Beginnings of Trouble

In the summer of 2007, fear spread that subprime mortgage loans would be vastly higher than had been estimated, and investors began to flee risky investments. Paulson's early response mainly relied on pressuring private entities to fix the problem rather than undertake explicit government action. In October 2007, he gathered Wall Street chief executives at the Treasury Department and began talks that led to the "Master Liquidity Enhancement Conduit," which was envisioned as a private fund that would stabilize the market for troubled financial entities attached to banks called Structured Investment Vehicles. That effort ultimately fizzled.

Another early effort was the "Hope Now Alliance" program, in which mortgage companies, consumer advocates and investors in mortgage loans reached a voluntary agreement - after jaw-boning by Paulson - to create a standardized procedure to delay by five years the resetting of certain adjustable rate mortgages for people who were making their current mortgage payment but could not handle a higher rate.

But as the crisis deepened and the economy worsened in early 2008, Paulson undertook more direct government intervention. In March 2008, investment bank Bear Stearns was on the verge of failing when the Federal Reserve, after extensive consultation with and an endorsement from Paulson, decided to extend the company emergency loans and then, two days later, to put $30 billion of taxpayer money at risk to enable it to be sold to J.P. Morgan Chase. Under pressure from Paulson, who wanted Bear Stearns shareholders to suffer a major loss, J.P. Morgan was to pay only $2 per share (it was later changed to $10 a share, with the government exposed to only $29 billion in losses).

The Bailout Broadens

The government-chartered Fannie Mae and Freddie Mac emerged as a source of weakness in the financial system, as investors globally were unsure whether they would be able to weather the housing downturn, and if they didn't, whether the government would cover their debts. That drove up rates on mortgage loans, contributing to further weakness in the housing market and overall economy.

In July 2008, Paulson asked Congress for the authority to use government money to back the companies, arguing that if he had the authority, he would be less likely to do it. "If you've got a squirt gun in your pocket, you may have to take it out," Paulson told a Senate panel. "If you've got a bazooka and people know you've got it, you may not have to take it out."

By September 2008, Paulson used that weapon. As losses by Fannie and Freddie mounted to a degree that threatened insolvency, Paulson had the companies put in conservatorship, a legal status similar to bankruptcy. That essentially put the government on the hook for the $5.4 trillion worth of mortgages the companies own or guarantee.

Less than a week later, the next financial giant to cry for help was investment bank Lehman Brothers. Paulson warned Lehman CEO Richard Fuld to find a buyer, but none materialized. The bank crumbled, leading to a general disintegration of the credit market in which banks refused to lend to each other. As a result of this domino effect, Merrill Lynch sold itself to Bank of America and American International Group was bailed out by the government with $85 billion worth of credit (now the U.S. owns 80% of AIG). Paulson knew he had to do something to get banks lending money again. His team had worked on possible crisis scenarios, and they eventually went to Congress with the $700 billion bailout plan.

TARP

Known in the Bush administration as the 'break the glass' plan, Paulson asked Congress for $700 billion in fall 2008 to buy banks' troubled assets. He did not mention using the money to provide capital to banks, even though Federal Reserve Chairman Ben Bernanke had suggested doing just that. When the Treasury secretary submitted the outline of his audacious plan to Hill lawmakers, it was a mere three pages long. It did not provide for any oversight or restrictions on executive pay. It gave full control to Paulson. Congress was not happy.

"Paulson's arrogance is shown not only in how he treated rank-and-file members at the hearings, but in his original proposal, which has to be regarded as a ransom note: 'We've got your 401(k) and you'll never see it alive again unless we get $700 billion in unmarked bills,'" said Rep. Brad Sherman (D-Calif.).

The first draft of Paulson's bailout plan failed to pass Congress. But 400 pages later, with Congressional oversight and restrictions, the $700 billion plan got through the House and Senate on Oct. 3. President Bush quickly signed it into law as the Troubled Asset Relief Program (TARP). By Oct. 14, 2008, Paulson had concluded that asset purchases would be too slow, complex and offer not enough bang for the buck in stabilizing the financial system. Investing the money into banks, he concluded, would be faster. He brought in chief executives of the nation's most important banks and made them an offer they couldn't refuse: multi-billion dollar investments, in the form of preferred stock, by the government.

Paulson used most of the money he had access to - an initial installment of $350 billion in the TARP - for capital infusions into banks, to the consternation of some in Congress, who were angry he did not use any of the funds to directly aid homeowners at risk of losing their homes to foreclosure. He did end up using $17 billion of the money for emergency loans to automakers General Motors and Chrysler, which otherwise were at risk of suffering a disorderly bankruptcy.

Paulson has defended his use of the money, arguing that the American economy's tailspin would be still worse had Congress not authorized the bailout.

'''Our objectives in asking Congress for a financial rescue package were to first stabilize a financial system on the verge of collapse, and then to get lending going again to support the American people and businesses,' Mr. Paulson said at a Congressional hearing. 'If the financial system were to collapse, it would significantly worsen and prolong the economic downturn.'"

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