Henry Paulson - On the Brink - Inside the Race to Stop the Collapse of the Global Financial System

The SED’s success is one of the achievements I am most proud of, and I am delighted to see it continued by the Obama administration. By focusing on our bilateral strategic relationship, the SED kept our dealings with the Chinese on an even keel through a wave of food- and product-safety scares. And when the financial crisis erupted, the relationships we had built and strengthened with Chinese officials helped us to maintain confidence in our system. That was crucial, given China’s vast holdings of U.S. debt.

Though I took an expansive view of my position, I took care not to run roughshod over other Cabinet secretaries’ turf. I well remember Steve Hadley, the president’s national security adviser, cautioning me that I needed to be properly deferential to Condoleezza Rice. “Her first concern,” he said, “will be that you can’t have two secretaries of State, one for economics and one for everything else.”

When I told Condi about my ideas for the SED, I made the case that a strong economic relationship would help her in her foreign policy leadership role. I made clear to her, “There’s one secretary of State. That’s you. I just want to coordinate and work with you, and help you achieve what you want to achieve.”

Condi and I hit it off from the start. I’d met her when she was the provost at Stanford University and I was CEO at Goldman Sachs. Former secretary of State and Treasury George Shultz, who was at Stanford’s Hoover Institution, had called me and asked if I would meet with her. She was an expert on Russia and was interested in working for Goldman. Now, I hadn’t seen the Russian financial crisis coming—none of us had—so I thought she might be a great asset. But she decided instead to join George W. Bush’s campaign.

Condi and I had lunch my second day at Treasury. She knew the president very well, and she gave me great advice on how to relate to him, suggesting that I make sure to spend time alone with him. Condi is smarter and more articulate than I am. I’m no diplomat and I’m terrible on protocol—where to stand and that sort of thing—but I do know how to get things done. More than once she had to tell me, “Remember, you’re number two in protocol, right after the secretary of State. Walk out right behind me.”

In the early days, with Condi watching out for me, I was fine. But when she wasn’t, problems sometimes arose. In 2007, President Bush hosted the nation’s governors at a conference in Washington at the White House. Condi was unavailable, so Wendy and I were supposed to sit beside George and Laura Bush during the after-dinner entertainment in the East Wing. We got to talking with California governor Arnold Schwarzenegger about environmental issues, and when the time came to sit down, Wendy and I took seats in the back of the room, leaving two empty chairs next to the president and First Lady. Finally, Bob Gates, the Defense secretary, moved over and took one of the vacant seats. Everybody was laughing, especially my Cabinet colleagues. As we walked out after the event, the president said to me, “Paulson, do you want to be a governor?”

But that wasn’t my worst faux pas. President Bush hated it when cell phones went off in meetings. In January 2007, I was in the Oval Office for a meeting with José Manuel Barroso, the president of the European Commission. As dictated by protocol, I sat on the couch to the left of the president, beside Condi. My phone, I thought, was turned off.

We were all listening intently as the two leaders engaged in a pleasant discussion, when my cell phone began to ring. I jumped like I’d been stabbed with a hot stick. I patted myself down, looking first in my suit coat where I always kept the phone, but I couldn’t find it. In my desperation I stood up and checked under the couch cushions in case it had fallen down there—no luck. It just kept ringing, while my mortification level rose. Finally, Condi figured out where it was. She pointed to my right pants pocket, and I turned it off as quickly as I could.

“Paulson,” the president ribbed me later, “that’s a three bagger: in the Oval Office; with a visiting head of state; and you couldn’t find it.” I never let it happen again.

I wish I could say that the offending phone call concerned a critical Treasury matter, but in fact it was from my son, who had called to talk about the Chicago Bulls.

No one has ever accused me of being too smooth. I come at people aggressively and tell them how I think a problem should be solved. I listen to anybody with a good idea, then I make sure that the best solution is adopted. While this approach worked well for me in business, I found that decision making is much more complex and difficult in Washington, particularly on Capitol Hill.

No matter what the problem, large or small, there is no such thing as a quick solution when you deal with Congress. Frankly, you cannot get important and difficult change unless there’s a crisis, and that makes heading off a crisis quite challenging.

Working effectively with lawmakers is a big part of the job of a Treasury secretary, and although I knew it would be frustrating, I underestimated just how frustrating it would be.

We had some early successes in the international arena, staving off potentially harmful anti-China protectionist legislation and getting a bill that clarified the process for foreign investment in the U.S. But we stalled on a number of domestic initiatives, including the administration’s attempts to reform Social Security and Medicare.

Fannie Mae and Freddie Mac, the mortgage giants, presented another difficult legislative challenge. When I first arrived in Washington, I was living out of my suitcase at the St. Regis Hotel at 16th and K Streets. Washington summers are hot and humid, but I enjoyed running around the National Mall, past the monuments and museums, weaving my way through the throngs of tourists. One day in late June 2006, I had just returned to the hotel from a run, dripping wet, when Emil Henry, Treasury assistant secretary for financial institutions, and his deputy, David Nason, showed up at my room to brief me on the two GSEs.

I was no expert on the subject. But the administration and the Fed had warned for years about the dangers these companies posed, and it didn’t take a genius to see that something had to be done.

As I sat there dripping in my soggy running gear, Emil and David explained how Fannie and Freddie were odd constructs. Though they had public shareholders, they were chartered by Congress to stabilize the U.S. mortgage markets and promote affordable housing. Neither lent directly to homebuyers. Instead, they essentially sold insurance, guaranteeing timely payment on mortgages that were packaged into securities and sold by banks to investors. Their charters exempted them from state or local taxes and gave them emergency lines of credit with Treasury. These ties led investors all over the world to believe that securities issued by Fannie and Freddie were backed by the full faith and credit of the U.S. That was not true, and the Clinton and Bush administrations had both said as much, but many investors chose to believe otherwise.

In this murkiness, Fannie and Freddie had prospered. They made money two ways: by charging fees for the guarantees they wrote, and by buying and holding large portfolios of mortgage securities and pocketing the difference—or, in bankers’ talk, the “spread”—between the interest they collected on those securities and their cost of funds. The implicit government backing they enjoyed meant that they paid incredibly low rates on their debt—just above the Treasury’s own.

The companies also got a break on capital. Congress required them to keep only a low level of reserves: minimum capital equal to 0.45 percent of their off-balance-sheet obligations plus 2.5 percent of their portfolio assets, which largely consisted of mortgage-backed securities. Their regulator had temporarily required them to maintain an additional 30 percent surplus, but that still left the GSEs undercapitalized compared with commercial banks of comparable size. Together the companies owned or guaranteed roughly half of all residential mortgages in the U.S.—a stunning $4.4 trillion worth at the time.