Looking Back at the Brink: Questions for Hank Paulson
Henry M. Paulson left Goldman Sachs, where he was chairman and CEO for seven years, to become George W. Bush's third Treasury secretary in 2006. The first two, Paul O'Neill and John Snow, had been seen as wielding little power in Bush's war-focused cabinet, but history wouldn't allow that to happen in Paulson's case. A year after he took office the subprime mortgage crisis began, and the following year its effects threatened to take down the entire world financial structure. Paulson, along with Ben Bernanke and Timothy Geithner at the Federal Reserve, managed the government's response to the crisis, culminating in Congress's approval of the $700 billion TARP plan in the fall of 2008. Ever since, all three men have faced both praise and anger, for letting some firms fail and for saving others, for intervening in the crisis or not intervening enough. Bernanke and Geithner are still at the helm of the economy, as Fed chairman and current Treasury secretary, but Paulson left office a year ago with George W. Bush and has spent much of the time since writing his first book, On the Brink, an insider's account of the crisis.
On the Brink is Paulson's chance to give his side of what happened during those tense months, and he tells a compelling story, in which he, Bernanke, and Geithner worked to convince financiers, regulators, and politicians of the urgency of the crisis, and then found that it was snowballing even beyond their fears. Decisions were made on the fly, often without precedent, as they struggled to arrange the regulatory authority to do what they thought necessary--all during the peak of an already-dramatic presidential election. Paulson puts you inside the New York Fed when dozens of financiers hunkered down through the night to work how to save Lehman Brothers (and save their own firms if Lehman failed), and the famous and preposterous White House meeting in which senators and candidates John McCain and Barack Obama faced off over the TARP proposal then before Congress (and after which Paulson got down on one knee before Nancy Pelosi to plead for his proposal). There's a great deal of anger at the government and Wall Street, both of which Paulson represents for many people, for the way the crisis was handled and for the neglect and excesses that caused it, but On the Brink makes a vivid case for the necessity of what Paulson and his colleagues did, flawed as he admits some of their decisions might have been.
We had the chance to talk to Paulson a few days before the book was released, and you can listen to our podcast interview (in two parts) below, or read the full transcript after the jump:
Amazon.com: You accepted the job as Treasury secretary in 2006, with some reluctance. Did you have any idea what you were getting into?
Paulson: I had a pretty clear idea that there would be a credit crisis sometime when I was in Washington. And I told the president I thought there'd be one, and the first major meeting I had with him I spent just talking about that topic. But I did not anticipate a crisis of the magnitude we faced--didn't anticipate that at all--and I certainly was bordering on naive in my understanding of the regulatory powers and authorities in Washington.
Amazon.com: You mention in the book that you didn't see it coming from the housing sector.
Paulson: No, no. The president asked me what the source might be, and I told him there's no point in even trying to guess, because after the fact it's always obvious. But people hadn't predicted the Russian default or the Asia crisis, and I think the reason we didn't see it coming from the housing sector is that housing prices in the U.S., residential house prices, had generally gone up ever since World War II and we'd never seen a decline of that magnitude, so mortgages were seen as relatively safe investments and none of the models and none of the financial experts saw something the likes of what we encountered.
Amazon.com: In your author's note at the beginning of the book, you thank many of the people you worked with through those long months, but in particular you single out Ben Bernanke and Tim Geithner and the trust you had in each other. How did you find that trust so quickly? What did you each bring to the table?
Paulson: It was a great partnership. And we had a year to begin working together before the crisis. I chaired a group called the President's Working Group on Financial Markets, and that was a great forum for us to develop a relationship. And then I think the crisis itself forced an even closer relationship. What I appreciated the most was that we just didn't see the normal turf consciousness that we're seeing. Even now when they're trying to get financial reform legislation done in Washington you're seeing turf consciousness coming into play among some of the agencies. And during the crisis this was pretty much nonexistent.
Amazon.com: You talked about Bernanke's great knowledge of history. How much of a guide could history be?
Paulson: I can answer that two ways. First of all, history is a guide in one very real sense: that if you let the financial system collapse, and don't do enough to stave off disaster, the people who are going to suffer, the innocent victims, are going to be the American people. It's not going to be the banks, or the financial sector. So you need to do everything you can to put out the fire before it gets out of control. I think to that extent history was an important guide.
Otherwise, there wasn't much you could learn from history. That's a big lesson, but we were dealing with a financial system and markets very different from what had existed many years ago. Huge concentration in the industry, so if you had two or three firms go down in succession you'd have a domino effect. The whole system could collapse, and it wouldn't take much to have unemployment levels equal to what we had at the Great Depression, and it could happen very quickly. And we didn't have the tools we needed to work with. The regulatory system hadn't been updated since the Great Depression, essentially; the regulatory authorities hadn't. We didn't have the authorities for dealing with major non-banks, and winding them down. So in many ways what were doing was we were dealing with--I said in the book--duct tape and baling wire. We were making do with the authorities we had, which were woefully inadequate.
Amazon.com: And scrambling to get more authories.
Paulson: And scrambling to get more authorities. And in many ways this book is the story of the collision of politics and markets, and it's the story of a race against time to get more authorities. And I think one of the things that really comes through in the book is all of the different elements of the crisis that were coming at us simultaneously.
Amazon.com: Well, speaking of the effect that this eventually would have on the average American, one thing you talk about quite a bit in the book is that on one hand you want to get across that sense of urgency and communicate to the average American, who might not understand what a credit default swap is, what effect this could have on them, but on the other hand you don't want to roil the markets, you don't want to create a feeling of doom and stress, so you have to walk that line.
Paulson: Yeah, the communications challenge was huge, and it began with the fact that the crisis couldn't have come at a worse time, because it came just weeks before a major election, a presidential election. And so everyone in Congress who was running for election had to have one eye on their own election, because that's their job, and another eye on doing what we needed to get done. And of course anything that smacked of a bailout was very, very unpopular. But somehow or other it all came together, and we got the authorities we needed from Congress, and a good number of leaders up there cast very heroic votes, in my judgment, because they knew they were going to be unpopular votes.
Amazon.com: And the lines--as far as ideological lines--of who was with you and against you from time to time were not what you would always expect.
Paulson: Yeah, you're right. First of all, the president believed, just as I did, in free-market principles. None of us liked the idea of private business benefiting from taxpayer assistance, the idea of putting capital in banks. But the president took the view--he understood, first of all, that if the financial system went down, this is our economy, and that people who were going to suffer were going to be the American people, and that was going to be the first priority. So he was quite willing to move away from some of the bedrock Republican principles.
I worked very closely with the Democratic leadership of the House, because they were the leaders and that's what it was going to take to get things done. So we worked closely with the Democrats. The Republicans in the Senate were overwhelmingly favorable to doing what we had to do. They understood, like I did, that these were very unpleasant, unpopular, obnoxious things we needed to do to rescue the financial institutions, but they were better than the alternative. The Republicans in the House had the hardest time. I had the most difficult time working with them. I think maybe if they had been in the lead, and it was happening on their watch, it would have been a bit easier.
But again, the difficulty here was when the markets froze, it was clear to me, and to Ben and to Tim, that the economy was going to be suffering out four, five, six weeks. It just had to happen. It would have been like if all the highways in America had shut down and you wouldn't get any products in the stores. We could see that. But the members of Congress couldn't see that, so they just had to operate on faith that if we didn't do something, the whole system was going to go down and there was going to be real havoc. And then we had trouble, because once we went in and stabilized things, the economy then, inevitably, turned down. It had to turn down, given the shock the credit markets had taken. And so the members of Congress then became very unhappy and said, "You came and asked for all these powers, you did things, and we still have got this huge problem." And we had to explain, "Well, we understand there's a huge problem, but it would have been much bigger if you hadn't acted."
Amazon.com: Yeah, I was trying to think of a way to explain this. It's almost like someone was crossing the road and you saw a semi about to hit them that they didn't see, and so you tackled them--
Paulson: You could just see it. We could see it and it was one of the most frustrating--when I look at the things I could have done better, there were a lot of them and they come out in the book, but the communications challenges were huge. I mean, I sat there when the capital markets froze, before we went to Congress, and the money markets weren't working, and I just tried to think about how to explain this. Because I knew--I was seeing major, blue-chip industrial companies that were having trouble raising financing, so I knew with $3.4 trillion of money market funds, and with everything that was just getting ready to break apart, that if the system had collapsed there'd be thousands and thousands and thousands of mainstream industrial companies--middle-sized companies, large companies--that wouldn't be able to raise their short-term funding, finance their inventories, pay their people. People wouldn't have been able to pay their bills. This would have rippled through the economy. We would then have had--well, today we have over 10% unemployment. That's terrible. And that's after everything we've done. If the system had collapsed, when we were on the brink, unemployement easily could have been at the 25% level that we saw at the Great Depression, and the value destruction--much greater than we've had in terms of home prices and in terms of people's savings accounts and stock portfolios and so on.
Amazon.com: And now it looks like 2010 is going to be the year that the Obama administration--well, they're still tackling the economy, but they're also going to tackle financial reform. In the last section of your book you mention some lessons that you took out of the crisis.
Paulson: Yeah, this is absolutely critical. And I am not shocked but very unhappy we don't have this yet, because people in this country are angry. Now they're very angry about bonuses and compensation levels on Wall Street, and rightfully so, after everything that's been done to save Wall Street. But what they should be angry about is that we have a system that made this necessary. And so what we need to do is we need to channel some of that anger toward fixing the system so never again do we have major financial institutions that are too big to fail.
What I believe we need is--first of all, what we need is a major overhaul of the regulatory system which does the following: We need resolution authorities so any financial institution can be wound down and liquidated so it doesn't go through the bankruptcy process and so it doesn't hurt the financial system and the American economy. In other words, we'd be able to have the authorities to liquidate a big, failing company so it doesn't have to be bailed out. We need a systemic regulator: one regulator that isn't just focused on the trees but is focused on the whole forest, and can intervene with any institution, regardless of the form of the institution or the business activity, if that regulator sees something that threatens the system. And then of course we need a strong global accord with stronger capital rules and liquidity rules.
And then we need to rethink housing. I spend a lot of time in the book talking about Fannie Mae and Freddie Mac, the two huge financial institutions that right now are doing virtually all of our mortgage financing, and the government's behind them. But part of why we got here is we have so overstimulated and overincented housing in the United States that we got homeownership to levels that were unsustainable. And so we need to rethink housing policy: restructure, scale down Fannie and Freddie, but look at a whole series of other things--FHA programs, the mortgage interest deduction--because the combined weight of all of these things I think is just too much.
And then we need to address also what I call these global economic imbalances, which for the most part are our proclivity, as a nation and a people, to save too little and to borrow too much. I think this led to huge capital flows and huge excesses in the system, which is the root cause of this crisis.
And then of course the last lesson, which is a very unfortunate one, is that, one thing I learned is that in Washington you're not going to get anything really big and important and difficult done if it's a change, unless it's a crisis. So even if I'd been omniscient and seen this thing coming just the way it came, there wasn't much more I could do. Because we were working hard to get reform of Fannie and Freddie, but we couldn't get that reformed, or get the legislation we needed, until just before these institutions were ready to collapse. And of course when we went to get the TARP from Congress, even when the whole system was on the brink, the House voted no the first time. So again, I think one lesson, a painful lesson, is that it takes a crisis to get something difficult done in Washington.
Amazon.com: And do you worry that the further we get from the crisis the harder it will be to make those necessary reforms?
Paulson: Of course I do. The thing I worry about the most is I don't want another Treasury secretary to ever be sitting there like I was, without the tools and authorities you need to protect our country, protect our economy, and protect the people. It's a helpless feeling and it's a terrible feeling, and we should never be in this place. Our authorities need to be updated, our financial regulatory structure needs to be updated, and I'm optimistic about the future if we do this.
If we don't, we will have another crisis. You always do. That's the history of mankind. If you go back, as long as we've had banks and financial institutions, there have been excesses, no matter how hard you try to avoid them, and there are going to be financial crises, and we need the tools in place and the regulatory system in place to be able to have a better visibility into what's going on and then be able to put out the fire when it starts, without costing the American people as much as this one did.
Amazon.com: Well, it's been a year since you left the Treasury Department, and you spent most of it writing this book. You're an old English major--what was it like to write your first book?
Paulson: I wish I could tell you it was a pleasant process. I'm an English major, I've enjoyed writing my whole life, but this was humbling for me, because I recognized that I didn't have the talent to write this book without a lot of help. I spent hours and hours and hours drafting and redrafting, editing, and it was made difficult by a number of factors. First, I didn't have notes, and we didn't have a lot of records to look at. Things were moving very quickly. I've always had a good memory, but there was so much stress during the crisis. It took ten or twelve or fifteen people who worked with me at Treasury and others in government to help me just recall everything. And doing that brought back a lot of the stress all over again.
So just to put it all together, and then to write something--which we tried to do, we tried to write something that's a fast-paced narrative where you don't have to have a PhD in finance to understand it, and yet to still be technically accurate and correct: something that the average American can read and understand, and something that finance experts would look at and still think is relevant. To me that was a real challenge, and I had some great help. Mike Carroll, who had been an editor of the Institutional Investor and someone I had known for years and understood finance, was very helpful to me. But I've got great respect now for anyone who's ever written a book.