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

Then French president Nicolas Sarkozy made an impromptu call to President Bush requesting a meeting, along with European Commission president José Manuel Barroso, after the October 17 European Union–Canada Summit in Quebec City. Sarkozy and U.K. prime minister Gordon Brown had been sparring over which of them would lead reform efforts in Europe. Brown envisioned a new Bretton Woods–style gathering to overhaul the world economic order set in place during World War II. Sarkozy, who held the presidency of the European Union, had called for replacing the failed “Anglo-Saxon” model of free markets and advocated a major summit in New York, which he considered the epicenter of the problem.

The White House suspected that Sarkozy was looking to pull off a publicity coup on our home turf. President Bush invited him to a sit-down at Camp David, where a meeting could be better shielded from the media glare. The two agreed to get together on Saturday, October 18. French finance minister Christine Lagarde and I would join them, along with Secretary of State Condi Rice, who canceled a trip to the Middle East to attend.

On Friday afternoon, Wendy and I left by helicopter from the South Lawn of the White House, with the president and Laura Bush, Condi, and Steve Hadley and his wife, Anne. Marine One carried us over the Washington Monument and off to Camp David in half an hour. At about 4:00 p.m. Saturday, Sarkozy, Barroso, and Lagarde arrived. Thirty minutes later we were sitting down in the main lodge, Laurel, in the same homey wood-paneled conference room where I had made my first official presentation to the president back in 2006. While we met, Wendy took the opportunity to go looking for warblers.

Inside, Sarkozy was singing a sweet song of his own. Lively and articulate, the French leader used every bit of charm at his disposal to try to persuade President Bush to agree to a summit in New York on the order of the G-8, reasoning that the small group’s shared values would make it easier to agree on a plan.

Selling hard, Sarkozy said that hosting the summit would demonstrate President Bush’s leadership. The president agreed on the need for a meeting but insisted on a more inclusive group, such as the G-20, which included China and India. He wanted to focus on broad principles and a blueprint for regulatory and institutional reform. By contrast, Sarkozy was looking to put his stamp on a host of specific topics like mark-to-market accounting and the role of the rating agencies.

“That is not for us,” President Bush said. “We’re going to have our experts do that.”

The French leader came right back at him. “These experts are the ones that got us in trouble in the first place,” Sarkozy said, looking directly at me. He would later suggest that finance ministers shouldn’t even be in the room at the summit.

Sarkozy dominated the hour-long meeting in Laurel, but he must have left frustrated. He’d won agreement on a meeting—which we had already decided to hold—but little beyond that. In the end, President Bush, Sarkozy, and Barroso released a joint statement that said the U.S., France, and the European Union would reach out to other world leaders to hold an economic summit shortly after the U.S. elections.

As preparations for the summit got under way, the Europeans, with the exception of Gordon Brown, resisted meeting with the entire G-20. As a concession, President Bush agreed that Spain and the Netherlands—which were not members of the G-8 or G-20—could attend the gathering of the bigger group as guests of the EU presidency. Chinese president Hu Jintao was the first world leader to sign on. The Saudis expressed their reluctance, worried that they would be blamed for high oil prices, and pressed to make a big financial contribution to a fund for poorer countries, but I called Finance Minister Ibrahim al-Assaf and reassured him. On Wednesday, October 22, the White House was able to announce that President Bush had invited the leaders of the G-20, representing some 85 percent of the world’s GDP, to a November 15 summit in Washington to discuss the crisis.

That day brought other, much less welcome news when Tim Geithner told me that AIG would need a massive equity investment. I was shocked and dismayed. On September 16 the New York Fed had loaned the company $85 billion; then in early October it had extended an additional $37.8 billion. Now, Tim said, the company would soon report a dreadful quarterly loss, which would trigger rating downgrades; the resulting collateral calls would be disastrous. Initially, AIG had confronted a liquidity crisis; now it faced a severe capital problem. Tim believed the only solution was an injection of TARP funds.

AIG was systemically important and could not be allowed to fail, but I was distressed at the prospect of using TARP money. Not only would this drain our limited funds, reducing our capacity going forward, but the insurer was so obviously unhealthy—and politically tarnished—that it would enflame public resentment of bailouts and make it harder to get Congress to release the final $350 billion of TARP when we needed it. Furthermore, the taxpayers might never get their money back from a capital injection in AIG.

With the November elections just a couple of weeks away, foreclosure relief was another hot-button issue. Housing advocates complained that the government wasn’t doing enough, but much of the public strongly opposed bailing out people who had run into trouble on their mortgages. Some of the hardest-hit states happened to be key battlegrounds in the presidential election: Florida, Nevada, Ohio, and Arizona.

I soon found myself at odds with Sheila Bair, even though I admired her energy and her efforts to deal with problem mortgages. Following IndyMac’s July failure, the FDIC, working off the principles for a fast-track systemic approach pioneered by Treasury’s HOPE Now program, developed an innovative plan in which the thrift’s loans were modified to cap monthly mortgage payments. Initially the limit was set at 38 percent of pretax income. (Subsequently it was cut to as low as 31 percent.) To make this work, banks could either lower interest rates or extend the life of loans. The FDIC applied the so-called IndyMac Protocol to every failed bank or thrift that it took control of.

But Sheila wanted to dramatically broaden the scope of the relief efforts. She had called me at Camp David before Sarkozy’s visit to argue that language in the TARP legislation gave Treasury the authority to guarantee mortgages the government didn’t own to prevent foreclosures—and that the cost of doing so didn’t have to come out of TARP funds. Nor was there a limit on the funds the government could use.

It was the first I’d heard of this argument, and I strongly disagreed, questioning its legal validity. I could only imagine the public outrage if we declared that Treasury’s authorities included the power to insure mortgage modifications to the extent we deemed appropriate! But I told Sheila I would study her plan.

Sheila was very effective at taking an idea, simplifying it to make it broadly understandable and appealing, and then driving hard through any objections that stood in the way. Her plan would give an incentive to lenders to modify loans by offering downside protection when they agreed to use the IndyMac Protocol. If a loan modified under her program went into default and foreclosure, the government would cover half of the loss suffered by the lender. Eventually, she would propose using some of TARP’s $700 billion to fund that guarantee.

Sheila’s plan would soon put us on the spot. On October 23, the Senate Banking Committee held a hearing to examine the government’s regulatory response to the financial crisis. Shortly before the session, Chris Dodd called me to advocate Sheila’s foreclosure relief proposal. I assumed she had been talking to him. I said it was promising but that it raised serious questions, some of them legal.