All The Devils Are Here: Unmasking the Men Who Bankrupted the World (47 page)

Where were the regulators as this buildup of risk was taking place? They were nowhere to be found. Just as the banking regulators had averted their eyes from the predatory lending on Main Street, so did they now ignore the ferocious accumulation of risk, much of it tied to subprime mortgages, on Wall Street.

No regulator had the authority—or the ability—to systematically look across institutions and identify potential system-wide problems. That role just didn’t exist in America’s regulatory scheme. The Fed, for one, had little insight into the packaging and endless repackaging of mortgages. In part, this was because the Gramm-Leach-Bliley Act prevented it from conducting detailed examinations of the nonbank subsidiaries of the big banks. In other words, even though it was responsible for regulating the big bank holding companies, it had to rely on the SEC to oversee, for example, a bank’s trading operation.

In any case, the Fed wasn’t all that eager to look too deeply. Like all the regulators, the Fed believed that the risk was off the banks’ books and distributed into the all-knowing market. The attitude was: “Not our role to tell the market what it should and should not buy,” in the words of a former Fed official. This was true even after Alan Greenspan retired in early 2006 and was replaced by Princeton economist Ben Bernanke.

The Fed also had enormous—and unwarranted—faith in bank management. A GAO report would later find that all the regulators “acknowledged that they had relied heavily on management representation of risks.” In 2006, the Fed had conducted reviews of stress-testing practices at “several large, complex banking institutions,” according to the GAO. It found that none tested for scenarios that would render them insolvent and that senior managers “questioned the need for additional stress testing, particularly for worst-case scenarios that they thought were implausible.” From 2005 through the summer of 2007, the Fed issued internal reports called “Large Financial Institutions’ Perspectives on Risk.” The report for the second half of 2006, issued in April 2007, stated, “There are no substantial issues of supervisory concern for these large financial institutions” and that “Asset quality across the systemically important institutions remains strong.”

In at least one notable case, regulators reached for responsibilities that they weren’t capable of handling. It took place in 2004 and involved the Securities and Exchange Commission, whose chairman at the time was William Donaldson.

Historically, the SEC oversaw everything that had to do with the buying
and selling of stocks. The five big American investment banks—Bear Stearns, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers—all came under the regulatory purview of the SEC. But they had all formed holding companies and had affiliates engaged in all kinds of activities—such as derivatives trading—that had nothing to do with selling stocks. Astonishingly, no government agency regulated the holding companies.

In 2002, the European Union ruled that these holding companies had to be supervised by a U.S. regulator, or the EU would do the job itself for the subsidiaries that fell under their jurisdiction. This was
not
something the American investment banks wanted to have happen, so they asked the SEC to set up a program called Consolidated Supervised Entities, or CSE. It created a voluntary supervisory regime, thus getting around the SEC’s lack of statutory authority to regulate the holding companies.

It would become part of the lore of the financial crisis that the CSE somehow abolished a previously held limit of 12 to 1 leverage at the broker-dealer level and allowed the banks to use their internal models to determine the capital they should hold. But the first part of that wasn’t really true. The 12 to 1 limit hadn’t been in place since 1975. At the end of 2006—that is, well after the implementation of the CSE—the investment banks’ leverage was no higher than it had been at the end of 1998, when LTCM went down. In fact, according to the GAO, three firms had more leverage at the end of 1998 than they did at the end of 2006.

No, the SEC’s real failure was something else. By setting up CSE, the SEC gave the impression that it had the manpower, the skill, and the savvy to see risks developing at the holding company level. It did not—something even its own commissioners seemed to understand at the time. In a recording of the fifty-five-minute meeting in which the five members of the SEC signed off on the CSE, commissioners can be heard saying things like, “This is going to require a much more complicated compliance, inspection, and understanding of risk than we’ve ever had to do…. You think we can do this?” and “What if someone doesn’t give us adequate information? How will we enforce it?” The greatest note of caution came from Harvey Goldschmid, a Democratic commissioner. “We’ve said these are the big guys and clearly that’s true,” he said. “But that means if anything goes wrong, it’s going to be an awfully big mess.”
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“I equate the CSE regime to the USDA putting its imprimatur on rancid meat,” says a former Bush administration official. “Bad regulation is much worse than no regulation because you create conditional expectations of safety. It helped feed the fiction that these risks could be quantified or even understood.”

This, then, was the situation in May 2006: risk was building up everywhere in the system; the housing bubble was reaching its frenzied finale; Wall Street firms were madly churning out CDOs; subprime originators were making loans to anyone with a pulse; everything was interconnected in ways that were dangerous for the financial system; and the regulatory apparatus, charged with protecting the safety and soundness of the banking system, was in complete denial. This was what Henry Paulson Jr. was going to have to deal with, as his nomination to be secretary of the Treasury was announced late that month.

To the outside world, the news that Paulson was leaving Goldman Sachs to become Treasury secretary could not have been less surprising. Didn’t every senior Goldman Sachs executive eventually join the government? By that point, the list included John Whitehead (deputy secretary of state in the Reagan administration), Steve Friedman (National Economic Council), Joshua Bolten (OMB director and George W. Bush’s chief of staff), Jon Corzine (senator and later governor of New Jersey), Robert Rubin (of course), and many others.

Yet to Goldman insiders, Paulson’s departure was startling. He had never expressed the slightest interest in the job. He didn’t make lavish campaign contributions, or serve as finance chairman for ambitious politicians, or even hang around politicians. He told everyone, whether they were close confidants or passing acquaintances, that he was staying put at Goldman. Head fakes had never been his style. As he later related in his memoir, when he first got the call from the White House in the spring of 2006, he agreed to a meeting with the president, but then quickly canceled when John Rogers,
the firm’s veteran Washington hand, told him that going to the meeting was tantamount to accepting the offer.

Having been through several ineffectual Treasury secretaries, Bush wanted Paulson badly, largely because his Goldman Sachs credential gave him a stature his predecessors had lacked. Paulson was initially deterred by “fear of failure, fear of the unknown,” he later wrote. But he finally said yes. “I didn’t want to look back and have been asked to serve my country and declined,” he later explained. “So I just took the plunge.” He did so after getting an unprecedented agreement from Bush that he would have real power: regular access to the president, on a par with the secretaries of State and Defense, and the ability to bring in his own people.

For Paulson, one of the toughest parts of his decision was telling his mother. His entire family, including his wife, Wendy, and his mom, Marianna, was deeply opposed to the Bush administration. In his book, Paulson recalls standing in the kitchen of his house in Barrington, Illinois, announcing the news. “You started with Nixon and you’re going to end with Bush?” his mother replied. “Why would you do such a thing?”

In some ways, Paulson was an odd choice for Bush. As an ardent environmentalist, Paulson believed that climate change was real, a view not embraced by the White House. More important, he was neither a partisan Republican nor a free-market ideologue. He would later cite the pressure on him to get rid of Sarbanes-Oxley, the law passed in the wake of the Enron scandal, which Republicans in Congress hated. Paulson refused. “I don’t find a single provision bad,” he said.

He also worried about the widening gap between rich and poor—also not a subject often discussed in the Bush White House. In a speech at Columbia on August 1, 2006, he said that “amid this country’s strong economic expansion, many Americans simply aren’t feeling the benefits.” The comments sent Republicans into a tizzy.

Like all captains of industry who join the Treasury, Paulson was in for a bit of a shock after his nomination was approved by the Senate in July 2006. He hadn’t understood how outdated Treasury’s systems were—there was no real-time access to market information, and the voice mail system was antiquated. (Voice mail has long been Paulson’s primary method of communication.) As he recounts in his book, he was shocked to discover that “an extraordinary civil servant named Fred Adams had been calculating the interest rates on trillions of dollars in Treasury debt by hand nearly every day for thirty years, including holidays.” Nor had Paulson fully appreciated how
limited Treasury’s tools were: Treasury was not a bank regulator. It had moral suasion, but no supervisory levers, and it couldn’t spend money unless it had been appropriated. “At Goldman, he had the responsibility, but also unbridled command over thousands,” says one Treasury employee. “Here, he had the responsibility times a thousand, but no ability to command.”

The new Treasury secretary gave longtime department aides a bit of a shock as well. “People were taken aback by Hank’s aggressiveness,” says one staffer. “He’s a force of nature. He gets people to do stuff they’d never do.” They weren’t used to a boss as relentless or as blunt as he was. Paulson also made decisions by talking, and frequently repeating himself. “If you’re in a meeting with experts, you usually let the experts talk,” says one staffer. “But when it’s Hank, then the first ten minutes are Hank talking!” Like many, this staffer grew to respect and admire Paulson. But for people who didn’t know him well, it was his “let’s get this done yesterday” demeanor that stuck in their minds. Staffers quickly spread stories of Paulson’s impatience and his odd mannerisms. “He’d just appear in people’s offices and start talking while you had your back to him typing,” marveled one person, who also remarked that Paulson gave Treasury an energy and sense of purpose that it had lacked. Later, during the crisis, Paulson would come in, eat oatmeal, and then, by seven a.m., start making the rounds. His longtime assistant, Christal West, would send out a heads-up: “Be prepared! He’s roaming!”

Like everyone both on Wall Street and in Washington, Paulson didn’t see—and wouldn’t see for a long time—just how bad things were and where they were headed. He would later argue that even if he had seen it coming, he still couldn’t have done anything, given the inadequate tools at his disposal and the difficulty he faced in getting Congress to take action even after the situation had become dire. “If I had been omniscient, there’s not a single additional thing I could have done that would have made a difference,” he’d later say.

What is surprising, in retrospect, is that Paulson did try to do something. He is anxious by nature, and you could see that anxiety at work—that fear of what might be lurking around the corner—in the actions he took when he got to the Treasury. He was convinced that the country was headed toward another financial disruption. His reasoning was simple: in recent history, financial crises seemed to occur every four to eight years. The country was due. He and Ben Bernanke ran scenarios so they could prepare for different kinds of crisis: a spike in energy prices, say, or the failure of a big hedge fund. War games, the staff called them. Treasury’s conclusion, after researching all
of the agency’s past statements about financial crises, was, as one former staffer puts it, “Treasury equals confidence. The Fed equals liquidity. Specifics are for the rest of the agencies.”

That August, in Paulson’s first visit to Camp David, he gave the president a presentation on the growth in over-the-counter derivatives, focusing in particular on credit derivatives. Paulson had long seen that the market was rife with problems. When he was at Goldman Sachs, industry players were complaining that others were assigning trades without consulting the original counterparty, and there were processing and payment errors galore. Even before he left Goldman, Paulson, along with Rubin’s old protégé Tim Geithner, by now president of the New York Fed, had begun pushing to fix such “back office” problems. But at Camp David, Paulson went beyond the back office issues, showing that while credit derivatives could be legitimately used to hedge an existing position, they also created risk and leverage that wasn’t readily apparent. Finally, he told the group that no one knew the total number of credit default swaps outstanding. “There was incredulity at the table,” Paulson recounts. “The reaction was ‘How can you have a market this big and this opaque? You mean you can tell us the dollar value of the bonds GM has outstanding, but you can’t tell us the CDSs outstanding?’ ”