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

There was no time to waste. That day Freddie sold $2 billion of short-term notes at their worst spreads ever. I called Josh Bolten and said, flatly, there was no good alternative to conservatorship.

The next morning I went to the Situation Room on the ground floor of the West Wing of the White House, with its secure communications equipment, to talk to the president, who was at his ranch in Crawford, Texas. There were several video screens on the far wall of this windowless room, and one displayed the president, who was relaxed and wearing a sports shirt. Once the national security briefing was through, I posted the president. I told him straightaway that I was worried about Lehman. It was looking for a solution to its problems, and we had been trying to help, but it didn’t look like any investor was stepping up. We would do what we could, but there was a chance it would go down.

I then took the president quickly through our thinking on the GSEs. As always, he wanted to know what our long-term plan was, because he did not like the underlying structure that had produced profits for shareholders and losses for the taxpayers—and had led to all the problems. I said I thought that when the crisis was over they ought to be downsized, have their missions shrunk, and be recast as utilities, but felt we needed to defer that discussion until well after we had bolstered them financially and markets were stable. The president was completely supportive. He said, as he would frequently: “It won’t always look good, but we are going to do what we need to do to save the economy.”

Through the week the examiners from the Fed and the OCC continued to scrutinize the books of the GSEs, while trying to bring their FHFA counterparts up to speed. Meantime, our teams at Treasury worked double-time to refine our plans. Ken Wilson was running an informal employment agency, drawing on his extensive contacts to line up replacement CEOs and nonexecutive chairs for both Fannie and Freddie.

Just about everyone lived at the Treasury for the three days of the Labor Day weekend. We didn’t know it then, of course, but it was a preview of how we would spend most of the fall, with senior and junior staffers alike surrendering their weekends, weeknights, and just about any trace of a personal life to try to solve problems that kept getting bigger than we had anticipated. All that weekend, we met, broke out into separate teams, reconvened, and ran frequent conference calls.

Ben proved again to be an incredible stand-up guy. He did not miss a meeting the entire weekend—and there were many. He was there to do what he thought was right for the country, even if some at the Fed worried he was getting too involved. Fed vice chairman Don Kohn and governor Kevin Warsh also joined our deliberations, along with the Board’s general counsel, Scott Alvarez. Jim Lockhart was present with his senior staff and Rich Alexander, FHFA’s outside legal counsel from Arnold & Porter, whose work was invaluable in preparing the legal case. Morgan Stanley was on-site, with lawyers from Wachtell plugged in from New York.

It was gratifying to see how everyone cooperated. When I asked for help, FDIC chairman Sheila Bair sent over her most experienced professional, Art Murton. Crucially, no one leaked any word of what we were up to. Everyone understood the stakes.

We reviewed all of our alternatives in a thorough and systematic way. My staff wanted to be sure we had an airtight case for conservatorship, given the GSEs’ reputation as the toughest street fighters in town. I was less worried about the details than my colleagues were: I didn’t think they completely recognized the awesome power of government and what it would mean for Ben and me to sit across from the boards of Fannie Mae and Freddie Mac and tell them what we thought was necessary for them to do.

Bob Scully of Morgan Stanley and Dan Jester had come up with the idea of using a version of a keepwell agreement, which is a contract between a parent company and a subsidiary in which the parent guarantees that it will provide necessary financing for the subsidiary. It was an inspired idea: Treasury’s authority was good for 18 months, and guaranteeing debt for 18 months wasn’t going to do much for investors in long-term debt. The keepwell, which became known as the Preferred Stock Purchase Agreement, allowed us to maintain a positive net worth at the companies no matter how much they lost long into the future. By entering into that agreement before December 31, 2009 (when our temporary authority expired), we would be acting within our authority, while providing investors the necessary long-term assurances. As losses were realized in the future, we could dip into the keepwell and increase the amount of financial support by purchasing preferred shares.

We had to decide how big to make the keepwells. We wanted a big number to send a message, and the only constraint was the debt ceiling, which had been increased by $800 billion. We initially set the size at $100 billion for each GSE. (The Obama administration would eventually increase the keepwells to $200 billion each as losses soared at the companies.)

It was crucial to win over FHFA’s examiners because it would be next to impossible to put the GSEs into conservatorship without their support. They wanted to base their argument for doing so on Fannie’s and Freddie’s unsafe and unsound practices. But we knew, and the Fed and OCC agreed, that we couldn’t take Fannie and Freddie down on a technicality—and besides, there were gross inadequacies in the quality and quantity of their capital.

A lot of work had to be done. Fed and OCC examiners scouring the portfolios had come up with estimates of embedded losses that were multiples of what the GSEs said they thought the losses were. The Fed and the OCC took FHFA through their models and assumptions, and finally persuaded Lockhart’s people to change their minds.

The companies were struggling to solve their problems. Fannie was more diligent and more helpful. It had in fact raised $7.4 billion, while Freddie, despite its assurances, hadn’t raised any equity. At one point, Fannie executives came in and gave a PowerPoint presentation, in which for the first time they made it clear they had no access to capital markets. Even so, their projections of losses were below what the examiners were coming up with.

Fannie’s cheekiness was breathtaking. The essence of the presentation was: We’re in deep trouble unless you do something to help us. But since we are clearly compliant with our regulatory capital requirements, you can’t touch us other than to do what the statute allows you to do, which is inject capital on terms we agree to. Fannie even tried to make it seem that their plight was our fault, that our having gotten the bazooka had caused everyone to lose confidence in them. Hence, we should fix things on terms favorable to them.

But the problem wasn’t the bazooka. It was that the market realized before the GSEs did that they were doomed. And Fannie was living in a world that the markets were declaring was dead and over.

As the Fannie team went through its slides, I said very little. I just sat there, and they thought I was being positive. Normally I’m the hammer: I challenge, I push to get the best possible result. Now I just looked on and nodded. As my staff said afterward, it was a classic example of people taking away the message they were looking for.

Right up to the end, Lockhart had quite a task trying to move his people to where he and we wanted them. They needed to be led to the conclusion they knew was right. Doing so would in effect overturn the work they’d done for years. But they were moving forward slowly. On September 1, FHFA wrote the GSEs to suspend the August 22 letter that had said their capital was adequate and informed them that the agency was conducting a new review of the adequacy of their reserves.