Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

CHAPTER TWO

In a leafy enclave of northwest Washington, D.C., Hank Paulson was pacing back and forth in his living room, his cell phone sitting in its usual place, against his ear. It was Easter Sunday, exactly one week after the takeover of Bear Stearns, and Paulson had promised his wife, Wendy, that they’d take a bicycle ride in Rock Creek Park, the large public space that bisects the capital, just down the road from their home. She had been annoyed with him all weekend for spending so much time on the phone.

“Come on, just for an hour,” she said, trying to coax him out of the house. He finally relented; it was the first time in more than a week that he would try to take his mind off work.

Until his phone rang again.

Seconds later, after hearing what the caller had to say, the Treasury secretary exclaimed, “That makes me want to vomit!”

It was Jamie Dimon on his speakerphone from his wood-paneled office on the eighth floor of JP Morgan’s headquarters in Midtown Manhattan, overlooking a barren Park Avenue. He had just told Paulson something the Treasury secretary didn’t want to hear: Dimon had decided to “recut” his $2-a-share deal for Bear Stearns and raise the price to $10.

The news wasn’t completely unexpected. Paulson, who could be relentless, had phoned Dimon virtually every day that week (interrupting his early-morning treadmill jog at least once), and based on those conversations, he knew a higher price for Bear was a possibility. In the days since announcing the deal, both men had become justifiably worried that disgruntled Bear shareholders would vote down the deal in protest of the low price, creating another run on the firm.

But Dimon’s decision still roiled Paulson. He had expected that if Dimon did raise the price, he’d hike it by no more than a few dollars—up to $8 a share, say, but not into double digits.

“That’s more than we talked about,” replied Paulson, who was now whispering into the phone in his unmistakable raspy voice, hardly able to believe what he was hearing. Just a week earlier, when Dimon had indicated that he was prepared to pay $4 a share, Paulson had privately instructed him to lower the price: “I could see something nominal, like one or two dollars per share,” he had said. The fact was, Bear was insolvent without the government’s offer to backstop $29 billion of its debt, and Paulson did not want to be seen as a patsy, bailing out his friends on Wall Street.

“I can’t see why they’re getting anything,” he told Dimon.

So far, nobody other than Dimon knew that the Treasury secretary of the United States of America was behind the original paltry sale price, and Paulson wanted to keep it that way. Like most conservatives, he still honored the principle of “the invisible hand”—that widely held, neoclassical economic notion that official intervention was at best a last resort.

As a former CEO himself, Paulson understood Dimon’s position perfectly well. He, too, wanted to restore calm to the markets, for it had been a nail-biter of a week. After the $2-a-share purchase price had been announced, Bear’s shareholders and employees had practically revolted, threatening to upend not just the deal but also the entire market. And in the hastily arranged merger agreement, Dimon had found a glaring error, which he blamed on his lawyers, Wachtell, Lipton, Rosen & Katz: Bear’s shareholders could vote against the deal, and JP Morgan would still be on the hook to guarantee its trades for an entire year.

Dimon recounted to Paulson how Ed Moldaver, a longtime broker at Bear—“an asshole,” in Dimon’s estimation—had publicly mocked him during a meeting Dimon had called to explain the transaction to Bear employees. “This isn’t a shotgun marriage,” Moldaver scowled in front of hundreds of Bear staffers. “This is more like a rape.”

In Washington, Paulson now revealed to Dimon that he was facing a similar revolt, for most people in government thought everyone on Wall Street was greedy and overpaid, and bailing them out was about as popular a notion as raising taxes. “I’m getting it from all sides,” he confided.

To make matters worse, it was a presidential election year. On Monday, a day after the Bear Stearns deal was announced, Democratic candidate Senator Hillary Clinton, who at the time had a slight lead in national polls, criticized the bailout, going so far as to link the Bush administration’s rescue of Bear Stearns to the problems in Iraq.

Barney Frank, the Democratic chairman of the House Financial Services Committee, was every bit as harsh. He, too, turned the deal into an indictment of Paulson’s boss, President Bush. “All these years of deregulation by the Republicans and the absence of regulation as these new financial instruments have grown have allowed them to take a large chunk of the economy hostage,” Frank complained. “And we have to pay ransom, like it or not.”

While attacking the rescue plan was one of the few completely bipartisan affairs in town, the Republicans hated it for different reasons. The conservatives believed that the marketplace would take care of everything, and that any government intervention was bound to make things worse. “First, do no harm!” they’d say, quoting Hippocrates’ Epidemics. A little blood might be spilled, but creative destruction was one of the costs of capitalism. Moderate Republicans, meanwhile, were inundated with complaints from their constituents, who wondered why the parties responsible for decimating their 401(k)s deserved any taxpayer money at all.

Everyone was calling it a “bailout”—a word Paulson hated. As far as he was concerned, he had just helped save the American economy. It was a bailout in the literal sense of bailing water out of a sinking boat, not a handout. He didn’t understand why no one in Washington could see that distinction.

At some level, though, he knew there would be hell to pay, no matter how correct his prognosis proved to be. While the president publicly praised him and the deal, Bush, privately, was livid. The president understood the necessity of the bailout, but he also appreciated how it would be politicized. “We’re gonna get killed on this, aren’t we?” he had asked Paulson, knowing full well that the answer was yes.

Paulson didn’t need to be reminded where the president stood on the issue. The Wednesday before the Bear deal, Paulson had spent the afternoon in the Oval Office advising Bush on the speech he would give that coming Friday to the Economic Club of New York at the Hilton Hotel. Bush had included a line in his remarks asserting that there would be no bailouts.

“Don’t say that,” Paulson insisted, looking over the draft.

“Why?” Bush asked. “We’re not going to have a bailout.”

Paulson broke the bad news to him: “You may need a bailout, as bad as that sounds.”

All in all, the situation had become Paulson’s worst nightmare: The economy had turned into a political football, his reputation was on the line, and he was stuck playing by Washington rules.

Henry Paulson’s understanding of how things worked in the nation’s capital was part of the reason he had turned down the job of Treasury secretary not once, but twice in the spring of 2006. He knew Washington; his first job after college had been at the Defense Department, and he had worked in the Nixon White House for a number of years after that. So he appreciated the risks that the job presented. “I will get down here and I won’t be able to work with these people, and I’ll leave with a bad reputation. Look at what people said about Snow and O’Neill!” he said. His predecessors, John Snow and Paul O’Neill, had both come to Washington as wizards of their respective industries but had departed with their legacies tarnished.

He agonized for months before making his decision. As far as he was concerned, he already had the best job in the world: CEO of Goldman Sachs, the most revered institution on Wall Street. As its chief executive, Paulson traveled around the world, focusing much of his attention on China, where he had become something of an unofficial U.S. Ambassador of Capitalism, arguably forging deeper relationships with Chinese leaders than had anyone in Washington, including the secretary of State, Condoleezza Rice.

Joshua Bolten, President Bush’s new chief of staff, was pushing especially hard for Paulson to come on board. He had convinced the president that Paulson’s close ties in China could be a huge plus, given the rapid and geopolitically significant rise of the Chinese economy. Professionally, Bolten knew Paulson well. A former Goldman Sachs insider himself, he had worked for the firm as a lobbyist in London in the 1990s and served briefly as the chief of staff to Jon Corzine, when he headed the firm.

But Bolten wasn’t making any headway with Paulson—or the Paulson family, for that matter. It didn’t help that Paulson’s wife, Wendy, could not stand the president’s politics, even though her husband had been a “pioneer” for Bush in 2004—a designation given to those who raised more than $100,000 for the president’s reelection campaign. His mother, Marianna, was so aghast at the idea that she cried. “You started with Nixon and you’re going to end with Bush? Why would you do such a thing?” she sobbed. Paulson’s son, a National Basketball Association executive, and daughter, a reporter for the Christian Science Monitor, were also initially against his making the move.

Another key doubter was Paulson’s mentor, John Whitehead. A former Goldman chairman and a father figure to many at the bank who had served in the State Department under Reagan, Whitehead thought it would be a big mistake. “This is a failed administration,” he insisted. “You’ll have a hard time getting anything accomplished.”

In an interview in April, Paulson was still dismissing talk that he was a candidate for Treasury secretary, telling the Wall Street Journal, “I love my job. I actually think I’ve got the best job in the business world. I plan to be here for a good while.”

Meanwhile, Bolten kept pushing. Toward the end of April, Paulson accepted an invitation to meet with the president. But Goldman’s chief of staff, John F. W. Rogers, who had served under James Baker in both the Reagan and G.H.W. Bush administrations, urged him not to attend the meeting unless he was going to accept the position. “You do not go to explore jobs with the president,” he told Paulson. Rogers’s point was impossible to dispute, so Paulson awkwardly called to send his regrets.

Paulson and his wife, however, did attend a luncheon at the White House that month for President Hu Jintao of China. After the meal they took a stroll in the capital, and as they walked past the Treasury Building, Wendy turned to him.

“I hope you didn’t turn it down because of me,” she said. “Because if you really wanted to do it, it’s okay with me.”

“No, that’s not why I turned it down.”

Despite his reluctance, others believed Paulson’s decision was not quite final, and Rogers, for one, thought his boss secretly did want the job. On the first Sunday afternoon of May, he found himself fretting in his home in Georgetown, wondering whether he had given Paulson bad advice. He finally picked up the phone and called Bolten. “I know Hank told you no,” he told him, “but if the president really wants him, you should ask him again.”

When Bolten called and repeated his pitch, Paulson wondered whether his resistance to the overtures was really a matter of a fear of failure. At Goldman he was known as someone who “runs to problems.” Was he now running away from them?

Paulson is a devout Christian Scientist and, like most members of the faith, he deeply admires the writings of Mary Baker Eddy, who, seeking to reclaim early Christianity’s focus on healing, founded the First Church of Christ, Scientist, in Boston in 1879. “Fear is the fountain of sickness,” she wrote. Fear “must be cast out to readjust the balance for God.”

Paulson was already having second thoughts about turning down the Treasury job when James Baker followed up on Bolten’s call. Baker, the GOP’s éminence grise, confided to him that he had told the president that Paulson was by far the best candidate for the position. Deeply flattered, Paulson assured him that he was giving the idea serious consideration.

That same week, John Bryan, the chief executive of Sara Lee and a longtime friend, Goldman director, and client of Paulson’s from when he was an investment banker in Chicago, offered him this advice: “Hank, life is not a dress rehearsal,” he said. “You don’t want to be sitting around at eighty years old telling your grandchildren you were once asked to be secretary of the Treasury. You should tell them you did it.”

Paulson finally accepted the position on May 21, but because the White House did not plan to announce the appointment until the following week after running a background check, he was left in the awkward predicament of attending the annual meeting of Goldman partners that weekend in Chicago without being able to tell anyone that he was resigning. (Ironically enough, the guest speaker that day was the junior senator from Illinois, Barack Obama.) But with the newspapers—not to mention his colleagues—still speculating about whether he would join the administration, Paulson hid upstairs in his hotel room throughout the event.

On Wall Street, there are two kinds of bankers: the silky smooth salesmen who succeed based on wits and charm, and those who persist with bulldog tenacity. Paulson was of the latter type, as the White House soon discovered. Before he officially accepted the job, Paulson made certain to see to a few key details. If thirty-two years at Goldman Sachs had taught him anything, it was how to cut the best deal possible. He demanded assurances, in writing, that Treasury would have the same status in the cabinet as Defense and State. In Washington, he knew, proximity to the president mattered, and he had no intention of being a marginalized functionary who could be summoned at Bush’s whim but couldn’t get the chief executive to return his calls. Somehow he even got the White House to agree that its National Economic Council, headed by Allan Hubbard, a Harvard Business School classmate of Paulson’s, would hold some of its meetings at the Treasury Building, and that the vice president, Dick Cheney, would attend them in person.

Hoping to silence any suggestion that he would favor his former employer, he voluntarily signed an extensive six-page “ethics” agreement that barred him from involving himself with Goldman Sachs for his entire tenure. His declaration went far beyond the regular one-year time period required for government employees. “As a prudential matter, I will not participate in any particular matter involving specific parties in which The Goldman Sachs Group, Inc. is or represents a party for the duration of my tenure as Secretary of the Treasury,” he wrote in a letter that served as the agreement. “I believe that these steps will ensure that I avoid even the appearance of a conflict of interest in the performance of my duties as Secretary of the Treasury.” It was an avowal that would certainly hinder his power, given Goldman’s role in virtually every aspect of Wall Street, and one that he would later desperately try to find ways around.

One additional condition came with the appointment: Paulson would have to divest his huge holding of Goldman Sachs stock—some 3.23 million shares, worth about $485 million—as well as a lucrative investment in a Goldman fund that held a stake in the Industrial and Commercial Bank of China. Because new Internal Revenue Service rules allowed executives who entered into government service to sell their interests without a penalty, Paulson saved more than $100 million in taxes. It was perhaps one of the most lucrative deals he ever struck, but for many months prior to the crisis, he watched chagrined as Goldman’s shares rose from about $142, when he sold them, to their high of $235.92 in October 2007.

Henry Merritt Paulson Jr. was officially nominated for Treasury secretary on May 30, 2006. Just seven days later, the Washington Post featured a profile of him that opened: “In an administration with just two and a half years to go, Henry M. Paulson Jr., President Bush’s nominee for Treasury secretary, may have little chance to make a mark on many economic issues.”

Nothing could have played more effectively to his immediate sense of buyer’s remorse—and motivated him to overcome the challenge.

By Wall Street standards, Paulson was something of a baffling outlier, a titan who had little interest in living a Carnegie Hill multimillionaire’s life. A straight-shooting Midwesterner, he had grown up on a farm outside Chicago and had been an Eagle Scout. He and Wendy assiduously avoided the Manhattan society scene, trying to get to bed before 9:00 p.m. as often as they could, and preferred bird-watching in Central Park—Wendy led tours in the mornings for the Nature Conservancy—near their two-bedroom, twelve-hundred-square-foot apartment, a modest residence for one of the highest-paid executives on Wall Street. Paulson wore a plastic running watch, and any inclination he might have had to spend money was discouraged by Wendy, the daughter of a Marine officer whose frugality had kept him firmly grounded. One day, Paulson came home with a new cashmere coat from Bergdorf Goodman, to replace one that he had had for ten years. “Why did you buy a new coat?” Wendy asked. The next day, Paulson returned it.

And despite his prodigious fund-raising for President Bush, he hardly fit the image of a Republican hard-liner. A hard-core environmentalist whose only car was a Toyota Prius, he was the subject of a good deal of negative publicity—and the scourge of some annoyed Goldman Sachs shareholders—when in 2006 he donated 680,000 acres of land Goldman owned in the South American archipelago of Tierra del Fuego to the Wild-life Conservation Society. As it happened, his son was on the society’s board of advisers. Although the irony could not be appreciated by anyone at the time, the firm had acquired the ecologically sensitive South American land as part of a portfolio of mortgage defaults.

Paulson had a long history of exceeding others’ expectations. Despite his relatively modest frame—six feet one, 195 pounds—he had been an all-Ivy League tackle for Dartmouth, where his ferociousness in playing earned him the nicknames “The Hammer” and “Hammering Hank.” But unlike his hard-partying teammates, he kept orange juice and ginger ale in a refrigerator at his fraternity, Sigma Alpha Epsilon, to drink during beer parties. (He met his future wife on a blind date when she was a student at Wellesley; Wendy’s classmates there included Hillary Rodham, who in some ways was her rival. Wendy was president of the class of 1969; Hillary was president of the student body.) Paulson graduated Phi Beta Kappa from Dartmouth in 1968 with a major in English literature.

Paulson had first come to Washington in 1970, after graduating from Harvard Business School, and at the time he didn’t even own a suit. Armed with a recommendation from one of his undergraduate professors at Dartmouth, Paulson landed a job as a staff aide to the assistant secretary of Defense and would soon display some of the skills that would later make him such an effective salesman at Goldman Sachs. In just two years he advanced to the White House, where he became assistant director of the Domestic Policy Council, then headed by John Ehrlichman, who would later be convicted of conspiracy, obstruction of justice, and perjury in the Watergate cover-up. Paulson served as a liaison with the departments of Treasury and Commerce. “Given how [Hank] moved from a low-ranking position in the Pentagon to the White House, you have to conclude he’s got pretty good antenna for what’s going on,” recalled a friend and former Goldman executive, Kenneth Brody. “[B]ut when Watergate came, there was never a mention of Hank.”

When Wendy became pregnant with their first child in 1973, Paulson, eager to earn some money, decided to leave the Nixon White House and started looking for work in the financial sector—but not if it meant living in New York. He interviewed with a number of financial firms in Chicago, and of all the offers he received, he was most attracted to two Manhattan firms with major Chicago offices: Salomon Brothers and Goldman Sachs. He decided on Goldman after Robert Rubin, a Goldman partner and future Treasury secretary, Gus Levy, a legend at the firm, and John Whitehead, among others, convinced him that he could be successful there and never have to live in Gotham. His salary: $30,000.

In January 1974, Paulson moved his family back to where he had grown up, Barrington Hills, a town of fewer than four thousand residents northwest of Chicago. Paulson bought five acres of the family farm from his father, who was a wholesale jeweler. There, up a winding road from his parents’ home, he built an unpretentious wood-and-glass house, nestled among tall oak trees at the end of a half-mile driveway.

At Goldman, Paulson was given an unusual amount of responsibility for a junior investment banker. “You know, Hank, we ordinarily don’t hire guys as young as you into this role but, you know, you look old,” Jim Gorter, a senior partner, told him, referring to his rapidly receding hairline. Having quickly proved himself with important Midwestern clients like Sears and Caterpillar, he was soon marked as a rising star at the firm’s Manhattan headquarters. In 1982 he made partner, placing him in an elite group of men and a few women who were entitled to share directly in the firm’s profits. When he became co-head of investment banking and a member of the firm’s management committee from Chicago, he was obliged to spend a great deal of time on the phone, which he did somewhat famously, leaving interminable messages at all hours of the day.

Only four years later, in September of 1994, however, Goldman Sachs was in turmoil. An unexpected spike in interest rates around the world had hit the firm hard, sending profits tumbling more than 60 percent during the first half of the year. Stephen Friedman, the firm’s chief executive, suddenly announced he was resigning; thirty-six other Goldman partners soon left, along with their capital and connections.

To stanch the bleeding, the firm’s board turned to Jon Corzine, Goldman’s soft-spoken head of fixed income. The directors saw Paulson as a natural number two who would not only complement Corzine but send a signal that investment banking, Paulson’s specialty, would remain as key an area as ever for Goldman. They were betting that Corzine and Paulson could form a partnership as powerful as that of Friedman and Robert Rubin, and before them, John Whitehead and John Weinberg.

There was only one problem with the plan: Neither man cared much for the other.

At a meeting at Friedman’s apartment on Beek man Place, Paulson expressed resistance to the idea of working under Corzine, or even of relocating to New York, which he had doggedly avoided all these years. Corzine, who was known to be especially persuasive in one-on-one encounters, suggested that he and Paulson take a walk.

“Hank, nothing could please me more than to work closely with you,” Corzine said. “We’ll work closely together. We’ll really be partners.” Within an hour they had reached a deal.

On arriving that year in New York, Paulson moved quickly. He was so focused on work, he never even had time to inspect the apartment Wendy wanted them to purchase before he agreed to buy it, sight unseen.

As president and chief operating officer respectively, Paulson and Corzine worked tirelessly in the fall of 1994 to address Goldman’s problems, traveling around the world to meet with clients and employees. Paulson was given the unenviable task of cutting expenses by 25 percent. Their efforts paid off: Goldman Sachs turned around in 1995 and had strong profits in both 1996 and 1997. Yet the crisis convinced Corzine and some others at Goldman that the firm needed to be able to tap the public capital markets so that it could withstand shocks in the future. The solution, they believed, was an initial public offering.

But Corzine did not have a strong enough hold on the firm when, in 1996, he first made the case to its partners for why Goldman should go public. Resistance to the idea of an IPO was strong, as the bankers worried it would upend the firm’s partnership and culture.

But with a big assist from Paulson, who became co-chief executive in June 1998, Corzine ultimately won the day: Goldman’s initial public offering was announced for September of that year. But that summer the Russian ruble crisis erupted and Long-Term Capital Management was teetering on the brink of collapse. Goldman suffered hundreds of millions of dollars in trading losses and had to contribute $300 million as part of a Wall Street bailout of Long-Term Capital that was orchestrated by the Federal Reserve Bank of New York. A rattled Goldman withdrew its offering at the last minute.

What was known only to a small circle of Paulson’s closest friends was that he was actually considering quitting the firm, tired of Corzine, New York, and all the internal politics. However, the dynamic at Goldman shifted dramatically in December 1998: Roy Zuckerberg, a big Corzine supporter, retired from Goldman’s powerful executive committee, leaving it with five powerful members: Corzine, Paulson, John Thain, John Thornton, and Robert Hurst. At the same time, Goldman’s board had become increasingly frustrated with Corzine, who had engaged in merger talks with Mellon Bank behind their backs.

A series of secret meetings in various apartments quickly followed and resulted in a coup worthy of imperial Rome or the Kremlin. Persuaded to stay and run the firm, Paulson and the three other committee members agreed to force Corzine’s resignation. Corzine had tears in his eyes when he was told of their decision.

Paulson became sole chief executive, with Thain and Thornton as co-presidents, co-chief operating officers, and heirs presumptive. And in May 1999, shares of Goldman made their trading debut in a $3.66 billion offering.

By the spring of 2006, Paulson had stayed longer in the CEO spot than he had expected and had risen to the very top of his profession. He was awarded an $18.7 million cash bonus for the first half of the year; in 2005 he was the highest paid CEO on Wall Street, pulling in $38.3 million in total compensation. Within Goldman he had no challengers, and his hand-picked successor, Lloyd Blankfein, was patiently waiting in the wings. The bank itself was the preferred choice as adviser on the biggest mergers and acquisitions and was a leading trader of commodities and bonds. It was paid handsomely by hedge funds using its services, and it was emerging as a power in its own right in private equity.

Goldman had become the money machine that every other firm on Wall Street wanted to emulate.

After thirty-two years at Goldman, Paulson had a tough time adjusting to life in government. For one, he had to make many more phone calls because he could no longer blast out long voice-mail messages to staffers, as was his custom at Goldman; Treasury’s voice-mail system, he was repeatedly informed, did not yet have that capacity. He was encouraged to use e-mail, but he could never get comfortable with the medium; he resorted to having one of his two assistants print out the ones sent to him through them. And he had little use for the Secret Service officers accompanying him everywhere. He knew CEOs who had security with them constantly, and he had always considered such measures the ultimate demonstration of arrogance.

Much of the Treasury staff did not know what to make of Paulson and his idiosyncracies. The staffers would go to Robert Steel, his deputy secretary and a Goldman alum, for advice on how best to interact with their quirky new boss. Steel would always tell them the same three things: “One: Hank’s really smart. Really smart. He’s got a photographic memory. Two: He’s an incredibly hard worker, incredibly hard. The hardest you’ll ever meet. And he’ll expect you to work just as hard. Three: Hank has no social EQ [emotional quotient], zero, none. Don’t take it personally. He has no clue. He’ll go to the restroom and he’ll only halfway close the door.”

Early in his tenure, Paulson invited some staff members to his house, a $4.3 million home in the northwestern corner of Washington (which, in a bizarre coincidence, had once belonged to Jon Corzine). The group gathered in the living room, whose big windows looking out over the woods almost made it seem as if they were sitting in a fancy tree house. Surrounding them were photographs of birds, most of them taken by Wendy.

Paulson was intensely explaining some of his ideas to the group. Wendy, thinking it odd that her husband had forgotten to offer their guests anything to drink on such a hot summer day, interrupted the meeting to do so herself.

“No, they don’t want anything to drink,” Paulson said distractedly before resuming the meeting.

Some time later Wendy came out with a pitcher of cold water and glasses, but no one dared indulge in front of the boss.

Paulson had inherited a department that was in disarray. His predecessor, John Snow, the former chief of the railroad company CSX, had been marginalized, and the demoralized staff felt both neglected and underappreciated. Paulson thought he could remedy that. But what surprised him was how few employees there actually were. He had assumed that government inefficiency would guarantee that he would have to deal with thousands of bodies being underutilized. Although he now oversaw a department of 112,000, it was light on the financial side, and he knew he would have to bring in seasoned Wall Street veterans who knew what it meant to work hard.

The Goldman connection was the one factor of which Paulson had to be mindful, as impractical as that seemed to him. He knew conspiracy theories about Goldman’s supposed influence over Washington bloomed anew whenever a top Goldman executive took a government job, whether it concerned Robert Rubin’s becoming Treasury secretary under Clinton or even Jon Corzine’s election as senator from New Jersey, despite being ousted from the firm. (Rubin, who was now at Citigroup, also reminded him before he took the job about being careful in dealing with Goldman.)

In his first few weeks on the job, as the economic clouds were gathering but no one was yet forecasting a storm, Paulson focused on improving the morale at Treasury. He visited departments that had not seen a cabinet member for years and ordered the refurbishment of the building’s basement gym. Paulson was serious about physical fitness and often biked around the capital, whenever Wendy could get him off the phone.

Early on, Paulson had concerns about the markets. In his first briefing with President Bush and his economic team, at Camp David on August 17, 2006, he warned that the economy was overdue for a crisis. “When there is a lot of dry tinder out there, you never know what will light it,” he said. “We have these periods every six, eight, ten years, and there are plenty of excesses.”

Paulson made it clear that the administration would have to confront at least one serious problem: the subprime mortgage mess, which had already begun to have repercussions. Bear Stearns and others were deeply involved in this business, and he needed to find a way to obtain “wind down authorities” over these troubled broker-dealers. Traditional banks had the Federal Deposit Insurance Corporation, or FDIC, and the Federal Reserve effectively protecting them from going bankrupt; these agencies had a built-in transition plan that allowed them to take failing banks safely into receivership and auction them off. But the FDIC had no authority over investment banks like Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers, and unless Paulson was given comparable power over these institutions, he said during the meeting, there could be chaos in the market.

On March 27, 2008, at 8:30 a.m., just three days after the “recut” Bear deal, Paulson and his lieutenants gathered for a meeting. He’d just arrived from his usual workout at Sports Club/LA in the Ritz-Carlton hotel a few blocks away. His brain trust, Bob Steel, Jim Wilkinson, David Nason, Michele Davis, Phillip Swagel, Neel Kashkari, and several others, crammed into his office on the third floor of the Treasury Building, which overlooked the White House’s Rose Garden and afforded dramatic views of the Washington Monument to the south.

Paulson took a chair in the corner of the high-ceilinged space, its walls already decorated with dozens of his wife’s photographs of birds and reptiles. Some staffers found seats on his blue velvet couch; others stood, leaning against his mahogany desk, with its four Bloomberg screens flickering on top.

Paulson held these meetings with his inner circle each morning at 8:30 a.m., except for every other Friday, when he had breakfast with Ben Bernanke, the chairman of the Federal Reserve. Paulson would have preferred to have the staff meetings start even earlier, but these were government workers, and he was already pushing them pretty far. Most of his senior team were being paid around $149,000 a year, though each of them could have potentially been making much more in the private sector.

As Paulson went around the room doing a postmortem on Bear, he stopped at David Nason. Nason, the thirty-eight-year-old assistant secretary for financial institutions, had joined Treasury in 2005 and was its resident policy-making brain. A Republican and free-market champion, Nason had been warning at these meetings for months about the possibility of another Bear Stearns-like run on one or more banks. He and other Treasury officials had come to recognize that Wall Street’s broker-dealer model—in which banks could count on ever-dependable overnight financing by other investors—was by definition a tinderbox. Bear had taught them how quickly a bank could crumble; in an industry whose lifeblood was simply the confidence of other investors, it could wane quickly at the hint of a problem. But however perilous the overall situation, Nason remained dead set against bailouts, a concept he couldn’t abide.

Instead, Nason told the group that Treasury had to concentrate its efforts on two fronts: obtaining the authority to put an investment bank through an organized bankruptcy, one that wouldn’t spook the markets, and more immediately, urging the banks to raise more money. In the previous six months, U.S. and European banks—including Citigroup, Merrill Lynch, and Morgan Stanley—had managed to bring in some $80 billion in new capital, often by selling their stakes to state-run investment funds—known as “sovereign wealth funds”—in China, Singapore, and the Persian Gulf. But it clearly wasn’t enough, and the banks had already been forced to tap the investors with the deepest pockets.

With the Bear Stearns situation seemingly behind them, Paulson focused his attention this morning on what he thought would be the next trouble spot: Lehman Brothers. Investors may have been mesmerized by Erin Callan’s performance at the earnings conference call, but Paulson knew better. “They may be insolvent, too,” he calmly told the room. He was worried not only about how they were valuing their assets, which struck him as wildly optimistic, but about their failure to raise any capital—not a cent. Paulson suspected that Fuld had been foolishly resisting doing so because he was hesitant to dilute the firm’s shares, including the more than 2 million shares he personally held.

Paulson’s analysis of Lehman had been heavily colored by Goldman Sachs’ commonly held view of the firm during his time there: It didn’t have the same level of class or talent. While Paulson had at least once referred to Lehman as “a bunch of thugs” when he was at Goldman, he did nonetheless respect its hard-driving culture, admiring how aggressively Lehman bankers hustled. And they were loyal, almost to a fault; it was a tight-knit group that reminded him of Goldman’s partnership.

Still, there was something about Fuld that made him nervous. He was a risk taker—recklessly so, in Paulson’s view. “He’s like a cat; he’s had nine lives,” he said at one staff meeting. Paulson believed that his old Goldman colleague, Bob Rubin, had unwittingly bailed out Fuld in early 1995 when, as Treasury secretary, he provided aid to Mexico during its peso crisis. Lehman had wagered a fortune on the direction of the Mexican peso without hedging that bet, and it had gotten it wrong. Paulson remembered the moment well—and told his staff about it—because of accusations at the time that Rubin had actually organized the international bailout in an effort to save Goldman Sachs.

Fairly or not, Paulson lumped Fuld in with what he saw as the rear guard on Wall Street, financiers like Ken Langone and David Komansky, the type who were habitual power lunchers at Manhattan’s San Pietro restaurant and were friends of Richard Grasso, a symbol of excess. Paulson had been a member of the New York Stock Exchange’s Human Resources and Compensation Committee that had approved a $190 million payday for Grasso, the NYSE chairman. Fuld had been on that committee as well; Langone had been its chairman. After the uproar over the size of Grasso’s compensation package, Paulson wanted him out. In his view, Grasso hadn’t been just greedy; he had been deceitful. Eliot Spitzer, the New York attorney general, then at the top of his game, soon became involved in the matter, suing both Grasso and Langone. It was in the resulting battle that Paulson came to dislike Grasso’s cronies, who seemed all too ready to throw Paulson under a bus if it suited their purposes.

But as secretary of the Treasury, he was obliged to be a diplomat, and as such, needed to maintain good relationships with all the Wall Street CEOs. They would be huge assets, his eyes and ears on the markets. If he needed “deal flow,” he preferred to get it directly from them, and not from some unconnected Treasury lifer whose job it was to figure these things out.

About a month after he settled into the job, in the summer of 2006, Paulson called Fuld, whom he reached playing golf with a friend in Sun Valley, where he had a home. Fuld had just teed off on the 7th hole, a par 5, dogleg left, when he heard his cell ringing. Although mobile phones weren’t allowed on the course, he picked up anyway, and no one protested.

“I know this call may be a little unusual,” Paulson began. “You and I have been trying to kill each other for years.”

Fuld laughed, flattered by Paulson’s acknowledgment of him as a worthy opponent.

“I’d like to be able to call you from time to time,” Paulson continued, “to talk markets, deals, competition; to find out what your concerns are.”

Fuld was pleased by the gesture and told him as much.

After that conversation they talked to each other regularly. Indeed, Paulson came to rely heavily on Fuld for market intelligence, and, in turn, shared his own views about the markets, which Fuld regarded as the official read. Almost to his surprise—given how much he had vilified the man when he was Goldman’s CEO—Paulson found Fuld to be engaging and impressively hands-on. Although he still didn’t completely trust him, he knew he could work with him.

But in the current market climate, the past few calls had been particularly tricky, and the next one would be especially so.

As Paulson’s morning meeting came to an end, he handed out a number of assignments to his staffers, one of which was urging Neel Kashkari and Phil Swagel to hurry up and finish a draft of an apocalyptic white paper they had been working on about how the government should think about saving the financial system if it started melting down.

As everyone began to leave, the Treasury secretary stopped Bob Steel and pulled him aside to discuss the special assignment he had given to himself. “I’m going to lean on Dick,” he announced.

An hour later his assistant, Christal West, had Dick Fuld on line one.

“Dick,” Paulson said cheerily, “how are you?”

Fuld, who had been in his office waiting for the phone call, answered, “Holding up.”

They had checked in with each other a handful of times over the past week since the Bear deal, but they hadn’t discussed anything substantial. This morning’s call was different. They talked about the fluctuations in the market and Lehman’s stock. All the banks were suffering, but Lehman’s share price was being hammered the most, down more than 40 percent for the year. More worrisome was that the shorts were smelling blood, meaning that the short position—the bet that Lehman’s stock had much further to fall—was swelling, accounting for more than 9 percent of all Lehman shares. Fuld had been trying to convince Paulson to have Christopher Cox, chairman of the SEC, get the short-sellers to stop trashing his firm.

Paulson was not unsympathetic to Fuld’s position, but he wanted an update on Lehman’s plans to raise capital. Fuld had already been hearing from some of his top investors that this would be a wise course of action, especially while things were still relatively positive for the firm in the press.

“It would be a real show of strength,” Paulson said, hoping to persuade him.

To Paulson’s surprise, Fuld said he agreed and had already been thinking about it. Some of his bondholders had been pressing him to raise money on the back of the firm’s positive earnings report.

“We’re thinking about reaching out to Warren Buffett,” Fuld replied. That had been a carefully considered remark; Fuld knew that Paulson was a friend of the legendary Omaha investor. Although Buffett had a public disdain for investment bankers in general, for years he had used Goldman’s Chicago office for some of his business, and Paulson and Buffett had become friends.

An investment by Buffett was the financial world’s equivalent of a Good Housekeeping Seal of Approval. The markets would love it. “You should pitch him,” Paulson said, relieved that Fuld was finally taking action in that direction.

Yes, Fuld agreed. But he had a favor to ask. “Could you say something to Warren?”

Paulson hesitated, reflecting that it probably wasn’t a particularly good idea for a Treasury secretary to be brokering deals on Wall Street. The situation could only be complicated by the fact that Buffett was a Goldman client.

“Let me think about it, Dick, and get back to you,” Paulson said.

On March 28, Warren Buffett, the legendary value investor, sat in his office at Berkshire Hathaway’s Omaha headquarters, working at the plain wooden desk that his father had once used, waiting for Dick Fuld’s call. A day earlier, the call had been arranged by Hugh “Skip” McGee, a Lehman banker, who had reached out to David L. Sokol, chairman of Berkshire Hathaway-owned MidAmerican Energy Holdings. (Buffett receives such pitch calls almost daily, so he regarded this one as a fairly routine matter.)

He didn’t know Fuld well, having met him on only a few occasions; the last time they had been together, he had been seated between Fuld and Paul Volcker, the former chairman of the Federal Reserve, at a Treasury dinner in Washington in 2007. Wearing one of his trademark off-the-rack, no-fuss suits and tortoise-rimmed glasses, Buffett had been making the rounds when he had managed to spill a glass of red wine all over Fuld just before dessert arrived. The world’s second-richest man (after Bill Gates) turned crimson as the dinner guests—a group that included Jeffrey Immelt of General Electric, Jamie Dimon of JP Morgan Chase, and former Treasury secretary Robert Rubin—looked on politely. Fuld had tried to laugh the spill off, but the wine had landed directly in his lap. The two hadn’t seen each other since.

When Debbie Bosanek, Buffett’s longtime assistant, announced that Dick Fuld was on the line, Buffett set down his Diet Cherry Coke and reached for the receiver.

“Warren, it’s Dick. How are you? I’ve got Erin Callan, my CFO, on with me.”

“Hi there,” Buffett greeted him in his dependably affable manner.

“As I think you know, we’re looking to raise some money. Our stock ’s been killed. It’s a huge opportunity. The market doesn’t understand our story,” Fuld said, before launching into his sales pitch. He explained that Lehman was looking for an investment of $3 billion to $5 billion. After some back and forth, Buffett made a quick proposal: He indicated he might be interested in investing in preferred shares with a dividend of 9 percent and warrants to buy shares of Lehman at $40. Lehman’s stock had closed at $37.87 that Friday.

It was an aggressive offer by the Oracle of Omaha. A 9 percent dividend was a very expensive proposition—if Buffett made a $4 billion investment, for example, he’d be due $360 million a year—but that was the cost of “renting” Buffett’s name. Still, Buffett said, he needed to do some due diligence before committing to even those terms. “Let me run some numbers and I’ll get back to you,” he told Fuld before hanging up.

In Omaha, Buffett had already begun doing a little soul searching, uncertain if he could even bring himself to put his money into an investment bank again. In 1991 he had rescued Salomon Brothers when the storied New York investment house was on the brink, but he quickly realized then that he couldn’t bear the culture of Wall Street. If he now came to Lehman’s assistance, the world would be scrutinizing his participation, and he was well aware that not only would his money be on the line, but his reputation as well.

Even though Buffett had often traded in the market using hedges and derivatives, he despised the trader ethos and the lucrative paydays that enriched people he thought were neither particularly intelligent nor created much value. He always remembered how unnerved he had been after paying out $900 million in bonuses at Salomon, and was especially stunned when John Gutfreund, the firm’s chairman, had demanded $35 million merely to walk away from the mess he had created. “They took the money and ran,” he once said. “It was just so apparent that the whole thing was being run for the employees. The investment bankers didn’t make any money, but they felt they were the aristocracy. And they hated the traders, partly because the traders made the money and therefore had more muscle.” Buffett decided to hunker down that evening at his office and pick apart Lehman’s 2007 annual report. After getting himself another Diet Cherry Coke, he began to read Lehman’s 10-K, its annual report, when the phone rang; it was Hank Paulson. This seems orchestrated.

Paulson began as if it were a social call, knowing all too well that he was walking a fine line between acting as a regulator and a deal maker. Nonetheless, he quickly moved the discussion to the Lehman Brothers situation. “If you were to come in, your name alone would be very reassuring to the market,” he said, careful not to push his friend too far. At the same time, in his roundabout way, he made it clear that he wasn’t about to vouch for Lehman’s books—after all, for years Buffett had heard him, as a top executive at Goldman, rail against other firms he thought had been too aggressive in both their investments and their bookkeeping.

After years of friendship, Buffett was familiar with Paulson’s code: He was a hard-charging type, and if he wanted something badly enough, he would say so directly. He could tell now that Paulson wasn’t pressing too hard. The two promised to stay in touch and then bade good night.

Buffett returned to his examination of Lehman’s 10-K. Whenever he had a concern about a particular figure or issue, he noted the page number on the front of the report. Less than an hour into his reading, the cover of the report was filled with dozens of scribbled page citations. Here was an obvious red flag, for Buffett had a simple rule: He couldn’t invest in a firm about which he had so many questions, even if there were purported answers. He called it a night, resolved that he was unlikely to invest.

On Saturday morning, when Fuld called back, there quickly seemed to be a problem separate and apart from Buffett’s concerns. Fuld and Callan were under the impression that Buffett had asked for a 9 percent dividend and warrants “up 40”—meaning that the strike price of the warrants would be 40 percent more than their current value. Buffett, of course, thought he had articulated that the strike price of the warrants would be at $40 a share, just a couple dollars from where they were now. For a moment, they were all talking past one another as if they were Abbott and Costello performing “Who’s on First?” Clearly, there had been a miscommunication, and Buffett thought it was just as well. The talks ended.

Back at his desk in New York, an annoyed Fuld told Callan that he considered Buffett’s offer to be preposterously expensive and that they should seek investments from other investors.

By Monday morning, Fuld had managed to raise $4 billion of convertible preferred stock with a 7.25 percent interest rate and a 32 percent conversion premium from a group of big investment funds that already had a stake in Lehman. It was a much better deal for Lehman than what Buffett was offering, but it hardly came with the confidence an investment from him would have inspired.

Later that morning, Fuld called Buffett to inform him of the success of his fund-raising effort. Buffett congratulated him but privately wondered whether Fuld had used his name to help raise the money.

Although he never brought the subject up, Buffett found it curious that Fuld never mentioned what he imagined was an important piece of news that had crossed the tape over the weekend: “Lehman hit by $355 million fraud.” Lehman had been swindled out of $355 million by two employees at Marubeni Bank in Japan, who had apparently used forged documents and imposters to carry out their crimes.

Once again it reminded Buffett of his experience at Salomon—this time when John Gutfreund and Salomon’s legal team hadn’t told him that the firm was involved in a massive auction bid-rigging scandal of Treasury bills, a scandal that nearly took down the firm.

You just can’t trust people like that.