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

“How did we get to this point?” the president asked in frustration. He wanted to understand how we couldn’t let a financial institution fail without inflicting widespread damage on the economy.

I explained that AIG differed from Lehman, because Lehman had issues with both capital and liquidity, whereas AIG just had a liquidity problem. The investment bank had been loaded with toxic assets worth far less than the value at which they were carried, creating a capital hole. Nervous counterparties had fled, draining liquidity.

In AIG’s case the problem wasn’t capital—at least we didn’t think so at the time. The insurer held many toxic mortgages, but its most pressing problem was a derivatives portfolio that included a large amount of credit default swaps on residential mortgage CDOs. The decline in housing values, and now the cuts in AIG’s ratings, required it to post more collateral. Suddenly, AIG owed money seemingly everywhere, and it was scrambling to come up with $85 billion on short notice.

“If we don’t shore up AIG,” I said, “we will likely lose several more financial institutions. Morgan Stanley, for one.”

I noted that an AIG collapse would be much more devastating than the Lehman failure because of its size and the damage it would do to millions of individuals whose retirement accounts it insured. I added that I was worried about the flight I saw from money market funds and commercial paper. Chris Cox let us all know the Reserve Primary Fund had just broken the buck.

The president found it hard to believe that an insurance company could be so systemically important. I tried to explain that AIG was an unregulated holding company comprising many highly regulated insurance entities. Ben chimed in with a pointed description: “It’s like a hedge fund sitting on top of an insurance company.”

Ben said that under the Fed’s plan, the government would lend AIG $85 billion, charging the company LIBOR plus 850 basis points, or about 11.5 percent at that time. The government would end up with 79.9 percent ownership, substantially diluting the existing equity, and would gradually liquidate the company to pay off the Fed’s loan.

“Someday you guys are going to have to tell me how we ended up with a system like this and what we need to do to fix it,” the president said, noting that we would have to put together a more consistent and comprehensive approach to the crisis.

I couldn’t have agreed more. Sunday night, with Lehman about to file for bankruptcy, I had warned the president that we might have to ask Congress for broader powers to stabilize the financial system as a whole. Now, while still in firefighting mode as we dealt with the five-alarm emergency of AIG, I didn’t raise the issue of going to Congress again. But I knew that when the time came, President Bush would support me.

The president was admirably stalwart. Even though the predominant mood at the time, both generally and on the Hill, was against bailouts, President Bush didn’t care. His goal was to leave the country in as strong a financial position as possible for his successor. Skeptics may doubt me, but this is the truth: In any accurate recounting of the financial crisis, you won’t find the president playing politics with these decisions—not one instance. He was genuinely trying to do his best for the country as he backed our AIG rescue plan.

“If we suffer political damage, so be it,” he said.

Afterward I got confirmation of what Chris had said about the Reserve Fund. While we were with the president, the Reserve had announced that it would halt payment of redemptions for one week on its Primary Fund, a $63 billion money market fund that was caught with $785 million in Lehman short-term debt when the investment bank entered bankruptcy. On Monday, investors had flooded the company with requests for redemptions; by mid-afternoon Tuesday, $40 billion had been pulled. The fund had officially broken the buck, the first to do so since 1994, when the Denver-based U.S. Government Money Market Fund, which had invested heavily in adjustable-rate derivatives, fell to 96 cents.

The sense of panic was becoming more widespread. Dave McCormick and Ken Wilson came in to tell me that they had heard from their Wall Street sources that a number of Chinese banks were withdrawing large sums from the money market funds. They had also heard that the Chinese were pulling back on secured overnight lending and shortening the maturity of their holdings of Fannie and Freddie paper—all signs of their battening the hatches. I asked Dave to track down the Chinese rumors and report back to me as soon as possible.

While we were in the PWG meeting, Morgan Stanley released its third-quarter earnings, rushing them out a day early. Its reported $1.43 billion in profits were down 7.6 percent from a year earlier but better than expected. Not that it helped much: after briefly rallying, Morgan Stanley’s shares fell 10.8 percent on the day, to $28.70, while its CDS rates ended at 728 basis points, after spiking to 880 basis points at one point. Goldman Sachs had released its earnings that morning: at $845 million, its net income was down 70.4 percent from the previous year.

Later I got an earful from John Mack, who said Morgan Stanley was in jeopardy. John was a strong leader, at once personable and tough. He was no whiner, but I could tell he was scared. What he had predicted Sunday night had come to pass: investors were losing confidence, and the short sellers were after his bank. His cash reserves were evaporating, and he was doing everything he could to hold things together.

“Hank,” John said, “the SEC needs to act before the short sellers destroy Morgan Stanley.”

Since Monday he had been calling senators, congressmen, the White House, and me, trying to persuade everyone to push the SEC to do something about abusive short selling. He wasn’t alone. John Thain also called that afternoon to press about short selling. Shareholders had not yet approved Merrill’s deal with Bank of America, and he was taking nothing for granted. But his immediate concern was Morgan Stanley. The failure of another major institution, he knew, would be devastating.

Ben and I had arranged to meet with congressional leaders that evening, but first Tim and I had to call AIG chief Bob Willumstad to confirm that the Fed was on track to make the loan—and to tell him that he was being replaced. He had been CEO for just three months; before that he had served as AIG chairman after a long financial services career that included retail banking at Citigroup. He was highly regarded for his acumen and integrity, but with AIG he had encountered more than he could handle—perhaps more than anyone could have handled. Through it all, Willumstad was an incredible gentleman, even calling Ken Wilson and voluntarily forfeiting the severance payments that were written into his management contract.

I next had to make arrangements to go to the Hill. In the afternoon, I’d run into resistance trying to get something scheduled. Before the PWG meeting I had spoken with Nancy Pelosi more than once, telling her that although the Fed hadn’t made a final decision yet on the AIG loan, we probably would need to meet with congressional leaders to discuss it. I told her it was an emergency, but she’d replied: “This is difficult to schedule on short notice. Do we need to do it tonight?”

When I got back to my office from the White House, I tried Harry Reid. I’d always found the Senate majority leader to be a sincere, trustworthy, hardworking partner. The son of a Nevada miner, he had come up the hard way, and his modesty and earnestness appealed to me.

“We have a real problem with AIG,” I told him. “The Fed is going to have to step in. I need you to get the leadership together.” He agreed, and we scheduled a meeting for 6:30 p.m.