Andrew Sorkin - Too Big to Fail - The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

However much these concerns preoccupied Paulson, he kept them to himself; he never discussed business with Wendy. The topic of Lehman was off-limits within the family for another reason: Hank’s younger brother, Richard Paulson, worked as a fixed-income salesman in Lehman’s Chicago office. They purposely avoided discussing the matter whenever they spoke, but he knew that if Lehman were to fail, his brother could lose his job.

Paulson was also grappling with another potential setback: He might be losing his deputy, Bob Steel, who was on the short list to run Wachovia, the giant Charlotte-based bank that had just ousted its CEO after reporting a $708 million loss tied to the housing market. Paulson and Steel had talked about the prospect in June, when things were calmer, and Paulson had even encouraged him to pursue the position. But now it looked as if it was actually going to happen, leaving Paulson with a big hole to fill. The timing could not have been worse: Steel’s jurisdiction included Fannie Mae and Freddie Mac—the government-sponsored enterprises (GSE) that had been the engine of the real estate boom and were now coming undone.

By the time Paulson had flown back home on a private chartered jet to Dulles Airport on Monday afternoon, his worst fears were being realized. The financial markets were in a meltdown, but for reasons Paulson could not quite put his finger on. Freddie tumbled as much as 30 percent on Monday, before recovering to end down 17.9 percent. Fannie shares slid 16.2 percent, to their lowest level since 1992. Other financial stocks were suffering as well; Lehman shares closed down more than 8 percent. As he tried to absorb all that, Steel announced that he had gotten the job, and it would be announced publicly on Tuesday.

At home that night in his living room, Paulson paged through the piles of faxes that had been sent to him by his assistant at Treasury. One of them was the report that had set off the panic: Bruce Harting, an analyst at Lehman Brothers, wrote that revised accounting rules might require Fannie and Freddie to raise an additional $75 billion in combined new capital. The report revived all the fears about the two mortgage giants, reminding investors of how thin a cushion they had if the housing slump deepened. If confidence was eroding in the government-sponsored enterprises—businesses that the market believed had the implicit backing of taxpayers—the entire U.S. economy could be threatened.

Paulson could see that unease about Fannie and Freddie was growing. On CNBC’s Squawk Box that Tuesday morning, James B. Lockhart III, chairman of the Office of Federal Housing Enterprise Oversight, which regulated Fannie and Freddie, tried to calm the markets: “Both of these companies are adequately capitalized,” he said. “Both of these companies are managing through these issues and have tested management teams.”

Paulson had a one-word judgment of that assessment that he later shared with his staff: “Bullshit.”

For months Paulson and his team had been discussing ways to unwind Fannie and Freddie should a real crisis hit—he considered their situation far more important to the long-term health of the economy than Lehman’s or the other investment banks’. But he knew it was all too easy to get bogged down in the political fighting over the controversial companies that had made home ownership a near right during the boom. With its critics insisting that Fannie and Freddie were neck-deep in the subprime mess, Paulson had a year earlier called the debate over Fannie and Freddie “the closest thing I’ve seen to a holy war.”

While shares of the companies recovered on Tuesday from the Monday sell-off, both were still trading below $20, and there were other indications of nervousness. Credit default swaps on the debt sold by Fannie and Freddie—essentially, insurance—were trading at levels reserved for companies with credit ratings five levels below their own triple-A ratings, the highest a company could have. Those ratings were, in fact, more a reflection of the government’s implicit backing than the companies’ own fundamentals.

As Paulson and his staff prepared for a congressional hearing two days hence to discuss the fates of Fannie and Freddie, Steel stuck his head into the conference room next to his office.

“Okay, Hank. I’m taking off.”

Paulson glanced up for a moment. “Okay, Bob. I’ll see you later.”

“No, no,” said Steel. “I mean, this is it. I’m leaving .”

Finally realizing that Steel was bidding his farewells to the staff, Paulson got up to see his deputy off.

As they walked down the hall, Paulson joked, “You’re getting out just in time.”

Virtually from the moment that Congress created Fannie Mae (originally the Federal National Mortgage Association) in 1938, it was politically divisive. A product of the housing slump of the Great Depression and Franklin Delano Roosevelt’s New Deal, the company was formed to buy loans from banks, savings banks, and other lenders in order to promote home lending by reducing lenders’ risk and to increase the amount of capital available for housing. Republicans saw Fannie as a mere sinecure for their political opponents. In 1968, with a federal budget burdened by the costs of both the Vietnam War and the Great Society, Lyndon Johnson began the process of privatizing Fannie. As a sop to its critics, a rival company, the Federal Home Loan Mortgage Corporation, or Freddie Mac, was created in 1970.

Fannie and Freddie played the political game even more fiercely than their opponents, spending millions of dollars on armies of lobbyists on Capitol Hill. Each company was a revolving door for the powerful in Washington—both Republican and Democrat. Newt Gingrich and Ralph Reed, among others, worked as consultants for Fannie or Freddie; Rahm Emanuel was a board member of Freddie.

By the 1990s, Fannie’s chief executive could boast, without much exaggeration, that “we are the equivalent of a Federal Reserve system for housing.” At their pinnacle the two mortgage giants—neither of them an originator of loans—owned or guaranteed some 55 percent of the $11 trillion U.S. mortgage market. Beginning in the 1980s, the two companies also became important conduits for the business of mortgage-backed securities. Wall Street loved the fees it collected from securitizing all kinds of debt, from car loans to credit card receivables, and Fannie’s and Freddie’s portfolios of mortgages were the biggest honeypot around.

But in 1999, under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages. The move was presented in the press as a way to put homes within the reach of countless Americans, but providing loans to people who wouldn’t ordinarily qualify for them was an inherently risky business, as telegraphed by the New York Times the day the program was announced:

“In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”

The success of the two companies in both the financial and political arena inevitably fostered a culture of arrogance. “[We] always won, we took no prisoners and we faced little organized political opposition,” Daniel Mudd, then the president of Fannie Mae, wrote in a 2004 memo to his boss. That overconfidence led both companies eventually to move into derivatives and to employ aggressive accounting measures. They were later found by regulators to have manipulated their earnings, and both were forced to restate years of results. The CEOs of both companies were ousted.