On the Brink (9 page)

In the early days, with Condi watching out for me, I was fine. But when she wasn’t, problems sometimes arose. In 2007, President Bush hosted the nation’s governors at a conference in Washington at the White House. Condi was unavailable, so Wendy and I were supposed to sit beside George and Laura Bush during the after-dinner entertainment in the East Wing. We got to talking with California governor Arnold Schwarzenegger about environmental issues, and when the time came to sit down, Wendy and I took seats in the back of the room, leaving two empty chairs next to the president and First Lady. Finally, Bob Gates, the Defense secretary, moved over and took one of the vacant seats. Everybody was laughing, especially my Cabinet colleagues. As we walked out after the event, the president said to me, “Paulson, do you want to be a governor?”

But that wasn’t my worst faux pas. President Bush hated it when cell phones went off in meetings. In January 2007, I was in the Oval Office for a meeting with José Manuel Barroso, the president of the European Commission. As dictated by protocol, I sat on the couch to the left of the president, beside Condi. My phone, I thought, was turned off.

We were all listening intently as the two leaders engaged in a pleasant discussion, when my cell phone began to ring. I jumped like I’d been stabbed with a hot stick. I patted myself down, looking first in my suit coat where I always kept the phone, but I couldn’t find it. In my desperation I stood up and checked under the couch cushions in case it had fallen down there—no luck. It just kept ringing, while my mortification level rose. Finally, Condi figured out where it was. She pointed to my right pants pocket, and I turned it off as quickly as I could.

“Paulson,” the president ribbed me later, “that’s a three bagger: in the Oval Office; with a visiting head of state; and you couldn’t find it.” I never let it happen again.

I wish I could say that the offending phone call concerned a critical Treasury matter, but in fact it was from my son, who had called to talk about the Chicago Bulls.

No one has ever accused me of being too smooth. I come at people aggressively and tell them how I think a problem should be solved. I listen to anybody with a good idea, then I make sure that the best solution is adopted. While this approach worked well for me in business, I found that decision making is much more complex and difficult in Washington, particularly on Capitol Hill.

No matter what the problem, large or small, there is no such thing as a quick solution when you deal with Congress. Frankly, you cannot get important and difficult change unless there’s a crisis, and that makes heading off a crisis quite challenging.

Working effectively with lawmakers is a big part of the job of a Treasury secretary, and although I knew it would be frustrating, I underestimated just how frustrating it would be.

We had some early successes in the international arena, staving off potentially harmful anti-China protectionist legislation and getting a bill that clarified the process for foreign investment in the U.S. But we stalled on a number of domestic initiatives, including the administration’s attempts to reform Social Security and Medicare.

Fannie Mae and Freddie Mac, the mortgage giants, presented another difficult legislative challenge. When I first arrived in Washington, I was living out of my suitcase at the St. Regis Hotel at 16th and K Streets. Washington summers are hot and humid, but I enjoyed running around the National Mall, past the monuments and museums, weaving my way through the throngs of tourists. One day in late June 2006, I had just returned to the hotel from a run, dripping wet, when Emil Henry, Treasury assistant secretary for financial institutions, and his deputy, David Nason, showed up at my room to brief me on the two GSEs.

I was no expert on the subject. But the administration and the Fed had warned for years about the dangers these companies posed, and it didn’t take a genius to see that something had to be done.

As I sat there dripping in my soggy running gear, Emil and David explained how Fannie and Freddie were odd constructs. Though they had public shareholders, they were chartered by Congress to stabilize the U.S. mortgage markets and promote affordable housing. Neither lent directly to homebuyers. Instead, they essentially sold insurance, guaranteeing timely payment on mortgages that were packaged into securities and sold by banks to investors. Their charters exempted them from state or local taxes and gave them emergency lines of credit with Treasury. These ties led investors all over the world to believe that securities issued by Fannie and Freddie were backed by the full faith and credit of the U.S. That was not true, and the Clinton and Bush administrations had both said as much, but many investors chose to believe otherwise.

In this murkiness, Fannie and Freddie had prospered. They made money two ways: by charging fees for the guarantees they wrote, and by buying and holding large portfolios of mortgage securities and pocketing the difference—or, in bankers’ talk, the “spread”—between the interest they collected on those securities and their cost of funds. The implicit government backing they enjoyed meant that they paid incredibly low rates on their debt—just above the Treasury’s own.

The companies also got a break on capital. Congress required them to keep only a low level of reserves: minimum capital equal to 0.45 percent of their off-balance-sheet obligations plus 2.5 percent of their portfolio assets, which largely consisted of mortgage-backed securities. Their regulator had temporarily required them to maintain an additional 30 percent surplus, but that still left the GSEs undercapitalized compared with commercial banks of comparable size. Together the companies owned or guaranteed roughly half of all residential mortgages in the U.S.—a stunning $4.4 trillion worth at the time.

Oversight was weak. They had dual regulators: the Department of Housing and Urban Development oversaw their housing mission, while the Office of Federal Housing Enterprise Oversight (OFHEO), an overmatched HUD offshoot, created in 1992, kept watch on their finances.

In short, Fannie and Freddie were disasters waiting to happen. They were extreme examples of a broader problem that was soon to become all too evident—very big financial institutions with too much leverage and lax regulation.

But change was hard to come by. The GSEs wielded incredible power on the Hill thanks in no small part to their long history of employing—and enriching—Washington insiders as they cycled in and out of government. After accounting scandals had forced both GSEs to restate years of earnings, their CEOs were booted, and House and Senate efforts at reform broke down in a dispute over how to manage the size and composition of the GSEs’ portfolios. These had been expanding rapidly and moving into dicier assets—exposing Fannie and Freddie to greater risk.

Answering one of my many questions, Nason pointed out a simple fact: “Two-thirds of their revenue comes from their portfolios, and one-third comes from the securitization business.”

I didn’t need to hear much more than that. “That’s why this is next to impossible to get done,” I said. Their boards had a fiduciary duty to resist giving up two-thirds of their profit, and they would.

The administration, I concluded, had to be more flexible to accomplish any meaningful reform. My idea was to work off a bill that had passed the House the previous year by a three-to-one margin. It would have established a new entity, the Federal Housing Finance Agency, and given it powers, equal to those of banking regulators, to oversee Fannie’s and Freddie’s portfolios.

This House bill had passed with bipartisan support, and I was convinced we could negotiate tougher standards. The White House, however, had opposed it. Convinced that Fannie and Freddie were simply too powerful for their regulator to control, it wanted Congress to write clear statutes limiting the investment portfolios. The administration’s thinking was aligned with a Republican-backed Senate bill, which authorized a more powerful regulator and capped the GSEs’ portfolios. But once the November midterm elections gave the Democrats control of both chambers, the need for flexibility became clear.

Fortunately, I had been forging relationships on both sides of the aisle. One was with longtime Democratic congressman Barney Frank of Massachusetts. With his gravelly voice and pugnacious demeanor, Barney is famous not only inside the Beltway but, for wildly different reasons, to fans of
The O’Reilly Factor
and
Saturday Night Live
. Barney’s a showman with a quick, impromptu wit. But he’s also a pragmatic, disciplined, completely honorable politician: he never once violated a confidence of mine. Secure in his seat, he pushes for what he thinks is right. To get things done, he’s willing to deal, to take half a loaf.

Right from the start, he indicated that he was willing to work with me on GSE reform, hashing out the issues of portfolio limits and regulation. Even as we made progress, I ran into opposition inside the administration, leading to one of the worst meetings I would ever have at the White House.

On November 21, David Nason and I met in the Roosevelt Room with HUD secretary Alphonso Jackson and a large group of White House staff that included NEC director Al Hubbard, White House counsel Harriet Miers, and deputy chief of staff Karl Rove. Across the hall from the Oval Office, the Roosevelt Room serves as a daily meeting room for White House staff. With a false skylight and no windows, it’s designed for serious business, and this meeting was no exception.

I explained my position that we should be willing to negotiate on the GSEs, then we went around the table to get people’s opinions. Hubbard declined to declare himself, but everybody else was dead set against my approach. I was used to dissent and debate, but I couldn’t remember the last time everyone in the room had opposed me on an issue. I found this frustrating in the extreme. They were right on principle, but if we didn’t compromise, there would be no reform.

My response, more or less, was a bit petulant: “I know better than all of you on this. I’m going to send a memo to the president.”

I drafted my memo and sent it around. Rove protested that it was disrespectful of the administration’s no-compromise position, and he offered to help me rewrite it over Thanksgiving weekend. I swallowed my pride and accepted. In any event, Rove made clear that I would get my way.

“You’re going to win this because the president will not want to undercut his new Treasury secretary,” he said quietly.

A few days later, on the Sunday after Thanksgiving, I attended a meeting with President Bush in his residence. At the end, he took me aside, handed the memo back to me, and said simply, “Hank, that’s why I brought you here. You go do it.”

We didn’t get a bill passed in the lame-duck session, but Barney made good on his promise to honor the agreements we’d reached after the new Congress came in the following year. By the end of our negotiations in late May, we had pushed a far-from-perfect bill through the House. But our efforts went nowhere in the Senate. The new Banking Committee chairman, Chris Dodd, was running for president so for all practical purposes, the important committee business was put on hold, and the Senate did nothing on the GSEs.

I don’t have a lot of patience for people who came out of the woodwork after we put Fannie and Freddie into conservatorship and declared: “Here’s what I said before: I saw it coming.” Anyone can make a speech pointing out a problem, but the way you solve that problem is by working hard, hacking it out, and, frankly, eating a little dirt.

I came to Washington determined to compromise when necessary to make change happen. But that is not the culture of our capital. It would take until July 2008 to get meaningful GSE reforms passed. By then it was almost too late.

C
HAPTER 4

Thursday, August 9, 2007

T
he crisis in the financial markets that I had anticipated arrived in force on August 9, 2007. It came from an area we hadn’t expected—housing—and the damage it caused was much deeper and much longer lasting than any of us could have imagined.

I was in my car on my way to the Federal Reserve when I got a call shortly after 7:00 a.m. from Clay Lowery, the acting undersecretary for international affairs, who told me that the European markets were in turmoil. Earlier that morning, continental time, BNP Paribas, France’s biggest bank, had halted redemptions on three investment funds that held mortgage-backed bonds, citing a “complete evaporation of liquidity” that had made it impossible to value “certain assets fairly regardless of their quality or credit rating.”

The action was disturbing, but it came with news that was even more alarming: Europe’s credit markets had tightened dramatically, as banks hesitated to lend to one another. In response, the European Central Bank (ECB) had announced that it would make as much money available as European banks needed at its official rate of 4 percent. Euro-zone overnight borrowing rates, which normally tracked the official rate, had reached 4.7 percent. Within a couple of hours of its announcement, the ECB would reveal that 49 banks had borrowed a stunning total of 94.8 billion euros, or $130 billion. That was more than the central bank had lent after the 9/11 attacks.

I sped on to my scheduled breakfast with Ben Bernanke. I was eager to see him—we’d skipped the previous week’s breakfast since I had only just returned from China. Before I’d come to Washington, I’d hardly known Ben, but I liked him immediately, and soon after I settled in at Treasury, he and I began to meet for breakfast every week. It was such an established routine, and I’m enough of a creature of habit, that when I arrived at the Fed I could count on seeing, already set out for me, a bowl of oatmeal along with glasses of orange juice, ice water, and Diet Coke.

In the year I’d been in government, Ben and I had developed a special bond. Though we shared some common interests, such as a love of baseball, our relationship was 95 percent business. What made it special was our complete candor—laying all the cards on the table, determining where we had differences, and talking very directly about them. I kept Ben abreast of what I saw happening, passing along to him any market color I picked up from my conversations with senior bankers in the U.S. and around the world, including difficulties we’d begun to see in July with funding based on the London Interbank Offered Rate (LIBOR).