, but the state of the capital markets was very much on the ministers’ minds.

There was a great deal of discussion about mark-to-market, or fair-value accounting. European bankers, led by Deutsche Bank CEO Joe Ackermann, had cited this as a major source of their problems, and a number of my counterparts were understandably looking for a quick fix. Many favored a more flexible approach, but I staunchly defended fair-value accounting, in which assets and liabilities are recorded on balance sheets at current-market prices rather than at their historical values. I maintained that it was better to confront your problems head-on and know where you stood. Frankly, I believed the European banks had been slower than our own to confront their problems partly because of these differences in accounting practices. But I sensed that my European colleagues were increasingly aware of the seriousness of the banking problem.

The G-7 meeting featured an “outreach dinner” in the Treasury’s Cash Room for financial CEOs. Most of the major institutions were represented: the guest list included John Mack of Morgan Stanley, John Thain of Merrill Lynch, Dick Fuld, Citigroup chairman Win Bischoff, JPMorgan CEO Jamie Dimon, and Deutsche’s Ackermann.

The mood was dark. A few of the bankers thought we were nearing the end of the crisis, but most thought it would get worse. I went around the table and called on people, asking how we had gotten to where we were.

“Greed, leverage, and lax investor standards,” I remember John Mack saying. “We took conditions for granted, and we as an industry lost discipline.”

“Investment managers now know what we don’t know,” noted Herb Allison, the TIAA-CREF CEO, in what was his last day on the job. “We used to think we knew a lot more about these assets, but we’ve been burned, and until we see large-scale transparency in assets, we’re not going to buy.”

Mervyn King, governor of the Bank of England, took a look at the big picture, questioning whether we had allowed the financial sector to become too big a part of our economies.

“You are all bright people, but you failed. Risk management is hard,” he said to the assembly. “So the lesson is, we can’t let you get as big as you were and do the damage that you’ve done or get as complex as you were—because you can’t manage the risk element.”

The bankers complained bitterly about hedge funds, which they felt were shorting their stocks and manipulating credit default swaps and, in the CEOs’ minds, all but trying to force some institutions under. Almost every one of them wanted to regulate the funds, and no one wanted that more than Dick Fuld, whose face reddened with anger as he asserted, “These guys are killing us.”

As we left the dinner, Dave McCormick, who served as the main liaison to the G-7 and other countries’ finance ministries, told me, “Dick Fuld is really worked up.”

I told Dave I wasn’t surprised. Lehman was in a precarious position. “If they fail, we are all in deep trouble,” I said. “Maybe we can figure out how to sell them.”

Congress had recessed for two weeks in the second half of March, and lawmakers got an earful from constituents who were worried about the ongoing housing woes and the weakening economy—and were in some cases resentful about what they perceived as the government bailout of Wall Street. The House and the Senate pushed ahead with housing legislation, which included a constellation of plans for foreclosure mitigation, affordable housing, and bankruptcy relief. Democrats, led by Chris Dodd and Barney Frank, pushed HOPE for Homeowners, a Federal Housing Administration program to provide guarantees to refinance mortgages for subprime borrowers at risk of losing their homes.

Republican lawmakers, particularly in the House, lambasted many of these proposals as bailouts of deadbeats and speculators. And the White House threatened a veto because of its displeasure with bankruptcy modifications of mortgages and a proposal to distribute $4 billion in Community Development Block Grants to state and local governments to buy foreclosed properties. I myself had real doubts about the efficacy of many of the proposals—we calculated that HOPE for Homeowners would aid 50,000 borrowers at most.

But GOP senators had returned from the spring recess more in a mood for compromise. On April 10 the Senate voted 84 to 12 in favor of a $24 billion bill of tax cuts and credits designed to boost the housing market.

On April 15, Bob Steel, Neel Kashkari, Treasury chief economist Phill Swagel, and I met with Ben Bernanke and some of his aides at the Fed to review a contingency plan that Neel and Phill had been working on for some time. Termed the “Break the Glass” Bank Recapitalization Plan, after the fire axes kept ready in glass cases until needed, the paper laid out the pros and cons of a series of options for dealing with the crisis.

Among its main options, the government would get permission from lawmakers to buy up to $500 billion in illiquid mortgage-backed securities from banks, freeing up their balance sheets and encouraging lending. Other moves included having the government guarantee or insure mortgage-backed assets to make them more appealing to investors, and having the FHA refinance individual mortgages on a massive scale. “Break the Glass” also laid out the possibility of taking equity stakes in banks to strengthen their capital bases—though not as a first resort.

“Break the Glass” was the intellectual forerunner of the Troubled Assets Relief Program (TARP) we would present to Congress in September. In April, however, the state of the markets was not yet so dire, nor was Congress anywhere near ready to consider granting us such powers.