If the financial history of the globe is a topic of interest to you Hank Paulson’s new book, On The Brink is a must read. Tim Geithner and Ben Bernanke were central players in that part of our history, but after reading this book you come away with the conclusion that it was Paulson who was pulling the strings every inch of the way.
There were some aspects of the book that I found to be not credible; there was one critical section that I thought the facts were a bit distorted. I think there was one part of the story that was omitted. As a result I was left questioning how many other aspects of this story were ‘skewed’.
Start with what I think is an indisputable fact. Hank Paulson is one of the smartest financial guys in the world. He is one of the top investment bankers; he knows debt and corporate finance as well as anyone. Throughout his book Hank demonstrates his knowledge and establishes the fact that he knows everyone in the game on a first name basis.
Given that as a backdrop, I have issues with the credibility of the following sections of the book:
I) What did he know (suspect) and when did he know it?
On August 17, 2006 the newly appointed TSec. met in Camp David with President Bush and his economic team. At that meeting Paulson said:
If you look at recent history, there is a disturbance in the capital markets every four to eight years.
Hank added in the book, “I was convinced we were due for another disruption”.
Hank was very much a hands-on CEO at GS before becoming TSec. He was a big risk taker, but he was very measured in his bets. I think it is important to look at GS’s record in the years preceding 2006 as a clue to Paulson’s thinking.
In the 2003-2006 periods Wall Street was coining money in originating/packaging and distributing Sub Prime and Alt-A mortgages. In those same years GS consistently ranked last or next to last on the league tables of how much of this business was done. If GS wanted to be #1 in this business they could have been. They had the brains, the balance sheet and the moxie. So for me this is a sign that the senior management at GS took a hard look at a big money making operation and said, “This one is going to stink, let’s keep a low profile”.
I think that Paulson was a big factor in steering GS away from the junk mortgage pitfall that ended up killing the competition. He had made up his mind on this issue years before the August 06 Camp David meeting. He saw on a daily basis the absolute junk that was coming from Wall Street. I maintain that when he spoke, he knew in the back of his mind that the source of the “next financial crisis” he was warning about was going to be bad mortgages.
If in 2006 Hank had sounded the alarm bell as he had inside of GS that there would have been a different outcome in 08 and 09. There were plenty of people (including myself) who were looking at the debt that was being created from the junk and saying, “This is just getting silly”. Paulson was too smart and too connected to have not seen this. He does not acknowledge this in his book. He claimed that he smelled trouble, but did not know where it would come from. I find that hard to believe.
II) The TARP debt-for-equity flip-flop
Anyone who knows corporate finance knows that equity is worth 10X’s more than debt. Paulson knows this from forty years ago. With this in mind, the time line of how the TARP program was shifted from one of buying distressed assets to buying the equity in the banks is important.
The TARP program was sold to the public and to Congress as a program to buy toxic assets that were “clogging” the system. Congress agreed to the $700b program on October 2, 2008. It contained a provision whereby Treasury could use the funds to acquire equity if necessary, but the expectations by all were that Treasury would be buying toxic assets and not common or preferred shares. Ten days later on October 12th, Paulson changed the game and switched from buying troubled mortgages to buying equity in the banks.
In the book, Paulson gives credit to two unlikely sources for the change in his thinking. Warren Buffet and Ben Bernanke. I think he just used those two as the basis for the change in plans. They just confirmed what he wanted do all along. Paulson makes reference to a discussion on September 30th 2008 with Bernanke:
Ben Bernanke told me that he thought that solving the crisis would demand more than illiquid asset purchases”. In Bernanke’s view, “we would have to inject equity capital into financial institutions.
So it was Ben that planted the seed for the massive flip-flop on the use of TARP funds. I think the seed was already there and Hank used Ben to support what he had already concluded.
Nine days after TARP was passed (October 11) Paulson had a phone conversation with Warren Buffett. During that call, Buffett urged Paulson to consider investing the TARP money in low coupon preferred stock in the banks as an alternative to buying assets. Paulson describes this as a ‘eureka’ moment, the point where he became convinced that this was the right way to use the money. He said of this phone call, “I was convinced Warren’s was the best way to make a capital purchase program attractive to banks”.
For me, this version of history does not pass the smell test. I believe that Paulson was well aware of the leverage that could be obtained by investing in equity versus debt. He describes in the book how $70b of equity could cover $700b in debt at a bank. Hank knew the value of equity. I maintain that his plan was all along to acquire equity, but he knew he could not sell that plan to Congress, so he masked his plans with a debt buyback. That the TARP legislation was drafted to give him the ability to buy equity was not a mistake of history, it was a part of a plan that Paulson had considered from the very beginning.
After the decision had been made to change the use of Funds and the money had been committed, Paulson continued to have Neel Kashkari (visibly) chasing after a methodology to implement an asset purchase program. This was done as a smoke screen to Congress to demonstrate that the original intent of the legislation, to buy troubled assets, was being pursued. No TARP money was ever used to buy the assets it was intended for.
The James Lockhart, OFHEO/FHFA Connection
A significant part of the book is spent relaying the facts leading up to the conservatorship of the GSEs, Fannie (FNM) and Freddie (FRE). I think there was a significant misrepresentation of the facts in the book. On page 6 Paulson says:
I had spent much of August working with Lockhart. A friend of the president’s since their prep school days, Jim understood the gravity of the situation, but his people, who had said recently that Fannie and Freddie were adequately capitalized, feared for their reputations.
This is not factually correct. It was not ‘some of Lockhart’s people’ who made the statement that F/F were adequately capitalized. It was Lockhart himself. In the days that followed, both Paulson and the president* repeated Lockhart’s words. Headlines and links on this ():
The fact that the president*, the TSec. and the chief regulator of the GSE’s all made misleading public statements regarding the health of the GSEs just months before they were put into conservatorship is an important part of this history. We now know, both from the book and other information, that there was a very high level of concern regarding the Agencies at exactly the time that these statements were made. These were listed companies with a big stock float; misleading information on their health was made public. Our highest officials repeated that information.
This aspect of the story was not put in the proper perspective. The implications of Lockhart’s words along with Paulson’s and the president’s role were glossed over. It is my opinion that a mistake was made with these statements. Paulson did not acknowledge that. This puts a taint on the entire narrative. If I can’t trust this aspect of the story, I have trouble believing in the rest of the information as well.
A Missing Link?
In numerous sections Paulson makes clear that as TSec he actually did not have much power to commit money toward fixing problems. He had no bazooka and he wanted/needed one. To do anything, he had to have the prior permission of Congress. TARP ultimately became his congressional bazooka. Hank and his staff knew early on that they needed the ability to act decisively and without the consent of Congress. They looked endlessly for ways to fight the battles without having to go to the Hill. They even used the 1934 Exchange Stabilization Fund to guaranty the money market funds. This step was effective; it showed how resourceful they were. It showed how far they were willing to push the envelope.
One unused arrow in Treasury’s quiver was the Federal Financing Bank ("FFB"). This is a doghouse bank owned by Treasury. It finances government agencies like HUD and the Post Office. It makes long-term loans to rural electrics, it provides financing for foreign arms sales. The FFB has made big loans to the FDIC in the past. It has a mandated ceiling on its balance sheet of $500 billion. In 2008 it had assets of only $50b, it had $450b of buying bower. So this bank had to have been considered as a tool for Hank to use. He left no other stone unturned. I, for one, can’t believe that he did not consider FFB when he was looking for a bazooka and he didn’t want to ask congress for a new one. There is no mention of the FFB in the book. I found that odd.
The following is not based on facts that I can deliver to you. Therefore treat it as such. **
I wrote a piece sometime ago on the FFB. Later on, someone who claimed to have the minutes of the FFB May 2008 Board minutes contacted me. (The minutes are not public) I did not review this; portions of it were read to me on the phone. There was one comment that struck me. I do not recall the exact language. The essence was that in the minutes there was a reference to a meeting that took place outside of the Board Meeting and at that meeting there was some discussion of using FFB to acquire significant quantities of mortgage related assets. No details of that meeting were included in the minutes. As TSec. Hank Paulson was the Chairman of the Board of the FFB, he had to be part of those discussions. FFB was his “baby”.
My thinking on this has always been that the idea of using FFB to acquire assets was a continuation of the ‘Break the Glass’ plan that was developed by Treasury in February/March of 2008. This was the blue print for TARP. The missing link to the break the glass plan was where does the money come from? FFB was a possible candidate given that it was controlled and run by Treasury and had the capacity to buy a lot of assets. FFB was not designed to do this. My assumption was that it was looked at and it was determined that there were legal (political?) restrictions on FFB that would not allow it to be the bazooka that Hank wanted. (Note: FFB did go on to buy $400mm of worthless Hope Now bonds. So it was used as a popgun not a bazooka.)
There is another more speculative side to this. What mortgage assets were being considered for purchase? The toxic ones or was there consideration back in May of 2008 to acquire the MBS of Fannie Mae, Freddie Mac and Ginnie Mae? We will never know. There is no discussion of this in the book and the details of that meeting back in May of 08 will remain a mystery.
In the Author’s Note, Paulson says, “I have been blessed with a good memory”. I wonder why his memory is not so good on this aspect of the story.
*On July 10, 2008 I was asked to draft a question re: the GSEs that would be posed to President Bush by a FOX business reporter. I did that, and the question was asked. Bush totally dodged my question and responded, “Their (F/F’s) regulator (James Lockhart, his childhood friend) has said, ‘they are adequately capitalized’”. End of interview. I don't have a clip of this, but Roger Ailes at FOX does. Someday it will be re-aired as part of this history.
**I write to government agencies all the time. I ask them questions. They often say, ‘Buzz off”. Sometimes they say, “Here’s the info you wanted.” It is rare that I do not get a response. I didn’t get any from these:
- 12/3/2009 to FFB: Hello, I am a journalist. I write about financial matters.
- Can you provide me with the Email link that has the minutes of May 2008 FFB board meeting?
- 12/14/2009 to FFB: Hello again. I am disappointed at the lack of response on my request. Possibly I should put some cards on the table.
I have reviewed the May 2008 board minutes. I took notes but do not have a copy. I know that you have given this link to other journalists. I learned of this from them. They contacted me to help with a story on this. I know that there is a reference in the minutes to a secret meeting. I know that the topic of this secret meeting was a discussion as to the feasibility of the FFB acquiring Mortgage Bonds. This meeting is an important part of that history. I would like to know more about it. I believe my readers (2mm this year) would also like to know about it.
- Please reconsider my request. Thank you.