Hank Paulson’s new book is called On the Brink, but it could well have been entitled Over the Edge.
Hank Paulson’s new book is called On the Brink, but it could well have been entitled Over the Edge. The story of his role as US Treasury Secretary throughout the great banking crash of 2008–9 gives an impression of people being swept along by a swirling chaos of unexpected events, often completely out of control.
‘This is the economic equivalent of war,’ Paulson said in the middle of the financial crisis in 2008, scrambling to find a resolution for AIG before the insurance behemoth brought down the entire economy. Warfare is certainly what it felt like. For those who lived out the financial crisis on trading desks around the world, reading Paulson’s account will be like reliving the nightmare weekend when Lehman Brothers collapsed in September 2008.
The story starts with Paulson agonising over whether to accept the job as Treasury Secretary in an administration that had become terminally unpopular, not least with his own family. Little more than a year after he eventually accepts, he finds himself facing the early rumblings of the coming crisis. Serial problems — weaknesses in the US housing market, the collapse and rescue of Bear Stearns, the bailout of Fannie Mae and Freddie Mac (the US government-sponsored mortgage firms) — all overlap in a slow motion rehearsal of the crises to come.
The desperate deal-making and interventions put off the evil day, but at a price. We witness moral hazard in the making. As the Lehman’s collapse looms, the leaders of the major American investment banks clearly expect the government to step in to rescue Lehmans and the other at-risk banks in the same way they rescued Bear Stearns and Fannie and Freddie. They clearly believe in ‘too big to fail’. Indeed, Dick Fuld, the Lehman chief, insists on $10 a share for his worthless bank at one point, partly from hubris, and partly because he does not think the government will let him go under. This risk-blind behaviour goes on almost to the very end.
The core of the tale is the crucial weekend when Paulson tries to cobble together a private sector rescue for Lehman. Paulson paints an extraordinary scene, of the ultra-competitive leaders of the big American investment banks, alpha males all, trying to work together to rescue their rivals. You can almost smell the testosterone and adrenaline coming off the page.
As the troubles at Lehman Brothers developed, Paulson writes that the British Chancellor of the Exchequer, Alistair Darling, was someone with whom he thought he had ‘a good working relationship and who shared [his] views on the markets’, concluding that Darling was a ‘straight shooter’. You can get no greater compliment than that from an American. As Lehman careered towards disaster, the special relationship quickly turned sour as Paulson found that he and Darling, were, in Churchill’s phrase, ‘separated by a common language’.
Paulson had been counting on Barclays to come to Lehman’s rescue, but in the final hours, Paulson received a call from John Varley, the CEO of Barclays, who said that ‘the FSA had declined to approve the deal’. ‘The British screwed us,’ Paulson cried, landing the blame for Lehman’s collapse squarely at Alistair Darling’s door.
Paulson does not go as far as to accuse Darling of duplicity, but he acknowledges that something was certainly lost in translation. Darling had expressed that the FSA and Treasury had ‘some concern’ about the stress that a Barclays-Lehman acquisition would place on our already beleaguered financial system in the UK.
The Chancellor’s strong warning, wrapped in his characteristic Scottish courtesy, was completely lost on the American Treasury Secretary. Paulson writes, ‘It occurred to me that I had not caught his [Darling’s] true meaning. …What I’d taken as understandable caution should have been taken as a clear warning.’
There are reasons to doubt this version of events. There is another story going around, that the FSA would have approved the deal had Paulson been willing to share the risk of supporting the merger. A former trader at Lehman, Lawrence McDonald, claims that ‘Darling was willing to do it 50:50 and that it was Paulson who said no’. At the Treasury Select Committee last week, Barclays CEO John Varley said that he never even asked FSA CEO Hector Sants for the go-ahead on the deal because the Americans had refused to support the transaction in the first place. Paulson writes that ‘The Fed could not legally lend to fill a hole in Lehman’s capital’.
As one can imagine, the situation was incredibly complex. As the most talented minds were seeking a solution for Lehman at the Federal Reserve, news of impending disaster at Merrill Lynch and at AIG started to trickle in. The contagion was spreading.
In addition to the complexity of the situation, Paulson and Darling failed to understand each other’s regulatory structure. Darling’s caution was partly a reluctance to increase the City’s exposure to the shaky American markets, but in large part he was facing a restriction of British law. Moreover, Paulson himself recognised that the regulatory structure ‘had not begun to keep up with the evolution of the markets … [which] led to counterproductive competition among regulators, wasteful duplication in some areas, and gaping holes in others”.
The contagion soon started to infect the rest of Wall Street. A few days after Lehman’s collapse, a senior Vice-Chairman at Morgan Stanley rang Paulson to say that speculators and short-sellers were calling for blood, undermining confidence in his bank and pummelling its shares. Disaster spilled out of the stock markets and into markets for commercial paper, threatening the survival of large companies like GE by shutting down their access to short-term liquidity.
Engineering the bailout imposed a massive personal and political cost on Paulson and his colleagues. Suffering from nausea and dry heaves at moments of extreme stress, Paulson had to assent to emergency measures that contradicted his innate instincts. Paulson agreed to ban short-sales on 799 financial stocks for ten days at the height of the crisis, a move that, he wrote, felt like burning books. After agreeing to bail out AIG, the President told Paulson, ‘Someday you guys are going to have to tell me how we ended up with a system like this and what we need to do to fix it’. It was a good question. Financial crisis and collapse is nothing new. In relatively recent times, we have seen the spectacular collapse of individual institutions like Salomon Brothers and Long Term Capital Management, not to mention the savings and loan calamity in the 1980s and the crisis in the Lloyd’s of London reinsurance market.
The last chapter changes pace from the frenetic, adrenaline-charged tempo of the crisis and adopts a more reflective tone. For the first time we perceive in this highly intelligent, experienced, driven man some glimmers of wisdom, albeit one chapter and two years too late.
He offers a few lessons from the crisis, probably as applicable to the UK as to the US. We have been borrowing too much from other countries with high savings rates, like China and Japan. Our regulatory system is outmoded and fails to address the financial structures that we have developed recently. The system itself was carrying far too much leverage, especially in complex, opaque instruments. Finally, financial institutions that are too big to be resolved pose a risk to an economy that has come to expect the government to be the bearer of risk of last resort.
David Davis MP is the chairman of the Future of Banking Commission.