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

With the G-7 coming to town, Ben Bernanke and I knew we would be very busy all weekend, so we moved our Friday breakfast ahead a day. In the small conference room off my office, we grimly reviewed the dire situation in the U.S. and the need to move quickly. We agreed that we needed to outline a bold, credible plan to restore market confidence.

I briefed Ben on Treasury’s progress with the capital program and guarantees. He filled me in on the Fed’s progress in fashioning a more expansive commercial paper funding facility that would be available to all highly rated issuers, including industrial companies. Days earlier, Ben had suggested using TARP money, but I had declined. I hadn’t wanted the revamped commercial paper facility to be TARP’s first program, and we needed to save the funds, not use them for programs the Fed could fund itself. But Ben’s idea had set me thinking, and I had asked Steve Shafran to work on a facility for the frozen consumer loan market using a structure similar to what Ben had suggested, a facility in which TARP would bear the risk of the first losses.

During our quick meal, we previewed the G-7 meeting, and Ben gave me a thoughtful memo listing nine specific actions we could take to support our critical institutions. The ideas Ben suggested had already been under discussion or were in earlier drafts of our planned G-7 communiqué. This didn’t surprise me given how closely Treasury and the Fed had been working together on these issues—including the previous weekend when we were drafting the PWG statement.

I thanked him and after breakfast asked Dave McCormick to see if he could use any of Ben’s words in the draft communiqué for the G-7 meeting. He incorporated Ben’s ideas into the appendix, which we titled “The Action Plan.”

That morning I met in my small conference room with Mervyn Davies, chairman of Standard Chartered Bank. He proudly told me that Standard Chartered would not participate in the U.K. plan. It did not need government capital, he said.

Afterward he took me aside and asked in a low voice about Citigroup and GE. “Are either of those two going down?” he asked. “What we hear isn’t good.”

This jolted me. Obviously Citi had problems, but this was the first time I’d heard the chairman of another major bank speculate that it might fail. And even though I’d had concerns about GE, I had assumed that with the Fed now buying commercial paper, the company would weather the crisis. I had a high regard for Mervyn; I trusted his judgment and greatly appreciated his candor. It also occurred to me that he might be viewing GE as a concerned counterparty.

That day Treasury was consumed with preparations for the G-7 meeting starting the next afternoon. Dave McCormick headed the effort, and in a stroke of diplomatic inspiration, he suggested that I invite Sheila Bair to the group’s Friday dinner, where we would be discussing the Swedish and Japanese experience in dealing with massive bank failures. I called her that morning and told her how important the G-7 was going to be: the Europeans needed reassurance about the U.S. government’s commitment to our important financial institutions. I asked if she would give a presentation to all the assembled central bankers and finance ministers, take them through the FDIC’s powers, and explain how she had used these to solve the Wachovia crisis. She readily agreed.

At noon Dan Jester and David Nason came to my office to review their progress on the capital program to help domestic financial institutions. They took several of us through their proposed term sheet, soliciting my decisions on a few sticky issues. They had chosen to abandon the idea of the government’s matching the capital raising of the banks, and I agreed. Matching made great political sense, but the market was effectively closed for bank equity offerings, and there was no point in trying something the market would not accept. I also approved their recommendation that we take preferred stock to balance the sometimes inconsistent goals of stabilizing the system while protecting the taxpayer: banks would get needed capital without raising the specter of nationalization.

We also debated limits on executive compensation. I agreed with my political advisers—Michele Davis, Kevin Fromer, and Bob Hoyt—that TARP’s most stringent restrictions should apply. This meant, for example, that rather than just eliminating golden parachutes in the new contracts of certain executive officers, the top officers of banks accepting capital would have to forgo any such payments in existing contracts as well; they would also have to provide for clawbacks of pay if financial statements were found to be materially inaccurate.

There were a few outstanding issues. We needed to get bank regulators to sign off on the treatment of the capital for regulatory purposes, and I also wanted to nail down a pricing mechanism that would ensure widespread participation while keeping the program voluntary. But overall I felt confident we finally had the framework for a workable approach.

In any case, we needed to get a capital program together immediately to help the financial system. The short sellers had wasted little time justifying John Mack’s worries, returning to the market on Thursday to drive shares of both Morgan Stanley and Merrill Lynch down 26 percent. Morgan Stanley’s CDS still hovered around 1,100 basis points.

The bad news continued to pour in from around the world. By Thursday morning, Iceland had shuttered its stock market and seized the country’s biggest bank, Kaupthing. The two next-biggest banks were also now under government control. LIBOR-OIS spreads had ballooned to a new record of 354 basis points.

I had a very long, difficult call with the president that afternoon, partly to discuss his role in the G-7 and G-20 meetings that weekend. He was looking for any ray of hope on the financial front. He had done everything that I had recommended, including politically unpopular actions that went against Republican principles, and here we were, worse off than ever. He pressed me about the capital program and asked, “Is this what it’s going to take to end this thing?”

“I don’t know, sir,” I admitted, “but I hope it’s the dynamite we’ve been looking for.”

I felt unhappy that nearly a week after TARP’s passage, I still had mostly bad news to deliver. Europe had big problems; seven countries had already had to rescue banks. I continued to be concerned about Citigroup, GE, and, most of all, Morgan Stanley, with the Mitsubishi UFJ deal still in question. Even though President Bush always encouraged me to be candid, this was a low moment for me. Later that day Josh Bolten called to empathize, and to reiterate the president’s support.

“I just wonder, Hank, why, after all the steps we’ve taken to stabilize the market, are the markets not responding?”

“Josh, I wonder exactly the same thing,” I said.

Late in the day Citigroup dropped its bid for Wachovia, saying it would not block a merger with Wells Fargo (though its $60 billion lawsuit would continue). On the surface this provided a shred of good news, but after my conversation with Mervyn Davies I had to wonder what would happen to Citi now that its problems were harshly illuminated.

As the demands of the crisis grew, I had made Dave McCormick, the undersecretary of international affairs, my point man on Morgan Stanley. Though only in his early 40s, Dave was a seasoned manager and great communicator, able to work with finance ministers as well as their deputies.

First thing Friday morning, I went to Dave’s office. “We are really going to have to get something done with Morgan Stanley,” I told him.