On Monday, July 28, my TIME colleague Michael Duffy and I paid a visit to the Treasury building in Washington to talk to Treasury Secretary Hank Paulson. Parts of the interview made their way into my article in the current issue of the magazine. After the break, you can read some more parts. The interview was pretty long (just over an hour) and large swaths of it were on-background or off-the-record, so what follows is a much-abridged slice, not a true transcript. On the positive side, this means it’s short enough that you might actually want to read it to the end.
Justin Fox: Why is this all happening?
This is, I believe, a result of excesses that have built up over some time. Excesses not just in housing with unsustainable appreciation, but in financial institutions with excess leverage, and more leverage than was understood to be the case, because it was embedded in the form of highly complicated financial products. And we’d gone so long without a problem. Almost 10 years, 9 years. And part of the reason was we’d had these relatively benign economic conditions, with high levels of yield and low levels of liquidity, and money looking for yield and mispricing risk.
At the heart of this is housing. We will not have the financial markets issue behind us until we’ve turned the corner on housing. I don’t think that needs to mean until the last housing issue is behind us, because that will go on for years, but until the biggest part of this correction is behind us and we have more stability in prices.
Michael Duffy: A lot has been written about financial crises of the late 1990s. This involved a bigger lift.
I believe that our long-term fundamentals compare very favorably with any other country around the world. But this time it is the U.S. economy and U.S. mortgages. Before, we approached challenges emanating from elsewhere. Right now the issues we have are U.S. issues.
Duffy: And in addition to being homegrown, there hasn’t been a regulatory fix like this since the savings and loan crisis.
The market had changed so dramatically. We’d been focused on two things: Over the counter derivatives and private pools of capital–hedge funds. So the huge focus we had in the President’s Working Group on Financial Markets was on making sure that there was the right transparency and risk controls and not too much leverage when you looked at the relationship between the hedge funds and the banks and investment banks and prime brokers. Regulators totally missed the SIVs and the conduits. These things almost become obvious after the fact.
Duffy: Has it opened your eyes to what the next round, next point of weakness might be?
Here’s what it’s opened my mind to, and I’ve thought a lot about this: You need a system that is in balance, because only when the system is in balance will you be able to deal with the next round, whatever that is. I think to get a system in balance what you need on the regulatory side is a regulatory structure and authorities that match the financial system. The ones now are outdated. You need a way to let big financial institutions, whether they’re depositary institutions or not, fail. Because you need that market discipline. And you’re going to need to have someone that is able to look broadly across the whole economy and be able to get information and be able to have enough authorities, even though they’re not a primary regulator, to foresee some of these problems, and have responsibility for dealing with it.
Fox: Do you think government’s really capable of turning the screws when things get especially frothy in markets?
No. I don’t think they are, totally. You and I both agree that they’re not, there will always be these issues. That doesn’t mean that we shouldn’t have a regulatory structure that’s got a better chance to work. And most important of all you need to have a system where you can let organizations fail.
When we did the regulatory blueprint, and a lot of people didn’t understand this, we said if you’re starting de novo, what would you do? We came up with something that is just objectives-based. One regulator could focus on investor protection, and consumer protection, one on safety and soundness, and then a macrostability regulator to look across the entire economy. We knew you couldn’t do that right away. But I know that the system we had was way out of date because it was established right after the Depression.
Fox: The question of too big to fail, that’s something people have been talking about since the 1980s. It seems like everybody agrees that that’s what we need, and yet we seem to keep moving toward a situation in which there are more and more institutions that are too big to fail.
You’re right. You’re right. That’s–you’re right. I will just tell you that regulations alone won’t solve it. I guarantee you that. I come from a world where I watched investment banks fail. When I ran one, we never ran it with the assumption that we could go to the Fed.
I do understand though, I just couldn’t be clearer with Freddie and Fannie, that they are absolutely esssential to our capital markets, to what we’re doing in housing. Stability has got to be far and away the priority. But when the regulator’s in place, as we work our way through this period, we need the will as a country to deal with some of these tougher issues. I believe you’re going to find that some of the leaders up on the Hill, in both houses, recognize that just in terms of changes in the regulatory system and some of the other challenges we’re going to need to act.
Fox: The logistics of a week and a half ago: were you just sitting there glued to the phone the whole time?
I spend a lot of time on the phone. I find I assimilate information by talking to people and getting inputs from many people and I also find that I never believe in assume. I always said to my kids, don’t assume. I say to the people here, don’t assume. Pick up the phone and call and talk to people.
Bear Stearns we’d been watching for a long time, but it came up suddenly. With Fannie and Freddie, it wasn’t that sort of a crisis. I was well aware that anything we did needed to be worked through Congress, and Congress was going to be going home. And it was also clear to me that this was so important we couldn’t get to the point where there was serious erosion of confidence.
I watched it all week, talked with people Friday morning. We’d been working, we had our plans, we’d been thinking about it. Friday morning I went over to see the President early. I also had lunch with him. I spent a lot of time talking to the Fed because I thought the strongest support would be if the Fed was there with a backup line. And when we talked, the question was do we want to announce something the following week or on Sunday, and I felt that since we really had work to do with Congress and was talking to investors around the world, we should really do it on Sunday.
Fox: So it wasn’t quite so much a feeling of oh, they’re going to collapse on Monday if we don’t act.
No, it was a feeling of, we have a Congressional calendar and also I think they were so essential to the stability of our capital markets and so essential to our housing that we didn’t want to take any chances. We just wanted to be on the front end of this.
I wanted something that was very broad. What I explained to Congress was the more flexibility I have, the more confidence that gives to the market, the less likelihood the authorities will be used, and the better for the taxpayers. Just trust us to decide what makes most sense to protect the taxpayers, and that we will consult with you, the leadership. I’m gonna consult–I believe in survival. But I certainly don’t want to put the system at risk by saying we have to go back and get legislative authority.
To me we saw the best of our Congress, because this was something they had not done before. It was not conventional, it was in the best interest of the United States of America. And the ability to move and move quickly and do this I think was extraordinary. I’m just grateful for all the hours I spent building relationships, getting to know people there, and building some level of trust.
The thing that I underestimated in this job is even when you don’t have major issues there are things every day that if you define your job expansively… When I talk to young people, they say, “How do you have a successful career.” I say, “You define your job expansively.” At Goldman Sachs I always said, “You will promote yourself before I promote you.” Because you define your job expansively. If you define your job expansively, you can find ways to make a difference every day.