On the Brink (19 page)

“Are you going to work with us?” Shelby asked Mudd and Syron. “Do you guys really want to get this done?”

Under Shelby’s no-nonsense gaze, they said yes, and I left the Russell Building feeling very optimistic and determined to draft the language that would help fix Fannie and Freddie.

It wouldn’t be a moment too soon.

In early May, Fannie announced a first-quarter loss of $2.2 billion—its third straight quarterly loss—cut its common stock dividend, and announced plans to raise $6 billion through an equity offering. Eight days later, Freddie announced its first-quarter results—a loss of $151 million—along with plans to raise $5.5 billion in new core capital in the near future.

On May 6, Treasury officials met with a group of large mortgage lenders to speed up loan modifications for qualified homeowners facing foreclosure. That same day, the White House issued a statement outlining its opposition to the housing stimulus bill working its way through the House. Officially known as H.R. 3221, this ungainly and complicated piece of legislation had begun life as an energy bill in 2007, before turning into a housing vehicle in February. It contained a hodgepodge of provisions that were expensive and likely to be ineffective. The administration considered the bill burdensome, prescriptive, and risky to taxpayers. The legislation addressed GSE reform, but the White House was concerned about the other measures. I was convinced we could work with Barney Frank to fashion an acceptable compromise.

On the Senate side, our summit meeting with Dodd and Shelby was paying dividends. After considerable wrangling, they ushered the Federal Housing Finance Regulatory Reform Act of 2008 through the Senate Banking Committee on May 20. It provided for a strong new GSE regulator, the Federal Housing Finance Agency, with the authority to set standards for minimum capital levels and sound portfolio management.

After Bear Stearns, it would not have been unusual for the regulators involved to have resorted to turf building and finger pointing. That’s too often the way in Washington. But we knew how important it was that we continue to act in a united way. We were focused on increasing market confidence in the remaining four investment banks by encouraging them to take tangible steps to strengthen their balance sheets and their liquidity management.

The Primary Dealer Credit Facility (PDCF) allowed the Fed to conduct on-site examinations of institutions regulated by the SEC. I had dispatched a Treasury team led by David Nason to visit the investment banks to find out how the process was working. They met with the firms’ CFOs, treasurers, and lawyers, and found that the arrangement was working fine—Lehman was the most pleased to have the Fed on-site.

But there was a considerable amount of tension and borderline mistrust between the agencies. Chris Cox was open and cooperative, but some SEC staff were understandably uneasy that their agency could be overshadowed by the Fed on the regulation of securities firms. I had a lot of confidence in the New York Fed, because it had been proactive and creative in dealing with Bear and consistently tried to get ahead of the curve.

I believed it vitally important for the regulators to work together. Ben Bernanke and Chris Cox agreed. They weren’t interested in turf wars. They cared, as I did, about market stability and wanted the Fed inside the firms to protect that.

Traditional protocol would have left the agencies to sort out their issues, but I took the initiative in mid-May to convene a meeting with Ben, Tim Geithner, Chris Cox, Bob Steel, and David Nason. The SEC and the Fed agreed to draft a memo of understanding that would set ground rules to coordinate on-site examinations and to improve information sharing between the agencies. We also discussed how long the PDCF should run. It was a temporary program, created under Federal Reserve emergency authority, and was scheduled to expire in September. I supported Ben and Tim’s view that the facility should be extended.

It would have been easy to leave many technical and legal issues for the regulators to work out, but the policy and greater economy implications were too great for Treasury to sit on the sidelines.

Even as we worked on these regulatory matters, the heat was rising under Lehman Brothers. In April a New York hedge fund manager named David Einhorn had announced that he was shorting Lehman. Then, on May 21, at an investment conference in New York, he raised the ante, questioning Lehman’s accounting of its troubled assets, including mortgage securities. He insisted that the bank had vastly overvalued these assets and had underreported its problems in the first quarter. With his frequent television appearances and negative public comments, Einhorn seemed to be leading a crusade against Lehman.

Almost on cue, the firm’s health took a turn for the worse. On June 9, the bank released earnings for the second quarter a week early, reporting a preliminary loss of $2.8 billion, owing to write-downs in its mortgage portfolio. Lehman also said it had raised $6 billion in new capital—$4 billion in common stock and $2 billion in mandatory convertible preferred shares. But the damage was done. The shares had tumbled from $39.56 the day of Einhorn’s speech to $29.48.

I had been constantly in touch with Dick Fuld. (My call log would show nearly 50 discussions with him between Bear Stearns’s failure and Lehman’s collapse six months later, and my staff probably was on at least as many calls.) He asked me what I thought of his president and his chief financial officer. How would the market react if he replaced them? I said I didn’t know, but there was a chance the market would see that as a desperate act. On June 12, he fired longtime friend Joseph Gregory, who was president and chief operating officer, and demoted Erin Callan, his chief financial officer. Herbert (Bart) McDade, a senior member of Dick’s team and the company’s former global head of equities, replaced Gregory, while co–chief administrative officer Ian Lowitt succeeded Callan. Lehman shares touched a new year low of $22.70. They would end June at $19.81.

All year, Dick had been struggling to come to grips with the erosion of confidence in his firm. Yet even though he was on full alert, he remained overly optimistic. He would insist Lehman didn’t need capital and then reluctantly raise it, hoping to calm the market. Finally, after the second-quarter numbers went public, he admitted that he needed to find a buyer or a strategic investor by September, when new results would be released.

“What are your third-quarter earnings going to be like?” I asked.

“Not good.”

Yet even in their efforts to find that buyer or investor, Dick and his people found it hard, I think, to price the firm attractively enough. When I talked with him about possible buyers, I pointed out—and Dick agreed—that Bank of America was the most logical candidate. Not only did BofA lack a strong investment banking business, but CEO Ken Lewis had great confidence in his own ability to buy and assimilate things. He had bought Countrywide and Chicago’s LaSalle Bank in the last year. He was in a buying mood. Dick had his lawyer, Rodge Cohen, call Lewis, and Lewis had Gregory Curl, BofA’s head of global corporate development and planning, look at Lehman’s books. But after Curl and his team had done their work, BofA decided not to pursue a deal.

My conversations with Dick were becoming very frustrating. Although I pressed him to accept reality and to operate with a greater sense of urgency, I was beginning to suspect that despite my blunt style, I wasn’t getting through.

With Lehman looking shakier, I asked my senior adviser, Steve Shafran, to begin contingency planning with the Fed and SEC for a possible failure. Steve, a brilliant 48-year-old former Goldman Sachs banker who had retired from the firm in 2000, was an expert financial engineer. A widower who had moved to Washington to raise his four children, he had offered to help me on a part-time basis. As the crisis unfolded, Steve would work around the clock as a go-to problem solver.

While Bob Hoyt and his people combed through Treasury history to see what authorities we might use if Lehman failed, Treasury, the Fed, and the SEC worked to assess potential damages and devise ways to minimize these. They identified four areas of risk that had to be controlled in any collapse: Lehman’s securities portfolio, its unsecured creditors, its triparty repo book, and its derivatives positions. The team managed to hammer out some possible protocols over the course of three months.

The SEC would want to be sure it could ring-fence the broker-dealer and ensure that all customers got back their collateral; the Fed might be able to step in and take over the triparty repo obligations of Lehman, which were secured. But figuring out what to do with the derivatives book proved elusive. There were no silver bullets, and I worried that the team wasn’t doing enough. Wasn’t there something else we could try, I’d ask, some legal authority we could invoke?

But there was none. The financial world had changed—with investment banks and hedge funds playing increasingly critical roles—but our powers and authorities had not kept up. To avoid damaging the system, we needed the ability to wind down a failing nonbank outside of bankruptcy, a court process designed to resolve creditor claims equitably rather than to reduce systemic risks. I raised the issue publicly for the first time at a speech in Washington in June. And I followed that up with a July 2 speech in London.

Shafran’s team briefly worked on crafting legislation to give the secretary of the Treasury wind-down powers. Barney Frank was supportive but cautioned us against trying to push legislation that was so complex substantively and politically. We concluded there was no way we could get what we needed passed with the congressional summer recess on the way and presidential elections in November. We knew it wasn’t going to be easy to work with the inadequate authorities we had, but we also knew that aggressively making the case for new authorities might itself precipitate Lehman’s failure. Instead, Barney encouraged the Fed and Treasury to interpret our existing powers broadly to protect the system, saying: “If you do so, I’m not going to raise legal issues.”

Meantime, the housing and GSE reform legislation continued to move much slower than expected. Initially, we’d thought it would be done by the July 4 recess, but that deadline had slipped away as Republicans dug in against homeowner bailouts, placing much of the burden for passage on the Democrats.

While Congress dithered, the markets got jittery. I was at a meeting of finance ministers from the Americas and the Caribbean in Cancún, Mexico, on June 23, when I heard that Freddie Mac shares had dropped below $20. That was off more than $10 since they’d announced plans to raise capital in March. I’d been hoping all along that the GSEs would be able to raise capital. Fannie had done so in May and June, raising $7.4 billion in common and preferred stock. But Freddie had not done anything. Now they would not be able to access the market, and we did not have the legislation we needed to protect them or the taxpayers.

I put in a call to Barney Frank to find out the progress of the bill, but I couldn’t reach him. I had just gone into the lavatory in the hotel where the finance ministers were meeting, when Barney returned my call.

“Barney,” I said, “you’re getting me in a men’s room in Mexico!”

“Don’t drink the water,” he replied without losing a beat. Barney then told me he was committed to GSE reform and optimistic about getting our legislation.

On June 28 I went on a five-day trip to meet with political leaders, finance ministers, and central bankers in Russia, Germany, and the U.K. After seeing Russia’s finance minister, Alexei Kudrin, a voice of reason and a straight-shooting reformer, I had meetings scheduled with Prime Minister Vladimir Putin and President Dmitry Medvedev.

Once I arrived at the White House, as the Russian government building is called, an official tried to usher me into the conference room where Putin and I were to meet. There was a long table, and at the end of the room a gallery with the press and TV cameras. It was clear that the Russians intended to make me sit there and cool my heels in front of the U.S. and Russian press until the great man arrived. But my chief of staff, Jim Wilkinson, had other ideas.

“Whoa!” he exclaimed. “We’re not going to let the U.S. secretary of the Treasury be a political prop for Putin.”

So we remained in the hall, and we waited and waited, concerned that we wouldn’t make our next meeting, with Medvedev at the Kremlin. Putin was, I imagine, flexing his muscles, showing that he was more important than the new president.

Finally, the prime minister arrived, and we walked into the meeting room together. We had agreed to exchange brief opening statements, then dismiss the media and begin our meeting. But instead Putin launched into a soliloquy on the U.S. financial crisis. With oil prices at record highs, the Russians were feeling their oats. I spoke about the work we had been doing with Kudrin on sovereign wealth funds, and Putin responded, “We don’t have a sovereign wealth fund. But we are ready [to create one], especially if you want us to.”

Frankly, this was too good a political opportunity for Putin to pass up. In 1998 it was a humiliating Russian default that started the global financial crisis. And now he was temporarily able to point to a reversal of fortunes.

Our private session was much more productive, like all such Putin meetings: he was direct and a bit combative, which made it fun. He never took offense, and we could spar back and forth. We discussed the U.S. economic situation, then went four rounds on Iran. I talked about the Russian banks living up to the United Nations sanctions, and he pushed back hard, saying, “They’re our neighbors, and we have to live with them. We don’t want a nuclear weapon in Iran, and I’ve talked to the president many times about this, but sanctioning them is not the way to do it.”

The talk turned to the World Trade Organization, a sore subject for Putin. He basically said, “We’ve made many concessions, and if we don’t get admission to the WTO, we’re going to pull back the concessions we made. I have Russian companies telling me that we have gone too far to open up to foreign competition. So this is going to get done soon, or we’re going to start pulling things back.”