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Paulson to the rescue (pg. 2)

By Marc Gunther, senior writer
Last Updated: September 19, 2008: 11:24 AM EDT

Quietly Paulson rebuilt morale at Treasury. Some 112,000 people work for the department, which includes the IRS, the U.S. Mint, and a law-enforcement arm that hunts down money launderers who finance terrorists and drug lords. Most of the rank-and-file have never met the boss, but Paulson was the first Treasury Secretary in memory to visit an obscure unit called Financial Management Services, which issues government checks. Those colleagues returned the favor when the department wanted to rush out 115 million economic-stimulus checks this spring; Paulson was told that the job couldn't be done during tax season, but he made certain it was. Last year he ordered a makeover of the dilapidated gym in the basement of the Treasury Building. Paulson, who played on the offensive line at Dartmouth (and was an all-Ivy League guard), is 6-foot-2 and a bit of a fitness nut. This is called sweating the small stuff. Much of it is second nature to the man from Goldman, where a big part of a leader's job is to make sure that team players feel valued.

***

Like most CEOs who have been smiled upon by fate, Paulson is an optimist. His can-do spirit is valuable when tackling daunting problems, but it is less helpful in spotting trouble on the horizon. Paulson and others say he talked about the likelihood of a crisis in the markets during his early days in office, but he was slow to acknowledge one when it hit. In early August 2007, President Bush quoted Paulson as telling him, "This is far and away the strongest global economy I've seen in my business lifetime." This rosy assessment was served up after two hedge funds were wiped out, credit-rating agencies had begun to downgrade subprime debt, and a German bank called IKB imploded. Several days later, short-term credit markets froze, the European Central Bank injected $129 billion into the banking system, and the Fed followed suit. Even then Paulson sought to accentuate the positive. "We are going to work through this problem just fine," he said, perhaps hoping to soothe jittery investors. "These things take a while to play out." He was right about that last part.

Within weeks Paulson started trying a bunch of measures to deal with the housing downturn. Treasury supported three big banks that announced they would create a $75 billion fund to provide liquidity to the market for housing-related bonds. The goal was to buy assets from structured investment vehicles, or SIVs, that held mortgage bonds of questionable value, but the fund never got off the ground.

Hope Now, another private-sector housing initiative driven by Paulson and his team, has fared better. "I'll talk as long as you want about that," he says proudly. An alliance of mortgage lenders, credit counselors, and loan-servicing firms, Hope Now says it has helped more than two million distressed homeowners avoid foreclosures by providing loan workouts, modifications, or new repayment plans. Some surely would have worked things out with lenders on their own, but Paulson's efforts brought the industry together to cut through technical, legal, and accounting obstacles. "He applied the stick with a smile, but he applied the stick," says Steve Bartlett, a former Congressman who is now CEO of the Financial Services Roundtable, an industry group.

Paulson brought all his persuasive powers to bear when Congress and the President began talking in January about boosting the sluggish economy. First he convinced Bush not to put forth any specific plan, which would only be opposed by Democrats in Congress. Then he embarked on an inside-the-Beltway version of shuttle diplomacy, engaging the White House, Pelosi, Boehner, and others. "He's very engaging, very open," says Congressman McCrery. "He gives one the sense that his visit or call is not perfunctory." Paulson got results. Pelosi gave up her efforts to extend unemployment benefits and food stamps. (They came back in a later bill.) Boehner agreed to support cash payments to working families, an idea the GOP had rejected, in exchange for getting corporate and small-business tax cuts. One thing Paulson and the White House did not want in the bill or anywhere else was a more targeted effort to stimulate the housing market by making direct payments to overextended homeowners. The notion of bailing out borrowers who were teetering on the edge of default was anathema to Republicans.

***

Ah, but then came Bear Stearns. In better times the venerable investment bank might have been allowed to go under, Paulson told Fortune. "The freedom to fail goes right along with the freedom to succeed," he says. During Japan's banking crisis of the 1990s he would tell Japanese friends, "It's a heavy tax on your markets and your society if you don't let institutions fail." But Paulson says that the U.S. government lacks the regulatory authority needed to unwind the complex and hard-to-value assets and liabilities of an investment bank in the way the Federal Deposit Insurance Corp. is set up to manage commercial bank failures. Instead Paulson, Bernanke, and New York Fed chief Tim Geithner persuaded J.P. Morgan Chase to take over the foundering Bear Stearns with a promise of $29 billion in financing from the Fed. "Bear Stearns was easy for me, because it was clear that, given where we were at the time, failure would have created a huge problem." But Paulson wanted to avoid the appearance (or reality) of a bailout for investors. "When there is intervention, I really believe that the shareholders need to lose. Bear Stearns was a great old institution, but I don't know how you can put government money in there and protect the shareholders."

While Paulson was slow to grasp the seriousness of the credit crunch, he'd known about the problems with Fannie and Freddie for years. "They are an odd construct, with a difficult dual mandate to serve both a public mission and private shareholders," he has said. Paulson's first real dustup with White House staff, in fact, arose in 2006 when they disagreed with him about how hard to come down on Fannie and Freddie, which the administration essentially wanted to strip of their favored status. Paulson persuaded Bush to support a compromise bill to regulate them, even if it wasn't as tough as Republicans wanted. "The elephant was too big for the tent," Paulson recalls. "Regulation needed to catch up."

Two years later it did, with a vengeance. On a Sunday afternoon in mid-July, Paulson stood on the steps of the Treasury Building to ask Congress to give a Republican administration that sees itself as pro-market the power to nationalize Fannie and Freddie. That was a shocker, if only because earlier that week he had assured the lawmakers that "their regulator has made clear that [Fannie and Freddie] are adequately capitalized." Paulson disagreed with that judgment but couldn't say so, because shareholders and creditors were already fleeing the wildly overleveraged lenders. Soon after, Paulson was back on the Hill, saying that he never expected to use his powers: "If you've got a bazooka, and people know you've got it, you may not have to take it out." Once again, his optimism was unwarranted. The unfolding political drama reinforced the market's anxieties. The fact was that both companies were in trouble, as Paulson learned when a 40-person team from Morgan Stanley, working on behalf of the Treasury, began poring through their books.

His carefully crafted takeover plan resolved some problems and put off others. With Fannie, as with Bear Stearns, shareholders took the big hit. "In terms of the equity," Paulson says, "I don't think there's anyone out there who thinks they've been bailed out because Hank Paulson is here. Look at the terms of those securities. We came in ahead of the preferred and the common [stock]. We got 79% of the equity before we put a dollar in."

The critical point was that creditors were protected. Among them are central banks in Asia (which had already been shedding U.S. mortgage debt), community banks across America, pension funds, mutual funds, and investment banks. That creates a so-called moral hazard - lenders could be tempted to take imprudent risks in the future, expecting another bailout - but it comes with an asterisk, as Paulson notes. Fannie and Freddie are unique because their debt had the implied backing of Uncle Sam. Federal regulators, for example, permitted banks to treat Fannie and Freddie's paper as if it were T-bills or cash in order to meet their capital requirements.

***

Left open is the question of how to fix Fannie and Freddie and what they will look like down the road. The current plan is to let them grow until 2010, in order to buoy the housing market, and then cut them down to a manageable size. "We've got competing objectives," Paulson concedes. "We've got, first and foremost, stability in the financial markets. Secondly, we need to get through our housing correction as quickly as possible." Yet Fannie and Freddie also need to be managed conservatively enough to reassure creditors that they are well capitalized. "This is all about our financial system and about our economy," says Paulson. "It's orders of magnitude more important than Bear Stearns."

The financial crisis will no doubt outlast Paulson's tenure. People forget that the savings-and-loan mess took a decade to clean up. Paulson's self-assessment? "I want to simply say that I did the very best I could to be constructive, recognizing that no one person can come down [to Washington] and change everything," he says. Paulson usually responds forcefully to every question, but when I ask on my way out whether he has enjoyed his tour of duty in Washington, he hesitates. "I feel a lot of pressure," he says. "Goldman was a lot more fun."  To top of page

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