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

In the end, we cut the proposal down to three pages, and it turned out to be a three-page political mistake.

We asked for broad power to spend up to $700 billion to buy troubled assets, including both mortgages and mortgage-backed securities, under whatever terms and conditions we saw fit.

The assets would be priced using market mechanisms such as reverse auctions, in which sellers put out bids—not buyers, as is normally the case. Once purchased, they would be managed by private asset managers. The returns would go into Treasury’s general fund, for the benefit of U.S. taxpayers.

Reflecting the urgency of the situation, our draft asked for Treasury to have the maximum discretion to retain agents to carry out the asset purchases, and for protection from lawsuits by private parties who might attempt to derail or delay the program. This freedom from judicial review we modeled in many respects after the Gold Reserve Act of 1934.

We were pilloried for the proposal—not least because it was so short, and hence appeared to some critics as if it had been done offhandedly. In fact, we’d kept it short to give Congress plenty of room to operate; April’s “Break the Glass” review of policy options on which this outline was based was itself ten pages long. Making no provision for judicial review came across as overreaching, and that provision eventually went out the door. But nearly all of what we would ask for, and what would eventually form the basis of the legislation, was in those three pages.

Nonetheless, we could have managed our introduction of the TARP legislation more adroitly. At a minimum, we ought to have sent up the three pages as bullet points, rather than as draft legislation. We might have sent it up sooner: it went to the Hill at midnight, and waiting all day had put lawmakers, their staffs, and the media on pins and needles. And as Michele Davis later pointed out to me, we should have held a press conference that night to explain the language more clearly. We would have saved ourselves a lot of trouble had we emphasized that our proposal was an outline. But the entire staff was crunching to get the language right, and there was no time to consider niceties like news conferences. Later, of course, we would hold many such late-night press briefings.

Even with TARP sketched out, a temporary money market guarantee in place, and a short-selling ban in operation, I still couldn’t breathe easily, because of the intense pressure on Morgan Stanley and Goldman Sachs. They were the top two investment banks in the world—not only for their prestige but also for the sheer size of their balance sheets, their trading books, and their exposures. Their counterparty risk was enormous, much bigger than Lehman’s. And we unequivocally knew that the market could not tolerate another failure like that of Lehman.

Morgan Stanley was particularly beset. Friday’s government actions had done wonders for its shares, which rose 21 percent to $27.21, and its credit default rates had fallen by more than a third. But its clients and counterparties had lost confidence; since Monday, hedge funds had been pulling their prime brokerage accounts, and other institutions were shying away from the firm. In one week the reserves available to the Morgan Stanley parent company had plunged from about $81 billion to $31 billion. We knew that if Morgan Stanley fell, the focus would turn to Goldman Sachs.

On Friday evening, around 6:30 p.m., John Mack called to update me. He was scrambling for a solution. He desperately needed a merger or a show of support from a strategic investor, but he had not gotten far with China Investment Corporation (CIC), Beijing’s sovereign wealth fund, which he had thought might consider an additional equity investment in his firm.

“We’re not making as much progress as I would like,” he acknowledged. “The Chinese need to know that the U.S. government thinks it is important to find a solution.”

“I’ll talk to Wang Qishan,” I assured him. I added that I was prepared to ask President Bush to say something to China’s president, Hu Jintao, if it would be helpful and necessary.

After I got off the phone with John, I spoke with Ben and Tim to set our plan of attack for Saturday and Sunday. Deal talk dominated our conversation, as it would throughout the weekend. We believed that Wachovia and WaMu were on the edge of failing. They were plagued by piles of bad assets and had genuine solvency issues. By contrast, Morgan Stanley and Goldman Sachs were suffering from a lack of confidence. Morgan Stanley also faced a near-term liquidity crunch.

Morgan Stanley and Wachovia had discussed a merger earlier in the week. Morgan Stanley had concluded that it couldn’t do one without enormous amounts of government assistance because of Wachovia’s huge exposure, about $122 billion, to so-called option ARMs. Among the most toxic of loans, these adjustable-rate mortgages let borrowers choose from different payment methods; they frequently came with introductory teaser rates and often contained a feature by which the low mortgage payments caused the loan balance to grow.

Tim had had serious doubts as to whether a Morgan Stanley–Wachovia combination would be credible to the market. Both institutions were too wobbly, and these talks ended without Morgan Stanley’s requesting or the Fed’s offering assistance.

Spurred by the Federal Reserve, we discussed a range of ways to combine the investment banks with commercial banks. Our rationale was simple: confidence in the business model of investment banks had evaporated, so merging them with commercial banks would reassure the markets. In truth, I didn’t like the idea of creating megabanks—they were too big and complex to manage effectively, and I believed that both Morgan Stanley and Goldman Sachs had better balance sheets than many of the commercial banks. But we had to find a way to reduce the likelihood of a failure of the investment banks—and the collapse of our financial system.

The Fed was also working on backup plans to enable Goldman and Morgan Stanley to become bank holding companies. This would bring them under the supervision of the Fed, which inspired more confidence in investors than the SEC. That, however, was Plan B, and we didn’t believe it would be enough to save the two investment banks unless they could also raise capital from strategic investors. But in the ongoing market panic, both investment banks were having trouble finding credible partners.

Whatever we did, we felt that by Monday we had to give the market a signal that Morgan Stanley and Goldman Sachs weren’t going to fail. The SEC’s short-selling ban had bought them a grace period, but there was no time to waste.

I arrived at the office at 9:15 a.m. Between the investment banks and the TARP legislation, I spent much of the day on the phone, taking multiple calls from, among others, both Barack Obama and John McCain.

Treasury and the White House held a midmorning conference call on legislative strategy. Our goal was to keep TARP as simple as possible while pressing for as broad a set of authorities as we could get. Treasury would lead the administration’s effort, with Neel Kashkari, Bob Hoyt, and Kevin Fromer negotiating with legislative staff on the Hill. We also had to make sure our proposal worked for the White House and the Office of Management and Budget.

My mind was focused on the danger to the investment banks. Tim and I had spoken early that morning, and several times afterward. My style, when I’m on the phone and pressed for time, is to race through things, then say, “Okay, bye.” If people don’t know me, they’ll find they’re talking to an empty line. I wound up calling Tim repeatedly that morning because I kept hanging up too quickly.