Can Paulson Save the Economy?
By Justin Fox / Washington
It is late on a summer afternoon, and Treasury Secretary Henry Paulson is sipping a Diet Coke in his giant corner office a patch away from the White House and doling out career advice. His secret to success? "You define your job expansively."
He practices what he preaches. Lured to Treasury from Goldman Sachs two summers ago by a President in need of domestic-policy credibility, Paulson has grabbed the rudder of a $14 trillion national economy churning its way through a maelstrom. There's always a danger in attributing too much economic impact to one government official, and Paulson certainly shares responsibility with Federal Reserve Chairman Ben Bernanke and Congress -- and with his boss, President George W. Bush. But if there is one person whose actions right now will determine whether the combination of crashing house prices, struggling lenders and punishingly high energy prices proves catastrophic for the U.S. economy, it is the man at Treasury.
Paulson made his reputation and his fortune on Wall Street as a dealmaker, and it is in crafting deals that he has distinguished himself in Washington. His most recent and most impressive such coup was the quick passage of a massive housing bill in late July over the objections of many Republican lawmakers and even some White House aides. The legislation gave Paulson something unprecedented and very expansive: a blank check from Congress that he and whoever succeeds him at Treasury can use until the end of 2009 to bail out or take over Fannie Mae and Freddie Mac, the troubled government-created firms that at the moment are funding the vast majority of mortgage loans being made in the U.S.
It's been an impressive performance, especially coming from a member of the lame-duck Administration of an unpopular President. What's not at all certain, though, is whether it's all going to work -- to revive housing, prevent recession and avert a future mortgage bailout of epic, trillion-dollar proportions. The candidates for President are watching closely: both Barack Obama and John McCain have generally endorsed Paulson's actions, but it's clear that -- with Obama's candidacy propelled in part by economic discontent -- McCain has a greater stake in the current Administration's success. Either way, the next President's options will be determined in large part by what Paulson can pull off in the next few months.
Picking Up the Phone The first two Treasury chiefs of the Bush years never pulled off much at all. Paul O'Neill, the former CEO of aluminum maker Alcoa, battled with the White House over deficit spending (he wanted less of it) and lost. His successor, John Snow, former CEO of railroad giant CSX, toed the Administration's low-tax, anti-regulation line so faithfully as to be almost invisible.
Paulson, 62, came to the job with a bit of Washington experience, dating to the Nixon White House. He had just spent seven years running Goldman Sachs, the current cream of Wall Street firms (and also the place that prepared Robert Rubin for his successful 1990s tenure at Treasury). But the key to understanding Paulson's approach is that he spent the bulk of his career not as a manager but as an investment banker. What a good investment banker does is build relationships -- chiefly with the CEOs of companies whose business he is courting, but also with anybody else who can help make deals happen.
"Let me just say this -- I believe in relationships," he intones during a lengthy interview in his office. A 6-ft. 1-in. (1.85 m) former Dartmouth football star with a permanently hoarse voice and a direct manner, Paulson doesn't go out of his way to be ingratiating. He does go out of his way to keep the conversation going. "I spend a lot of time on the phone," he says. "I find I assimilate information by talking to people and getting inputs from many people. I always said to my kids, 'Don't assume.' I say to the people here, 'Don't assume. Pick up the phone and call and talk to people.'"
Building a rapport with President Bush was Paulson's first priority upon taking office. But he also set out to build or reinforce strong ties with the Fed's Bernanke, other Cabinet members, his counterparts overseas, Wall Street CEOs and -- perhaps most important -- congressional Democrats. Before his appointment, Paulson had been a generous donor to Republican candidates. But he refused to campaign for Republicans in the 2006 congressional elections -- a decision that endeared him to the new leadership after the Democrats swept to victory.
During his first year in office, Paulson's most high-profile relationship-building efforts were with the Chinese government, in a series of top-level meetings in Beijing and Washington. These weren't a flop -- Paulson proudly points to the failure of anti-China trade legislation in Congress and the 20% rise in the yuan vs. the dollar -- but they weren't a dramatic success either. Then came trouble, which spread from subprime mortgages to financial markets in general in August 2007. The chief connection was that subprime loans -- those sold to less qualified borrowers -- were purchased and repackaged by Wall Street into supposedly low-risk investment products called collateralized debt obligations (CDOs). When shaky borrowers began defaulting en masse on their mortgages, the whole scheme unraveled.
The President's Working Group on Financial Markets, an inter-agency collection of regulators led by Paulson, had actually been looking into potential problems with hedge funds and derivatives. But they missed CDOs. Paulson terms the oversight "obvious after the fact." Not so, say some observers. "I've got a lot of respect for Paulson and his credentials," says Glenn Hubbard, who was chairman of the President's Council of Economic Advisers in the early Bush years and is now dean of Columbia Business School. "But this looks like the Fed and Treasury were lurching from crisis to crisis, when much of this was forecastable."
Early on, it was Bernanke and the Federal Reserve that took the lead, with various measures meant to keep financial markets functioning and banks lending. But as house prices kept dropping, the problem began to shift. It was no longer just that financial institutions were wary of lending, but also that some would go under from the losses they were taking on mortgages and mortgage-related securities.
For banks and thrifts, there are well-defined procedures for dealing with insolvencies through the Federal Deposit Insurance Corp. But much of the financial action in recent years has moved to companies for which there is no such shutdown plan. When Wall Street firm and major mortgage player Bear Stearns experienced something akin to a bank run in March, the solution that Paulson and Bernanke came up with was a hastily arranged sale to JPMorgan Chase & Co., backed by a $29 billion guarantee from the Fed. The Fed is responsible for keeping prices stable and credit flowing. Bailing out troubled lenders to prevent a financial meltdown is a entirely different kind of job, one that most economists say belongs in the hands of Treasury and Congress -- in part because they're more directly accountable to taxpayers.
Treasury Takes Charge Paulson doesn't disagree, and the legislation to backstop Fannie Mae and Freddie Mac -- the government-created, shareholder-owned corporations that buy the bulk of U.S. mortgages and repackage them as securities -- can be seen as the first big step toward Treasury's taking the cleanup job out of the Fed's hands. Fannie and Freddie owe or guarantee immense quantities of debt ($5.2 trillion, or almost as much as the Federal Government owes investors) but hold only tiny capital reserves to insure against losses. With house prices down 18% nationally since mid-2006 and defaults rising, worries were growing that they might be insolvent.
Paulson says that unlike the situation with Bear Stearns, there was never a moment when the two firms appeared in imminent danger of failure. But he saw far more dire potential consequences than in the case of Bear. "Their securities move like water among all of the financial institutions," he says of Fannie and Freddie. If holders ranging from central banks in Asia to community banks in Iowa had lost confidence, the ensuing sell-off might have been catastrophic.
On a more mundane level, Paulson was aware that Congress had only a few weeks left in session. There was already a housing bill well along in the legislative process that provided for a new, tougher regulator for Fannie and Freddie (among many other things). So Paulson jumped into action. On Friday, July 11, he met twice with President Bush, bypassing White House economic advisers who opposed any kind of taxpayer bailout. Over the weekend, he talked to congressional leaders. And all along, he was consulting with Bernanke. On Sunday the 13th, Paulson made the dramatic announcement on the steps of the Treasury building that he was seeking an unlimited line of credit to backstop Fannie and Freddie, plus the authority to buy shares in the companies. Within two weeks, Congress delivered. The President signed the measure into law July 30.
"I think that we were stampeded into panic legislating," says Spencer Bachus, the ranking Republican on the House Financial Services Committee, who voted against the bill. But that's the loser's perspective. In Paulson's view, Congress was simply doing what made sense. "The more flexibility I have, the more confidence that gives to the market, the less likelihood the authorities will be used and the better for the taxpayers," he says. In other words, Trust me. Do we have much of a choice?
-- With reporting by Michael Duffy / Washington