WASHINGTON (Reuters) - Worn down by a deepening housing crisis, U.S. Treasury Secretary Henry Paulson and other Washington policy-makers have converted from proponents of hands-off government to reluctant interventionists ready to extend the occasional, expensive helping hand.
It was not the smoothest transition for Paulson, a Goldman Sachs veteran who was seen as a strong and knowledgeable bridge between Washington and Wall Street when he took up his cabinet post in July 2006.
Many of his former financial market colleagues welcomed his appointment because they believed he would work to relax some rules put in place after accounting scandals took down companies such as Enron and WorldCom earlier in the decade.
Instead, a year of credit market turmoil has exposed gaping holes in supervision, and Paulson’s legacy may be that he laid the groundwork for the biggest overhaul of financial regulation since the aftermath of the Great Depression in the 1930s.
When markets seized up one year ago, Paulson annoyed some on Wall Street who thought he underestimated how quickly problems in the subprime mortgage market could infect the global economy. Last month, he incurred the wrath of some fellow Republicans in Congress, who likened Paulson’s pledge to backstop mortgage finance companies Fannie Mae FNM.N and Freddie Mac FRE.N to socialism.
In Paulson’s own words, he was simply “playing the hand that I have been dealt” when he agreed to offer an undefined credit line and buy stock in Fannie Mae and Freddie Mac to bolster the two government-sponsored enterprises.
However, he was able to engineer bipartisan agreement on a rescue, with presidential elections just months away, underlining the pragmatic approach Paulson brought to the Treasury from his three-decade tenure on Wall Street.
“I would rather not have been in the position of asking for extraordinary authorities to support the GSEs,” Paulson said on July 31. “We saw a clear need to strengthen Fannie and Freddie’s ability to continue to play their important role in financing mortgages and in our capital markets more broadly.”
Back in August 2007, Paulson took some ribbing for insisting that rising defaults on subprime loans, given primarily to borrowers with sketchy credit histories, were “contained” and posed little threat to the rest of the financial system, let alone the economy.
Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey, said there is a long-standing tradition of treasury secretaries “accentuating the positive.”
“Nothing is served by excessive candor,” he said. “The danger is that you end up looking completely out of touch.”
By March 2008, Paulson had changed his tune as many economists warned the United States was tipping into a recession. Paulson acknowledged the U.S. economy was in a “sharp decline” and has stuck to similar language since then.
That same month, Paulson and Federal Reserve Chairman Ben Bernanke faced their toughest test when investment bank Bear Stearns was pushed to the brink of bankruptcy, forcing them to work around the clock to orchestrate a Sunday night fire sale of the company to JPMorgan to prevent a disorderly collapse.
Bert Ely, a longtime banking industry consultant and critic of Fannie Mae and Freddie Mac, said Paulson and Bernanke’s hands were forced by a “perfect storm” as the bursting of the housing bubble exposed massive problems in housing finance, lending standards, securitization and asset values.
They had little choice but to step in to prevent a market meltdown, he said, but this could prolong the problem by not letting housing prices fall to their equilibrium level and by encouraging Wall Street to engage in other risky behavior.
Ely said government steps to erect a financial firewall “are simply an effort to patch things over to avoid a complete collapse but believe me they are by no means a policy solution, because we haven’t addressed the underlying causes.” This “just kind of buys time,” he said.
“One could argue that the helping hand of government may set us up for bigger problems down the road,” Ely added.
Before Bear Stearns, Paulson often stressed the importance of market discipline and transparency as a means to prevent financial excess. But as the turmoil quickly spread to Europe and Asia, it became clear the financial system had evolved much more rapidly than the regulatory system that was supposed to monitor it.
The moniker “too big to fail” -- once reserved for only the largest companies in the world -- was replaced by the notion of “too interconnected to fail,” which could now be applied to scores of firms, and neither Paulson nor Bernanke was prepared to test exactly where the boundary lay.
It will fall to Paulson’s successor to do the heavy lifting on regulatory reform, but he began the debate in March when he proposed reducing the number of regulators and giving the U.S. central bank broader authority to oversee financial firms.
Wrightson ICAP’s Crandall said regardless of who wins the November presidential election, the new administration will be left with a great deal of unfinished business when it takes over in January.
“To a much greater extent than usual, it’s going to be important for the incoming administration to identify their treasury secretary early,” Crandall said.
Editing by Neil Stempleman