On the Money at Treasury
Working Behind the Scenes, Paulson Had His Department Ready to Confront the Credit Crisis

By Neil Irwin
Washington Post Staff Writer
Tuesday, November 20, 2007

When Henry M. Paulson Jr. took the helm of the Treasury Department 16 months ago, he spoke in soaring terms about shaping America's competitive destiny. At his confirmation hearing, not a single question focused on the housing market or the mortgage industry.

But just under the surface, a lending crisis was about to burst into full boil.

Now, as crises in the mortgage and financial markets raise fears of a recession, he has moved forcefully to try to prevent the worst outcomes. Using the skills he developed during three decades at Goldman Sachs, he persuaded banking executives to create a private fund that could buy up investment instruments so that their collapse would not infect the broader economy. His staff is developing policies to stem the flood of foreclosures anticipated in the coming months. His legacy as Treasury secretary is likely to be that of crisis manager.

Paulson, 61, has won praise from Congress for being flexible and creative in responding to the problems. He has also drawn criticism: from the left, for not acting on a housing meltdown that affected millions of Americans until it threatened big banks; from the right, for assenting too readily to new regulation of the financial system.

"I think we're working our way through this," Paulson said in an interview in his office last month. "But I also recognize that it's going to take longer for these markets to operate the way they should be, and until they are, there's a certain amount of" -- he paused for a moment, as if searching for words that would not fuel further panic -- "fragility in the system."

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In a domestic financial crisis, there are limits to a Treasury secretary's powers. He cannot force markets to calm down. He cannot cut interest rates, which is the purview of the Federal Reserve.

"There's not a whole lot of magical buttons over there to push," said Robert S. Nichols, president of the Financial Services Forum and a former Treasury official.

So, as markets for a wide range of debt products went haywire in late July and August, Paulson took little visible action. Publicly, he said that damage in the mortgage sector appeared "largely contained." Privately, he was furiously gathering information -- mostly by working the phones incessantly.

"I think everybody who's dealt with Hank has had situations where he's called at 4:30 and been told you're in the men's room," said Joshua B. Bolten, the White House chief of staff, "and [he] calls back at 4:33 and wants to know if you're out of the men's room yet."

Paulson drew on more than 30 years of high-level contacts. He called James Dimon, chief executive of J.P. Morgan Chase, to educate himself about the market for mortgages, a business that has not been of major interest to Goldman Sachs. "He doesn't know the consumer mortgage business like we do," Dimon said. "It's 'What are the spreads, what could be ameliorated, what could be fixed, what policies make sense? Do you think this will help, do you think that will help?' "

He called American Express chief executive Kenneth I. Chenault to learn whether businesses and consumers were reducing their spending. (They weren't, at that point.) He called James W. Owens, chief executive of the construction-equipment company Caterpillar, to ask how the problems were affecting industrial firms.

In August, as investors lost faith in a variety of debt products and refused to buy them at any price, Paulson continued to assemble information, and his staff started brainstorming policies that might ease the millions of foreclosures that analysts had begun to forecast. After his normal 12-hour days in the Treasury Department building, he spent evenings making more calls from his Northwest Washington home.

Staffers say that the atmosphere, particularly during the height of the crisis, was surprisingly informal. Paulson would regularly pop into the office of Treasury Undersecretary Robert Steel, a former colleague at Goldman Sachs, or the assistant secretary for financial markets, Anthony Ryan, to share some nugget he had just learned or to bounce around an idea. "Everyone's in and out of everybody's offices all the time," Steel said. "It's just the way the building works."

In September, as the damage mounted, he invited senior executives from Citigroup, J.P. Morgan Chase and a dozen other major banks to a series of meetings at Treasury to discuss a kind of self-bailout. Some of the banks were facing serious problems with what are known as structured investment vehicles. These off-the-balance-sheet funds had invested heavily in the market for subprime mortgages, which are made to borrowers with shaky credit histories. If these funds collapsed, major banks might have to cut back dramatically on loans to preserve cash.

The banks agreed to create a $75 billion fund that would stand ready to buy up or lend against securities from those troubled structured investment vehicles. Paulson described his Treasury team's role as one of getting private companies to do a deal that was in their mutual interest, and noted that no taxpayer money would go into the fund.

But by using his clout to get executives talking, Paulson may have set a precedent for government intervention to rescue financial institutions in trouble, which could encourage financiers to take more irresponsible risks.

Barney Frank (D-Mass.), chairman of the House Financial Services committee, said he supported Paulson's move, calling it a form of "soft regulation." But some conservatives didn't care for it.

"They're trying to avoid a fire sale of these assets," said Kevin A. Hassett, a senior fellow at the American Enterprise Institute. "But sometimes you need to have a fire sale if you've had a fire."

In October, Paulson called for an overhaul of the byzantine system for regulating banks. He also indicated openness to national standards for mortgage brokers, and other regulatory steps that have traditionally been more popular with Democratic than Republican administrations.

"I believe in markets. I don't believe in unregulated markets," Paulson said last month. "I've seen what can happen if regulation doesn't keep up with market growth."

Democrats still complained that not enough was being done for homeowners threatened with foreclosure. Sen. Charles E. Schumer (D-N.Y.), chairman of Congress's Joint Economic Committee, said: "The feeling I have is that Paulson would do some of these on his own but is being a good soldier within the administration."

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Paulson had originally been reluctant to take the Treasury job. His predecessors' experiences were not encouraging. President Bush's first Treasury secretary, Paul H. O'Neill, was edged out of major decisions and then fired. His second, John W. Snow, was widely viewed as more a spokesman for the administration than a powerful decision maker.

Bush convinced Paulson, whose 32 years at Goldman Sachs included seven as chairman and chief executive, that he would play a pivotal role in making policy. In particular, Paulson was expected to manage economic relations with China, a nation he had visited dozens of times in his career.

Accepting the nomination, Paulson described his mission in lofty language, referring to the "competitive zeal of the American people," staking out a broad role overseeing global relationships and trying to ensure America's place in the 21st-century economy.

But among his first actions as Treasury secretary were steps to prepare the department for a financial crisis.

Snow had shut down a "markets monitoring room" to save money. Paulson re-opened the space, where five staff members now analyze data on the stock, bond and currency markets all day, and notify senior Treasury officials when they behave oddly.

The President's Working Group on Financial Markets, created after the 1987 stock market crash to coordinate response to a financial crisis, had rarely been meeting. Some of the key staffers from different agencies didn't even have one another's cellphone numbers. Paulson scheduled quarterly meetings of its lead members, including himself and the directors of the Federal Reserve, Securities and Exchange Commission, and Commodity Futures Trading Commission. He also directed the various agencies to develop contingency plans for a crisis, according to people who were in the meetings.

The group conducted "tabletop exercises," which essentially were financial war games, going through the mechanics of how each agency might act in the event of, say, a 1,000-point one-day drop in the Dow Jones industrial average.

Staffers traded cellphone numbers and drew up phone trees. They set up conference call lines and figured out how to get announcements to the media. (All the agencies would use the Treasury Department press room.)

The system got its first test Feb. 27, after the Chinese stock market tanked and the Dow appeared to fall 546 points. Using the new communication system, the agencies involved rapidly found out that part of the decline was caused by a computer glitch, so the damage was not as severe as it looked. Panic averted. The system tested that day has been in near constant use in the past four months, keeping key decision makers in touch through the roller coaster ride in financial markets.

Meanwhile, Paulson, a relative neophyte at Washington politics, cultivated relationships on Capitol Hill. When Frank mentioned to him that a constituent was being detained in China over a passport dispute, Paulson asked a senior Chinese official about the case on his next visit there. The constituent, Frank said, was quickly allowed to return home. Frank calls Paulson "reasonable and flexible."

"All of my training was to look at facts," Paulson said. "I didn't have political training because facts aren't political. Facts are facts."

But he has adapted. "The best idea in the world, if you can't sell it, you can't persuade people, it isn't any good."

Staff researcher Richard Drezen contributed to this report.

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