Late March 2008

For the first few days after the Bear Stearns rescue, the markets calmed. Share prices firmed up, while credit default swap spreads on the investment banks eased. Some at Treasury, and in the market, thought that after seven long months, we had finally reached a turning point, just as the industry intervention in Long-Term Capital Management had marked the beginning of the end of 1998’s troubles.

But I remained wary. Bear Stearns’s failure had called into question not only the business models but also the very viability of the other investment banks. This uncertainty was unfair for those firms that, after adjusting for accounting differences, had stronger capital positions and better balance sheets than many commercial banks. But these doubts threatened the stability of the market, and we needed to do something about the situation.

The Fed’s opening of its discount window to the primary dealers on March 17 had been a big boost. Because of its potential exposure, the Fed, working jointly with the SEC, began to put examiners on-site. This was a critical move. Investors who had lost confidence in the SEC as the investment banks’ regulator would be reassured to see them under the Fed umbrella.

The regulators’ initial analyses showed that Merrill Lynch and Lehman Brothers had the most work to do to build larger liquidity cushions. Merrill suffered from its share of well-publicized mortgage-related problems, but the firm was diversified and had by far the best retail brokerage business in the U.S., along with a strong brand name and a global franchise. I believed they would be able to find a buyer if they had to. Having worked with John Thain when he was Goldman’s president and COO, I was optimistic that he would get a handle on Merrill’s risk exposure and take care of its balance sheet. If anyone understood risk, it was John.

Lehman was another matter. I was frankly skeptical about its business mix and its ability to attract a buyer or strategic investor. It had the same profile of sky-high leverage and inadequate liquidity, combined with heavy exposure to real estate and mortgages, that had helped bring down Bear Stearns. Founded in 1850, Lehman had a venerable name but a rocky recent history. Dissension had torn it apart before it was sold to American Express in 1984. A decade later it was spun off in an initial public offering. Dick Fuld, as CEO, had done a remarkable job of rebuilding it. But in many ways, Lehman was really only a 14-year-old firm, with Dick as its founder. I liked Dick Fuld. He was direct and personable, a strong leader who inspired and demanded loyalty, but like many “founders,” his ego was entwined with the firm’s. Any criticism of Lehman was a criticism of Dick Fuld.

As Treasury secretary, I often turned to Dick for his market insights. A former bond trader, he was shrewd, willing to share information, and very responsive. I could tell that Bear’s demise had shaken Dick. How far he was willing to go to protect his firm was another question.

For some time, I had been encouraging a number of commercial and investment banks to recognize their losses, raise equity, and strengthen their liquidity positions. I said that I had never, over the course of my career, seen a financial CEO who had gotten into trouble by having too much capital.

I emphasized this point to Fuld in late March. He maintained he had enough capital but knew he needed to restore confidence in Lehman. Shortly after, Dick called to say that he was thinking of approaching General Electric CEO Jeff Immelt and Berkshire Hathaway CEO Warren Buffett as possible investors. Dick said he served on the New York Fed board with Immelt and could tell that the GE chief liked and respected him. And he thought Berkshire Hathaway would be a good owner. I told Dick that GE was unlikely to be interested but that calling Warren Buffett was worth a try.

A few days later, on March 28, I was lying on my couch at home, watching ESPN on my birthday, when the phone rang. Dick was calling to say he had talked to Buffett. He wanted me to call Warren and put in a good word. I declined, but Dick persisted. Buffett, he said, was waiting for my call.

It was a measure of my concern for Lehman that I decided to see just how interested Warren was. I picked up the phone and called him at his office in Omaha. I considered Warren a friend, and I trusted his wisdom and invariably sound advice. On this call, however, I had to be careful about what I said. I pointed out that I wasn’t Lehman’s regulator and didn’t know any more than he did about the firm’s financial condition—but I did know that the light was focused on Lehman as the weakest link, and that an investment by Warren Buffett would send a strong signal to the credit markets.

“I recognize that,” Buffett said. “I’ve got their 10-K, and I’m sitting here reading it.”

Truth is, he didn’t sound very interested at all.

I learned later that Fuld had wanted Buffett to buy preferred stock at terms the Omaha investor considered unattractive.

The following week, Lehman raised $4 billion in convertible preferred shares, insisting it was raising the capital not because it needed to, but to end any questions about the strength of its balance sheet. Investors greeted the action heartily: Lehman’s shares rose 18 percent, to above $44, and its credit default spreads dropped sharply, to 238 basis points from 294 basis points.

It was April 1—April Fools’ Day.

Bear Stearns’s failure in March had highlighted many of the flaws in the regulatory structure of the U.S. financial system. Over the years, banks, investment banks, savings institutions, and insurance companies, to name just some of the many kinds of financial companies active in our markets, had all gotten into one another’s businesses. The products they designed and sold had become infinitely more complex, and big financial institutions had become inextricably intertwined, stitched tightly together by complex credit arrangements.

The regulatory structure, organized around traditional business lines, had not begun to keep up with the evolution of the markets. As a result, the country had a patchwork system of state and federal supervisors dating back 75 years. This might have been fine for the world of the Great Depression, but it had led to counterproductive competition among regulators, wasteful duplication in some areas, and gaping holes in others.

I had aimed my sights at this cumbersome and inefficient arrangement from my first days in office. In March 2007, at a U.S. Capital Markets Competitiveness Conference at Washington’s Georgetown University, participants from a wide spectrum of the markets had agreed that our outmoded regulatory structure could not handle the needs of the modern financial system. Over the following year, Treasury staff, under the direction of David Nason, with strong support from Bob Steel, had devised a comprehensive plan for sweeping changes, meeting with a wide variety of experts and soliciting public comment. On March 31, 2008, we unveiled the final product, called the Blueprint for a Modernized Financial Regulatory System, to a standing-room-only crowd of about 200. There must have been 50 reporters there amid the marble and chandeliers of the 19th-century Cash Room.

Calling for the modernization of our financial regulatory system, I emphasized, however, that no major regulatory changes should be enacted while the financial system was under strain. I hoped the Blueprint would start a discussion that would move the reform process ahead. And I stressed that our proposals were meant to fashion a new regulatory structure, not new regulations—though we clearly needed some.

“We should and can have a structure that is designed for the world we live in, one that is more flexible, one that can better adapt to change, one that will allow us to more effectively deal with inevitable market disruptions, and one that will better protect investors and consumers,” I said.

Long-term, we proposed creating three new regulators. One, a business conduct regulator, would focus solely on consumer protection. A second, “prudential” regulator would oversee the safety and soundness of financial firms operating with explicit government guarantees or support, such as banks, which offer deposit insurance; for this role we envisioned an expanded Office of the Comptroller of the Currency. The third regulator would be given broad powers and authorities to deal with any situation that posed a threat to our financial stability. The Federal Reserve could eventually serve as this macrostability regulator.

Until this ultimate structure was in place, the Blueprint recommended significant shorter-term steps that included merging the Securities and Exchange Commission with the Commodity Futures Trading Commission; eliminating the federal thrift charter and combining the Office of Thrift Supervision with the Office of the Comptroller of the Currency; creating stricter uniform standards for mortgage lenders; enhancing oversight of payment and settlement systems; and regulating insurance at the federal level.

Though our team worked closely with other agencies in crafting the Blueprint, we had run into some disagreements with the Federal Reserve. It wanted to retain its role as a bank regulator, particularly its umbrella supervision over bank holding companies; without this it felt it couldn’t effectively oversee systemically important firms. We saw no reason to highlight our differences. We all agreed that it would not be wise for the Fed to relinquish these responsibilities in the short run because it was the bank regulator with the most credibility—and resources. Ben Bernanke supported the Fed’s taking on the new macro responsibilities from the beginning. But he and Tim Geithner wanted to be sure, and rightly so, that we gave the Fed the necessary authorities and access to information to do the thankless job of super-regulator. (I was pleased to see that the Obama administration, in its program of reforms, echoed the Blueprint’s call for a macrostability regulator.)

The Blueprint did not focus much on government-sponsored enterprises like Fannie Mae and Freddie Mac. We did note that a separate regulator for the GSEs should be considered, and we also recommended that they fall under the purview of the Fed as market stability overseer.

Meantime, I was determined to push forward on the reform of the two mortgage giants. As credit dried up, their combined share of new mortgage activity had grown from 46 percent before the crisis to 76 percent. We needed them to provide low-cost mortgage funds to support the housing market. Hence the importance of their March 19 announcement that they would be making up to $200 billion in new funds available to the markets, in conjunction with planned new capital raising.

By April it was clear that the downturn would be long, and not just in the U.S.—mortgage activity in the U.K., for example, had ground to a near halt. Oil prices continued to rise, the dollar stumbled, and the press was filled with stories of food shortages, and riots, in several countries.

I traveled to Beijing to meet with Wang Qishan, who had replaced Wu Yi as vice premier, to set the table for the next round of the Strategic Economic Dialogue. I had known and worked with Wang, whom I considered a trusted friend, for 15 years. A former mayor of Beijing, with an appetite for bold action and a sly sense of humor, he had guided his country out of the SARS crisis and led the preparation for the 2008 Olympic Games. Though we spent considerable time discussing the vital issues of rising energy prices and the environment, which were to be the focus of our upcoming June meeting, Wang was most interested in the problems in the U.S. capital markets. I was candid about our difficulties but mindful that China was one of the top holders of U.S. debt, including hundreds of billions of GSE debt. I stressed that we understood our responsibilities.

In truth, U.S. markets were weakening again. Banks continued their efforts to raise capital, even as they suffered more big losses. On April 8, Washington Mutual said it would raise $7 billion to cover subprime losses, including a $2 billion infusion from the Texas private-equity group TPG. On April 14, Wachovia Corporation announced plans to raise $7 billion. Merrill Lynch reported first-quarter losses of $1.96 billion on $4.5 billion in write-downs, mostly from subprime mortgages, while Citigroup recorded a $5.1 billion loss, owing to a $12 billion write-down on subprime mortgage loans and other risky assets.

A somber mood prevailed when the G-7 held its ministerial meeting in Washington on April 11. That day, the Dow plunged 257 points, after General Electric’s first-quarter earnings came in lower than expected. Talk of oil prices, which were topping $110 a barrel on their way to a July high of nearly $150, dominated the meeting, but the state of the capital markets was very much on the ministers’ minds.

There was a great deal of discussion about mark-to-market, or fair-value accounting. European bankers, led by Deutsche Bank CEO Joe Ackermann, had cited this as a major source of their problems, and a number of my counterparts were understandably looking for a quick fix. Many favored a more flexible approach, but I staunchly defended fair-value accounting, in which assets and liabilities are recorded on balance sheets at current-market prices rather than at their historical values. I maintained that it was better to confront your problems head-on and know where you stood. Frankly, I believed the European banks had been slower than our own to confront their problems partly because of these differences in accounting practices. But I sensed that my European colleagues were increasingly aware of the seriousness of the banking problem.

The G-7 meeting featured an “outreach dinner” in the Treasury’s Cash Room for financial CEOs. Most of the major institutions were represented: the guest list included John Mack of Morgan Stanley, John Thain of Merrill Lynch, Dick Fuld, Citigroup chairman Win Bischoff, JPMorgan CEO Jamie Dimon, and Deutsche’s Ackermann.

The mood was dark. A few of the bankers thought we were nearing the end of the crisis, but most thought it would get worse. I went around the table and called on people, asking how we had gotten to where we were.

“Greed, leverage, and lax investor standards,” I remember John Mack saying. “We took conditions for granted, and we as an industry lost discipline.”

“Investment managers now know what we don’t know,” noted Herb Allison, the TIAA-CREF CEO, in what was his last day on the job. “We used to think we knew a lot more about these assets, but we’ve been burned, and until we see large-scale transparency in assets, we’re not going to buy.”

Mervyn King, governor of the Bank of England, took a look at the big picture, questioning whether we had allowed the financial sector to become too big a part of our economies.

“You are all bright people, but you failed. Risk management is hard,” he said to the assembly. “So the lesson is, we can’t let you get as big as you were and do the damage that you’ve done or get as complex as you were—because you can’t manage the risk element.”

The bankers complained bitterly about hedge funds, which they felt were shorting their stocks and manipulating credit default swaps and, in the CEOs’ minds, all but trying to force some institutions under. Almost every one of them wanted to regulate the funds, and no one wanted that more than Dick Fuld, whose face reddened with anger as he asserted, “These guys are killing us.”

As we left the dinner, Dave McCormick, who served as the main liaison to the G-7 and other countries’ finance ministries, told me, “Dick Fuld is really worked up.”

I told Dave I wasn’t surprised. Lehman was in a precarious position. “If they fail, we are all in deep trouble,” I said. “Maybe we can figure out how to sell them.”

Congress had recessed for two weeks in the second half of March, and lawmakers got an earful from constituents who were worried about the ongoing housing woes and the weakening economy—and were in some cases resentful about what they perceived as the government bailout of Wall Street. The House and the Senate pushed ahead with housing legislation, which included a constellation of plans for foreclosure mitigation, affordable housing, and bankruptcy relief. Democrats, led by Chris Dodd and Barney Frank, pushed HOPE for Homeowners, a Federal Housing Administration program to provide guarantees to refinance mortgages for subprime borrowers at risk of losing their homes.

Republican lawmakers, particularly in the House, lambasted many of these proposals as bailouts of deadbeats and speculators. And the White House threatened a veto because of its displeasure with bankruptcy modifications of mortgages and a proposal to distribute $4 billion in Community Development Block Grants to state and local governments to buy foreclosed properties. I myself had real doubts about the efficacy of many of the proposals—we calculated that HOPE for Homeowners would aid 50,000 borrowers at most.

But GOP senators had returned from the spring recess more in a mood for compromise. On April 10 the Senate voted 84 to 12 in favor of a $24 billion bill of tax cuts and credits designed to boost the housing market.

On April 15, Bob Steel, Neel Kashkari, Treasury chief economist Phill Swagel, and I met with Ben Bernanke and some of his aides at the Fed to review a contingency plan that Neel and Phill had been working on for some time. Termed the “Break the Glass” Bank Recapitalization Plan, after the fire axes kept ready in glass cases until needed, the paper laid out the pros and cons of a series of options for dealing with the crisis.

Among its main options, the government would get permission from lawmakers to buy up to $500 billion in illiquid mortgage-backed securities from banks, freeing up their balance sheets and encouraging lending. Other moves included having the government guarantee or insure mortgage-backed assets to make them more appealing to investors, and having the FHA refinance individual mortgages on a massive scale. “Break the Glass” also laid out the possibility of taking equity stakes in banks to strengthen their capital bases—though not as a first resort.

“Break the Glass” was the intellectual forerunner of the Troubled Assets Relief Program (TARP) we would present to Congress in September. In April, however, the state of the markets was not yet so dire, nor was Congress anywhere near ready to consider granting us such powers.

Later that afternoon, the longtime block to GSE reform broke. At my urging, Chris Dodd had called a meeting with Richard Shelby and the chief executives of Fannie Mae and Freddie Mac. We gathered in Dodd’s offices at the Russell Senate Office Building, in a small room that was unusually warm and intimate for an office on the Hill. Wood-paneled, with red curtains and carpet, it was decorated with memorabilia from Dodd’s long political career, including photos of his father, Thomas J. Dodd, who had also served as a U.S. senator from Connecticut. It was a strangely homey setting for a meeting between some of the fiercest opponents on the GSE issue.

Although Dodd, like many leading Democrats, was sympathetic to Fannie and Freddie, Shelby had long wanted to put them under stricter supervision; in 2005 he had backed an unsuccessful bill that would have drastically reined in their portfolios.

Fannie’s chief, Dan Mudd, the son of famed CBS News correspondent Roger Mudd, had grown up in Washington and had spent much of his career working at GE Capital, the finance unit of GE. Unlike many who rode the Washington gravy train, he knew how to run a real business and had been recruited to clean up Fannie after the accounting scandal of 2004. Since then, he had built a strong, loyal team.

Freddie Mac’s CEO, Dick Syron, a former CEO of the Boston Fed and the American Stock Exchange, faced a more difficult situation. He had a problematic board, and I wasn’t convinced he could deliver on what he promised.

By the time we sat down together, it was clear that the two CEOs recognized that something needed to be done. But the key was Shelby, who had finally decided that it was time to act.

Before we went in, my legislative aide, Kevin Fromer, reminded me, “This is Dodd’s meeting, so let Dodd run it.” He knew I had a tendency to jump in and take over.

But after a few pleasantries, Dodd turned to me. I made clear that Fannie and Freddie were critically important to helping us get through this crisis; that we needed to restore confidence in them; that reform required a new, stronger regulator; and that it was crucial for them to raise capital. Mudd noted that Fannie planned to raise $6 billion; Syron was noncommittal.

We’d come with a list of crucial unresolved issues, and at Shelby’s prompting I asked David Nason to run through them. They concerned the new regulator’s increased jurisdiction over the portfolio, including the power to force divestitures, its ability to set and temporarily increase capital requirements without congressional approval, and its oversight of new GSE business activities. Other issues included increasing conforming loan limits for high-cost areas and setting up an affordable housing fund.

“Well,” Shelby said, “those are the key items.”

Shelby is a formidable talent, a crafty legislator, and an astute questioner. But, frankly, I never clicked with him. He was a true conservative. I don’t think he ever really trusted me, because I came from Wall Street, and he hated the Bear Stearns rescue. This was the rare time in the two and a half years I was in D.C. where I saw him do much more than sidestep an issue or point out the problems with someone else’s proposal.

But here Shelby took charge, and I saw the Alabama senator at his best.

“I liked our bill,” I remember him saying. “But I know I can’t get everything I want.”

Shelby was now ready to move. For him, the big issues were how to deal with the sizes of the portfolios and new product approval. Treasury cared mostly about systemic risk and safety and soundness matters, while Dodd—like Barney Frank—wanted bigger loan limits and an affordable housing fund.

“Are you going to work with us?” Shelby asked Mudd and Syron. “Do you guys really want to get this done?”

Under Shelby’s no-nonsense gaze, they said yes, and I left the Russell Building feeling very optimistic and determined to draft the language that would help fix Fannie and Freddie.

It wouldn’t be a moment too soon.

In early May, Fannie announced a first-quarter loss of $2.2 billion—its third straight quarterly loss—cut its common stock dividend, and announced plans to raise $6 billion through an equity offering. Eight days later, Freddie announced its first-quarter results—a loss of $151 million—along with plans to raise $5.5 billion in new core capital in the near future.

On May 6, Treasury officials met with a group of large mortgage lenders to speed up loan modifications for qualified homeowners facing foreclosure. That same day, the White House issued a statement outlining its opposition to the housing stimulus bill working its way through the House. Officially known as H.R. 3221, this ungainly and complicated piece of legislation had begun life as an energy bill in 2007, before turning into a housing vehicle in February. It contained a hodgepodge of provisions that were expensive and likely to be ineffective. The administration considered the bill burdensome, prescriptive, and risky to taxpayers. The legislation addressed GSE reform, but the White House was concerned about the other measures. I was convinced we could work with Barney Frank to fashion an acceptable compromise.

On the Senate side, our summit meeting with Dodd and Shelby was paying dividends. After considerable wrangling, they ushered the Federal Housing Finance Regulatory Reform Act of 2008 through the Senate Banking Committee on May 20. It provided for a strong new GSE regulator, the Federal Housing Finance Agency, with the authority to set standards for minimum capital levels and sound portfolio management.

After Bear Stearns, it would not have been unusual for the regulators involved to have resorted to turf building and finger pointing. That’s too often the way in Washington. But we knew how important it was that we continue to act in a united way. We were focused on increasing market confidence in the remaining four investment banks by encouraging them to take tangible steps to strengthen their balance sheets and their liquidity management.

The Primary Dealer Credit Facility (PDCF) allowed the Fed to conduct on-site examinations of institutions regulated by the SEC. I had dispatched a Treasury team led by David Nason to visit the investment banks to find out how the process was working. They met with the firms’ CFOs, treasurers, and lawyers, and found that the arrangement was working fine—Lehman was the most pleased to have the Fed on-site.

But there was a considerable amount of tension and borderline mistrust between the agencies. Chris Cox was open and cooperative, but some SEC staff were understandably uneasy that their agency could be overshadowed by the Fed on the regulation of securities firms. I had a lot of confidence in the New York Fed, because it had been proactive and creative in dealing with Bear and consistently tried to get ahead of the curve.

I believed it vitally important for the regulators to work together. Ben Bernanke and Chris Cox agreed. They weren’t interested in turf wars. They cared, as I did, about market stability and wanted the Fed inside the firms to protect that.

Traditional protocol would have left the agencies to sort out their issues, but I took the initiative in mid-May to convene a meeting with Ben, Tim Geithner, Chris Cox, Bob Steel, and David Nason. The SEC and the Fed agreed to draft a memo of understanding that would set ground rules to coordinate on-site examinations and to improve information sharing between the agencies. We also discussed how long the PDCF should run. It was a temporary program, created under Federal Reserve emergency authority, and was scheduled to expire in September. I supported Ben and Tim’s view that the facility should be extended.

It would have been easy to leave many technical and legal issues for the regulators to work out, but the policy and greater economy implications were too great for Treasury to sit on the sidelines.

Even as we worked on these regulatory matters, the heat was rising under Lehman Brothers. In April a New York hedge fund manager named David Einhorn had announced that he was shorting Lehman. Then, on May 21, at an investment conference in New York, he raised the ante, questioning Lehman’s accounting of its troubled assets, including mortgage securities. He insisted that the bank had vastly overvalued these assets and had underreported its problems in the first quarter. With his frequent television appearances and negative public comments, Einhorn seemed to be leading a crusade against Lehman.

Almost on cue, the firm’s health took a turn for the worse. On June 9, the bank released earnings for the second quarter a week early, reporting a preliminary loss of $2.8 billion, owing to write-downs in its mortgage portfolio. Lehman also said it had raised $6 billion in new capital—$4 billion in common stock and $2 billion in mandatory convertible preferred shares. But the damage was done. The shares had tumbled from $39.56 the day of Einhorn’s speech to $29.48.

I had been constantly in touch with Dick Fuld. (My call log would show nearly 50 discussions with him between Bear Stearns’s failure and Lehman’s collapse six months later, and my staff probably was on at least as many calls.) He asked me what I thought of his president and his chief financial officer. How would the market react if he replaced them? I said I didn’t know, but there was a chance the market would see that as a desperate act. On June 12, he fired longtime friend Joseph Gregory, who was president and chief operating officer, and demoted Erin Callan, his chief financial officer. Herbert (Bart) McDade, a senior member of Dick’s team and the company’s former global head of equities, replaced Gregory, while co–chief administrative officer Ian Lowitt succeeded Callan. Lehman shares touched a new year low of $22.70. They would end June at $19.81.

All year, Dick had been struggling to come to grips with the erosion of confidence in his firm. Yet even though he was on full alert, he remained overly optimistic. He would insist Lehman didn’t need capital and then reluctantly raise it, hoping to calm the market. Finally, after the second-quarter numbers went public, he admitted that he needed to find a buyer or a strategic investor by September, when new results would be released.

“What are your third-quarter earnings going to be like?” I asked.

“Not good.”

Yet even in their efforts to find that buyer or investor, Dick and his people found it hard, I think, to price the firm attractively enough. When I talked with him about possible buyers, I pointed out—and Dick agreed—that Bank of America was the most logical candidate. Not only did BofA lack a strong investment banking business, but CEO Ken Lewis had great confidence in his own ability to buy and assimilate things. He had bought Countrywide and Chicago’s LaSalle Bank in the last year. He was in a buying mood. Dick had his lawyer, Rodge Cohen, call Lewis, and Lewis had Gregory Curl, BofA’s head of global corporate development and planning, look at Lehman’s books. But after Curl and his team had done their work, BofA decided not to pursue a deal.

My conversations with Dick were becoming very frustrating. Although I pressed him to accept reality and to operate with a greater sense of urgency, I was beginning to suspect that despite my blunt style, I wasn’t getting through.

With Lehman looking shakier, I asked my senior adviser, Steve Shafran, to begin contingency planning with the Fed and SEC for a possible failure. Steve, a brilliant 48-year-old former Goldman Sachs banker who had retired from the firm in 2000, was an expert financial engineer. A widower who had moved to Washington to raise his four children, he had offered to help me on a part-time basis. As the crisis unfolded, Steve would work around the clock as a go-to problem solver.

While Bob Hoyt and his people combed through Treasury history to see what authorities we might use if Lehman failed, Treasury, the Fed, and the SEC worked to assess potential damages and devise ways to minimize these. They identified four areas of risk that had to be controlled in any collapse: Lehman’s securities portfolio, its unsecured creditors, its triparty repo book, and its derivatives positions. The team managed to hammer out some possible protocols over the course of three months.

The SEC would want to be sure it could ring-fence the broker-dealer and ensure that all customers got back their collateral; the Fed might be able to step in and take over the triparty repo obligations of Lehman, which were secured. But figuring out what to do with the derivatives book proved elusive. There were no silver bullets, and I worried that the team wasn’t doing enough. Wasn’t there something else we could try, I’d ask, some legal authority we could invoke?

But there was none. The financial world had changed—with investment banks and hedge funds playing increasingly critical roles—but our powers and authorities had not kept up. To avoid damaging the system, we needed the ability to wind down a failing nonbank outside of bankruptcy, a court process designed to resolve creditor claims equitably rather than to reduce systemic risks. I raised the issue publicly for the first time at a speech in Washington in June. And I followed that up with a July 2 speech in London.

Shafran’s team briefly worked on crafting legislation to give the secretary of the Treasury wind-down powers. Barney Frank was supportive but cautioned us against trying to push legislation that was so complex substantively and politically. We concluded there was no way we could get what we needed passed with the congressional summer recess on the way and presidential elections in November. We knew it wasn’t going to be easy to work with the inadequate authorities we had, but we also knew that aggressively making the case for new authorities might itself precipitate Lehman’s failure. Instead, Barney encouraged the Fed and Treasury to interpret our existing powers broadly to protect the system, saying: “If you do so, I’m not going to raise legal issues.”

Meantime, the housing and GSE reform legislation continued to move much slower than expected. Initially, we’d thought it would be done by the July 4 recess, but that deadline had slipped away as Republicans dug in against homeowner bailouts, placing much of the burden for passage on the Democrats.

While Congress dithered, the markets got jittery. I was at a meeting of finance ministers from the Americas and the Caribbean in Canc?n, Mexico, on June 23, when I heard that Freddie Mac shares had dropped below $20. That was off more than $10 since they’d announced plans to raise capital in March. I’d been hoping all along that the GSEs would be able to raise capital. Fannie had done so in May and June, raising $7.4 billion in common and preferred stock. But Freddie had not done anything. Now they would not be able to access the market, and we did not have the legislation we needed to protect them or the taxpayers.

I put in a call to Barney Frank to find out the progress of the bill, but I couldn’t reach him. I had just gone into the lavatory in the hotel where the finance ministers were meeting, when Barney returned my call.

“Barney,” I said, “you’re getting me in a men’s room in Mexico!”

“Don’t drink the water,” he replied without losing a beat. Barney then told me he was committed to GSE reform and optimistic about getting our legislation.

On June 28 I went on a five-day trip to meet with political leaders, finance ministers, and central bankers in Russia, Germany, and the U.K. After seeing Russia’s finance minister, Alexei Kudrin, a voice of reason and a straight-shooting reformer, I had meetings scheduled with Prime Minister Vladimir Putin and President Dmitry Medvedev.

Once I arrived at the White House, as the Russian government building is called, an official tried to usher me into the conference room where Putin and I were to meet. There was a long table, and at the end of the room a gallery with the press and TV cameras. It was clear that the Russians intended to make me sit there and cool my heels in front of the U.S. and Russian press until the great man arrived. But my chief of staff, Jim Wilkinson, had other ideas.

“Whoa!” he exclaimed. “We’re not going to let the U.S. secretary of the Treasury be a political prop for Putin.”

So we remained in the hall, and we waited and waited, concerned that we wouldn’t make our next meeting, with Medvedev at the Kremlin. Putin was, I imagine, flexing his muscles, showing that he was more important than the new president.

Finally, the prime minister arrived, and we walked into the meeting room together. We had agreed to exchange brief opening statements, then dismiss the media and begin our meeting. But instead Putin launched into a soliloquy on the U.S. financial crisis. With oil prices at record highs, the Russians were feeling their oats. I spoke about the work we had been doing with Kudrin on sovereign wealth funds, and Putin responded, “We don’t have a sovereign wealth fund. But we are ready [to create one], especially if you want us to.”

Frankly, this was too good a political opportunity for Putin to pass up. In 1998 it was a humiliating Russian default that started the global financial crisis. And now he was temporarily able to point to a reversal of fortunes.

Our private session was much more productive, like all such Putin meetings: he was direct and a bit combative, which made it fun. He never took offense, and we could spar back and forth. We discussed the U.S. economic situation, then went four rounds on Iran. I talked about the Russian banks living up to the United Nations sanctions, and he pushed back hard, saying, “They’re our neighbors, and we have to live with them. We don’t want a nuclear weapon in Iran, and I’ve talked to the president many times about this, but sanctioning them is not the way to do it.”

The talk turned to the World Trade Organization, a sore subject for Putin. He basically said, “We’ve made many concessions, and if we don’t get admission to the WTO, we’re going to pull back the concessions we made. I have Russian companies telling me that we have gone too far to open up to foreign competition. So this is going to get done soon, or we’re going to start pulling things back.”

After the long wait for Putin, we barely made the meeting with Medvedev, who was a couple of miles away in the Kremlin. Once more I had to endure some public gloating about the U.S. financial crisis, though he was more moderate and polite in front of the cameras than Putin. Behind closed doors Medvedev was very engaged, and as he peppered me with questions, he revealed a good understanding of markets. I was surprised not to be asked about Fannie Mae and Freddie Mac, because Kudrin had told me to be ready to talk about the GSEs, and Putin himself had raised the subject in 2007 with President Bush. I was soon to learn, though, that the Russians had been doing a lot of thinking about our GSEs’ securities.

Shortly after I returned from my trip, on Monday, July 7, the Federal Reserve and the SEC announced that they had finally signed a memo of understanding. The next day, speaking at an FDIC-sponsored forum on mortgage lending in Arlington, Virginia, Ben Bernanke signaled that the Fed was considering extending into 2009 the duration of the Primary Dealer Credit Facility and the Term Securities Lending Facility, its lending programs for primary government dealers.

But there was more bad news than good. The same day the Fed and the SEC announced their agreement, a report came out of Lehman Brothers, of all places, speculating that Fannie and Freddie might need as much as $75 billion in additional capital. It set off an investor stampede. Freddie’s stock dropped almost 18 percent, to $11.91, on July 7, while Fannie’s shares fell more than 16 percent, to $15.74. Both stocks rebounded somewhat the next day, as a result of assurances from their regulator, the Office of Federal Housing Enterprise Oversight, but they plunged again on July 9. I made two public statements myself that week in support of the GSEs. Each time, the market steadied for a while then resumed its downward tilt. Short sellers were becoming active. The press and investors in the U.S. and around the world were losing confidence in Fannie’s and Freddie’s viability. The GSEs went to the market almost as often as the U.S. government, with funding needs in the tens of billions of dollars every month. We couldn’t afford a failed auction of their securities.

Investment banks were sinking, too, and Lehman was hit hardest. Its shares dropped 31 percent that week, while its credit default swaps ballooned out to 360 basis points on Friday from 286 basis points on Monday.

I’d hoped that a combination of capital raising and reform would be enough to shore up the GSEs. Fannie had raised some equity, but Freddie had missed the opportunity, and Congress still had not acted on the proposed reforms. Now, we would need much more. For the first time, I seriously considered going to Congress for emergency powers on the GSEs. Before, with Democrats and Republicans at war, it had been impossible to get relatively modest things done without a crisis.

But now we had one—and we needed to act swiftly. I made a series of calls to alert key Hill leaders to the worsening situation and let them know, without being too specific, that we might need more authorities in the bill. Next, I needed to explain the urgency of this situation to the president and to request his permission to formally approach Congress. I knew he was always at work by about 6:45 a.m., so Friday morning I called Josh Bolten and asked to see President Bush. I walked over just after 7:00 a.m. and joined the president in the Oval Office, where I ran through my concerns about the capital markets, the vulnerability of Lehman, and the need to move on the GSEs. Later that morning, the president was to meet with his economic team at the Department of Energy to discuss oil prices, which hit a peak of $147.27 that day. I arranged to ride over with Josh and the president in his limo. I asked the president to publicly affirm the importance of the GSEs after his meeting.

“We’re probably going to have to take emergency action,” I said. “But you can help calm the markets in the meantime.”

The president understood the gravity of the moment. After the meeting, he called in the press, as was the custom, and made a point of emphasizing how important Fannie and Freddie were. I also gave a statement, noting that we were focused on supporting Fannie and Freddie “in their current form.” I hoped to calm market fears of a government takeover that would wipe out shareholders.

Later we had lunch in the president’s private dining room, adjacent to the Oval Office, with Vice President Cheney and Josh. I had come to ask for the authority to deal with Fannie and Freddie, but the first words out of my mouth were “I don’t believe there’s a buyer for Lehman.”

I mentioned that I’d spoken with former Fed chairman Alan Greenspan, who believed we should get authority to wind Lehman down, in case of failure.

Then I laid out the case for acting quickly on the GSEs, requesting permission to ask Congress for power to, among other things, invest in the mortgage giants. I didn’t provide a lot of details, because we were still debating what we would need. The president said it was unthinkable to let Fannie and Freddie fail—they would take down the capital markets and the dollar, and hurt the U.S. around the world. Although he disliked everything the GSEs represented, he understood that we needed them to provide housing finance or we weren’t going to get through the crisis. The first order of business, he said, was “save their ass.”

July 11 turned out to be a day for the books. The president and the Treasury secretary’s reassuring words about the GSEs failed to soothe the markets—Fannie’s shares fell 22 percent, to $10.25, while Freddie’s dropped 3.1 percent, to $7.75. Then, late in the afternoon, the Office of Thrift Supervision seized the teetering IndyMac Federal Bank, with more than $32 billion in assets, and turned it over to the FDIC. It was to that point the third-biggest bank failure in U.S. history.

The news reports of that day showed the first scenes of depositors lined up in the hot sun outside the failed thrift’s headquarters in Pasadena, California, desperate for their money. The government guaranteed deposits up to $100,000, but these citizens had lost faith in the system. This all-too-eerie reprise of the haunting images of the Great Depression was the last thing anyone needed just then.