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David Cho /Washington Post: On
Treasury Secretary Henry M. Paulson Jr

A Conversion in 'This Storm'

First of two articles by David Cho

Treasury Secretary Henry M. Paulson Jr. had a stern message for more than two dozen of the nation's most powerful hedge fund managers gathered in the third-floor conference room near his office.

Paulson told them it was time to begin regulating the opaque realm of hedge funds, reversing his long-held opposition. "You should not be thinking about how to fight it but how to make it work," he recounted telling them at the meeting last month.

They were stunned. One manager recalled muttering as he walked out: "What happened to the Hank Paulson we knew?"

With his 30-month tenure nearing its end, Paulson is leaving behind a legacy of federal interventionism that few would have expected from this former head of the investment giant Goldman Sachs .

When he arrived in Washington as one of Wall Street 's most successful bankers, he was skeptical of government meddling. But as a regulator facing the worst financial crisis in nearly a century, he engineered a series of massive federal intrusions into the markets while persuading reluctant bank executives and influential politicians to fall in behind him.

His evolution in thinking has extended even beyond these government programs to a set of new beliefs that he has yet to trumpet publicly or, in most cases, even share privately with colleagues on Wall Street and in the White House . While they, too, have changed some of their views on regulation, Paulson disclosed that he has traveled an even greater distance.

"My thinking has evolved a lot to the point where I've seen regulation up close and personal," he said in a series of interviews. It wasn't just the crisis that changed him. It was every bit as much sitting behind the desk where he fashioned new regulation. "I've realized how flawed it is and how imperfect, but how necessary it is," he added.

Even though President Bush has been warning the next administration in speeches not to over-regulate the markets, Paulson said he will unveil proposals in coming weeks urging President-elect Barack Obama and the new Congress to endow the federal government with broad new authorities to take over any failing financial institution, not just banks.

A Republican, Paulson would bring government into some of Wall Street's most private quarters. He said banking regulators should have a major say in how financial firms compensate their executives and that the Federal Reserve should have the power to regulate any financial company it considers crucial, including hedge funds and private-equity firms. He added that the policy statement he crafted on hedge funds in January 2007, which stated they should not be regulated, was wrong.

In reshaping his philosophy, he has had to feel his way even as the once-familiar financial landscape shifted around him. Some senior government officials who worked with him said he invented much of the government's response on the fly.

In reflecting on his term, which comes to an end in January, Paulson said his biggest regret was not seeing the extent of the financial crisis as it developed. But he defended every major action he took.

"We were always behind. We saw the problem, but it took us a while to see the severity of the problem," he said. "But even if we had been more clairvoyant, we wouldn't have been able to do much differently that what we have done."

* * *

Paulson had long believed that free markets work only if companies, no matter how big or vital to the financial system, could pay for their mistakes by failing. Nothing is as powerful a motivator as the possibility of a collapse, he would say.

He articulated this philosophy in a July speech in London and continued to maintain this viewpoint in public even as troubled Wall Street giant Lehman Brothers edged toward the brink in September. In interviews at the time, he warned of the dangers of repeatedly offering government guarantees to companies. Just three days before Lehman failed, Paulson reinforced the point, telling reporters and Wall Street executives that no government money would be used to save the 158-year-old investment bank.

But behind the scenes, Paulson had already shifted his position. He communicated a different message to executives at Barclays , a British bank that he had recruited to buy Lehman and save it from collapse.

"I said, 'There wouldn't be government support,' " Paulson said. "They said they wouldn't buy it without government support."

"Then I said, 'Well, give us your best deal with government support, and let me try to figure out how to make it work.' " Though he had concluded that the Treasury Department did not have the authority to give Lehman money, he was willing to see whether the Federal Reserve would help bail out the bank, much as the Fed had provided crucial guarantees for the sale of the ailing investment bank Bear Stearns in March.

In the end, Barclays's British regulator blocked the Lehman deal. The Fed, in turn, refused to prop up a company without a buyer from private industry.

Ultimately, Lehman failed, not because of Paulson's convictions about how free markets should work but because he could not arrange a deal to save the firm, even with taxpayer money.

The fallout from Lehman's bankruptcy filing Sept. 15 was severe. The firm had relationships with a wide range of hedge funds and financial firms. Some could not get their money back. Suddenly, investors on Wall Street could no longer be assured that their money was safe in any investment bank.

Just a day later, Paulson dropped publicly any pretense that large firms would be allowed to fail. Along with Timothy F. Geithner , president of the Federal Reserve Bank of New York , Paulson put together an $85 billion loan for the insurance titan American International Group . Before the end of the week, Paulson headed to Capitol Hill to ask for the authority to spend $700 billion on an unlimited number of banks and financial firms whose troubles could put the entire financial system in jeopardy.

A former Wall Street chief executive who knew Paulson would try to save Lehman with public money said this exemplified his pragmatism. He had made the tough call to do what was necessary for the financial system even if this meant betraying his earlier convictions, said the executive, who spoke on condition of anonymity.

While critics on Wall Street now accuse Paulson of inconsistency, some senior government officials said he has been ideally suited to grapple with a fast-moving and complicated financial meltdown. His shifting views, while startling, are not that surprising because his beliefs have never been grounded in ideology, these officials said.

"These are unprecedented times," said Sheila C. Bair , chairman of the Federal Deposit Insurance Corp. , who has worked closely with Paulson and occasionally clashed with him. "He doesn't have an ideological bias one way or the other. He's tried to be receptive as he developed responses, and to his credit, he is willing to go where folks have dared not to go in terms of regulation."

It was Paulson, for instance, who pressed the Securities and Exchange Commission to temporarily ban short selling of financial stocks in September, according to three sources familiar with the matter.

"If you had asked me, that was one thing in 100 years I would have never done before I came down here," Paulson recalled. "But in the middle of this storm with everything going on, I said, 'Whatever we are doing right now isn't working, so go ahead and do it.' "

A short sale allows an investor to profit when the price of a stock declines. Wall Street bankers traditionally avowed that short selling is a fundamental part of stock trading and crucial to proper pricing. But the chieftains of the big banks, including John J. Mack of Morgan Stanley , John A. Thain of Merrill Lynch and Richard S. Fuld Jr. of Lehman Brothers, were telling Paulson they were convinced that traders were using the practice to drastically drive down the share prices of their companies, Paulson said.

Paulson said in an interview that the decision to ban short selling belonged to SEC Chairman Christopher Cox . But Paulson said he strongly supported it.

"Cox wanted to do it, but he wanted to do it only with the support of me and the Fed," Paulson said. "For me, it was a little like book burning."

* * *

Paulson also came around to the idea of massively intervening in the markets to prevent the failures of financial firms, despite his worries that such a bailout would motivate companies to take excessive risks because of the prospect of a government backstop -- a problem known as moral hazard.

As far back as January, Paulson said, he began to discuss the outlines of this plan with Fed Chairman Ben S. Bernanke .

After Bear Stearns nearly imploded in March, Paulson asked his staff to start sketching out the initiative on paper, said two federal sources familiar with the matter.

Then, on the eve of Lehman's bankruptcy filing in September, Paulson thought it was time to move ahead. He was alarmed not only by the plight of AIG but by the possibility of Washington Mutual , Wachovia and several large banks in Europe failing all at once, he recalled. He ordered his staff to draft legislation that would give the Treasury new authority, including the ability to buy toxic assets from banks and inject capital directly into financial companies in exchange for ownership stakes, a senior government official said. The stakes for the world economy had escalated, and he hoped Congress would recognize the peril.

In the hallways of Capitol Hill and before the television cameras, Paulson emphasized the first proposal, which involved the government buying troubled assets and allowing the market to set their prices. But even though he had already developed contingency plans to make direct capital injections, he disparaged the idea during congressional hearings. In late September, he told the Senate: "There were some that said we should just go and stick capital in the banks. . . . But we said the right way to do this is not going around and using guarantees or injecting capital, and there's been various proposals to do that, but to use market mechanisms."

Yet before the rescue package had been enacted by Congress, this free marketeer had already decided that a bigger bang for the federal buck would be direct capital infusions, in essence a partial nationalization of the country's banks.

Last week, he announced that the program to buy toxic assets would be shelved altogether in favor of a proposal to inject capital into a wider range of financial firms, in an effort to loosen the markets that finance auto, student and other consumer loans.

Some corporate executives said Paulson's on-the-job education was costly. It would have been better, they said, if the Treasury had never volunteered to buy the troubled securities. Once Paulson abandoned this plan, their values plummeted, burning bigger holes in the balance sheets of some financial firms.

* * *

When the Bush administration asked Paulson to be Treasury secretary in 2006, many of Paulson's closest friends questioned whether he could adapt to life inside the Beltway.

Paulson exuded confidence as he moved through Wall Street's inner circles, but not eloquence in front of the podium. And some said they raised doubts about whether he could handle the heat of Capitol Hill hearings -- or whether the White House would simply undercut his authority.

Paulson said he has become far more comfortable in Washington than in New York. An Illinois farm boy, he never adapted to the New York lifestyle, never enjoyed swinging deals along a golf course.

Even from the beginning of his tenure at the Treasury, it was clear that Paulson might break the mold. When he accepted the administration position in the summer of 2006, his allies on Wall Street urged him to revise the Sarbanes-Oxley Act, which was adopted in 2002 in response to a string of accounting scandals at Enron and other firms. The legislation had increased accountability for public companies but at some expense to their bottom line.

Upon reviewing the act closely, Paulson said, "I could not find a single idea in it that was wrong."

Some who worked with him during the early part of his tenure said his thinking on regulation appeared surprisingly amorphous.

"Unlike most 60-year-olds, he came to Washington with less formed views on policy," said one senior government official who is close to Paulson. "So if you wanted to be generous, you could say he has developed policy responses that fit each problem, that he is pragmatic. If you wanted to be critical, you would say these are policy responses that are without rhyme or reason. And I think there's some truth in both of those."

Paulson said he never imagined when he took the post that he would end up proposing far-reaching regulatory programs.

And in the coming weeks, he is planning to announce a valedictory set of proposals to modernize Washington's aging regulations and extend their reach into matters that traditionally have fallen beyond the purview of federal officials.

Paulson said he will urge Congress and the administration to grant the Fed broad discretion to examine the books of any firm, regulated or unregulated. This would require large hedge funds, private-equity firms and other now-unregulated financial entities to accept a charter from the Fed and open their financial records to its officials.

He added that executive compensation for financial firms also needs substantial reform, which could be accomplished partly through banking regulation.

Paulson said he pushed the five major federal banking agencies over the past weeks to release a guidance document that would require firms to eliminate compensation that encourages risky behavior by traders and executives.

Paulson said the document, which was issued last week, has not "gone far enough" in reforming executive compensation but he was optimistic that the document "creates a vehicle" to tackle the issue in the future.

Moreover, he said he is also working on a proposal that would grant the federal government broad new powers to take over a wide range of financial firms whose collapse could endanger the financial system. Currently, this authority exists only for banks.

The companies could be required to contribute to a fund that would help cover the cost of closing them in an orderly fashion if they cannot be saved.

Paulson said Congress would have to define which companies meet the criteria and determine how much they would contribute.

None of these measures, however, will be as much debated by history as his most significant legacy: the $700 billion rescue for the financial system. Paulson said he regretted that his tenure "will be viewed as so controversial" because of this program.

But the allies he has won in Washington -- including fellow regulators and some lawmakers from both sides of the aisle -- predicted that he would be judged more kindly.

"If the rescue does work, that will be a huge part of his legacy," said Bair, the FDIC chairman. "Even if it doesn't and we have to do other measures . . . I think history will view him favorably as someone who tried programs and took some risks and tackled this crisis with the best information that was available to him."

A Skeptical Outsider Becomes Bush's 'Wartime General'

Second of two articles by David Cho

The pressure on Henry M. Paulson Jr. in early September was greater than at any other time during his tenure as Treasury secretary. As he pored over the books of mortgage giants Fannie Mae and Freddie Mac , he discovered that they were about to collapse and that the financial markets would experience what he called "a meltdown to end all meltdowns."

The federal government would have to seize the firms. But the law said their management would have to agree, and his own staff had reservations about whether Paulson had the legal authority to force them to surrender.

"Trust me," came Paulson's curt answer. "I'll get it done."

During his 28 months at the Treasury, Paulson has accumulated more power than nearly any of his predecessors and has wielded it boldly, even brazenly at times, in a bid to tame the financial crisis of a lifetime. He has burst through the customary boundaries that separate federal agencies, bent regulations to his will and pushed up against legal limits. As financial firms tumble and traditional oversight agencies prove impotent, Paulson has filled the void with his 6-foot-1 frame, summoning the rest of Washington and Wall Street to get in line.

"Even if you don't have the authorities -- and frankly I didn't have the authorities for anything -- if you take charge, people will follow," Paulson said in an interview. "Someone has to pull it all together."

He said regretfully that the financial upheaval has forced him to be a modern Robert Moses, the controversial 20th-century urban planner who acquired minor government posts and stretched their authority to reshape New York City as he saw fit. Though Moses never held elected office, he remade the landscape of New York through the cunning exercise of power.

Paulson had twice rebuffed the Bush administration by the time it offered him the post of Treasury secretary in April 2006. Paulson finally agreed but insisted on some terms. He would answer only to President Bush and not be subject to meddling by the president's economic policy advisers. And, Paulson recalled, he wanted it in writing.

The agreement laid the foundation. After the financial crisis erupted last year, Bush privately dubbed Paulson his "wartime general" on the economy, essentially telling him he would have White House backing for whatever measure he pursued, Paulson recalled in a series of interviews. That commitment endured even as Paulson steered the administration far from Republican orthodoxy on free markets.

Paulson used his influence within the administration to win even broader powers from Congress, allowing him to nationalize major financial institutions, either in part or entirely. The bills were sweeping in scope and gave him the latitude to spend hundreds of billions of dollars as he saw fit.

And Paulson unilaterally pushed his authority to craft initiatives even when, according a senior government official, he was not sure he had an airtight legal basis.

Confronted with the implosion of Fannie Mae and Freddie Mac, he didn't hesitate in identifying his course for the firms. He gave the companies' management just one day to review the Treasury's assessment of their situation, which revealed that each was on the verge of collapse. Then he summoned individually the two chief executives, Richard F. Syron of Freddie Mac and Daniel H. Mudd of Fannie Mae, to the third-floor conference room near his office in the Treasury building. Paulson sat across from them, along with Federal Reserve Chairman Ben S. Bernanke and the companies' regulator, James B. Lockhart III .

Paulson put it bluntly: "We are going to [take you over] and we want you to agree to it, and you will have a board meeting tomorrow and you are going to agree to it at your board meeting." Paulson never acknowledged that, under law, the companies had a choice in the matter.

Within days, Paulson had compelled them to agree that they would be nationalized.

"Not that I think it's a good thing; it should never work that way," he said. "But this was an extraordinary time period, and as much as I didn't want to do it . . . I knew what would happen if we didn't do it."

* * *

When President Bush first settled on a chairman of Goldman Sachs named Hank Paulson to be his new Treasury secretary, the administration couldn't seal the deal.

Nearly everyone Paulson talked to advised him not to do it. He spoke to family. He spoke to colleagues. They raised concerns about whether his reputation would be tarnished, as happened to Bush's first two Treasury secretaries, Paul H. O'Neill and John W. Snow . They proved ineffective, some political analysts said, because their authority had been undercut by the White House.

Even one of Bush's Cabinet secretaries counseled Paulson against coming to Washington, Paulson said. "Don't come down here; you can't trust them," he recalled being told. He declined to identify the Cabinet member.

Paulson was afraid of failing. "I will get down here and I won't be able to work with these people, and I'll leave with a bad reputation, and look at what people said about Snow and O'Neill," he said.

After the second time Paulson turned down the job offer, White House Chief of Staff Joshua B. Bolten , invited Paulson and his wife for lunch with Bush and President Hu Jintao of China. Paulson recalled feeling melancholy as he left the White House, reflecting on what he was about to pass up. He reconsidered.

Paulson sought out Allan B. Hubbard, director of the National Economic Council at the time, who guaranteed that the White House team would not undermine the Treasury Department .

Bolten said the toughest job was convincing Paulson that he could still accomplish important goals as Treasury secretary in the last years of the Bush administration. But giving Paulson written assurances that he would have broad authority at the Treasury was not hard for the White House.

"The real problem was getting Hank to be willing to do the job -- he was sitting on top of the world in early 2006," Bolten said. "He had heard that this is a very White House-centric operation, which in some respects it has been, and the secretary of Treasury did not have much authority and so on, and he wanted to be assured he would be leader of the economic team. To me that stuff was easy. The president would be in charge, but yes, you are the leader of the economic team."

The third time Paulson was asked, he accepted.

As turmoil in the financial markets escalated, Paulson's influence grew so great that he eclipsed the White House on economic policy. And when Paulson sought new authority from lawmakers to rescue the mortgage markets and financial companies, Bush told him he would "hang back" rather than risk that his poor popularity jeopardize Treasury's efforts on Capitol Hill , according to two sources familiar with the president's discussions with Paulson.

"I think the president of the United States was willing to defer to him and give him authority and liberate him from the constraints that the White House had forced on his predecessors," a senior government official said. "That was hugely important because it made him credible and able to negotiate with Congress."

In the summer, President Bush warned that he would block a landmark housing bill in Congress that in part would revamp the agency regulating Fannie Mae and Freddie Mac. That change was vital to Paulson. He persuaded the president to drop his veto threat, according to senior government officials.

"If you look at Paulson," said Rep. Barney Frank (D-Mass.), one of Paulson's key allies on Capitol Hill, "the one thing that's irreplaceable is his ability to bring George Bush along, and throughout this effort, the work . . . to persuade the president to do things that he otherwise would have resisted was important."

When Paulson went to Capitol Hill in September, asking for the authority to spend $700 billion to bail out financial firms, he said, he never worried that Bush would oppose him, though the plan was an unprecedented intrusion in the marketplace. The measure was initially defeated in the House of Representatives , primarily by Republican votes. But Bush never abandoned the proposal -- officially called the Troubled Asset Relief Program , or TARP, but better known around Washington as the Paulson plan -- instead intensifying lobbying efforts to get it passed.

"When the president stepped up big was when we lost the vote on the House," Paulson said. "He said, 'We will get it done, and we won't change one bit of your TARP. . . . the only thing we'll do is [think of] what sweetener do we have to add, and anything we add, will it gain more votes or lose more votes?' And the only thing he said is, 'We will run that process from the White House.' "

Under the plan, Paulson was granted sweeping discretion to decide how to use the $700 billion and which financial firms would get the money. He could hire firms to manage the program without having to obey the standard government rules for contractors. He could even decide how to place conditions on companies receiving government help, including limits on executive compensation.

In the end, Congress granted Paulson every authority he asked for.

* * *

Paulson acknowledges that such broad powers have a downside. It would be him -- not the White House -- who would be blamed if the emergency response to the crisis went awry.

"We may do things that are unpopular," Paulson said. "We may do things that we are forced to do. There may be things we have to do to respond to a systemic event, and there is no other authority to deal with it other than TARP. Then I will take one for the nation and take the criticism."

That uproar has already started. Yesterday, during a hearing on Capitol Hill, Paulson endured a barrage of criticism, mainly from Democratic congressmen, for repeatedly shifting directions on how the bailout billions will be used and for refusing to spend any of it on struggling homeowners or the ailing auto industry.

Treasury secretary is "fundamentally a lonely job," said a former senior Treasury official who advises Paulson. "It's very hard for anybody to know what goes into these kinds of judgments, and I'm sure he's dramatically changed by that. He has to live with all that second-guessing all the time."

Paulson said he always has tried to define his job expansively and plans to encourage his successor to do the same.

Senior government officials said Paulson helped craft rescue programs for financial firms, though he was not sure he had an unquestionable legal basis for the initiatives, including the bailouts of the failing investment bank Bear Stearns in March and the wounded insurance giant American International Group in September.

One senior official said similar legal doubts also applied to the Treasury's decision in September to grant a tax break to banks to help stabilize the financial system by encouraging them to merge. Treasury officials have said publicly that the tax-policy change is legal.

Paulson also supported the Federal Reserve Bank of New York in organizing the market for complex financial derivatives known as credit-default swaps. Some familiar with the effort said officials from the Fed and Treasury never knew whether they had the legal authority to interfere with the market for such derivatives but did so anyway because the opaque trading threatened the wider financial system.

At the same time, Paulson has muscled independent regulatory agencies to adopt his ideas. Several regulators said he often applied enormous pressure to get them to fall in line, for instance pushing the Securities and Exchange Commission to adopt a temporary ban on short selling and the Federal Deposit Insurance Corp. to introduce a new program to guarantee debt issued by banks. Paulson himself acknowledged that he had been the driving force behind a guidance document released this month by four regulatory agencies urging banks to use bailout money to increase their lending.

"Hank has taken his leadership role seriously," one of the regulators said. "And if he thinks he knows the right answer for a bank regulator, particularly for the Office of Thrift Supervision or the Office of the Comptroller of the Currency or Fannie and Freddie, he will not hesitate to express his views. To that extent, he's the benevolent dictator. He wants an answer, and he wants it yesterday."

Paulson said times forced him to take that role. Every major call in confronting the financial crisis, Paulson said, was his. No other regulator had the authority or will to do it, he said.

When the investment bank Lehman Brothers released disastrous second-quarter earnings this summer, shortly before it went bankrupt, Paulson asked its chief executive, Richard S. Fuld Jr. , what the next quarter would look like. Fuld said it might be worse. Paulson demanded that he find a buyer for the company.

Fuld balked, looking for other ways to save the firm. So Paulson moved ahead himself and tried, ultimately unsuccessfully, to engineer a deal.

"I was the only guy who drove that," Paulson said. "I called two banks when none of them were interested. I tried to get them interested. I urged them to do it. . . . That's what a Treasury Secretary needs to do when you are in a war."

David Cho is Washington Post Staff Writer. Petroleumworld does not necessarily share these views.

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