As Crisis Grew, a Few Options Shrank to One
By CHARLES DUHIGG, STEPHEN LABATON and ANDREW ROSS SORKIN
Published: September 7, 2008
This article was reported by Charles Duhigg, Stephen Labaton, and Andrew Ross Sorkin and written by Mr. Duhigg.
Jay Mallin/Bloomberg News
The government had hoped to prop up Fannie Mae and Freddie Mac with explicit federal backing, but investors were not sufficiently comforted.
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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.
More Articles in Business »A version of this article appeared in print on September 8, 2008, on page A1 of the New York edition.
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