Henry “Hank” Paulson is a farmer’s son from the Mid-West with a keen interest in saving the environment. His day job, however, is US Treasury secretary. This week, his task is to save the American economy by drawing out the toxic waste that is threatening to destroy it.
If he pulls it off, he will probably go down as the most celebrated Treasury secretary in history. If he doesn’t, his reputation will be in tatters and he may take the global economy with him.
Paulson, a tall and fit 62-year-old, used to enjoy walking and kayaking with his wife Wendy. For the past two weekends, he hasn’t even been home as he tried to rein in the financial panic gripping the markets in America and around the world. He has been locked in meetings in the fortress-like offices of the New York Federal Reserve in downtown Manhattan working on plans that were constantly overtaken by events.
Now comes the hard part. On Friday, he announced the outline of a last-ditch proposal to use “hundreds of billions” of American taxpayers’ dollars to buy up the poisonous derivatives at the heart of the crisis and to transfer them to what amounts to a state-owned toxic bank.
How will he do it? And will he succeed? Can the government really take on the notorious financial instruments tied to subprime mortgages, whose unfathomable loss of value has made the crisis self-perpetuating, and bury them in a vault funded by the taxpayer?
That depends not only on Paulson’s own financial skills but on the co-operation of Washington’s political class and whatever powers of persuasian President George Bush may have left in his last days in office.
If he does succeed, what are the implications for the American and world economies? And how on earth does the free-marketeering former chairman of Goldman Sachs — Paulson previously ran the world’s most powerful investment bank when not walking the Yukon Trail — find himself leading a nationalisation programme that would make Fidel Castro blush?
Paulson’s big idea has been a long time in the making. For at least a month, he and Treasury officials have discussed it in theory. It seemed to guarantee a solution to the crippling freeze in interbank lending: banks had stopped lending to each other because of mutual suspicions about hidden toxic assets. Global business runs on credit and with nobody lending it could grind to a halt. But the plan was also radical and highly expensive — and broke every rule of raw capitalism.
Paulson talked this over with Ben Bernanke, chairman of the Federal Reserve, and with his host for the last two weeks, Timothy Geithner, president of the New York Fed. Although they all agreed it could work, it was never Paulson’s favoured solution — until the events of past few days forced it past the planning stage.
LAST WEEK began with high drama on Wall Street and deep banality at the White House.
In the early hours of Monday, after a weekend of intense talks with bankers in New York, Paulson pulled the plug on Lehman Brothers, the investment bank. Later that day, as a fife and drum band played on the White House lawn, Bush betrayed no hint that America’s financial markets were falling apart at the seams.
It was left to his visitor, President John Kufuor of Ghana, to mention the elephant in the room. “Your tenure has been full of events and challenges, some very mind-boggling and hair-raising,” Kufuor told Bush. “My hope is that history would prove kinder to you.”
For three days last week, the president remained all but silent and mostly out of sight as Paulson grappled with the cataclysmic fall-out from the country’s worst financial crisis since the Great Depression of the 1930s. His reluctance to utter even the blandest of encouraging platitudes reflected two striking features of the carnage.
First, the economic influence of American presidents is severely limited. Secondly, US financial markets have become so complex and reliant on highly technical trading instruments that even some of the country’s best-known economists declared themselves bewildered by the head-spinning turn of events.
“As an economist, I am supposed to have something intelligent to say about the current financial crisis,” said Professor Steven Levitt, the author of Freakonomics, a best-selling guide on the way markets work. “To be honest, however, I haven’t the foggiest idea what this all means.”
There were some who believed that “Commissar Paulson”, as he is now mockingly known, hadn’t the foggiest idea either as he spent another $300 billion propping up the financial system.
Having lanced two of the largest toxic boils by letting Lehman Brothers collapse on Monday and rescuing the insurance giant AIG with an $85 billion loan on Tuesday, Paulson watched aghast on Wednesday as his dramatic actions were met by a worldwide stock market panic while interbank lending remained stubbornly frozen.
On Thursday morning he was out spending again as the Fed and other central banks pumped hundreds of billions in to the financial markets. Again, the plan failed miserably to encourage banks around the world to start lending.
Investors were so rattled that the Treasury had to stump up another $50 billion to shore up the nation's traditionally safe money-market mutual-funds as people demanded their money back.
The fire fighting was not working. Paulson, Bernanke and Geithner began dusting off their big plan.
WHAT Paulson hopes will be the beginning of the end started on Capitol Hill around a conference table in the offices of Nancy Pelosi, the Speaker of the House of Representatives. A Democrat, she is one of the Bush administration’s most high-profile political enemies. But in this tumultuous week, even with a presidential election campaign under way, a bipartisan ethos was emerging.
Paulson and Bernanke left the assembled politicians in no doubt about the seriousness of the situation. The Treasury secretary said he had a plan to deal with the crisis. “If it doesn't pass, then heaven help us all,” he reportedly said.
America was “literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally,” Senator Christopher Dodd, Democrat chairman of the Banking, Housing and Urban Affairs Committee reported after the meeting.
Paulson and Bernanke said the financial system was effectively tied in a knot and being pulled tighter and tighter by the day. Without help, the system would seize up. So far the credit crisis had been felt largely in financial services but the risk of it spreading to the wider economy was mounting.
Without radical action, they warned, America could enter a deep, multi-year recession akin to Japan’s lost decade of the 1990s. Political differences would have to be set aside and a solution pushed through quickly if the crisis was to be averted.
Despite the gloomy tone of Paulson’s briefing, the markets reacted with delight to leaks about his plan. Asian stocks shot up overnight, followed by London and New York as officials at the US Treasury Department raced on Friday to start drafting the legislation that will create the government-controlled entity.
As the outline of Paulson’s plan emerged so did the depth of his fears. The central cause of the credit crunch was the “illiquid mortgage assets that have lost value as the housing correction has proceeded”, said Paulson on Friday when he sketched out his proposals in public for the first time.
These illiquid assets are “choking off the flow of credit that is so important to our economy”. His solution, Paulson admitted, will cost “hundreds of billions” but “I am convinced that this bold approach will cost American families far less than the alternative — a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.”
Paulson wants the government to bring in a “troubled asset relief program”. (The entity has no name as yet, but let’s call it Tarp, an acronym that might appeal to Bush.)
“Tarp” would buy up all the toxic assets from a market now frozen with fear, giving the housing market time to settle and the underlying value of the mortgage-backed securities to rebound. Then in calmer days Tarp would sell them, perhaps even making a profit for the taxpayer.
America has been here before — albeit on a far smaller scale. During the last American banking crisis in the late 1980s and early 1990s, 747 savings and loans associations, also known as “thrifts”, collapsed. Deregulation had allowed them to expand their lending activities and many took advantage of the new lax environment to make a series of bad bets.
The government was forced to take over many of the S&Ls and set up the Resolution Trust Corporation (RTC) to manage the assets, which were sold off in partnership with businesses, so-called “equity partnerships”.
This is no repeat of the S&L disaster, however. Selling off commercial property, the heart of the S&L problem, was a doddle compared with selling a toxic soup of dodgy credit — especially when nobody knows what those assets are worth and nobody has the money to buy them. Government ownership may take the heat off the financial-services industry, it may even bring greater transparency to these troublesome assets, but it doesn’t guarantee that they are worth anything.
The S&L crisis costs an estimated $160 billion and, while it may arguably have contributed to the 1990-91 recession, its affects were mainly local. By contrast, the International Monetary Fund said in April that financial losses stemming from the American mortgage crisis could reach $1 trillion ($1,000,000,000,000).
Tens of thousands of people have been left homeless, leading financial institutions have been destroyed and the American government has been forced to nationalise its largest mortgage firms, Fanny Mae and Freddie Mac.
MANY big questions have yet to be answered. What will happen if the toxic Tarp continues to fail and needs more money to keep it alive? What happens to the shareholders in those companies whose ugliest assets are eradicated? Not everyone will be happy to see them reap the upside while the taxpayer picks up the tab.
In the end the solution may be palatable to nobody but better than the alternative. “It may be against Republican principles but it sure is in favour of economic principles,” said Wall Street legend Donald Marron, former UBS chairman and now head of the venture-capital firm Lightyear Capital. “You can’t afford to make a huge mistake here. Enough mistakes have been made.
“This is an extraordinary crisis. In most of the others it was the stock market that went down and that’s a much easier thing to measure. In this case it was the fixed-income markets and the credit markets, which are bigger than the stock markets in terms of dollars and touch every institution everywhere in the world. If this continues it will be unprecedented in terms of its impact.
“There isn’t enough capital in the market to buy these things and, more important, they are not understood well enough to be valued. All of this will take time, transparency and more openness than has existed so far.”
It will also need bipartisan political support in Congress over the next few days. As it involves taxes, it cannot be introduced simply by presidential fiat. Officials and politicians are working through the weekend in an effort to push the plan through legislative process by the end of this week.
Paulson’s plans will not be easy to sell. Ben Stein, polymath pundit, former speechwriter for President Nixon and one of America’s most popular financial writers, described Paulson’s new found love of interventionism as “catastrophic for the free enterprise system. I would like to see Paulson fired.”
Charles Geisst, professor of finance at Manhattan college and author of Wall Street: A History, called the plan the biggest act of interventionism in living memory. “Under a Republican administration, what greater irony is there than that?” he said — while conceding that “financial markets across the world are praying it will be enough to finally stop the credit crunch.”
On Wall Street some critics said Paulson should have stuck to his principles and let the mighty fall. “What does he think he’s doing? Running the world’s biggest hedge fund?” said one banker.
Cynics noted — somewhat unfairly — that only when Goldman Sachs came under fire from short sellers, as it did last week, did Paulson act. And away from Wall Street, tempers are even higher.
The subprime mortgages responsible for much of the financial mess have costs tens of thousands of people their homes. The city of Cleveland, where more than 34,000 homes have been repossessed since 2003, is currently suing many of the Wall Street banks.
Its Democratic mayor, Frank Jackson, said the banks, with government’s tacit support, had acted “like organised crime” and, only now that their own were being affected, was Paulson riding to the rescue.
“It’s not what happens that matters, it’s who it happens to,” said Jackson. “As long as it was only happening to Cleveland and certain groups in the city of Cleveland it was no problem, no problem at all.”
Barack Obama, in mid-campaign for the presidency, gave carefully worded support for the plan. Some on Wall Street doubt he or any other Democrat will stand in Paulson’s way.
“If this deal starts to fall apart, the markets are going to go into free-fall. In case you haven’t noticed we’re in an election year. Who wants to be blamed for that?” said one Wall Street banker.
Yesterday morning Bush ruefully conceded how far he had strayed from his ideological roots in backing the plan.
He told reporters: "I’m sure some of my friends out there are saying, I thought this guy was a market guy? What happened to him? Well, my first instinct wasn’t to lay out a huge market plan. My first instinct was to let the market work until I realised on being briefed by the experts how significant this problem became. So I decided to act and act boldly.”
Bush said problems in the system threatened “working people and the average family”. “Turns out there are a lot of interlinks throughout the financial system,” he said.
Tomorrow the world will be watching to see if Paulson’s plan can really calm the financial markets after their tumultuous ride. Regulators on both sides of the Atlantic have also taken the heat off the financial players by putting a temporary ban on the short-selling on financial stocks.
Like the president, Paulson has only a few months left in office. Will he soon have time to take up his hiking boots once again? Or will the toxic nightmare harry him far into the future?
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