Hank Paulson: This Is What It Was Like to Face the Financial Crisis
Sept. 15, 2008: Lehman Brothers files for Chapter 11 in the largest-ever U.S. bankruptcy
People weren’t taking Dick Fuld’s calls the weekend before Sept. 15, because Dick had been in denial for a long time. As the CEO of Lehman Brothers, he had asked the New York Fed and the Treasury weeks earlier to put capital into a pool of nonperforming illiquid mortgages that he wanted to put in a subsidiary he called SpinCo and spin off. We had explained that we had no authority to do that. He thought somehow there was something the government could do to help. How could it be that no one would want to buy his company? He just couldn’t believe it.
I was one of the few people speaking with him, and I told him what was happening: We couldn’t find a buyer, and without one, the government was powerless to save Lehman. He was devastated. You would have to be a CEO to really understand what he was going through. He obviously loved the firm—viewed it as his firm—and to have it go down when you’re at the helm, there can’t be much that’s more devastating than that professionally. But the Lehman Brothers bankruptcy on Sept. 15 was hardly the end of the crisis. It wasn’t the beginning, either. My goal had never been to go to Washington. My first year at Harvard Business School, 1969, I stopped studying. I was a good enough student that I could get by, so I spent most of my time at Wellesley College with Wendy Judge and persuaded her to marry me before the second year. Wendy got a job teaching swimming in Quantico, Virginia, so I got a job at the Pentagon. The only time I had ever worn a suit was to go to church. The only management experience I had was at a summer camp in Colorado. But, remarkably, I worked on my first bailout in those days.
Lockheed was a major defense contractor on the verge of bankruptcy, and the Nixon administration had gone to Congress to get a loan guarantee. I frankly didn’t think the government should intervene. The parts of Lockheed which were critical to the national defense could have been bought by other defense contractors, but this was hotly debated. Even then, bailouts were very unpopular.
As a result of the work I had done on Lockheed, I was approached by the White House. I went to work for a man named Lewis Engman, an assistant director of the White House Domestic Council. I was very green. I had a lot of questions, and Lew was a good mentor. He said, “If someone asks you to do something, and it doesn’t seem right, ask lots of questions. And any memo you write, ask yourself not only is it the right thing, but how would it look printed on the front page of the Washington Post.” I had started work in the Nixon White House in April 1972, just a few weeks before the Watergate break-in. That was terrific advice.
It was not hard for me to decide to leave government. In January of 1974, when I joined Goldman Sachs, it never occurred to me I might one day run the firm. If you were interested in management and running a big organization, you went to some industrial company. You didn’t work for an investment bank. I picked Goldman Sachs because I was really interested in the idea of multitasking, working, and advising clients in a lot of industries.
Early on at Goldman Sachs someone said, “Hank isn’t that smart. What he really does is just assimilate and absorb information from others.” I took that as a huge compliment. I worked with many CEOs there, some really good, some not so good. I worked and advised heads of state, government leaders. What I learned was that there’s no perfect leader. Everyone is flawed, and their strengths are usually the opposite of their weakness. “Hank is candid; Hank is indiscreet.” “Hank is decisive; Hank acts too quickly.”
The essential ingredient to the success of these CEOs was the team they put around them. If you don’t put people around you to compensate for your flaws, these big jobs always uncover them.
I had turned down being secretary of the Treasury twice in the spring of 2006 when I was approached a third time in April of that year. I accepted. I didn’t really know President Bush, and I had negotiated a number of conditions to my coming, including choosing my staff. But those preconditions would mean nothing if I couldn’t build a relationship with the president. And I had a terrific boss in George Bush. During the financial crisis he basically said, “You’re my wartime general, and you can get to me whenever you need to. We’ll talk about any issue.” And we did. I also was very fortunate to have great partners in Ben Bernanke and Tim Geithner, and our efforts benefited from an extraordinary level of trust and cooperation.
In July of 2006 the president was meeting with his economic team at Camp David. He had asked me to make a presentation on entitlement reform. Instead I asked for permission to talk about my concerns that there were real excesses in the economy. The excesses had been building up for many years, and I thought there was a high likelihood there would be a financial crisis while I was in Washington and while he was president. I talked about the over-the-counter derivative market and the lack of transparency there. I talked about the size of hedge funds. I didn’t talk about housing. When we finished the conversation, the president said, “Hank, what would cause the financial crisis?” I said, “I don’t know, sir. But after it happens, with 20/20 hindsight it will be obvious.”
I had been in Washington for a year when the causes began to reveal themselves. The biggest French bank, BNP Paribas, had funds that held subprime-related mortgage bonds. Three of those funds were frozen. There were calls for redemption, and there was a liquidity crisis. This led to massive concern across Europe. From that time on we were on high alert.
The president’s working group on financial markets convened and focused immediately on the complexity of mortgage securities. It used to be that if I wanted a mortgage on my home, which I did in 1974, I went to the First National Bank of Chicago. If I had problems, I could have gone to them, and if there was a reasonable solution we could have done a mortgage modification. But the model had changed. We had gone to a securitization model.1 Mortgages were sliced and diced, packaged in securities, and then sold in the public market around the world. Along with innovation came complexity, and complexity is the enemy of transparency. I had high school friends and grade school friends that got put into mortgages by unscrupulous brokers. Some lost their houses, and I spent time with them and looked at what they had been conned into accepting—they didn’t understand what they were signing on for. It was despicable.
As we moved into 2008, we had a number of U.S. institutions fail. Countrywide, the biggest originator of mortgages, was bailed out with an equity investment from Bank of America. Citibank, Merrill Lynch, Lehman Brothers, and Morgan Stanley all had trouble with their mortgage portfolios. None of us understood the full extent of what we were dealing with.
On March 13, Bear Stearns told us that without assistance they would fail the next day. They’d lost $2.4 billion the previous year in bad mortgage investments. I figured somewhere in the United States of America there had to be some emergency authorities to prevent a failing investment bank from going into the normal bankruptcy process. But the Fed had no authority to guarantee liabilities or inject capital. Neither did Treasury. We needed a buyer.
JPMorgan was willing to step in, supply the capital, and guarantee the trading book, but the Fed had to help facilitate that through a loan against a mortgage pool which was relatively illiquid. The original agreement was for the Bear shareholders to get $2 a share, and in order to get the deal done, they needed to get $10 a share.
A question I often get is, “Didn’t that create a moral hazard?” The argument goes something like this: If market participants presume that a government is always going to step in to save a failing institution, then those market participants will not subject that institution to the kinds of rigorous analysis and scrutiny that is needed. I had argued that the shareholders of Bear Stearns shouldn’t get more than $2 a share, and that argument was less about moral hazard than what was right. If the United States of America through the Fed was making a loan to prevent a bank from failing, why should shareholders get more money? Ben Bernanke and Tim Geithner argued that the greater good was preventing the failure. So I agreed to the terms. But initially I found it abhorrent.
The market turned almost immediately to Lehman Brothers, and after Bear Stearns, I was doing everything I could to encourage Dick Fuld to raise capital, to attract a strategic investor, or to sell the company. Meanwhile, Ben and I went to see Barney Frank. We needed emergency resolution authorities to keep failing investment banks out of bankruptcy, just like the government had with commercial banks. Barney said, “We won’t be able to get Congress to act unless you’re prepared to shout, ‘If we don’t get these authorities, you’re going to have an investment bank like Lehman Brothers fail and the consequences will be terrible.’ ” Of course, as soon as we started saying that, Lehman would have gone down.
Fannie Mae and Freddie Mac were created to make homeownership more affordable by subsidizing 30-year mortgages. Fannie Mae was set up in 1938, right after the Great Depression, Freddie Mac in 1970. These were government-sponsored entities, or GSEs. They had noble objectives; they also had major flaws.
The first was that, although they were not owned by the government and although there was no explicit government guarantee, the market assumed that the United States was behind them. There was an implicit guarantee, even though the government said there wasn’t.2 The second major flaw was they had weak regulation. Congress in its wisdom, or in this case lack thereof, had deprived the regulator of the same broad powers that a banking regulator had to make judgments. On top of all that, these were mega-institutions, nine times larger than Lehman Brothers. They had grown and grown and grown. The elephant was clearly too big for the tent.
Their independent regulator argued that they had plenty of capital, but we watched them in the market every week selling up to $20 billion of debt securities. If they hadn’t been able to sell their securities, it would spook investors, and you would get massive selloffs and big price declines and losses by all those holding their securities. If they totally collapsed, you would have Armageddon.
In July we went to Congress to get emergency authorities to deal with this threat—authorities we hoped we’d never have to use. But by mid-August, we had discovered that the GSEs had a large capital deficiency. After considering a number of options we concluded that we needed a plan where we actually took over the companies on a Sunday so we could open up Monday under new management. One of the CEOs called me and said, “Hank, what’s going on?”
I said, “I can’t tell you.”
I knew what they would be compelled to do if I talked to them. There is no way those CEOs or boards could agree with anything that undermined their shareholders, because they had a fiduciary duty to protect their shareholders’ interests. So there was no choice but to move quickly to put them into conservatorship, where, in essence, the government backstopped all of their debt securities.
When I briefed President Bush on this, he was fascinated. But he had a hard time believing we were going to be able to keep this secret. I said, “The first thing these guys need to hear is their heads hitting the floor.”
Right after stabilizing Fannie and Freddie, on Sept. 7, it became clear that Lehman was going to be under real pressure from investors. Most of the market participants were watching nervously, but expecting Uncle Ben and Uncle Hank would pull a rabbit out of the hat.
We needed something dramatic to focus people’s attention on the seriousness of the problem. Ben, Tim, and I decided to bring the heads of the major Wall Street firms into the New York Fed on a Friday to let them know the Fed had no authority to guarantee debt or put in capital, and that the government wasn’t going to be there because a loan to a disintegrating investment bank in the midst of a run wouldn’t be successful. We needed a buyer, and we needed these banks to assist the buyer if necessary. Frankly, I thought we were going to need two buyers that weekend, because I had a very strong view that whether Lehman failed or was bought, the market was going to turn immediately to Merrill Lynch.
That entire weekend was spent going from one meeting to the other while we talked with BofA and Barclays, hoping to get a transaction for Lehman Brothers. Sunday morning we came in expecting there to be a deal with Barclays, but we got signs that their U.K. regulator would reject the deal. That was just a terrible moment for me. Everyone was waiting for Tim and me to come down and report to them, and I wasn’t quite sure what to say. I was gripped with fear. I called Wendy and said, “Wendy, you know, I feel that the burden of the world is on me and that I failed and it’s going to be very bad, and I don’t know what to do, and I don’t know what to say. Please pray for me.”
She went immediately to one of our favorite Bible verses in Second Timothy: “For God hath not given us the spirit of fear, but of power and of love and of a sound mind.” Immediately I felt a sense of peace and renewed confidence. I thanked her and went down to talk to the bankers. We were fortunate that Bank of America bought Merrill Lynch. If they had bought Lehman instead, I believe that Merrill would have failed. That would have been even more harmful.
I remember waking up very early the morning of Sept. 15 in New York and looking out the window at all the people on the street walking to work. Some I’m sure worked at Lehman. Some worked at other banks. Others didn’t work at any bank. But their lives were about to change in very profound ways.
Lehman intensified the crisis—it was a symptom, not the cause. I don’t subscribe to the “domino theory” when it comes to Lehman. My former colleague, Ed Lazear, had a line that’s more apt: The crisis was like a giant popcorn popper,3 and it had been heating these kernels for a year as the crisis went on. Lehman might have been the first to pop, but we knew that weekend that Merrill Lynch and AIG were going to pop next, and many others in the U.S. and Europe were not far behind.
That week was like no other week I’ve ever had. We were dealing with multiple problems—the need to prevent the failure of AIG, the likely impending failure of other financial institutions, the need to prevent the implosion of money-market funds, and the need to go to Congress to request emergency authorities.
We had been working all week on how to request what we needed from Congress. At the heart of it was the ability to buy illiquid assets from financial institutions. We were talking in terms of hundreds of billions of dollars.
It was Thursday evening, Sept. 18, when Ben Bernanke and I met with the congressional leaders. So far many of them had not seen the financial crisis. It hadn’t rippled through to their constituents. Ben and I painted a picture of a financial system which was frozen. Banks weren’t lending to each other. Credit wasn’t flowing normally. I could see 25 percent unemployment, which is what we had after the Great Depression. There was going to be a disaster if we didn’t act immediately.
At the end of the week when I came up for air, it occurred to me I hadn’t talked to my best friend, my brother Dick. Dick was then a senior vice president, a veteran fixed-income salesman in the Chicago office of Lehman. I called, and he immediately started asking about me. He was very, very worried, because he knows that I take things hard. I told him I didn’t really have time to go into an explanation, but that we had done everything we could to save Lehman. He said, “I know it.” He wasn’t asking about what was happening to his stock or his retirement. He focused on me. I was quite emotional, but I didn’t have much time to be emotional.
Nine days later, on Saturday, Sept. 27, it looked like we were going to get a deal done in Congress to create the $700 billion Troubled Asset Relief Program. But negotiations bogged down and extended late into the night. Now all my life, if I’m really exhausted, I get the dry heaves. It sounds like I’m really sick, because I make a lot of noise. Rahm Emanuel came by. Harry Reid offered to get a doctor. I said I didn’t need it. I play tennis with Wendy, and a couple of times in the hot sun I’ve had the dry heaves. Our opponents thought it was a tactic. Wendy would say, “Hey, get back out here. That’s disgusting.” Of course, it would throw the other people off. In this instance it wasn’t a tactic, but I know that it helped accelerate things.
At least I thought it had. On Monday the House voted down TARP. Barney Frank, attempting to cheer me up, said, “Don’t worry, Hank. Sometimes kids have to run away from home and get hungry before they come back.” TARP did pass on a second vote, but all week that TARP was passing, the situation was worsening in the markets: Washington Mutual, the largest U.S. savings and loan, failed; Wachovia, the sixth-largest bank, was purchased as it was failing; European banks were teetering; and global credit markets had all but stopped functioning for financial institutions. We had gone to Congress with the expectation that we would be buying illiquid assets, but it was clear we needed to do something swifter and even more powerful. So we changed strategies and decided to inject capital directly into the banks.
My own view has always been to admit when you’re wrong and change course quickly. I didn’t have to have long debates with the White House staff about how bad the harm to the economy would be if the financial system went down. President Bush had a good feel, and he understood markets. He basically said, “Holy cow, you’ve told the whole world you’re going to buy illiquid assets. It’s going to be important how you explain it, but of course you’ve got to put capital in the banks.” The best advice he gave me was to do what’s right and ignore politics.
Sunday, Oct. 12, I called nine CEOs from the systemically important banks and asked them to show up at Treasury on Monday afternoon. We would present the program and ask them within a few hours to sign agreements where they would willingly take the capital.
Every bank wanted to be the tallest midget: No one wanted to admit they had a problem because they didn’t want to stigmatize themselves. So we designed a program that didn’t separate the healthy banks from the banks under duress, and we moved quickly to inject capital into hundreds of banks to recapitalize our financial system and restore confidence.
The only way we knew to do this was to put forward a program that would be attractive to the financial institutions, so they all would be encouraged to take capital for the good of the country. This was a program unlike any other in history.
All of the banks agreed, and for a short period of time, I breathed a sigh of relief.
The way I read the polls, TARP was more unpopular than torture. We don’t like bailouts in this country. If you take a risk and make money? That’s good. But if you take a risk and the government has to come in and save you? Well, I understood the anger.
I was never able to convince the American people that what we did with TARP was not for the banks. It was for them. It was to save Main Street. It was to save our economy from a catastrophe.
I knew Americans were angry when they thought the banks were hoarding and not lending as much as they would have liked. But how does the government make the banks lend? Even if you nationalize the banks, which we didn’t, do you want the government making lending decisions for the banks? That’s a recipe for disaster.
The other criticism of TARP, just the man-on-the-street feeling about it, was that in addition to not lending, huge bonuses were being paid to some bank executives. That infuriated me—the sheer cheekiness of it. Forget whether they were legally entitled to their bonuses, it was such a graceless lack of self-awareness and a total lack of understanding about how the rest of the world and the rest of America looked at them.
One of the things that I’m proudest of is that we worked with Democrats and Republicans to get Congress to do some pretty extraordinary things—twice. First with Fannie and Freddie and then with TARP, all before the system collapsed. The Obama administration took those programs, managed them well, and adapted them to market conditions. We had policy continuity across administrations, and the programs we left them worked. When we look at our flagship TARP bank and insurance company capital program, all the money has come back plus $32 billion. Excluding the Obama administration’s spending program for mortgage relief, the Treasury has already received more than it dispersed from all TARP investment programs.
I get asked all the time, “What’s the likelihood of another financial crisis?” And I begin by saying it’s a certainty. As long as we have markets, as long as we have banks, no matter what the regulatory system is, there will be flawed government policies. Those policies will create bubbles. They will manifest themselves in a financial system no matter how it’s structured and how it’s regulated. But the key thing is to have the tools and the political will to act forcefully to limit a crisis.
Now a number of things that we were forced to do during this crisis made the problem worse, beginning with big banks. To get through the night we needed to encourage consolidation, so today we have bigger banks and more concentration.
Too big to fail is an unacceptable phenomenon. Thanks to Dodd-Frank, regulators have better tools to deal with the failure of any large financial institution, but more still needs to be done with the shadow-banking markets, which I define to be the money-market funds and the so-called repo market, which supplies wholesale funding to banks.
When I came to Washington, Fannie or Freddie guaranteed or insured roughly half the new mortgages in America. Today about 90 percent of all new mortgages are insured by the government. So today it’s worse. I frankly find it abhorrent to even think about keeping Fannie or Freddie in conservatorship. If we do so, we’re just sowing the seeds of a future crisis.
But overall, do I believe that our financial system is stronger, better capitalized, and better regulated?
I sure do. And at the end of the day, more capital is the best defense against bank failure. —As told to Joe Berlinger and Josh Tyrangiel
Bloomberg Businessweek‘s first documentary, Hank: 5 Years From the Brink, directed by Academy Award nominee Joe Berlinger, is available exclusively on Netflix starting Sept. 16.