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

The disarray prompted the White House to debate whether President Bush should call a meeting of world leaders to tackle the crisis. I believed the key was to quickly find a solution to prevent a meltdown, but I did not think a summit was the way to do that—it could expose political divisions among countries, and this would further destabilize the markets. Over lunch on Monday I told Steve Hadley, Keith Hennessey, and Dan Price, the president’s talented and energetic assistant for international economics affairs, that any such meeting with world leaders should be held after our presidential election, albeit as soon as possible.

“This crisis will only get worse before it gets better,” I said.

Instead of meeting with his peers, I suggested President Bush call his fellow heads of state to urge them to send their finance ministers to the upcoming G-7 gathering ready to forge a solution. The International Monetary Fund and the World Bank were holding their annual get-togethers in Washington the next weekend. This meant that the G-20, which included representatives of both developed and emerging nations—including China, India, and Russia—would be in town. We decided to ask the chairman of the G-20, Brazilian finance minister Guido Mantega, to gather the group on Saturday.

On Monday I announced that Neel Kashkari would lead our TARP efforts as interim assistant Treasury secretary for financial stability. I made this an interim appointment because we were working to identify and vet permanent candidates acceptable to Obama and McCain.

Neel, who combined toughness with an engineer’s precision, was doing a typically fine job building a staff and organizational structure to move things forward. That morning he and his team had finished a 40-page PowerPoint presentation, outlining a massive undertaking. He had teams working on everything from hiring asset managers to figuring out how to conduct the auctions.

Although the Dow rallied late on Monday, it ended up below 10,000 for the first time in four years. Worldwide, more than $2 trillion in stock market value had evaporated. The uncertainty surrounding the fight for Wachovia hurt all financials. Early in the day Citi had reacted to its jilting by filing a $60 billion lawsuit, but agreed midday to freeze the litigation until Wednesday. Wachovia dropped nearly 7 percent, while Citi fell more than 5 percent, and Wells Fargo almost 3 percent. Credit default swaps on Morgan Stanley hit 1,028 basis points.

After the close, Bank of America reported a 68 percent drop in earnings for the third quarter and announced plans to raise $10 billion in equity. I knew that the next day would bring a fresh attack on bank stocks.

Early Tuesday morning I walked to the White House for a conference call with President Bush and British prime minister Gordon Brown, who told us that his government planned to inject capital into U.K. banks. He wanted our support and promised to coordinate with us. Brown also told the president that he should consider gathering the leaders of the G-20 together to deal with the problem. The president took in that suggestion, but his first priority was to ensure a good G-7 finance ministers’ meeting and come up with a coordinated plan of action.

Europe continued to suffer. Iceland, facing default on its obligations, had taken over two of its three largest banks and was negotiating a loan from Russia. Despite the country’s small population of some 300,000, its commercial banks had expanded aggressively to the point where their assets were several times greater than Iceland’s GDP. Now the entire country was caught in a liquidity squeeze, adding to the general jitters about Europe.

Something had to be done. The credit markets remained locked up, endangering businesses—and employment—around the world. On Tuesday, the Fed made another attempt to thaw the markets, unveiling its new Commercial Paper Funding Facility. The Fed’s first venture into the commercial paper market had been directed toward asset-backed paper issued by financial institutions. This new approach created a special purpose vehicle to buy three-month paper from all U.S. issuers, vastly improving the liquidity in the market. The new facility represented a radical move by the Fed, but Ben Bernanke and his board knew that extraordinary measures had to be taken.

That afternoon I moved a capital program one step further when Neel, Dan Jester, and I met with President Bush and a large contingent of White House staff in the Roosevelt Room. I had kept the president and his people up to date on equity investments, so he wasn’t surprised when presented with our thinking in greater detail.

From the start of the credit crisis, I had been focused on bank capital, encouraging CEOs to raise equity to strengthen their balance sheets. TARP had continued this focus. Banks were stuffed with toxic assets that they could unload only at fire-sale prices, which they were reluctant to do. By buying such assets at auction, we reasoned, we could jump-start the market, allowing banks to sell those bad assets in an orderly fashion, getting better prices and freeing up money to lend.

Initially, when we sought legislative flexibility to inject capital, I thought we might need it to save a systemically important failing institution. I had always opposed nationalization and was concerned about doing something that might take us down that path. But now I realized two crucial things: the market was deteriorating so quickly that the asset-buying program could not get under way fast enough to help. Moreover, Congress was not going to give us any more than the $700 billion we had, so we needed to make every dollar go far. And we knew the money would stretch much further if it were injected as capital that the banks could leverage. To oversimplify: assuming banks had a ten-to-one leverage ratio, injecting $70 billion in equity would give us as much impact as buying $700 billion in assets. This was the fastest way to get the most money into the banks, renew confidence in their strength, and get them lending again.

David Nason, Jeremiah Norton, and Dan Jester were working on a capital program, sorting through a variety of issues, from the type of instrument we might use to matters of pricing and other terms. They were moving quickly, but I wanted them to move even faster, and they grew accustomed to my asking for updates several times a day.

Because we were focused on supporting healthy institutions as opposed to rescuing failing ones, we considered a program in which the government would match any money the banks raised from private investors. We also explored different ways of taking an equity stake. Buying common stock would strengthen capital ratios, but common shares carried voting rights, and we wanted to avoid anything that looked like nationalization.

So we were leaning toward preferred stock that did not have voting rights (except in very limited circumstances) and could be repaid in full even if common shares substantially declined in value. Preferred is senior in priority to common stock and receives higher dividends, another bonus for the public.

We laid all of this out for the president, who listened with his usual attentiveness and concern.

“Are you still going to buy illiquid assets?” he asked.

“That’s the intent,” I said.

“You need to recognize where Congress and the American people are,” he said. “You are going to need to communicate this well.”

President Bush was right, but this dilemma haunted me throughout the crisis—how to make the public understand the grave situation we faced without inflaming the markets even further.

Certainly, we appeared to be facing an all-out run on the system. On Tuesday, fueled by concerns over bank stocks, the Dow tanked again, falling 508 points, or 5.1 percent, to 9,447; while the S&P 500 dropped below 1,000 for the first time since 2003. Bank of America’s shares plunged 26 percent, to $23.77. Morgan Stanley fell another 25 percent, to $17.65, raising the question of whether Mitsubishi UFJ would still want a deal.