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September
8, 2008
As Crisis Grew, a Few Options Shrank to One
By
CHARLES DUHIGG, STEPHEN LABATON and ANDREW ROSS SORKIN
This article was reported by Charles
Duhigg, Stephen Labaton, and Andrew Ross Sorkin and written by Mr. Duhigg.
For Freddie Mac, the beleaguered mortgage finance giant that was
desperately trying to avoid a government takeover, the moment of truth came
three weeks ago.
In a last-ditch effort to raise money to offset billions of
dollars of losses, Freddie’s chief executive, Richard F. Syron, traveled to New
York to huddle with potential investors at the headquarters of Goldman Sachs and a law firm,
Davis, Polk & Wardwell.
Over a couple of days, he and his lieutenants made their pitch —
only to have every option rejected, people briefed on the discussions said.
Empty-handed and crestfallen, Mr. Syron canceled plans to join his
family at their weekend home on Cape Cod and returned to Washington to deliver
the bad news to Treasury Secretary Henry M. Paulson Jr.: he still hadn’t found anyone willing
to save Freddie Mac.
Mr. Paulson and a team at the Treasury had been working for months
on plans to prop up both Freddie and its sister company, Fannie
Mae, hoping they would never have to act.
Now a consensus was emerging that they had little choice. If
Freddie’s and Fannie’s problems worsened, a crisis of confidence could spread
through the worldwide financial system, deepening the difficulties in the
housing market and further weakening the economy — in the midst of a
hard-fought presidential campaign.
So while Democrats gathered in Denver to nominate Senator Barack
Obama two weeks ago and Republicans met last week in St. Paul to
nominate Senator John
McCain, Mr. Paulson and his top aides worked nonstop — often for 18
hours a day, including Labor Day weekend — to scrutinize possibilities and complete
the details of a government takeover of both companies.
Mindful of the high stakes, Mr. Paulson convened a secure video
teleconference on Aug. 26 from a bunker under the West Wing of the White House
to brief President Bush, who was at his ranch in Crawford, Tex. Fannie’s and
Freddie’s situation was deteriorating, he advised the president, and something
needed to be done, according to a White House official who was not authorized
to speak to the media.
On Sunday, with the president’s blessing, Mr. Paulson announced
the solution: a takeover that could turn into the biggest and costliest
government bailout ever of private companies.
The action was a huge comedown for two powerful companies that had
long held enormous sway in financial boardrooms and government corridors.
“Today’s necessary but likely very expensive action for taxpayers
is the consequence of regulatory neglect and of a broader political system’s
reluctance to take on what should have been clearly seen as festering
problems,” said Lawrence H. Summers, who as Treasury secretary under
President Bill
Clinton had warned of mounting problems at the companies.
The downfall of Fannie and Freddie stems from a series of
miscalculations and deferred decisions, both by their executives and government
officials, according to company insiders, regulators, auditors and outside analysts.
The companies expanded rapidly in recent years, initially playing down the
risks posed by a housing bubble. Then, as the housing slump expanded
nationwide, they resisted raising enough new capital that might have provided a
financial cushion to weather the storm. Lawmakers, paralyzed by partisan
infighting, delayed strengthening regulatory oversight of the politically
powerful companies.
Mr. Paulson did not fully recognize the extent of Fannie’s and
Freddie’s financial problems until recent months. In July, seeking to avoid a
government takeover, he asked Congress for the power to bail out Fannie and
Freddie — hoping that gaining such authority would calm markets and make a
rescue unnecessary.
But he quickly learned that getting those powers made their
execution inevitable. His strategy did not anticipate that investors, already
spooked by a year of troubles in the financial markets, might panic any time
that rumors of problems at Fannie and Freddie cropped up.
The seizure of Fannie and Freddie is all the more surprising
because, as recently as late March, Washington viewed the companies as saviors
of the housing market and the economy, rather than as risks to them. Instead of
requiring Fannie and Freddie to scale back, regulators gave them a green light
to buy and guarantee more and bigger mortgages.
On March 19, James B. Lockhart, their chief regulator, dismissed
swirling rumors about their financial health. “The actions we’re taking today,”
Mr. Lockhart declared, referring to a decision to ease restrictions on how much
capital they were required to hold, “make the idea of a bailout nonsense in my
mind. The companies are safe and sound, and they will continue to be safe and
sound.”
With this vote of confidence, the battered stocks of the two
companies rose sharply, to more than $30 a share, levels they would not reach
again.
But within about a month, Mr. Paulson was becoming concerned about
the companies. In April, he met with their chief executives and top members of
the Senate Banking Committee in a closed-door session.
Over the previous years, as the housing bubble inflated, Fannie
and Freddie stepped up their purchases of the risky but profitable subprime and
alt-A loans that were at the root of the mortgage crisis. Though Congress had
just pushed Freddie and Fannie to accelerate purchases of loans to give the
housing market a boost, Mr. Paulson was now urging lawmakers to establish
stronger oversight and push the companies to raise more capital.
The companies’ thin financial cushions were becoming even more
stretched, Mr. Paulson said, according to people with firsthand knowledge of
the conversations; and if either company got into trouble, it could threaten
the already weakened economy.
In the months after, Fannie Mae managed to raise $7 billion in new
capital to offset losses, fulfilling a promise made to regulators. Freddie Mac,
however, failed to make good on its pledge to raise $5.5 billion. Still, though
the companies’ stock prices continued drifting downward, they continued to
borrow money without problem, which is crucial to their ability to buy
mortgages.
But in early July, as the housing crisis continued to widen and
deepen, confidence in the companies began to evaporate. Rumors spread that
Fannie and Freddie were not fully reflecting losses from rising foreclosures on
mortgages they held.
The stocks of both companies fell more than 60 percent during the
second week of July, to single-digit prices, and the cost of borrowing money
rose for both, reflecting anxiety over growing risk. Alarmed, Mr. Paulson asked
Congress to give him the authority to rescue the companies if necessary.
Congress quickly granted him that power.
At the time, Mr. Paulson said he hoped never to use the authority.
“If you’ve got a bazooka and people know you’ve got it, you may not have to
take it out,” he told one Congressional panel.
Just in case, however, Mr. Paulson began analyzing his options.
In late July, he called John
J. Mack, the head of the investment bank Morgan Stanley, and asked his firm to consider advising the
Treasury. Within the agency, Mr. Paulson told his deputies to start examining
contingency plans.
As those discussions progressed, a mantra emerged among top
officials, people with knowledge of the Treasury’s conversations said. The
government’s priorities were to maximize market stability, mortgage
affordability and taxpayer protection.
Mr. Paulson added a mantra of his own: he privately said he didn’t
want to “kick the can down the road” and leave the problems for a future
administration and Congress to solve.
Morgan Stanley assigned teams of financial analysts in the United
States, Britain and India to review loan data from Fannie and Freddie around
the clock, because of concerns that the problems might be worse than the
companies had revealed. Bankers estimated that it would take as much as $50
billion to offset the companies’ combined losses.
Throughout August, telephone conferences between officials and
advisers often began at 7:30 in the morning and lasted until 11 at night. Mr.
Paulson started telling friends that after winning authority to intervene, he
“felt like a dog who’d caught the bus and didn’t know what to do with it.”
As possibilities were debated, Treasury officials eventually
concluded that if they had to act, the best choice was a conservatorship — a
takeover that would make government backing of the companies’ debts and
obligations explicit but would remove the companies’ leadership while still
keeping them operating.
“They called it ‘sticking the companies in a timeout,’ ” said
one person with firsthand knowledge of the conversations. “It protects the
safety and soundness of the economy but also gives everyone breathing space.”
Most worrisome, the companies’ cost of borrowing was growing more
expensive, and central banks in Asia and Russia were scaling back their
purchases of the companies’ debt. Freddie, in particular, was in a bind. Unlike
Fannie, it had not raised capital earlier, when markets were less nervous. Mr.
Syron figured that the company had one final chance to raise money and signal
to debt investors that the company was viable.
However, when he went to New York, potential investors told Mr.
Syron there was too much uncertainty around the Treasury’s intentions; if
investors acted now, and Freddie was later seized by regulators, they would
lose everything they had invested.
Mr. Syron told Mr. Paulson that efforts to raise money had been
fruitless, prompting the Treasury secretary to set up the Aug. 26 video
conference call with the president.
After briefing the president, the Treasury moved quickly. Over
Labor Day weekend, Mr. Paulson convened meetings with Ben S. Bernanke, chairman of the Federal Reserve; Kevin Warsh, a Fed governor; and Mr.
Lockhart, Fannie and Freddie’s regulator.
Meanwhile, advisers from Morgan Stanley contacted Freddie Mac and
asked it to provide data on 12 million mortgages. Executives within Freddie Mac
viewed the request as a signal that they had won a brief reprieve because it
would take weeks to analyze that much information.
Unknown to either company, however, the decision for a takeover
had already been made. Mr. Lockhart last week started interviewing potential
candidates to replace the top executives. On Thursday, the last day of the
Republican convention, Mr. Paulson met with President Bush in the Oval Office.
Mr. Bush said the Treasury plan had his support.
The next day, Mr. Paulson called Mr. Syron and Mr. Mudd to
separate meetings at the offices of Mr. Lockhart without saying why. Freddie
was still looking for fresh capital and interviewing people for senior
positions. But in his meetings, Mr. Paulson said he intended to put both
companies into conservatorship. As part of that plan, Mr. Syron and Mr. Mudd
would both be required to step down.
Mr. Mudd pleaded with Mr. Paulson to spare Fannie Mae, people with
knowledge of the meeting said. He said that he abided last spring with
regulators’ demands to raise more capital, adding that the company was in
better financial health than Freddie.
Mr. Paulson responded that Freddie was nearing a crisis and that,
in the eyes of the markets, the companies were joined at the hip. He would not
treat them differently for fear that similar problems, over time, would engulf
Fannie Mae, but that time closer to the election. Mr. Paulson told both
companies that they had no choice.
President Bush returned from Camp David, the presidential retreat,
on Saturday morning. The Treasury secretary told him that the companies had
reluctantly agreed to the plan. Shortly before 11 a.m. on Sunday, in a
conference room across the hall from Mr. Paulson’s office, the Treasury
secretary and Mr. Lockhart signed the documents that give each company access
to up to $100 billion in taxpayer money to cover future losses — but also put
Fannie and Freddie directly under government control.
Edmund L. Andrews and Gretchen Morgenson contributed reporting.