On The Brink

Henry M. Paulson, Jr, “On The Brink (Inside the Race to Stop the Collapse of the Global Financial System), Business Plus, 2010, 457 Pages

Henry Paulson was former CEO of Goldman Sachs and then Treasury Secretary from 2006-2009. As Treasury Secretary Paulson was at the center of all the action throughout the crisis, he was even more at the center of the crisis than Ben Bernanke. This book captures the steady drumbeat of one crisis after another better than any I have read on this matter—we truly were On the Brink. Between March and September 2008, eight major U.S. financial institutions failed—Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia--six of the in September alone. And the damage was not limited to the U.S. More than 20 European banks, across 10 countries, were rescued from July 2007 through February 2009.

One of the most interesting book sections involves the reasons that Lehman Brothers was allowed to fail, and the reasons for changing TARP from buying toxic assets to capital injections into banks. He is not very convincing in the Lehman matter as he only states he had no authority to save it and it presented too much of a moral hazard. Yet weeks later AIG is saved. As far as TARP: it appears that the only way to get it through Congress was to portray it as a direct effort to buy up failing mortgages when, all along, they knew they needed capital infusions into banks capital structure where they could achieve a 10:1 effect with the infusions.

It is startling to remember when reading this book, that Paulson was a Republican and was appointed by George Bush. Yet all the Republicans (other than Bush) come off as less than helpful and how positively Paulson speaks about Barrack Obama, Nancy Pelosi, Chris Dodd, Harry Reid, Barney Frank, and John Kerry. Paulson is particularly critical of John McCain and the actions he took during the crisis. Paulson is generally critical of the rest of the Senate and House. We truly have a dysfunctional bunch in our House and Senate; particularly the Republicans.

My Notes:

Pg. 64: In retrospect, the crisis that struck in August 2007 had been building for years. The dangers for the U.S. economy had been obscured by an unprecedented housing boom, fed in part by the low interest rates that helped us recover from the downturn that followed the bursting of the late ‘90s technology bubble and the impact of the 9/11 attacks. The housing bubble was driven by a big increase in loans to less creditworthy, or subprime, borrowers that lifted homeownership rates to historic levels. In July 2006, fully 69 percent of U.S. households owned their own homes, up from 64 percent in 1994. Subprime loans had soared from 5 percent of total mortgage originations in 1994 to roughly 20 percent by July 2006. By the end of 2007, more than 50 percent of subprime loans were originated by mortgage brokers.

Pg. 67: Securitization of mortgages began in 1970 by the U.S. Government National Mortgage Association that allowed lenders to combine individual mortgages into packages of loans and sell interests in the resulting securities. In theory, this was all to the good. Banks could make fees by packaging and selling their loans and risks could be diversified around the world. However, lacking the ability of traditional lenders to examine the credit quality of the loans underlying these securities, investors relied on rating agencies—which employed statistical analyses rather than detailed studies of individual borrowers—to rate the structured products.

Pg. 74: In an average year 600,000 homes were foreclosed on.

Pg. 440: Four Lessons from the Crisis:
1. The structural economic imbalances among the major economies of the world that led to massive cross-border capital flows are an important source of the justly criticized excesses in our financial system. (We are living off Chinese savings).
2. Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age.
3. The financial system contained far too much leverage, as evidenced by inadequate cushions of both capital and liquidity. Much of the leverage was embedded in largely opaque and highly complex financial products.
4. The largest financial institutions are so big and complex that they pose a dangerously large risk.

Pg. 445: Congress should replace Fannie Mae and Freddie Mac with one or two private-sector entities that would purchase and securitize mortgages with a credit guarantee explicitly backed by the federal government. These entities should be set up like public utilities and governed by a rate-setting commission that would establish a targeted rate of return. This approach would address the inherent conflicts between private ownership and public purpose that are unresolved in the current GSE structure.

Pg. 449: The credit crisis also exposed the erosion in mortgage underwriting standards, particularly in the originate-to-distribute securitization chain. To strengthen the underwriting practices and better align the interests of all parties, sponsors of these securities should be required to keep a continuing direct economic stake in the mortgages so that they have some “skin in the game,” with exposure to any future credit losses.