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All this came to a head in March, when the investment firm Bear Stearns imploded. The Fed intervened, backstopping JPMorgan Chase's shotgun acquisition with a $29 billion guarantee. The Fed could do this because it doesn't have to ask Congress for money it can effectively print its own. But if the Fed simply issued more currency to patch every hole in the U.S. financial system, the dollar would eventually lose all credibility.
And so after Bear Stearns, a consensus developed at the Fed and Treasury that if more bailouts were called for, they should be done by Treasury, with congressional approval. That's when Paulson took command. He identified mortgage giants Fannie Mae and Freddie Mac as the shoes likely to drop next and decided that with $5.2 trillion in debt securities that were seen by investors worldwide as implicitly guaranteed by the U.S. government the companies couldn't be allowed to fail.
Paulson outmaneuvered a recalcitrant White House economic team and got approval directly from President Bush, then held a Sunday-morning press conference to announce that he was seeking major new powers and asking Congress for hundreds of billions of dollars to backstop the two firms. Within a couple of weeks, Paulson got what he had asked for. It was a bravura performance by a man who had risen to the top of the investment-banking profession on his ability to make deals happen.
At Goldman, Paulson had always been known more as a doer than a chin-stroking thinker. "He is like a heat-seeking missile going to problems," says Goldman board member and former Medtronic CEO William George, who has known Paulson for 30 years. And as he tried to articulate his philosophy at Treasury, Paulson talked himself into a bind. He drew a seeming line in the sand after Fannie and Freddie, making the case in speeches and interviews that some big firms had to fail. "You need that market discipline," he told me in July.
In mid-September, Paulson followed that hard line and let Lehman Brothers go under. "I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers," he told reporters the day the investment firm declared bankruptcy. He also said the government wasn't considering a loan to struggling insurance giant AIG.
Within days, the market's panicked reaction had changed Paulson's tune on AIG, which the Fed saved with a loan aided by Treasury. And now he says the issue with Lehman was that Treasury didn't have the power to do anything and the circumstances that allowed for the JPMorgan-Bear Stearns deal (a willing buyer and collateral that the Fed could lend against) weren't present.
This may be true, but it wasn't what Paulson said at the time, and these mixed signals confused markets and the public. When Paulson then headed to Capitol Hill to secure $700 billion in what became known as the Troubled Asset Relief Program (TARP), the signals got even more confused. At first, Paulson argued that the money should be used to buy distressed mortgage securities rather than to take direct stakes in financial institutions. "Putting capital into institutions is about failure," he said. "This is about success." Within weeks, he had switched course and committed almost half the $700 billion to direct investments.
This was almost certainly the right decision, but it was more evidence that the transition from dealmaker, which requires pragmatism, to policymaker, which favors consistency, was proving difficult for Paulson. Ask him what his philosophy of financial regulation is, and he begins, "My basic philosophy is hardly extreme. I believe in markets." A few sentences later he tacks back: "I've never been antiregulation. I've always believed that raw, unregulated capitalism doesn't work." Then another turn: What's needed, he says, is a regulatory setup in which financial institutions can fail without endangering the system. And another: Since we don't have that, he and the Fed have had to intervene to save financial institutions, because history teaches that the longer you wait to intervene, "the more economic havoc is wreaked." But wait: Interventions also distort markets.
It is as if he is circling the question, testing out every possible answer. His staffers at Treasury say this is how he makes decisions chewing over all the arguments and facts, then quickly making his call and not looking back. It's a pragmatic, flexible approach. It also means that with slight changes in the arguments or the facts, Paulson is capable of making the diametrically opposite decision. The result is a communications challenge for Treasury but also something of a quandary for those who would demonize Paulson.
"He's been criticized for two things," quips House Financial Services Committee chairman Barney Frank. "Preventing companies from going under and not preventing companies from going under." And so Frank, while he has battled with Treasury over the use of TARP funds, continues to look to Paulson to get things done. So does the rest of Washington.
When the city's focus turned from banks to the auto industry, Paulson at first avoided involvement. "There's something bizarre about Congress not voting to do something with the autos and then whispering in my ear, 'Use the TARP and don't tell us,'" he said on Dec. 10. "You know, 'Here's the revolver go do it for the good of the regiment. And then I'll criticize you after the fact.'" Two days later, after auto-rescue legislation crashed in the Senate, Paulson was hard at work trying to craft another bailout.
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