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

By late October, AIG was in dreadful shape, partly because of deteriorating conditions in the insurance business and partly because of its leveraged capital structure. The financial mess inherited by AIG’s new CEO, Ed Liddy, had turned out to be even worse than the Fed had expected. And the Fed’s $85 billion loan, with its high interest rate of LIBOR plus 8.5 percent, had imposed a heavy financial burden on a badly wounded company. But those terms, while intended to protect the taxpayer, were undermining the government’s investment. At the time of its rescue in September, we had not had the authority to put equity capital into AIG. Now we did. With the company expecting to announce a whopping loss on November 10, it would go down without a capital investment and a new financial plan in place.

Treasury needed to establish new TARP guidelines for an investment in a failing company, including stricter executive compensation guidelines than those in force for capital investments for healthy institutions. The Fed and its adviser, Morgan Stanley, also worked with AIG and its rating agencies to avoid a downgrade that would lead to crippling collateral calls.

Meantime, the automakers continued to struggle. The White House’s hopes of redirecting the $25 billion in low-interest fuel-efficiency loans to bail out the companies had hit a wall. It couldn’t legally be done unless Congress changed the language of its legislation, but Nancy Pelosi refused. She was unwilling to change the bill’s environmental focus. Instead, she insisted that I had the authority to use TARP funds to rescue the car companies, which had been pleading their case in Washington with some success.

On October 27, Moody’s downgraded the credit rating on GM’s and Chrysler’s debt, and the Dow fell 203 points to close at 8,176. The VIX, the Chicago Board Options Exchange’s volatility index, posted its second straight record day.

One day later, however, the Dow shot up 889 points, to 9,065, with nearly half the gain coming in the last hour of trading. Some analysts credited bargain hunting, while others attributed the rise to increased confidence resulting from Treasury and Fed actions. Though delighted to see the jump in share prices, I cautioned everyone not to overreact to one or two days in the market.

The imminent election contributed to the volatility in the markets. Obama had pulled well ahead of McCain, and although the Democratic candidate and I had enjoyed a frank, respectful relationship, he had begun to make pronouncements that distressed me, hitting hard on the issue of bank lending. I was concerned that McCain would pile on, making our efforts to get capital out to the banks even more difficult. On Tuesday evening, October 28, I called Rahm Emanuel to talk about it. I knew that Rahm was close to Obama and, as a former investment banker, understood the intersection of politics and markets as well as anyone. I also believed he was likely to hold a prominent position in the next administration.

“You should call Barack and deal with him directly,” Rahm said. “He likes you.”

That evening, Obama and I had an extensive conversation.

“Everyone is talking about making the banks lend more, but ‘more’ than what?” I asked. “I expect them to lend more than they would have without the program, but the government should not make lending decisions.”

“I recognize that this is not a simple issue, but the banks need to understand their responsibilities,” Obama replied, adding that compensation was even more explosive politically. He agreed to tone down his rhetoric but warned me that I should also be talking to McCain: if the Republican candidate jumped on either the lending or compensation issue, Obama would have to do likewise.

On October 30, I took the opportunity to deliver a pep talk to my staff, just before we began a lengthy strategy session in which I would lay out the assignments for the next few days. “I am so proud of this team, and all you have done in such a short amount of time,” I said. “I know you’re tired.”

But the capital purchase program had to be flawlessly executed, so I went on: “If you have family obligations, forget them. I’ll help you get jobs, I’ll kiss you on all four cheeks, but we’ve got one more big push before Thanksgiving.”

They burst out laughing—they had such extraordinary dedication and camaraderie. And of course everyone already expected that they were going to be on the job all weekend. That’s what we did. I had to fly to Chicago with Wendy to babysit our granddaughter—but I, too, knew that I would spend most of the weekend working.

Saturday, in fact, found me talking on my cell phone with Ben about foreclosure relief. He knew that the White House had never seen a mortgage mitigation plan that it favored, but like me, he believed that devising one would be critical to getting congressional approval to release the final tranche of TARP.

“The Fed will support you, if it’s one that makes sense,” Ben said.

I returned on Sunday evening and went directly to a meeting at Treasury where we once again discussed taking down the remaining $350 billion of TARP. To do so, we would need to explain how the funds would be used. After yet another discussion of potential strategies, I reluctantly concluded that a direct purchase program for illiquid assets was not a good use of our limited TARP dollars. The markets were getting worse, and every program I looked at either took too much time to implement or would not be big enough to make a difference. Capital investments were more powerful, and we had decided to reserve $150 billion for future bank capital programs and to set aside funds to expand beyond banks to insurance companies. To make this work politically, we would need to deal with foreclosures.

The next afternoon, at a meeting in the Roosevelt Room with a large group of senior White House staff and economic advisers, I decided to address the controversial mortgage relief issue directly. I said I didn’t think we should spend time debating the pros and cons of the issue.

“I know many of you strongly oppose government spending for foreclosures, and I can’t find a program that isn’t flawed,” I told them. “I’m just going to make the assertion that we need the second half of TARP, and we can’t get it without foreclosure relief.”

If we agreed on that, I said, I would go to the president and tell him that foreclosure relief was a political reality. I also dropped a bomb when I informed them we had decided against buying illiquid assets.

The White House staff didn’t argue with me, but I could see they were taken aback. Although they understood my reasoning, they knew that dropping the asset purchases would create a political and communications problem. Neither did they disagree with the need for the last tranche, but they pointed out the political difficulty of going to Congress to ask for the money without the asset-purchase plan in place.

I explained that we did have a purchase plan in mind, though not for toxic mortgages. I outlined the work Steve Shafran had been doing with the Fed to use TARP money to unlock the consumer credit markets, explaining how the new Fed lending facility would essentially guarantee a minimum price for asset-backed securities.

As soon as the questions about securitization started, I realized what we were up against. Ed Gillespie, who as counselor to the president oversaw communications, was a smart guy, and he asked very basic questions to help him figure out how to sell the program as a good use of TARP. He was echoed by Dan Meyer, the president’s assistant for legislative affairs.

“Hank, explain to me again this TALF securitization plan and why government intervention is necessary,” Ed said.

This wasn’t an encouraging sign. If these wise White House insiders had a hard time grasping the proposed program, how would lawmakers and the public get it? Even more important, would they understand and accept the surprise move away from buying illiquid assets?