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

I didn’t know how much more stress the system could bear.

It turned out that Angela Merkel’s Sunday night statement that Germany would stand behind its bank deposits was intended only as a confidence-building pledge, not as an announcement of government action. Germany would not authorize a guarantee as Ireland had. On Wednesday, the British government announced its own plan, a £500 billion ($875 billion) program to shore up its banking system. Eight banks, including the Royal Bank of Scotland and HBOS, had initially agreed to participate in the program.

The markets needed all the help we could give them. On Wednesday, in an unprecedented action, six central banks, including the Fed, the Bank of England, and the European Central Bank, all reduced policy interest rates. This was the first time in history that the Fed had coordinated a rate reduction with other banks; its federal funds rate target now stood at 1.5 percent.

European markets briefly rallied, but U.S. stocks opened lower despite these moves. LIBOR-OIS spreads soared to 325 basis points from 289 basis points the day before. And we could see the problems spreading to the emerging markets: on Wednesday, Indonesia’s stock exchange stopped trading after its main index fell 10 percent.

Given the global sweep of the problem, I knew there weren’t going to be any silver bullets for solving it. Rather, we would need to take a range of actions on a sustained basis.

While Jester and Nason worked through the details of a plan to make direct equity investments in banks, I watched the Europeans warily. We thought they might turn to a wave of defensive actions, including guarantees, not only for depositors but for unsecured bank borrowings. With fear rampant, such guarantees might help restore confidence in their banks, but they would put our banks at a disadvantage unless we did something similar.

We were seemingly watching a run on the global banking system, and we needed a blunt instrument to stop it the way our earlier guarantee of the money market funds had halted a panic in that sector. A week earlier Tim had suggested trying to get legislative authority for even more sweeping guarantees in the TARP legislation. That would have been impossible. But, as we’d noted in the PWG statement, the FDIC had the power to guarantee the debt of an individual bank.

We needed to know what the FDIC was prepared to do. After consulting with Tim, I called Sheila Bair.

We were facing a national emergency, and the Europeans were almost certain to act, I told her. Their economies were all disproportionately dependent on their banking systems: European bank assets were more than three times the size of the euro zone’s GDP, while U.S. bank assets were roughly the same size as our GDP. I asked Sheila if there was any way the FDIC could publicly commit to backing unsecured bank borrowings.

While Sheila understood the gravity of the situation, she worried that the FDIC didn’t have enough resources or the ability to assess the risk to its fund. She said she was prepared to work with me on this issue. I decided to strike while the iron was hot and proposed a meeting in my office with her and Ben, who was also eager to have a broad-based FDIC guarantee.

It was midmorning on that overcast fall day when Ben, Sheila, and I sat down together in my office, with Tim plugged in on my speakerphone from New York. I told Sheila that what she had done with Wachovia had been incredibly important. What if we applied elements of that approach more broadly?

“We’re looking to make a strong statement that we are not going to let any systemically important institutions go down,” I said.

I asked if the FDIC would be prepared to guarantee the debt of any such institution. Tim added that a broad guarantee was necessary to demonstrate a forceful commitment to protect our financial system.

I knew we were asking a lot. By law the FDIC had to use the least costly method to provide financial assistance to a failing bank, unless it invoked the systemic risk exception because it believed that an institution’s failure would seriously hurt the economy or financial stability. Now we were looking for an action that applied to all banks, not just an individual bank, and a guarantee that applied to new unsecured borrowings for bank holding companies, not just the insured institutions they owned. We weren’t going to reach an agreement today, but we needed to make progress.

Understandably, Sheila was very protective of the FDIC fund. “We only have about $35 billion, Hank.”

“If we don’t act, we are going to have multiple bank failures,” I said, “and there won’t be anything left in your fund.”

“This is vital,” Ben said.

We talked about the need for a broad guarantee of bank liabilities. Sheila finally indicated that she would keep working with us. After the meeting, I immediately sent her some draft language suggesting that “the FDIC, with the full support of the Fed and the Treasury, will use its authority and resources, as appropriate to mitigate systemic risk, by protecting depositors, protecting unsecured claims, guaranteeing liabilities, and adopting other measures to support the banking system.” I called Joel Kaplan with an encouraging update. “We may be getting there,” I said.

But I’d spoken too soon. Before long I got an e-mail from Sheila saying that she wasn’t certain she could move forward on this plan. I knew that I had overreached a bit and that my suggested language on an FDIC guarantee was too broad and general. When I called Joel again, however, I told him that I would keep working on Sheila, and that I had faith that she would come around.

In the meantime, I was determined to make a more definitive public statement about the need for capital injections, and with Michele Davis’s help I drew up a detailed update on the financial markets since TARP’s passage. I didn’t want to be too explicit—after all, we still didn’t have a program—but I wanted to build on the PWG’s statement on Monday.

“The markets want to hear that we are going to inject capital, but the politicians and the public don’t want to hear it,” she advised. “We should let the air out of the balloon a little bit at a time.”

At 3:30 p.m., during a live news conference, I released a four-and-a-half-page statement that, in describing our powers under TARP, made a point of listing first the ability to inject capital into financial institutions. I also noted that it probably would be several weeks before we made our first asset purchase. Because we still didn’t have a capital program in place, I didn’t allow a Q-and-A period. I’m sure that annoyed the press, which hadn’t had a chance to grill me since TARP had passed.

Neither my financial markets update, the British bank bailout, nor the central bank rate cuts cheered the morose markets. The Dow fell another 189 points to 9,258, and bank stocks suffered most. Bank of America’s shares dropped 7 percent, and Morgan Stanley’s fell 4.8 percent to $16.80; its CDS were above 1,100.

Adding to market woes, AIG was again bleeding. A few days earlier the company had said that it would sell everything but its property/casualty businesses to pay off its government debt. Now, it had run through most of its $85 billion loan—in barely three weeks. On Wednesday afternoon, the Federal Reserve announced it would lend an additional $37.8 billion to the company, secured by investment-grade bonds. It astonished me that not even $85 billion had been enough to stabilize the insurer.

I spoke to John Mack, and he was beside himself that the SEC’s short-selling ban would expire at midnight—before he could complete his deal with Mitsubishi UFJ. He wanted to know what Chris Cox planned to do. I agreed that the timing was terrible, but the fact was that Cox had painted himself into a corner during his TARP testimony when he promised that the SEC would lift the ban right after the legislation passed. I wondered how Morgan Stanley would pull through. The bank’s position had weakened since September 22, when it announced the investment from Mitsubishi UFJ. Its shares were now barely half that day’s price of $27, depressed by market fears that the deal would never happen. I, too, had my doubts.