Paulson Risks Goldman Standard as Fannie, Freddie Shares Erode

By Rebecca Christie and Matthew Benjamin
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Aug. 21 (Bloomberg) -- As soon as he became secretary of the U.S. Treasury in July 2006, Hank Paulson started preparing for a crisis.

In August 2006, at a meeting with President George W. Bush and his economic team at Camp David, Maryland, the former Goldman Sachs Group Inc. chief executive officer gave a talk about the capital markets.

Paulson held up over-the-counter derivatives as an example of financial innovation that could, under certain circumstances, blow up in Wall Street's face and affect the whole economy. ``My point was that we had gone eight years since the last serious problem in capital markets and that there'd been all of this innovation,'' Paulson said in an interview in late July.

Paulson also revived the President's Working Group on Financial Markets, a council of regulators consisting of the Federal Reserve, the Treasury, the Securities and Exchange Commission and the Commodities Futures Trading Commission.

Founded after the stock market crash of 1987, the group had fallen into disuse. Paulson began to build relationships among the agencies, figuring that the financial markets panel would be key to addressing the next crisis, no matter what that would be.

``No one would have predicted the Russian default in '98 or some of the things that happened in Asia,'' he says. ``But you still need to get ready to respond.''

Turbulent Times

In his two years at the Treasury, Paulson has witnessed some of the most turbulent economic times since the Great Depression.

Just in the past year, he's had to wrestle with a slumping economy and increasing home loan foreclosures, the subprime crisis, the collapse of Bear Stearns Cos. and the weakening of Fannie Mae and Freddie Mac. ``I can't remember when Treasury has been so deeply involved in the structure of securities markets,'' says James Cox, a professor at Duke University who specializes in securities law.

Paulson, 62, who was a football offensive lineman in college, hasn't just been spending his time fending off economic assaults. He brought his own list of things he wanted to accomplish in the 2 1/2 years remaining of the Bush administration.

A sampling: overhaul the Social Security system, improve economic relations with China, jump-start African financial markets and combat global warming by setting up a fund to help finance new energy-efficient technologies.

Defines Job 'Expansively'

``One of my management principles is to define your job expansively,'' Paulson says. ``I think I've defined the job here expansively.''

Not all of his initiatives have been successful. The Social Security plan and a bid to create Treasury-backed institutions to buy home mortgages were notable non-starters.

And he has drawn sharp criticism from some conservatives. Former presidential candidate Steve Forbes, a Republican, says Paulson could have avoided the Fannie-Freddie crisis altogether by cracking down on the two companies earlier.

For years, Republicans have called the firms ticking time bombs due to their private ownership and implied government guarantees. Paulson, says Forbes, should have made moves to fire their boards, recapitalize them and sever their ties to the government.

``Hank Paulson blew a supreme opportunity to make a substantial reform,'' Forbes says. ``He's caved in to the political pressure in Washington, which is, in essence, keep Fannie and Freddie largely as they are.''

Shares Tumble

During the past week, investor confidence in Fannie Mae and Freddie Mac has dwindled amid rising speculation that government intervention is inevitable. Share prices have plunged, as Wall Street watches for any sign that the two companies are no longer able to roll over their debt. Fannie has about $120 billion of debt maturing through Sept. 30, while Freddie has $103 billion, according to figures provided by the government-chartered companies and data compiled by Bloomberg.

In a debt sale this week, Freddie Mac paid yields that had the highest spread on record over U.S. Treasuries. In Aug. 20 trading, Fannie Mae slumped 27 percent and Freddie Mac dropped 22 percent, extending its losses to 90 percent for the year. Fannie Mae declined $1.61 to $4.40, the lowest since 1989, in New York after falling as low as $3.95. Freddie dropped 92 cents to $3.25, the lowest level since 1990, and earlier in the day fell to $2.95.

Since Paulson's plan was enacted, several prominent critics have spoken out in favor of nationalizing the two companies. Former Fed Chairman Alan Greenspan said the government should create a company like the Resolution Trust Corp. to sell off the assets of any failing financial institution while limiting taxpayer losses, in a new epilogue to his memoir.

Bill Gross Prediction

Meanwhile, Bill Gross, who manages the world's biggest bond fund, said Aug. 6 the U.S. Treasury will probably be forced to buy as much as $30 billion of preferred shares in both Fannie Mae and Freddie Mac. Richard Syron, Freddie Mac's chief executive, that same day said he believed his company would be able to avoid Treasury intervention.

While Paulson has made deals with politicians across the spectrum, he's also expanded his authority beyond the scope of any previous Treasury secretary. That's a big change for the Bush administration, which ousted its first Treasury secretary, Paul O'Neill, for his independent views and made his successor, John Snow, a traveling salesman for Karl Rove-designed economic policies.

During Snow's tenure, the Treasury complained of being left out of efforts to revamp Fannie and Freddie, says Vincent Reinhart, former director of the Fed's Monetary Affairs Division who's now at the American Enterprise Institute in Washington.

`Back in Business'

``The Treasury's back in business,'' Reinhart says.

At the Treasury, Paulson is drawing in large part on the skills he honed during his 32 years in investment banking. Paulson's signature style is to confront issues early, hold private meetings and build a consensus before announcing a deal, so that he's sure it will get the necessary backing, according to members of Congress and government staff who've worked with him.

Goldman, which was a partnership until 1999, has a culture of collegiality, says Edward Yingling, executive director of the American Bankers Association.

The bank has produced prominent political figures such as former Treasury Secretary Robert Rubin, former Deputy Secretary of State John Whitehead and Jon Corzine, who was a senator from New Jersey before becoming governor of that state.

Evoking Hamilton

Rubin, who served at the Treasury from 1995 to '99 after 26 years at Goldman and a stint at the White House, dealt with financial crises in Mexico and Asia, pushed for free trade and promoted budget policies that led to federal budget surpluses. When he retired, former President Bill Clinton called him ``the greatest secretary of the Treasury since Alexander Hamilton.''

Yingling says he asked Robert Steel, a former vice chairman at the investment bank who was Paulson's top domestic finance aide at the Treasury for almost two years, why the firm generates so many high-profile Washington officials.

``He said the culture at Goldman Sachs was not hierarchical and that people learned to work in teams and to work with people well,'' Yingling says. (Steel left the Treasury in July to become CEO of embattled bank Wachovia Corp.)

Executives like O'Neill and Snow, both of whom had a background in industry, tended to make a decision and have people go implement it, Yingling says. ``This town doesn't work that way,'' he says.

Gillette Deal

Paulson's consensus building doesn't mean he isn't forceful enough to win people over to his point of view. As chief of Goldman Sachs, he was often called in to woo clients and persuade them to sign with his firm. In January 2005, a month after Procter & Gamble Co. abandoned efforts to acquire Gillette Co., he helped revive discussions between the two firms with a phone call to A.G. Lafley, P&G's chief executive officer. The $57 billion deal, hammered out three weeks after Paulson's call, was the biggest that year.

As Goldman's chairman and CEO, Paulson also established relationships with politicians including Angela Merkel, now Germany's chancellor, Russian leader Vladimir Putin and former Chinese President Jiang Zemin. He says he's traveled to China at least 70 times during his career.

In the past 12 months alone, he went in December and March and was on vacation in Beijing in August to attend the Olympics. He may go again for the next round of high-level U.S.-China talks.

Paulson says he treats President Bush like a client, too. ``When you're advising a principal, you need to have a role where you are candid,'' Paulson says. ``But outside, there's never daylight between you and your boss.''

Fannie, Freddie

Paulson's coalition building faced one of its toughest tests in July, when the stocks of the two mortgage companies that account for almost half of the country's $12 trillion mortgage market began to collapse. Shares of Fannie Mae and Freddie Mac had lost more than 75 percent of their value in the first half of this year, as investors worried about the impact of the housing crisis on their holdings. While the two are government-chartered institutions, there was no explicit guarantee that the government would bail them out if they were to default.

On the morning of Friday, July 11, Paulson met with the president and convinced him to make a public comment about Fannie and Freddie. At the Energy Department later that day, Bush told reporters that the firms are ``very important institutions.'' He said he had discussed market concerns with his Treasury secretary. Paulson also tried to calm the markets, issuing a statement supporting the mortgage giants ``in their current form.''

Shares Slide

Both moves failed to stanch the bleeding. Fannie Mae declined $2.95, or 22 percent, to $10.25 in New York Stock Exchange trading on July 11, after passing through a low of $6.68 during the day. Freddie Mac fell 25 cents, or 3.1 percent, to $7.75 after reaching a low of $3.89.

Paulson's efforts were just beginning. He decided to seek sweeping new authority to extend emergency credit to the two companies and also to buy equity stakes in them if needed. He made ``unspecified'' powers the heart of his plan, which didn't spell out the amounts of money or terms of any bailout.

If investors knew the Treasury had power to rescue the mortgage giants, then an actual rescue might never be needed, Paulson says. Earlier in the year, Paulson had hoped Congress would create a stronger regulator for Fannie and Freddie before the firms reached a crisis point. ``I was hopeful we'd get the reform and we wouldn't have to use the plan,'' he says.

Bernanke Support

Still, Paulson knew that putting taxpayers on the hook for a possible bailout would be a tough sell on Capitol Hill. So he turned to Fed Chairman Ben S. Bernanke, whose support would be critical to convincing skeptical Democrats to back the plan.

During one of their weekly breakfasts, Paulson and Bernanke, 54, discussed the proposal and the possibility of the Fed extending an interim line of credit to Fannie and Freddie while Congress weighed the Treasury's proposal. Bernanke noted that such a move would be outside the Fed's normal duties, but that he'd consider it if Paulson thought Congress would quickly approve the Treasury's plan.

Paulson says Bernanke asked him if he believed that, in the middle of a presidential campaign, he could persuade a Democratic Congress to grant sweeping new powers to a lame-duck Republican administration. ``I took a deep breath and said yes,'' Paulson says.

Paulson immediately began calling congressional leaders to discuss the plan, making use of relationships he had been cultivating since his arrival at Treasury.

Consulting Lawmakers

Among others, he spoke with House Speaker Nancy Pelosi, a Democrat; Senate Majority Leader Harry Reid, also a Democrat; and House Minority Leader John Boehner, a Republican. Having Bernanke's backing helped with skeptical Democrats, says Reinhart, the former Fed official. ``Bringing the Federal Reserve into it brings a measure of independence that is consoling to the Congress,'' he says.

Paulson also lobbied the president, who'd threatened to veto any bill that contained major federal funding for community grants to enable municipalities to buy defaulted mortgages and help people stay in their homes.

The measure was sponsored by Democrats led by U.S. Representative Barney Frank, chairman of the powerful House Financial Services Committee. Paulson convinced Bush to back down from the veto threat, says White House spokeswoman Dana Perino. That helped to ensure the support of Frank and other Democrats. ``I think he's been very constructive,'' says Frank, 68, a Massachusetts Democrat. ``It's important to have a secretary of the Treasury that the president would listen to and respect.''

Treasury Steps

By the afternoon of Sunday, July 13, Paulson was confident enough to go public. Speaking on the steps of the Treasury Building, just hours before nervous Asian markets would open, he asked Congress for enormous new authority to backstop and oversee the beleaguered mortgage companies.

By Wednesday of that week, Fannie Mae's stock had rebounded 31 percent and Freddie Mac's was up 18 percent. On July 23, the House voted 272-152 in favor of the bill. Of the nays, only three were Democrats. Three days later -- just 13 days after Paulson's request -- the Senate passed it 72-13. All those opposed were Republicans.

Frank's Praise

Frank, a longtime foe of the administration, praised the bill after it was passed.

``Of the problems that were created by the reckless deregulation that led to the subprime crisis and the neglect of affordable housing that has marked Republican rule in Congress, this package of measures is the best response we could make,'' he said in a statement after the House vote. ``This will begin to lay the groundwork for a turnaround in the housing market.''

The legislation gives Paulson all of the major items he asked for, including unlimited authority for 18 months to make emergency loans to Fannie Mae and Freddie Mac and possibly buy stakes in the two mortgage giants. The legislation also created a long-sought new regulator to oversee Fannie and Freddie. Bush signed it into law on July 30.

Trading the presidential objections for Democratic backing was classic Paulson, says Edwin Truman, a senior fellow at the Peterson Institute for International Economics and a former Treasury official.

`He's a Dealmaker'

``He's a dealmaker,'' Truman says. ``It's one skill that Treasury secretaries need to have.''

That's especially the case when the economy is in danger, says Glenn Hubbard, Columbia Business School dean and the first chairman of Bush's Council of Economic Advisers.

``The time to judge economic policy management is in times of crisis, and I think he has brought the right skills to bear,'' Hubbard says. ``Even if I don't necessarily agree with everything he's done, I think he's been incredibly thoughtful, incredibly careful and a real leader.''

Paulson says timing played a big role in getting the program through.

``We recognized quite early on that if there was some concern or lack of confidence in their access to capital, this could create a serious problem,'' he says of the mortgage companies. ``But we certainly couldn't go to Congress and ask for these powers that would make it a self-fulfilling prophecy - - or we wouldn't have gotten the powers.''

Weekend Warrior

That the crisis in the share prices occurred on a Friday also worked for Paulson. As in the Bear Stearns bailout, Paulson cobbled together the Fannie and Freddie deal over the weekend, when markets are closed and the capital is quiet.

``He's used the fact that everyone in Washington goes out of town as his strength, because he stays in town and then works the phones and then gets a plan that he can unveil Monday morning,'' says Steven Bartlett, a former congressman who now leads the Financial Services Roundtable, a Washington-based advocacy group that represents large financial services companies.

Bartlett calls the negotiating marathons Paulson's ``famous weekenders.''

Since the plan was enacted, Paulson has reiterated that a bailout won't be necessary. ``We aren't going to comment on speculation,'' a Treasury spokeswoman, Jennifer Zuccarelli, said on Aug. 18. ``As the secretary has said, we have no plans to use these authorities.'' Yesterday, the Treasury's position was unchanged despite the plunging stock prices. ``We continue to stay in touch with the companies and their regulators and are staying on top of the situation,'' Treasury spokeswoman Michele Davis said.

Gathering Staff

Paulson likes to gather his staff in a room to hear from each of them before debating the merits and dangers of various policies, says David McCormick, who as Treasury undersecretary for international affairs is Paulson's top international aide.

``He really likes to sit down, go around the room and get conflicting views,'' McCormick says. ``People feel, I think, empowered.''

McCormick's first interaction with Paulson came in his previous job at the White House, when both were new to government. A Paulson aide asked McCormick, 43, to look at a draft of a speech for the Treasury secretary that addressed some international issues. McCormick sent the aide a note saying that he liked the text but that it seemed a tad long.

Five minutes later, he says, his phone rang and the Treasury secretary was on the line, wanting to know where the speech was too long and how to fix it.

`Incredibly Blunt'

Behind closed doors, Paulson's comments can have an edge. ``He is incredibly blunt,'' McCormick says. ``There's never shading with Hank, in the sense that I think you always are getting the straight picture.''

Paulson, who doesn't drink or smoke, has little time for frivolity on the job. Colleagues and lawmakers say he likes to limit interactions to serious discussions. ``I believe in substance,'' he says. ``I don't believe that you get things done just by getting together and having a drink or laughing, or interacting personally. While that's never a negative, you need to bring value.''

Henry M. Paulson Jr. developed a taste for hard work and a love of nature while growing up in Barrington, Illinois, a semirural community of 10,000 about 35 miles from Chicago with large areas of wetlands and forest preserves. Paulson still owns a farm there with his wife, Wendy, whom he married 39 years ago in September.

His father was a wholesale jeweler who raised Paulson to be a Christian Scientist and to become an Eagle Scout.

Harvard M.B.A.

At Dartmouth College in Hanover, New Hampshire, Paulson earned a degree in English and was a member of Phi Beta Kappa. He also was an all-Ivy League football player and a member of the Green Key Society, an honorary service group.

He now has two adult children, one of whom, Henry M. Paulson III, owns the Portland Beavers baseball team, the Triple-A affiliate of the San Diego Padres. His daughter, Amanda, runs the Chicago bureau of the Christian Science Monitor.

In 1970, Paulson earned a Master of Business Administration from Harvard Business School in Boston and then entered public service. From 1970 to '72, he was a staff assistant at the Defense Department, and from '72 to '73 he was a White House staff assistant, working alongside John Ehrlichman, the Nixon aide later jailed for crimes related to the Watergate break-in.

Paulson joined Goldman Sachs's Chicago office in 1974. There, he rapidly moved through the ranks, becoming managing partner and co-head of the firm's investment banking division. He was named co-chairman and co-CEO in 1998 and gained sole possession of those posts a year later, when he and other top executives pushed out Jon Corzine and took the firm public.

Goldman Shares

Paulson sold his 3.23 million shares in Goldman, worth about $500 million at the time, when he took the Treasury job, according to regulatory filings. He was exempted from paying capital gains tax on the sale of those stakes under a rule meant to avoid penalizing wealthy people who take government jobs and are forced to sell assets.

Paulson also sold about $25 million of holdings in a Goldman fund whose sole asset was a stake in Industrial & Commercial Bank of China, the world's largest publicly traded financial institution. The bank raised $22 billion in its initial public offering in October 2006, the world's biggest IPO.

Managing the U.S. relationship with China is an increasingly important part of the Treasury secretary's job. During the Fannie and Freddie crisis in July, Paulson used his credibility with Chinese leaders to reassure them that the U.S. mortgage companies weren't in jeopardy.

Talks With Chinese

``I clearly talked with the Chinese through this,'' Paulson says. ``They've worked with me enough that they knew I wouldn't say it unless I believed it.''

Chinese institutions own more than $30 billion of Fannie and Freddie paper, according to estimates by CLSA Ltd., the Hong Kong-based investment banking arm of France's Credit Agricole SA.

Two-thirds of that, or $20 billion, is owned by Bank of China Ltd., the country's third-biggest lender. China Construction Bank owns the second-largest amount, $7 billion. Spokesmen for Bank of China and China Construction Bank declined to comment.

Paulson has had some success with his attempts to get the Chinese to allow their currency, the yuan, to strengthen against the dollar. In 2005, while Snow was Treasury secretary, the People's Bank of China, the central bank, abandoned a system of fixed exchange rates and began setting a daily ``reference rate'' for the yuan versus the U.S. currency.

The Chinese central bank, which has the largest currency reserves in the world, allows the yuan to fluctuate as much as 0.5 percent on either side of the daily rate.

Weak Currency

U.S. officials argue that China -- the second-largest U.S. trading partner -- keeps its currency artificially weak, which makes Chinese exports more attractive in global markets. The U.S. trade deficit with China was $117 billion in the first six months of 2008, almost unchanged from a year earlier, according to Commerce Department data.

Paulson has cajoled the Chinese into letting the currency strengthen. Since he arrived at the Treasury, the yuan has risen about 14 percent against the dollar. That's a start, Paulson says. He'd like it to increase more.

Paulson says he's laid the groundwork for the two countries to work out future problems with the Strategic Economic Dialogue, a twice yearly U.S.-China economic summit he established in September 2006. The summit is a dialogue, not a negotiation, with both sides able to set the agenda.

Two to Talk

``You can't have a discussion if one side doesn't want to talk about it,'' says China expert Donald Straszheim, vice chairman of Roth Capital Partners, a U.S. investment bank specializing in emerging markets.

Paulson also convinced lawmakers, some of whom had been calling for measures to punish China, to be more patient with the emerging economic behemoth. Paulson has tried to focus the talks with China on the potential benefits an exchange-rate overhaul could bring to China's economy, McCormick says.

The Treasury secretary wrote an article for the September/October issue of Foreign Affairs outlining how a stronger currency could benefit China, including curbing inflation, which has been rising there.

Paulson's bid to revamp Social Security failed to change policy. Democrats balked at the Bush administration's proposal to create private investment accounts for individuals to manage their retirement money.

Pension Deficits

Republicans, meanwhile, ruled out raising payroll taxes to help bankroll the pension deficits that loom as baby boomers retire. In 2007, Paulson tried to revive the issue by establishing a set of assumptions about the pension program that both parties could live with. Despite Paulson's efforts, they couldn't agree.

Paulson says just getting the issue on the table is an accomplishment. ``My objective -- and we put out a series of reports and continue to -- has been to depoliticize the issue and do some things that make it easier for the next person sitting in the seat,'' he says.

Paulson was able to bridge the divide between the two parties with the economic stimulus program, aimed at keeping the U.S. economy from tipping into a recession.

Capitol Hill Talks

Paulson says he began to lay the groundwork in December 2007 and early 2008. He held hours of conversations on Capitol Hill with a wide swath of lawmakers.

Finally, he hammered out the details of the plan behind closed doors with House Speaker Pelosi and Minority Leader Boehner. Congress passed a $168 billion package in February, marking Paulson's first major success in Washington.

Some $92 billion in rebate checks had been mailed out to taxpayers at the end of July, with the aim of stimulating spending. So far, the economy hasn't sunk into a recession: It grew 1.9 percent in the second quarter, up from 0.9 percent in the first quarter.

Paulson's consensus-building style has its critics, too. He has been slow to respond to market crises and is overactive when he does engage, says Congressman Ron Paul, a Texas Republican who ran an unsuccessful 2008 presidential campaign.

``Behind the scenes, they're always trying to prop things up,'' Paul says. ``I think Barney Frank sort of likes him, which to anybody who may have believed in the free markets ought to raise questions.''

Covered Bonds

One of Paulson's next challenges is to try to build a U.S. market for covered bonds. The instruments allow banks to raise money while keeping mortgage loans on their books, using the actual assets as collateral, instead of packaging them into mortgage-backed securities.

First used in the 18th century by Prussia's Frederick the Great, covered bonds are a thriving $3 trillion market in Europe, where there is no equivalent of Fannie Mae or Freddie Mac. The bonds never caught on in the U.S., where just two banks, Bank of America Corp. and Washington Mutual Inc., have issued them.

Paulson sees the bonds as an opportunity to shore up the $12 trillion housing finance market. The idea has potential, observers say. ``I think it will give investors confidence,'' says Texas Tech law professor Ann Graham, who edits the Banking Law Prof Blog. ``It's another way to get liquidity into the housing market, and that's very important if we want a turnaround.''

Wall Street Connections

Paulson used his Wall Street connections as well as those he's made in Washington. In June, Treasury officials met with banks and investors behind closed doors to see what the market was lacking. Paulson also backed the Federal Deposit Insurance Corp.'s efforts to update regulations on how the bonds would be treated during a bank failure.

Then, in July, Paulson held a press conference to announce new guidelines for a U.S. covered-bond market. He was flanked by all four major U.S. bank regulators and representatives from ``future issuers'' -- the four largest U.S. banks.

The goal was to advance the covered-bond market without putting anyone out on a limb, says Neel Kashkari, a Treasury assistant secretary who followed Paulson from Goldman Sachs. ``If we get the issuers, the dealers and the investors to move at the same time, nobody has the risk of going first,'' he says.

As he navigates through economic turmoil, Paulson has still found time to work on one of his favorite causes: the environment. He's trying to start a $10 billion international fund under the auspices of the World Bank that would help emerging-market countries avoid investments in heavily polluting infrastructure. The proposed Clean Technology Fund has gotten $6 billion in informal commitments so far, McCormick says. Congress is considering the administration's request to kick in $2 billion.

Paulson's Future

Even in his globe-trotting days at Goldman, Paulson served as chairman of the Nature Conservancy and sat on the board of the Peregrine Fund, which works to protect endangered birds of prey. His office at Treasury is overrun by critters: photographs of otters, alligators and birds, as well as snapshots of him holding snakes and fish he caught.

Paulson, who's ruled out staying on at Treasury after Bush leaves office in January, says his next role may well be at an environmental group. ``A big part of my life will be devoted to conservation and the environment,'' he says. ``The only thing that isn't a certainty is whether that will be my primary or sole focus.''

Whatever the role, this will be the first plan in a long time for which Paulson doesn't have to consult anybody other than his wife.

To contact the reporters on this story: Rebecca Christie in Washington at Rchristie4@bloomberg.net; Matthew Benjamin in Washington at mbenjamin2@bloomberg.net.