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

I had hoped to get the last tranche for emergencies, and to have it in place for the new administration, but Joel Kaplan, Dan Meyer, and Ed Gillespie believed that we would have to clearly demonstrate a need for the money to persuade Congress to give it to us. Dropping the asset-buying plan would undermine our credibility, and I was beginning to understand that unless I faced an emergency, I might never be able to get the rest of the TARP money without the full support of the president-elect. I realized we needed to rethink our approach. At the same time, I decided to keep Neel working on options for asset purchases for the time being, because I knew that giving up on it would shock the market and subject us to a great deal of criticism.

I stewed over these issues all evening, through a dinner at the Brazilian ambassador’s residence and into the night. I saw no way around the political obstacles, but I dreaded being caught without money if another crisis arose. I tossed and turned a lot that night, thinking of the stricken look on Ed Gillespie’s face after I said I was dropping the plan to buy assets.

Despite the rain that covered the city, Washington thrummed with excitement on Election Day. Every election riveted the nation’s capital, of course, but this one carried particular historic resonance for the city’s African American majority. I had already voted by absentee ballot, so I went straight to my office. At 8:00 a.m. I called Joel Kaplan at the White House.

“I’ve been thinking about it,” I said, “and I don’t think we should try to take down the second half of TARP.”

Joel was hugely relieved, as was my team, who feared I was leading them into the second Battle of Little Big Horn. The president and vice president were also relieved when I met with them later that day in the Oval Office. I was convinced I had made the right decision, but I also knew that we had only a thin cushion to carry us through the long transition period leading up to January 20.

On Tuesday the Dow saw its biggest presidential Election Day rally ever, jumping 305 points, or 3.3 percent, to 9,625. The London interbank rate fell to its lowest level since November 2004. Market watchers credited the optimism to speculation that the government might extend its capital program to nonbank financial companies like GE.

Wendy stayed up to watch the election results, but I went to bed early. Obama was ahead, and I figured the election was a foregone conclusion. After the Democratic candidate was declared the winner at 11:00 p.m., Wendy woke me up to tell me the historic news. I went back to sleep comforted by the knowledge that our president-elect fully understood the threat our economy still faced. I was also relieved that the election was over and that I would no longer have to worry that our actions might become campaign issues. Now I would need to talk with the transition team to find out how they wanted to work with us.

In the meantime, Treasury still had plenty of business to take care of. On November 5, the day after the election, Jim Lambright and I sat down in the Oval Office with President Bush, Vice President Cheney, and Keith Hennessey. It was five days before AIG would release its third-quarter earnings.

Jim carefully explained the situation. AIG’s problems had been exacerbated by the crumbling financial markets; since the deal had been made, the global insurance business had slumped. Now the company’s credit default swaps had neared 2,400 basis points. That meant that it cost almost $24 to insure $100 of AIG credit—an extraordinarily high amount.

The market could see that AIG’s capital structure was unsustainable. The Federal Reserve’s loan had saved it, but the company still had too much debt. The loan’s high cost strained interest coverage, and its short, two-year duration created pressure to sell assets quickly in a soft market. Meantime, the company was still weighed down by substantial market and credit risks from its holdings of residential mortgage-backed securities and the credit default swaps it had written on residential MBS. It had even used its securities lending program to purchase residential MBS.

It turned out AIG’s third-quarter losses were going to be $24.5 billion pretax—even worse than we had expected. We needed to act quickly to inject $40 billion of TARP capital into AIG to avoid a rating downgrade that would trigger $42 billion in collateral calls and finish the company off.

The Fed’s restructuring plan would shift AIG’s worst mortgage-related assets and credit default swaps into two new Fed vehicles, called Maiden Lane II and Maiden Lane III, which together would hold $52.5 billion. That way any collateral calls triggered by a future downgrade would hurt the company less. More than 20 subsidiaries would be sold; AIG would become a much smaller, more narrowly focused property/casualty insurer.

Under the New York Fed’s plan, Treasury’s $40 billion would purchase senior preferred shares in AIG; in return we would receive a 10 percent dividend and warrants for 2 percent of the company’s shares. The Fed would scrap the $85 billion two-year loan, substituting a five-year $60 billion loan and cutting the interest rate from 8.5 to 3.0 percentage points over LIBOR. Under the New York Fed’s creative restructuring, the $150 billion deal would not increase the government’s 79.9 percent stake.

President Bush, frustrated with both the incompetence of the company’s prior management and the rating agencies that had failed to catch AIG’s problems earlier, once more found himself in the position of supporting a philosophically unpalatable bailout for reasons of necessity. After Jim had laid out the revised rescue plan, the president asked him, “Are you asking me or telling me this is going to happen?”

New to his job, Jim looked to me to answer.

“I’m telling you this is going to happen, Mr. President,” I said.

“Will we ever get the money back?”

This time Jim responded. “I don’t know, sir.”

“We need to be very clear that we’re doing this because it’s a systemically important company and we need to keep it from failing,” the president said.

President Bush’s anger quickly echoed across the country when taxpayers learned the government was revamping its September bailout plan and giving AIG easier loan terms along with much-needed capital. To the public, AIG symbolized everything that had gone wrong with the system—incompetence rewarded with big bonuses and lavish spending. While I shared their disgust, I told the president that AIG’s new CEO, Ed Liddy, was working his tail off for a salary of one dollar a year. But like the president, I understood that we had to hold our noses and save the company in order to protect the frail financial system.

The jittery markets didn’t maintain their elation about Obama’s triumph for long. Wednesday was another wild ride, with the Dow dropping 486 points, or 5 percent, to 9,139—the worst plunge on record for the day after a presidential election. Bank stocks were hard-hit, and though no institution appeared to be in immediate danger, Citigroup fell 14 percent to $12.63.

As we worked to bolster the banks, commercial real estate became a growing source of concern. I got a glimpse of just how bad the situation was when Wendy and I had dinner on November 8 with our friends New York Times columnist Thomas Friedman and his wife, Ann. Her father, Matthew Bucksbaum, had co-founded General Growth Properties in Des Moines with his brother Martin in 1954. The company was the second-largest mall operator in the U.S., but its stock had been tanking and I knew that it was struggling to avoid bankruptcy.

Ann was stoical, and we didn’t talk much about the situation that evening. But it seemed that everywhere I went, I encountered another grim reminder of the pain this crisis was inflicting on our nation and of how much we needed to repair our markets—not for the banks, but for Americans who depended on companies like General Growth for their livelihood.