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

Later that afternoon, the longtime block to GSE reform broke. At my urging, Chris Dodd had called a meeting with Richard Shelby and the chief executives of Fannie Mae and Freddie Mac. We gathered in Dodd’s offices at the Russell Senate Office Building, in a small room that was unusually warm and intimate for an office on the Hill. Wood-paneled, with red curtains and carpet, it was decorated with memorabilia from Dodd’s long political career, including photos of his father, Thomas J. Dodd, who had also served as a U.S. senator from Connecticut. It was a strangely homey setting for a meeting between some of the fiercest opponents on the GSE issue.

Although Dodd, like many leading Democrats, was sympathetic to Fannie and Freddie, Shelby had long wanted to put them under stricter supervision; in 2005 he had backed an unsuccessful bill that would have drastically reined in their portfolios.

Fannie’s chief, Dan Mudd, the son of famed CBS News correspondent Roger Mudd, had grown up in Washington and had spent much of his career working at GE Capital, the finance unit of GE. Unlike many who rode the Washington gravy train, he knew how to run a real business and had been recruited to clean up Fannie after the accounting scandal of 2004. Since then, he had built a strong, loyal team.

Freddie Mac’s CEO, Dick Syron, a former CEO of the Boston Fed and the American Stock Exchange, faced a more difficult situation. He had a problematic board, and I wasn’t convinced he could deliver on what he promised.

By the time we sat down together, it was clear that the two CEOs recognized that something needed to be done. But the key was Shelby, who had finally decided that it was time to act.

Before we went in, my legislative aide, Kevin Fromer, reminded me, “This is Dodd’s meeting, so let Dodd run it.” He knew I had a tendency to jump in and take over.

But after a few pleasantries, Dodd turned to me. I made clear that Fannie and Freddie were critically important to helping us get through this crisis; that we needed to restore confidence in them; that reform required a new, stronger regulator; and that it was crucial for them to raise capital. Mudd noted that Fannie planned to raise $6 billion; Syron was noncommittal.

We’d come with a list of crucial unresolved issues, and at Shelby’s prompting I asked David Nason to run through them. They concerned the new regulator’s increased jurisdiction over the portfolio, including the power to force divestitures, its ability to set and temporarily increase capital requirements without congressional approval, and its oversight of new GSE business activities. Other issues included increasing conforming loan limits for high-cost areas and setting up an affordable housing fund.

“Well,” Shelby said, “those are the key items.”

Shelby is a formidable talent, a crafty legislator, and an astute questioner. But, frankly, I never clicked with him. He was a true conservative. I don’t think he ever really trusted me, because I came from Wall Street, and he hated the Bear Stearns rescue. This was the rare time in the two and a half years I was in D.C. where I saw him do much more than sidestep an issue or point out the problems with someone else’s proposal.

But here Shelby took charge, and I saw the Alabama senator at his best.

“I liked our bill,” I remember him saying. “But I know I can’t get everything I want.”

Shelby was now ready to move. For him, the big issues were how to deal with the sizes of the portfolios and new product approval. Treasury cared mostly about systemic risk and safety and soundness matters, while Dodd—like Barney Frank—wanted bigger loan limits and an affordable housing fund.

“Are you going to work with us?” Shelby asked Mudd and Syron. “Do you guys really want to get this done?”

Under Shelby’s no-nonsense gaze, they said yes, and I left the Russell Building feeling very optimistic and determined to draft the language that would help fix Fannie and Freddie.

It wouldn’t be a moment too soon.

In early May, Fannie announced a first-quarter loss of $2.2 billion—its third straight quarterly loss—cut its common stock dividend, and announced plans to raise $6 billion through an equity offering. Eight days later, Freddie announced its first-quarter results—a loss of $151 million—along with plans to raise $5.5 billion in new core capital in the near future.

On May 6, Treasury officials met with a group of large mortgage lenders to speed up loan modifications for qualified homeowners facing foreclosure. That same day, the White House issued a statement outlining its opposition to the housing stimulus bill working its way through the House. Officially known as H.R. 3221, this ungainly and complicated piece of legislation had begun life as an energy bill in 2007, before turning into a housing vehicle in February. It contained a hodgepodge of provisions that were expensive and likely to be ineffective. The administration considered the bill burdensome, prescriptive, and risky to taxpayers. The legislation addressed GSE reform, but the White House was concerned about the other measures. I was convinced we could work with Barney Frank to fashion an acceptable compromise.

On the Senate side, our summit meeting with Dodd and Shelby was paying dividends. After considerable wrangling, they ushered the Federal Housing Finance Regulatory Reform Act of 2008 through the Senate Banking Committee on May 20. It provided for a strong new GSE regulator, the Federal Housing Finance Agency, with the authority to set standards for minimum capital levels and sound portfolio management.

After Bear Stearns, it would not have been unusual for the regulators involved to have resorted to turf building and finger pointing. That’s too often the way in Washington. But we knew how important it was that we continue to act in a united way. We were focused on increasing market confidence in the remaining four investment banks by encouraging them to take tangible steps to strengthen their balance sheets and their liquidity management.

The Primary Dealer Credit Facility (PDCF) allowed the Fed to conduct on-site examinations of institutions regulated by the SEC. I had dispatched a Treasury team led by David Nason to visit the investment banks to find out how the process was working. They met with the firms’ CFOs, treasurers, and lawyers, and found that the arrangement was working fine—Lehman was the most pleased to have the Fed on-site.

But there was a considerable amount of tension and borderline mistrust between the agencies. Chris Cox was open and cooperative, but some SEC staff were understandably uneasy that their agency could be overshadowed by the Fed on the regulation of securities firms. I had a lot of confidence in the New York Fed, because it had been proactive and creative in dealing with Bear and consistently tried to get ahead of the curve.

I believed it vitally important for the regulators to work together. Ben Bernanke and Chris Cox agreed. They weren’t interested in turf wars. They cared, as I did, about market stability and wanted the Fed inside the firms to protect that.

Traditional protocol would have left the agencies to sort out their issues, but I took the initiative in mid-May to convene a meeting with Ben, Tim Geithner, Chris Cox, Bob Steel, and David Nason. The SEC and the Fed agreed to draft a memo of understanding that would set ground rules to coordinate on-site examinations and to improve information sharing between the agencies. We also discussed how long the PDCF should run. It was a temporary program, created under Federal Reserve emergency authority, and was scheduled to expire in September. I supported Ben and Tim’s view that the facility should be extended.

It would have been easy to leave many technical and legal issues for the regulators to work out, but the policy and greater economy implications were too great for Treasury to sit on the sidelines.