Paulson's View of the Storm

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Henry Paulson was in shirt sleeves yesterday afternoon in his office at the Treasury Department, tie loose at the collar, feet propped up on the coffee table. Behind his desk, Bloomberg screens were blinking out instant price quotations from the turbulent financial markets, but Paulson wasn't focused on the short term for a change. He was discussing the long-term structural reforms he hopes will bring greater stability.

What's agonizing for Paulson is that he says he saw the storm clouds gathering two years ago when he became Treasury secretary. He recalls that in one of his first meetings with President Bush, he advised that "it was highly unlikely that we could go two and a half more years without another period of stress." He also warned about the growing use of derivatives -- financial instruments so complicated that they confuse even the people who buy and sell them -- and how they posed a fundamental risk to the markets. He cautioned the president that "there was more leverage embedded in the system than regulators realized," creating potentially dangerous levels of debt.

And he says he was troubled about Fannie Mae and Freddie Mac, the mortgage giants that had grown fat on an implicit (but never tested) government guarantee to back up their debt. "It didn't take a genius to know that there was a problem," he says. "The elephant was too big for the tent, frankly. They were too big, and they posed a systemic risk."

But it's one thing to sense that a crisis is looming and quite another to mobilize the federal government to do something about it. And these chronic financial problems were in Washington's "too hard" file.

The administration backed Paulson's decision in June 2007 to launch an elaborate program to create a new "Blueprint for Regulatory Reform." It proposed streamlining regulations, and a new role for the Federal Reserve as overall "market stability regulator," with an assignment Paulson likens to that of a roving free safety in football.

But by the time Paulson's blueprint was completed in March, the Bear Stearns crisis had erupted. The problems he had contemplated in theory were now exploding in fact. Three factors made this crisis different from ones in the past, he says: the complexity of the derivatives and other financial products in the system; the amount of leverage that was embedded on lenders' and borrowers' books; and the "unsustainable house-price appreciation that led to a housing correction that's still going on."

Paulson's job over the past several months has been crisis management. He says he has tried to follow the same rule he had at Goldman Sachs when he was chief executive: "If there's a problem, you don't run away from it, you run toward it." Certainly, he has been doing a lot of running.

Paulson and his fellow crisis manager, Fed Chairman Ben Bernanke, have been criticized for being too ad hoc in their policies, too quick to provide funds to rescue ailing financial giants, too little focused on the broader financial architecture. Conservatives, who regard Fannie and Freddie as bastions of liberal power and privilege, have argued that the two should be nationalized outright, rather than given new lines of credit and perhaps infusions of equity from the taxpayers.

Paulson counters that the critics aren't in the eye of the storm and don't understand the potential consequences of putting the $5 trillion of Fannie and Freddie mortgage debt on the federal books. Many in Washington and around the world have wondered whether Treasury bills would even keep their triple-A rating if Fannie's and Freddie's obligations doubled the national debt.

The other practical worry for Paulson is finding a mechanism for unwinding the skein of debt for financial institutions that aren't covered by banking regulations. If Bear Stearns had been allowed to collapse, for example, what would a bankruptcy judge have done with the billions of dollars in derivatives contracts -- and what would the other parties in these contracts have done in assessing their potential losses?

If Congress wants to avoid future bailouts similar to the one given Bear Stearns, "you need a resolution or wind-down facility," Paulson says, so that the liabilities of failing investment banks or hedge funds can be sorted out carefully, the way the Federal Deposit Insurance Corp. untangles the books of a failing bank.

The country needs to address the big systemic issues of regulation, Paulson says, but not in the middle of an emergency. "Right now, we need to emphasize stability. That's our top priority."

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