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

The GSEs’ situation had grown increasingly dire. On August 11, Standard & Poor’s had cut its preferred stock ratings for Freddie and Fannie, and the weekend I returned from China a piece titled “The Endgame Nears for Fannie and Freddie” appeared in Barron’s . The lengthy article laid out the poor prospects for the two GSEs and predicted a government takeover that would wipe out holders of common shares. The market reacted violently on Monday, driving the stocks to nearly 18-year lows.

The story was pretty accurate. While I was away, Fannie’s and Freddie’s books had been analyzed by the Fed; the OCC; our adviser, Morgan Stanley; and BlackRock, the New York money manager that had a long-term relationship with Freddie. They agreed that the organizations were sorely undercapitalized. And the quality of their capital was suspect: some of it consisted of intangible items, such as deferred taxes, that would not have been counted to the same degree as capital by financial institutions overseen by the banking regulators. What’s more, the GSEs had not adequately written down the value of guarantees provided by private mortgage insurers that had been downgraded by the rating agencies. Each of the companies looked to have true, economic capital holes amounting to tens of billions of dollars. (By November 2009, Fannie and Freddie would eat through all of their capital, and the government would be forced to inject more than $110 billion.)

We’d been prepared for bad news, but the extent of the problems was startling. We’d had no specific information when we’d pushed for extraordinary powers in July. Now, I told Josh Bolten that in all likelihood we would have to use our newly granted authorities.

We had evaluated such options as having the government backstop a private capital raising by the GSEs. But we’d become convinced that private capital would be impossible to raise unless we could clarify the GSEs’ future status or structure, which we could not. And there was no practical way to invest in them in their current form because any government investment needed to be approved by the GSEs. They had a fiduciary duty to protect their shareholders, but our duty was to protect the taxpayer.

I concluded that the only solution was to get FHFA to put the GSEs into receivership. I knew this would be a shock to Fannie and Freddie, to their investors, to Congress, and even to their regulator. I also knew we needed the support of the Fed. If we acted alone, some might believe that this was a Bush administration vendetta against Fannie and Freddie.

The situation was awkward for me. I’m a man of my word, and I had told Congress in July we did not intend to use the bazooka. But there was no alternative. I also knew we needed to keep our intentions confidential or Fannie and Freddie would run to their many friends on the Hill and possibly hinder us.

On August 19 I met privately with Ben Bernanke at the Fed. He was as concerned as I was, although he had been expecting Treasury to make an equity investment. But after I laid out the case for taking control of Fannie and Freddie and putting them in receivership, he offered his support on the spot. His staff would help document the capital hole in the GSEs. This was critically important because I wanted the Fed to attest to a capital deficiency in a letter.

“We’re with you 100 percent,” Ben told me.

Two days later, on August 21, I had lunch in my private dining room with Jim Lockhart, who headed the new FHFA, created by HERA to oversee Fannie and Freddie. Though outgoing and affable, Lockhart had a terrible relationship with the GSEs and their boards, after having pushed them hard to clean up their accounting problems. Because of his close ties to the White House, he was viewed as a megaphone for the administration.

I pressed him on the need for receivership, but he repeatedly told me that this would be difficult to do quickly because FHFA’s most recent semiannual regulatory exams had not cited capital shortfalls. He was scheduled to leave the next day for vacation in Nantucket, but I urged him to stay in Washington and work on our plan. He called me back to tell me he had canceled his vacation and that he would work through the weekend and let me know on Monday if receivership was feasible.

With that, we needed outside advice to guide us through the intricacies of the law and the corporate governance issues involved. Anticipating this, Ken Wilson had already contacted Wach-tell, Lipton, Rosen & Katz, a New York firm, and Bob Hoyt signed them up on Friday, August 22. This was another example of exemplary citizenship during the crisis. Just as Morgan Stanley had done, Wachtell, thanks to Ed Herlihy, the co-chairman of their executive committee, agreed to represent us for free and with no indemnification.

We hired them at 3:00 p.m. By the next morning they had torn through the GSEs’ debt and preferred stock documents, and concluded that going the receivership route would be perilous for a number of practical and technical reasons. That approach would be terribly disruptive to the GSEs’ businesses and extremely difficult to implement successfully in a short time frame, especially without the active involvement and cooperation of the GSEs’ management in the planning stages. It would also have posed risks of court challenges and the early termination of the GSEs’ valuable derivatives contracts. Receivership, which is used to liquidate companies, might trigger consequences every bit as bad as those we were trying to avoid, Wachtell said. By contrast, conservatorship was more like a Chapter 11 bankruptcy, where companies kept their current forms; it would provide a stable time-out for the GSEs to avoid defaulting on their debts and could be accomplished quickly.

We were in a race against time. The markets were fragile, and we knew that September was going to be even rockier. Lehman was going to announce a dreadful loss, and Washington Mutual and Wachovia both appeared headed for trouble. We needed to take care of Fannie and Freddie before then or we would have a real problem.

Initially, we had hoped to act by Labor Day. But we had to build a case for conservatorship, prepare to run the GSEs, and devise financing arrangements that would reassure bondholders and the market. There just wasn’t enough time, even as teams from Treasury, the Fed, FHFA, and other agencies worked around the clock.

Then on Monday, August 25, I received a disturbing report about FHFA. It turned out that the previous Friday, when Lockhart had told me he was on board for conservatorship, his people had sent the GSEs draft letters reviewing their second-quarter financial statements and concluding that the companies were at least adequately capitalized and in fact exceeded their regulatory capital requirements.

The drafts had included a special reminder that the FHFA had discretionary authority to downgrade that assessment. Even so, for FHFA to reverse and say now Fannie and Freddie had capital holes big enough to justify conservatorship gave the agency pause. Jim had quite a challenge on his hands: his agency had been renamed with the HERA legislation, but it still had the same people and same approach as it had had a month earlier. Only FHFA had the legal power to put the GSEs under, and I was worried about its backsliding.

I arranged to have Lockhart meet with Bernanke and me at Treasury so the two of us could offer him our support and encouragement. I said I understood that looked at narrowly, FHFA’s people might see conservatorship as an indication they hadn’t been sufficiently vigilant earlier, but Fannie’s and Freddie’s problems could not be swept under a rug, and a bold action would put FHFA on the right side of history. I stressed repeatedly that the GSEs needed capital, and I would not put taxpayer money in them in their current form. Any Treasury investment would be conditioned on conservatorship.