On the Brink (13 page)

On the following Tuesday I went to Nancy Pelosi’s conference room to meet with the Speaker, Senate Majority Leader Harry Reid, Senate Minority Leader Mitch McConnell, House Majority Leader Steny Hoyer, and House Minority Leader John Boehner. Reid and McConnell agreed to let the House take the lead on the stimulus, and Pelosi—clearly hungry for a bipartisan achievement after a slow first year as Speaker—worked her tail off. She dropped demands for unemployment and food stamp benefits in exchange for tax rebates for virtually everyone, regardless of whether they paid income tax or not.

The combination of slumping financial markets and the growing macroeconomic concerns gave us a powerful impetus. Economic conditions had become so worrisome that the Fed, on January 22, slashed the Fed funds rate by 75 basis points, to 3.5 percent, in a rare move made between scheduled Federal Open Market Committee meetings. (On January 30, it would cut the funds rate by another 50 basis points at its regular meeting.)

On January 24—just two days after I first went to the Hill—Pelosi, Boehner, and I announced a tentative agreement for a $150 billion stimulus plan centering on $100 billion in tax rebates for an estimated 117 million American families. Depending on income level, the stimulus would give as much as $1,200 to certain households, with an additional $300 for each child.

Because the stimulus was a bipartisan effort, I had to swallow a few things I didn’t like, including an increase in Fannie and Freddie’s loan limit for high-cost areas, to $729,750 from $417,000. Nonetheless, the stimulus represented a huge political and legislative accomplishment, and President Bush signed it into law on February 13, after a remarkably quick two-week passage through the House and the Senate. And the Internal Revenue Service and Treasury’s Financial Management Service did something that initially seemed impossible: they got all the rebate checks out by July. Some were sent out as early as late April, despite the crunch of tax season.

I hoped the stimulus would solve many of the economic problems. We believed we were looking at a V-shaped recession and assumed that the economy would bottom out in the middle of 2008.

The market difficulties had a decidedly global cast. At the G-7’s fall meeting in Washington, I had begun questioning the strength of European banks; they used a more liberal accounting method than U.S. banks, one that in my opinion covered up weaknesses. In January 2008, a group of Treasury officials, including Acting Undersecretary for International Affairs Clay Lowery, traveled to Europe to get a better handle on what was happening in its financial sector. After visiting a number of countries, including the U.K., France, Switzerland, and Germany, they concluded that Treasury’s suspicions were correct: European banking was weaker than officials were letting on.

On February 17, just a few days after President Bush signed the stimulus bill, U.K. chancellor of the Exchequer Alistair Darling announced that the British government would nationalize Northern Rock. The credit crisis had pushed the big mortgage lender to the brink of failure.

In the U.S., the markets continued to slip, troubled by oil prices, a weakening dollar, and ongoing concerns about credit. Over the week of March 3–7, the Dow lost almost 373 points, ending at 11,894—far below the 14,000 of the preceding October. That Thursday I traveled to California for a round of appearances in the San Francisco Bay Area, including a speech on March 7 at the Stanford Institute for Economic Policy Research. My talk centered on the U.S. housing situation, and I outlined our continuing efforts with HOPE Now and fast-track modifications, pointing out that more than 1 million mortgages, 680,000 of them subprime, had been reworked. In the question-and-answer period that followed, I fielded a query about whether I would consider guaranteeing mortgage-backed bonds issued by Freddie and Fannie. I sidestepped this, saying that the institutions needed reform and a strong regulator.

My audience included former Treasury secretary Larry Summers, who told me before the speech that he’d been looking into the GSEs. “This is a huge problem,” he said. Working off public numbers, he had done some analysis that led him to believe they were likely to need a lot of capital. “They are a disaster waiting to happen,” he said.

While I shared Larry’s concerns about the GSEs, in my mind the monoline insurers presented a more immediate problem. They had become the latest segment of finance hurt by the spiraling credit crisis, and their troubles imperiled a vast range of debt.

Fitch Ratings had downgraded Ambac Financial Group, the second-largest bond insurer, to AA in January. The move raised concerns that rival rating agencies would follow suit, causing other insurers to lose their high ratings. That meant that the paper they insured faced downgrades, including the low-risk debt that local governments issued to pay for their operations. Forced to pay more to borrow, U.S. cities might have to reduce services and postpone needed projects.

The monoline troubles had spilled over into yet another market sector—that of auction-rate notes, which were longer-term, variable-rate securities whose interest rates were set at periodic auctions. The market was sizable—slightly more than $300 billion—and was used chiefly by municipalities and other public bodies to raise debt, as well as by closed-end mutual funds, which issued preferred equity.

The vast majority of the auction-rate notes had bond insurance or some other form of credit enhancement. But with the monolines shaky, investors shunned the auction-rate market, which completely froze in February, as hundreds of auctions failed for lack of buyers. The brokerage firms that sold the securities had typically stepped in to buy them when demand lagged. But faced with their own problems they were no longer doing so.

Although the monolines did not have a federal-level regulator, I had asked Tony Ryan and Bob Steel to look for ways to be helpful to Eric Dinallo, the superintendent of insurance for New York State, who regulated most of the big monolines and had begun work on a rescue plan. New York governor Eliot Spitzer also got involved, testifying on the insurers’ troubles before a House Financial Services subcommittee on February 14.

I knew the governor from his days as New York State attorney general, and he called me on February 19 and 20 to discuss potential solutions. I saw him at the Gridiron Club’s annual dinner, held at the Renaissance Washington DC Hotel on March 8.

This good-natured roast of the capital’s political elite drew more than 600 people, including Condi Rice and a number of other Cabinet members. President Bush supplemented his white tie and tails with a cowboy hat and sang a song about “the brown, brown grass of home” to mark his last Gridiron dinner as president.

Wendy and I were glad to have a chance to chat with Eliot, whom Wendy knew from her environmental work, when he came up to the dais to speak to us. He was friendly and relaxed, and he looked like a million bucks as he talked to me about the monolines and thanked me for Bob Steel’s help.

Looking back now, I realize that Spitzer must have known that he would be named within days as the customer of a call-girl service, and that his world would come crashing down. But that night he looked like he didn’t have a care in the world.

C
HAPTER 5

Thursday, March 13, 2008

I
can’t remember many speeches I looked forward to less than the one I was scheduled to deliver Thursday morning, March 13, at the National Press Club.

My purpose was to announce the results of a study of the financial crisis by the President’s Working Group and to unveil policy recommendations affecting areas ranging from mortgage origination and securitization to credit rating agencies and over-the-counter derivatives like credit default swaps. We had worked hard on these proposals since August, coordinating closely with the Financial Stability Forum in Basel, which planned to release its response in April at the upcoming G-7 Finance Ministers meeting.

But our timing was dreadful. It seemed premature to suggest steps to avoid a future crisis with no end in sight to this one. As much as I wanted to cancel the speech, I felt that if I did, the market would have smelled blood.

I hurried through my brief remarks, preoccupied and impatient to get back to the office. It had been a rough week. The markets had taken a sharp turn for the worse, as sinking home prices continued to pull down the value of mortgage securities, triggering more losses and widespread margin calls. Financial stocks were staggering, while CDS spreads—the cost to insure the investment banks’ bonds against default or downgrade—hit new highs. Banks were reluctant to lend to one another. The previous weekend there had been a banking conference in Basel, and Tim Geithner had told me that European officials were worried that the crisis was worsening. It was an unsettling confirmation of conversations I had had with a number of European bankers.

The firm under the most intense pressure was Bear Stearns. Between Monday, March 3, and Monday, March 10, its shares had fallen from $77.32 to $62.30, while the cost to insure $10 million of its bonds had nearly doubled from $316,000 to $619,000. Other investment banks also felt the heat. The next-smallest firm, Lehman Brothers, which was also heavily overweighted in mortgages and real estate, had seen the price of CDS on its bonds jump from $228,000 to $398,000 in the same time. A year before, CDS rates on both banks had been a fraction of that—about $35,000.

On the Tuesday before my speech, the Fed had unveiled one of its strongest measures yet, the Term Securities Lending Facility (TSLF). This program was designed to lend as much as $200 billion in Treasury securities to banks, taking federal agency debt and triple-A mortgage-backed securities as collateral. The banks could then use the Treasuries to secure financing. Crucially, the Fed extended the length of the loans from one day to 28 days and made the program available not just to commercial banks but to all primary government dealers—including the major investment banks that underwrote Treasury debt issues.

I was pleased with the Fed’s decision, which let banks and investment banks borrow against securities no one wanted to buy. And I had hoped that this bold action would calm the markets. But just the opposite happened. It was an indication of the markets’ jitters that some took the move as a confirmation of their worst fears: things must be very serious indeed for the Fed to take such unprecedented action.

On Wednesday, most of America found itself temporarily diverted from the markets’ tremors when Eliot Spitzer announced he was resigning as New York’s governor following a two-day riot of news coverage after he was named as a client of a prostitution ring. I know many on the Street took pleasure in his troubles, but I just felt shock and sadness. The Gridiron dinner where he had seemed so carefree just days before seemed an eternity ago.

I was too preoccupied to dwell on Spitzer’s misfortunes. Not only did I have to prepare my own speech, but I’d also been advising President Bush on an upcoming address of his own. It was scheduled for Friday at the Economic Club in New York. The president hoped to reassure the country with a firm statement on the administration’s resolve. We were agreed on just about everything except for one key point. I advised him to avoid saying that there would be “no bailouts.”

The president said, “We’re not going to do a bailout, are we?”

I told him I wasn’t predicting one and it was the last thing in the world I wanted.

But, I added, “Mr. President, the fact is, the whole system is so fragile we don’t know what we might have to do if a financial institution is about to go down.”

When I stood at the podium at 10:00 a.m. that Thursday at the National Press Club, I knew only too well that the current system, weakened by excessive leverage and the housing collapse, would not be able to withstand a major shock.

To a room full of restless reporters I sketched the causes of the crisis. We all knew the trigger had been poor subprime lending, but I noted that this had been part of a much broader erosion of standards throughout corporate and consumer credit markets. Years of benign economic conditions and abundant liquidity had led investors to reach for yield; market participants and regulators had become complacent about all types of risks.

Among a raft of recommendations to better manage risk and to discourage excessive complexity, we called for enhanced oversight of mortgage originators by federal and state authorities, including nationwide licensing standards for mortgage brokers. We recommended reforming the credit rating process, especially for structured products. We called for greater disclosure by issuers of mortgage-backed securities regarding the due diligence they performed on underlying assets. And we suggested a wide range of improvements in the over-the-counter derivatives markets.

I finished and hurried back to the Treasury Building. I had hardly gotten inside my office when Bob Steel rushed in. Bob’s the consummate professional and is almost always upbeat. But that day he looked grim.

“I spent some time with Rodge Cohen this morning,” he said, mentioning the prominent bank lawyer advising Bear Stearns. “Bear is having liquidity problems. We’re trying to learn more.”

Before Bob had finished, I knew Bear Stearns was dead. Once word got out about liquidity problems, Bear’s clients would pull their money and funding would evaporate. My years on Wall Street had taught me this brutal truth: when financial institutions die, they die fast.

“This will be over within days,” I said.

I swallowed hard and braced myself. Whatever we did we would have to do quickly.

The crisis seemed to have arrived suddenly, but Bear Stearns’s plight was not a surprise. It was the smallest of the big five investment banks, after Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers. And while Bear hadn’t posted the massive losses of some of its rivals, its huge exposure to bonds and mortgages made it vulnerable. Bear had found itself in increasingly difficult straits since the previous summer, when, in one of the first signs of the impending crisis, it had been forced to shut down two hedge funds heavily invested in collateralized debt obligations.