How Free-Marketers Crafted Bank Program

By Peter Whoriskey
Washington Post Staff Writer
Saturday, November 8, 2008

When Treasury Secretary Henry M. Paulson Jr. needed someone to design one of the largest government interventions in the U.S. economy, he turned to one of his staff's most ardent disciples of free-market principles.

David Nason, a 38-year-old lawyer, then turned to his deputy, Jeremiah Norton, 31, a lawyer who colleagues say is even more devoted to the idea that the economy works best without government interference. Nason also brought in Dan Jester, 44, a former Goldman Sachs executive coaxed out of early retirement by Paulson. Jester, a lanky Texan with hair longer than is typical at Treasury, would be the "numbers guy."

Within 10 days, with markets crashing around them, the trio fashioned the terms of the $250 billion federal program to support the nation's banks. Along the way, they were pushed and prodded by a political team steeped in the ways of the White House and Capitol Hill that was less focused on free-market theory than on whether the program could win political support -- that it wouldn't be something ''people would scream over,'' as one said.

''You basically have to look at it in pragmatic terms,'' Nason said last week. ''We wanted to prevent a collapse of the financial system of the United States.''

The design of the federal program to invest in financial institutions, so far the largest single program in the government's $700 billion rescue effort, arose from Paulson's senior staff and inevitably reflects their talents, biases and experiences.

It is, in their view, more of a deal than an intrusion and Nason bristles at the idea that the program "nationalizes" the participating banks.

While Paulson and others had been mulling the possibility of making a government investment in banks for months, it wasn't until Sept. 30 that he asked Nason to draw up a plan, officials said.

The orders came during a meeting of the senior staff in the living room-like comforts of Paulson's office. A portrait of Alexander Hamilton overlooking the room, the group convened around a small coffee table, some seated on a blue plush couch, the others in chairs.

It was the day after the House had rejected the first $700 billion rescue plan and the Dow had plummeted 778 points. In the preceding days, several of the staff had worked so late that they just stayed all night and slept on their office couches. After Congress voted down the first rescue bill, the mood was low and it hardly seemed like the time to start designing a new initiative.

''We looked at each other and said, 'Uh . . . okay,' '' said Michele Davis, 42, the team's policy planning and communications director.

Her partners in the political arm of Paulson's team were Jim Wilkinson, a Texan who formerly worked for Condoleezza Rice and President Bush, and Kevin Fromer, previously an aide to former House speaker J. Dennis Hastert. They would ask over and over at meetings during the next days whether what Nason's team was fashioning would sell, politically.

The $700 billion rescue bill had given Treasury wide latitude to invest the money as officials saw fit, but any controversy arising from its implementation could compromise their effort to restore the nation's economic health.

''You don't want something that people scream over," Davis said. "That doesn't settle markets either.''

Given what amounted in some ways to a blank slate, Nason, Norton and Jester set to work. One of the key questions that arose: What should the government get in return?

Guided both by the rescue legislation and their instincts, Nason, Norton and Jester decided that in return for the government investment, the banks should give the government preferred stock shares.

Such shares have no voting rights -- that way, the government would not be in a position to influence the bank's operations, just as a free-marketer would hope.

The next critical question was how much the preferred shares should pay the government. Private investors were getting 9 or 10 percent on investments in financial institutions. But Nason's team wanted the program to attract banks, and they needed to offer a cheaper dividend rate to overcome the institutions' dislike of becoming entangled with the government.

Jester, relying on his contacts in the market, as well as Nason, decided that they should demand only a 5 percent dividend rate.

Paulson approved a 5 percent rate for the first five years. After that, the dividend rate would rise to 9 percent to encourage institutions to repay the government. The other politically charged decision was whether to force banks that took the money to abide by strict controls on executive compensation.

Free-market adherents typically argue that a company should be free to pay whatever it likes because it knows best how to maximize its profits. While Nason didn't express a strong view on executive pay provisions, the political advisers believed that more had to be done to limit pay.

Nason's team was "always looking at the goal of making the program attractive to healthy banks," Davis said. They "were leaning to the lower standard. They didn't want banks to be saying, 'No way, why would we be doing this?'

"Those of us who were more in the business of giving political advice asked, 'Well, how is the taxpayer protected?' "

The result: While not required by the legislation, the banks would be subject to what some analysts said was the most restrictive compensation limit in the law. Still, it wouldn't stop banks from richly rewarding their executives.

"The challenge all along was achieving the dual objective," Nason said. "The program had to be attractive enough to get banks to enroll and at the same time we had to protect the taxpayers."

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