“We’ve made a decision,” Paulson announced to his team and advisers in a conference room at Treasury the last week of August about the fate of Fannie and Freddie. “They can’t survive. We have to fix this if we are going to fix the mortgage market.”
Upon his return to Washington from Beijing, Paulson had spent a day listening to presentations from Morgan Stanley and others and had decided that they had no choice but to take action, especially as he watched the shares of both companies continue to slide. To Paulson, unless he solved Fannie and Freddie, the entire economy would be in jeopardy.
Morgan Stanley had spent the past three weeks working on what was internally called “Project Foundation.” Some forty employees had been assigned to the task, working nights and weekends. “It’s easier in jail,” complained Jimmy Page, an associate. “At least you get three meals a day and conjugal visits.”
The firm had undertaken a loan-by-loan analysis of the portfolios of the two mortgage giants, shipping reams of mortgage data from Fannie and Freddie off to India, where some thirteen hundred employees in Morgan’s analytic center went through the numbers on every single loan—nearly half the mortgages in the entire United States.
The Morgan Stanley bankers had also conducted a series of phone calls with investors to get a better sense of the market’s expectations. The outcome was, as Dan Simkowitz described it to the Treasury team: “The market cares what the Paulsons think. John Paulson and Hank Paulson. They want to know what John Paulson thinks is enough and they want to know what Hank Paulson is going to do.” (John Paulson was the most successful hedge fund investor of the past two years, having shorted subprime before anyone else, making some $15 billion for his investors and personally taking home more than $3.7 billion.)
The Morgan Stanley bankers estimated that the two mortgage companies would need some $50 billion in a cash infusion, just to meet their capital requirement, which should be equal to 2.5 percent of their assets; banks, at a minimum, had to have at least 4 percent. With the housing market deteriorating it was clear that the GSEs’ thin capital cushion was in danger.
Worse, Paulson had heard rumors when he was in China that Russia had approached some Chinese officials to suggest that both countries start selling large amounts of Freddie and Fannie debt to force the United States to prop them up. Jamie Dimon had separately called him and encouraged him to take decisive action.
Paulson led a discussion around the table at Treasury about whether it made sense to put Fannie and Freddie in Chapter 11 bankruptcy protection or whether conservatorship—in which the companies would still be publicly traded with the government as a trustee exercising control—was the better option.
Ken Wilson was a bit anxious about pursuing what Paulson was describing as a “hostile takeover” without more professional guidance. “Hank, there is no fucking way we can pursue these kinds of alternatives without getting a first-rate law firm,” Wilson told him.
“Okay,” Paulson agreed. “So what do you think?”
“Let me call Ed Herlihy at Wachtell and see if he’ll do it,” Wilson said. “The idea of putting these guys in Chapter 11 is a joke. These are still privately owned entities with obligations to shareholders and bondholders. It’s going to get ugly.”
Wilson had a compelling reason for having recommended Herlihy: He had been involved in some of the biggest takeover battles in corporate America. Earlier in the year he had helped advise JP Morgan Chase in its acquisition of Bear Stearns. His firm—Wachtell, Lipton, Rosen & Katz—was synonymous with corporate warfare. One of its founding partners, Martin Lipton, had devised among the most famous of antitakeover defenses, the “poison pill.” If Treasury was planning a government-led hostile takeover—the first in history—then Herlihy was certainly the lawyer they wanted.
They began their battle plans on the weekend of August 23. Herlihy and a team of Wachtell, Lipton lawyers came to Washington on a half dozen different Delta and US Airways shuttles in order not to arouse suspicion. Paulson walked them through the game plan, assisted by Dan Jester, the lanky Texan who had joined Treasury less than a month earlier. The hope was that like megamergers that are often completed over the course of a single three-day weekend to protect against a leak impacting the stock market, they could take Fannie and Freddie over during the Labor Day holiday, which was the following weekend.
The lawyers and the Treasury officials spent several hours debating possible tactics, relevant statutes, and the structures of each of the companies. Jester and Jeremiah Norton, another staffer at Treasury, outlined a plan to put capital into Fannie and Freddie, and an actual mechanism to take control of them, via the purchase of preferred stock and warrants.
But Paulson soon realized that the Labor Day target was going to be impossible. One of the lawyers had noticed that Fannie’s and Freddie’s regulator from the Federal Housing Finance Agency, James Lockhart, had written letters to both companies over the summer saying that they were considered adequately capitalized. “You’ve got to be kidding me,” Paulson replied when he heard about the letters. Treasury could face resistance from the GSEs’ supporters in Congress and from the companies themselves if the government were to reverse itself apparently arbitrarily. The companies’ claims that they were well capitalized and the regulator’s endorsement would both have to be challenged.
“That’s intangibles and all the stuff that I would call bullshit capital,” Paulson complained.
“We need to reconstruct the record,” Jester announced about the Federal Housing Finance Agency letters.
“Right, right,” Herlihy chimed in. “We need new letters that are pretty bad—or at least accurate.”
The Federal Reserve was then asked to provide examiners, and they would spend the next two weeks going through the books, desperately trying to document the capital inadequacies at Fannie and Freddie.
As the Treasury team went around the table, one issue kept getting raised about pushing forward with a takeover: What if the boards of the two companies resisted?
“Look, trust me,” Paulson said. “You don’t believe me, but I know boards, and they’re going to acquiesce. When we get done talking with them, they’ll acquiesce.”
On the morning of Tuesday, August 26, Paulson walked over to the White House and was escorted downstairs to the basement of the West Wing, where he was given a seat in the five-thousand-square-foot Situation Room. At 9:30 President Bush was beamed onto one of the large screens from his ranch in Crawford, Texas, for a secured videoconference with Paulson. After some brief pleasantries, Paulson laid out his plan to mount the equivalent of a financial invasion on Fannie and Freddie. Bush told him he could proceed with the preparations.
As Labor Day weekend approached, the Treasury team and its advisers started to plot the actual details of the dual takeover. They knew they would have to move quickly, with military precision, and in secrecy before the GSEs could start rallying their supporters in Congress. They wrote scripts specifying exactly what they would tell the companies and their boards. They wanted to make certain that there could be no compromises, no delays. Internally, Treasury officials talked about offering Fannie and Freddie two doors: “Door 1, you cooperate; Door 2, we’re doing it anyway.”
On Thursday morning, August 28, Bob Willumstad and AIG’s head of strategy, Brian Schreiber, walked into JP Morgan’s headquarters at 270 Park Avenue and, escorted by a security guard, were taken by private elevator to the firm’s executive floor, where they had an appointment with Jamie Dimon.