On the Brink (18 page)

“We should and can have a structure that is designed for the world we live in, one that is more flexible, one that can better adapt to change, one that will allow us to more effectively deal with inevitable market disruptions, and one that will better protect investors and consumers,” I said.

Long-term, we proposed creating three new regulators. One, a business conduct regulator, would focus solely on consumer protection. A second, “prudential” regulator would oversee the safety and soundness of financial firms operating with explicit government guarantees or support, such as banks, which offer deposit insurance; for this role we envisioned an expanded Office of the Comptroller of the Currency. The third regulator would be given broad powers and authorities to deal with any situation that posed a threat to our financial stability. The Federal Reserve could eventually serve as this macrostability regulator.

Until this ultimate structure was in place, the Blueprint recommended significant shorter-term steps that included merging the Securities and Exchange Commission with the Commodity Futures Trading Commission; eliminating the federal thrift charter and combining the Office of Thrift Supervision with the Office of the Comptroller of the Currency; creating stricter uniform standards for mortgage lenders; enhancing oversight of payment and settlement systems; and regulating insurance at the federal level.

Though our team worked closely with other agencies in crafting the Blueprint, we had run into some disagreements with the Federal Reserve. It wanted to retain its role as a bank regulator, particularly its umbrella supervision over bank holding companies; without this it felt it couldn’t effectively oversee systemically important firms. We saw no reason to highlight our differences. We all agreed that it would not be wise for the Fed to relinquish these responsibilities in the short run because it was the bank regulator with the most credibility—and resources. Ben Bernanke supported the Fed’s taking on the new macro responsibilities from the beginning. But he and Tim Geithner wanted to be sure, and rightly so, that we gave the Fed the necessary authorities and access to information to do the thankless job of super-regulator. (I was pleased to see that the Obama administration, in its program of reforms, echoed the Blueprint’s call for a macrostability regulator.)

The Blueprint did not focus much on government-sponsored enterprises like Fannie Mae and Freddie Mac. We did note that a separate regulator for the GSEs should be considered, and we also recommended that they fall under the purview of the Fed as market stability overseer.

Meantime, I was determined to push forward on the reform of the two mortgage giants. As credit dried up, their combined share of new mortgage activity had grown from 46 percent before the crisis to 76 percent. We needed them to provide low-cost mortgage funds to support the housing market. Hence the importance of their March 19 announcement that they would be making up to $200 billion in new funds available to the markets, in conjunction with planned new capital raising.

By April it was clear that the downturn would be long, and not just in the U.S.—mortgage activity in the U.K., for example, had ground to a near halt. Oil prices continued to rise, the dollar stumbled, and the press was filled with stories of food shortages, and riots, in several countries.

I traveled to Beijing to meet with Wang Qishan, who had replaced Wu Yi as vice premier, to set the table for the next round of the Strategic Economic Dialogue. I had known and worked with Wang, whom I considered a trusted friend, for 15 years. A former mayor of Beijing, with an appetite for bold action and a sly sense of humor, he had guided his country out of the SARS crisis and led the preparation for the 2008 Olympic Games. Though we spent considerable time discussing the vital issues of rising energy prices and the environment, which were to be the focus of our upcoming June meeting, Wang was most interested in the problems in the U.S. capital markets. I was candid about our difficulties but mindful that China was one of the top holders of U.S. debt, including hundreds of billions of GSE debt. I stressed that we understood our responsibilities.

In truth, U.S. markets were weakening again. Banks continued their efforts to raise capital, even as they suffered more big losses. On April 8, Washington Mutual said it would raise $7 billion to cover subprime losses, including a $2 billion infusion from the Texas private-equity group TPG. On April 14, Wachovia Corporation announced plans to raise $7 billion. Merrill Lynch reported first-quarter losses of $1.96 billion on $4.5 billion in write-downs, mostly from subprime mortgages, while Citigroup recorded a $5.1 billion loss, owing to a $12 billion write-down on subprime mortgage loans and other risky assets.

A somber mood prevailed when the G-7 held its ministerial meeting in Washington on April 11. That day, the Dow plunged 257 points, after General Electric’s first-quarter earnings came in lower than expected. Talk of oil prices, which were topping $110 a barrel on their way to a July high of nearly $150, dominated the meeting, but the state of the capital markets was very much on the ministers’ minds.

There was a great deal of discussion about mark-to-market, or fair-value accounting. European bankers, led by Deutsche Bank CEO Joe Ackermann, had cited this as a major source of their problems, and a number of my counterparts were understandably looking for a quick fix. Many favored a more flexible approach, but I staunchly defended fair-value accounting, in which assets and liabilities are recorded on balance sheets at current-market prices rather than at their historical values. I maintained that it was better to confront your problems head-on and know where you stood. Frankly, I believed the European banks had been slower than our own to confront their problems partly because of these differences in accounting practices. But I sensed that my European colleagues were increasingly aware of the seriousness of the banking problem.

The G-7 meeting featured an “outreach dinner” in the Treasury’s Cash Room for financial CEOs. Most of the major institutions were represented: the guest list included John Mack of Morgan Stanley, John Thain of Merrill Lynch, Dick Fuld, Citigroup chairman Win Bischoff, JPMorgan CEO Jamie Dimon, and Deutsche’s Ackermann.

The mood was dark. A few of the bankers thought we were nearing the end of the crisis, but most thought it would get worse. I went around the table and called on people, asking how we had gotten to where we were.

“Greed, leverage, and lax investor standards,” I remember John Mack saying. “We took conditions for granted, and we as an industry lost discipline.”

“Investment managers now know what we don’t know,” noted Herb Allison, the TIAA-CREF CEO, in what was his last day on the job. “We used to think we knew a lot more about these assets, but we’ve been burned, and until we see large-scale transparency in assets, we’re not going to buy.”

Mervyn King, governor of the Bank of England, took a look at the big picture, questioning whether we had allowed the financial sector to become too big a part of our economies.

“You are all bright people, but you failed. Risk management is hard,” he said to the assembly. “So the lesson is, we can’t let you get as big as you were and do the damage that you’ve done or get as complex as you were—because you can’t manage the risk element.”

The bankers complained bitterly about hedge funds, which they felt were shorting their stocks and manipulating credit default swaps and, in the CEOs’ minds, all but trying to force some institutions under. Almost every one of them wanted to regulate the funds, and no one wanted that more than Dick Fuld, whose face reddened with anger as he asserted, “These guys are killing us.”

As we left the dinner, Dave McCormick, who served as the main liaison to the G-7 and other countries’ finance ministries, told me, “Dick Fuld is really worked up.”

I told Dave I wasn’t surprised. Lehman was in a precarious position. “If they fail, we are all in deep trouble,” I said. “Maybe we can figure out how to sell them.”

Congress had recessed for two weeks in the second half of March, and lawmakers got an earful from constituents who were worried about the ongoing housing woes and the weakening economy—and were in some cases resentful about what they perceived as the government bailout of Wall Street. The House and the Senate pushed ahead with housing legislation, which included a constellation of plans for foreclosure mitigation, affordable housing, and bankruptcy relief. Democrats, led by Chris Dodd and Barney Frank, pushed HOPE for Homeowners, a Federal Housing Administration program to provide guarantees to refinance mortgages for subprime borrowers at risk of losing their homes.

Republican lawmakers, particularly in the House, lambasted many of these proposals as bailouts of deadbeats and speculators. And the White House threatened a veto because of its displeasure with bankruptcy modifications of mortgages and a proposal to distribute $4 billion in Community Development Block Grants to state and local governments to buy foreclosed properties. I myself had real doubts about the efficacy of many of the proposals—we calculated that HOPE for Homeowners would aid 50,000 borrowers at most.

But GOP senators had returned from the spring recess more in a mood for compromise. On April 10 the Senate voted 84 to 12 in favor of a $24 billion bill of tax cuts and credits designed to boost the housing market.

On April 15, Bob Steel, Neel Kashkari, Treasury chief economist Phill Swagel, and I met with Ben Bernanke and some of his aides at the Fed to review a contingency plan that Neel and Phill had been working on for some time. Termed the “Break the Glass” Bank Recapitalization Plan, after the fire axes kept ready in glass cases until needed, the paper laid out the pros and cons of a series of options for dealing with the crisis.

Among its main options, the government would get permission from lawmakers to buy up to $500 billion in illiquid mortgage-backed securities from banks, freeing up their balance sheets and encouraging lending. Other moves included having the government guarantee or insure mortgage-backed assets to make them more appealing to investors, and having the FHA refinance individual mortgages on a massive scale. “Break the Glass” also laid out the possibility of taking equity stakes in banks to strengthen their capital bases—though not as a first resort.

“Break the Glass” was the intellectual forerunner of the Troubled Assets Relief Program (TARP) we would present to Congress in September. In April, however, the state of the markets was not yet so dire, nor was Congress anywhere near ready to consider granting us such powers.

Later that afternoon, the longtime block to GSE reform broke. At my urging, Chris Dodd had called a meeting with Richard Shelby and the chief executives of Fannie Mae and Freddie Mac. We gathered in Dodd’s offices at the Russell Senate Office Building, in a small room that was unusually warm and intimate for an office on the Hill. Wood-paneled, with red curtains and carpet, it was decorated with memorabilia from Dodd’s long political career, including photos of his father, Thomas J. Dodd, who had also served as a U.S. senator from Connecticut. It was a strangely homey setting for a meeting between some of the fiercest opponents on the GSE issue.

Although Dodd, like many leading Democrats, was sympathetic to Fannie and Freddie, Shelby had long wanted to put them under stricter supervision; in 2005 he had backed an unsuccessful bill that would have drastically reined in their portfolios.

Fannie’s chief, Dan Mudd, the son of famed CBS News correspondent Roger Mudd, had grown up in Washington and had spent much of his career working at GE Capital, the finance unit of GE. Unlike many who rode the Washington gravy train, he knew how to run a real business and had been recruited to clean up Fannie after the accounting scandal of 2004. Since then, he had built a strong, loyal team.

Freddie Mac’s CEO, Dick Syron, a former CEO of the Boston Fed and the American Stock Exchange, faced a more difficult situation. He had a problematic board, and I wasn’t convinced he could deliver on what he promised.

By the time we sat down together, it was clear that the two CEOs recognized that something needed to be done. But the key was Shelby, who had finally decided that it was time to act.

Before we went in, my legislative aide, Kevin Fromer, reminded me, “This is Dodd’s meeting, so let Dodd run it.” He knew I had a tendency to jump in and take over.

But after a few pleasantries, Dodd turned to me. I made clear that Fannie and Freddie were critically important to helping us get through this crisis; that we needed to restore confidence in them; that reform required a new, stronger regulator; and that it was crucial for them to raise capital. Mudd noted that Fannie planned to raise $6 billion; Syron was noncommittal.

We’d come with a list of crucial unresolved issues, and at Shelby’s prompting I asked David Nason to run through them. They concerned the new regulator’s increased jurisdiction over the portfolio, including the power to force divestitures, its ability to set and temporarily increase capital requirements without congressional approval, and its oversight of new GSE business activities. Other issues included increasing conforming loan limits for high-cost areas and setting up an affordable housing fund.

“Well,” Shelby said, “those are the key items.”

Shelby is a formidable talent, a crafty legislator, and an astute questioner. But, frankly, I never clicked with him. He was a true conservative. I don’t think he ever really trusted me, because I came from Wall Street, and he hated the Bear Stearns rescue. This was the rare time in the two and a half years I was in D.C. where I saw him do much more than sidestep an issue or point out the problems with someone else’s proposal.

But here Shelby took charge, and I saw the Alabama senator at his best.

“I liked our bill,” I remember him saying. “But I know I can’t get everything I want.”

Shelby was now ready to move. For him, the big issues were how to deal with the sizes of the portfolios and new product approval. Treasury cared mostly about systemic risk and safety and soundness matters, while Dodd—like Barney Frank—wanted bigger loan limits and an affordable housing fund.