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

Commercial paper is essentially an IOU that is priced on the credit rating of the borrower and generally backstopped by a bank line of credit. It’s usually issued for short periods of time—90 days or less. And it’s often bought by money market funds looking for a safe place to get a higher rate of return than they would earn from short-term government bills. Companies use these borrowings to conduct their day-to-day business operations, financing their inventories and meeting their payrolls, among other things. If companies can’t use the commercial paper market, they have to turn to banks (which in September 2008 were reluctant to lend). When their access to short-term financing is in question, companies have to curtail normal business operations.

Now here was Jeff telling me that GE was finding it very difficult to sell its commercial paper for any term longer than overnight. The fact that the single-biggest issuer in this $1.8 trillion market was having trouble with its funding was startling.

If mighty GE was having trouble rolling its commercial paper over, so were hundreds of other industrial companies, from Coca-Cola to Procter & Gamble to Starbucks. If they all had to slash their inventories and cut back operations, we would see massive job cuts spreading throughout an already suffering economy.

“Jeff,” I remember saying, “we have got to put out this fire.”

Monday, September 15, had been grim. But on Tuesday, all hell broke loose.

Normally I left home by 5:45 a.m., went to my gym, and ran hard on the treadmill. Then I’d do some core exercises until 7:45 a.m. Fifteen minutes later I was in the office. (Those 90-second showers of my childhood sure helped me keep to this pace.)

That morning, sensing trouble, I skipped my workout, as I would for weeks, and went straight to the Markets Room, on the second floor of the Treasury Building, to get a quick fix from Matt Rutherford. What I learned was disturbing. Though the LIBOR-OIS spread had eased, financial institutions including Washington Mutual, Wachovia, and Morgan Stanley were under severe pressure. (The CDS of the venerable investment bank would soar from 497 basis points Monday to 728 basis points—a higher level than Lehman Brothers had traded at before its failure.)

I soon heard from Dan Jester and Jeremiah Norton, who were helping Tim out with AIG. I needed them in Washington, but Dan, in particular, had won Tim’s confidence, and I had reluctantly agreed to let him stay at Tim’s request. They gave me a discouraging update. The rating agencies had slashed the insurer’s credit rating on Monday, forcing it to post additional collateral on its huge derivatives book. To my utter amazement and disgust, AIG’s liquidity needs had mushroomed. On Sunday, the company was looking for $50 billion; now it would need an $85 billion loan commitment by the end of the day. A private-sector solution appeared very unlikely.

AIG’s incompetence was stunning, but I didn’t have time to be angry. I immediately called President Bush to tell him that the Fed might have to rescue AIG and would need his support. He told me to do what was necessary.

Tim Geithner called to tell me that he had talked with Ben Bernanke, who was amenable to asking the Fed board to make a bridge loan if the executive branch and I stood behind him. He said he thought $85 billion would be enough but stressed that we had to move quickly: the company needed $4 billion by the close of business Wednesday. Even this breathtaking assessment would prove optimistic. By late morning, we had learned AIG needed cash to avoid bankruptcy by day’s end—the total would eventually reach $14 billion.

Tim, Ben, and I reviewed our options with great care in an hour-long conference call at 8:00 a.m. that included Fed vice chairman Don Kohn and governors Kevin Warsh and Elizabeth Duke. Whatever else happened, we could not let AIG go down.

Unlike with Lehman, the Fed felt it could make a loan to help AIG because we were dealing with a liquidity, not a capital, problem. The Fed believed that it could secure a loan with AIG’s insurance subsidiaries, which could be sold off to repay any borrowing, and not run the risk of losing money. These subsidiaries were also more stable because of the strength of their businesses and their stand-alone credit ratings, which were separate from the AIG holding company’s ratings and troubles. By contrast, prior to Lehman’s failure, its customers had already begun to flee, causing the Fed to face the prospect of having to lend into a run. Moreover, the toxic quality of Lehman’s assets would have guaranteed the Fed a loss, meaning the central bank could not legally make a loan.

We set a plan of action: Tim would figure out the details of the bridge loan, while I worked on finding a new CEO for the company. We had less than a day to do it—AIG’s balances were draining by the second.

I asked Ken Wilson to drop everything and help. Within three hours he had pinpointed Ed Liddy, the retired CEO of Allstate and one of the savviest financial executives in the world. He reached Liddy in Chicago, then ran upstairs to my office to tell me to call him. I offered Ed the position of AIG chief on the spot. The job would be a thankless one, but I could think of no one else who had the ability and the grit to take it on.

On Tuesday morning, the consequences of Lehman’s failure were becoming more and more apparent. I received an astounding call from Goldman CEO Lloyd Blankfein. He informed me that Lehman’s U.K. bankruptcy administrator, Pricewaterhouse-Coopers, had frozen the firm’s assets in the U.K., seizing its trading collateral and third-party collateral. This was a completely unexpected—and potentially devastating—jolt. In the U.S., customer accounts were strictly segregated, and were protected in a bankruptcy proceeding. But in the U.K., the bankruptcy administrator had lumped all the accounts together and frozen them, refusing to transfer collateral back to Lehman’s creditors. This was particularly damaging to the London-based hedge funds that relied on Lehman as their prime broker, or principal source of financing.

Just about all the hedge funds in London and New York, whether or not they had any relationship with the bankrupt securities firm, became unnerved and leaped to a frightening conclusion: they should avoid doing business with any firm that could end up like Lehman. This was bad news for Morgan Stanley and Goldman, the leading prime brokers. Trading frequently and maintaining big balances, hedge funds were among their best, most profitable customers. Lloyd was afraid that if something wasn’t done, Morgan Stanley would fail, as clients began to run and hedge funds pulled their prime brokerage accounts. And even though Goldman had plenty of liquidity and cash, it could be next.

“Hank, it is worse than any of us imagined,” Lloyd said. If hedge funds couldn’t count on the safety of their broker-dealer accounts, he went on, “no one will want to do business with us.”

Hedge funds were just the tip of the iceberg. Liquidity was rapidly evaporating all over. When investors—pension funds, mutual funds, insurance companies, even central banks—couldn’t withdraw their assets from Lehman accounts, it meant that in the interlinking daisy chain of the markets, they would be less able to meet the demands of their own counterparties. Suddenly everyone felt at risk and increasingly wary of dealing with any counterparty, no matter how sterling its reputation or how long a relationship one firm had had with another. The vast and crucial Treasury repurchase market, under duress since August 2007, began to shut down.

This was awful news. When institutional investors, for example, purchased securities like corporate bonds, they frequently hedged their positions by selling Treasuries. But if they did not have the Treasuries in their inventory, they used the repo market to borrow them from other investors.