Poser for Paulson: the US Treasury chief wants a halt to public bail-outs

By Krishna Guha

At times this week, Hank Paulson must have felt as if he carried the fate  of American capitalism in his hands.

The US Treasury secretary began the week with a multi-billion dollar rescue of Fannie Mae and Freddie Mac, twin pillars of the country’s mortgage market, only to end it digging in against calls for a second bail-out, to help save Lehman Brothers, the investment bank.

After deploying public funds in the Fannie and Freddie deal, and earlier to help rescue Bear Stearns in March, it will not be easy for Mr Paulson to refuse to support a Lehman takeover. Yet by late on Friday, that was what he appeared determined to do. While pulling out all the stops to help facilitate a Lehman rescue, Mr Paulson is adamant that no government money should be involved, a person familiar with his thinking told the Financial Times.

Instead, the former Goldman Sachs chairman turned top financial official in the administration of President George W. Bush is reverting to his old role as a deal-broker, talking hour by hour with Ben Bernanke, chairman of the Federal Reserve, as well as Tim Geithner, New York Fed president and Richard Fuld, Lehman Brothers chief executive, not to mention top executives at other institutions that could be part of a rescue.

His message: regulators were prepared to be pragmatic to help facilitate a deal but there would be no repeat of the Bear Stearns model, in which the government sweetened the bank’s takeover by JPMorgan Chase by taking on all but the first $1bn (£559m, €706m) of losses on a $30bn portfolio of mortgage-backed securities. This time Mr Paulson has been determined to take the back seat. While pushing hard for a rescue takeover, he has appeared willing to countenance the risk that one might not be forthcoming and Lehman could fail.

In Mr Paulson’s eyes there are big differences between Lehman and Fannie and Freddie. The mortgage giants were vastly more important to the global financial system – their total liabilities are $5,400bn, a large chunk of which is held by foreign central banks whose support for the dollar is crucial. Fannie and Freddie were also much more important for the US economy, since they account for about three-quarters of all new US mortgages.

Moreover, their problems were rooted in their hybrid structure as “government-sponsored” private companies. Mr Paulson believed that the US government had caused this problem and was obliged to deal with it in a way that kept faith with the world’s investors. “Because the US government created these ambiguities, we have a responsibility to both avert and address the systemic risk,” he said last Sunday.

Mr Paulson also sees big differences between the situation at Lehman today and at Bear Stearns in March. The Treasury chief always insisted that he had intervened in March not to help Bear or its investors but to contain the systemic risks raised by its imminent failure. He sees the situation today as different for two main reasons: the markets have had six months to prepare for the possibility that Lehman could fail, and a new Fed facility ensures that it cannot suddenly run out of liquidity in the way that Bear did.

Aides have also advised Mr Paulson that Lehman is less involved in the vulnerable credit default swaps market – a market for insurance against defaults – than Bear was.

Mr Paulson (left) does not wish to fuel any further a growing bail-out culture in the US, which has already led the troubled automotive industry to seek billions of dollars in loan guarantees. He wants to prove to the markets that there is no one-size-fits-all approach to dealing with crises at individual financial institutions. A formula in which the government routinely steps in with public money to avoid a default on debt providing the equity is essentially wiped out, say analysts, has encouraged dealers to adopt a series of destabilising trades in the market.

Even so, a decision not to help save Lehman if a purely private deal looks impossible would still be momentous. Lehman is the fourth biggest investment bank in the US. Its assets are larger than Bear’s were and it is involved in many different financial markets, all of which could be disrupted by its failure.

Moreover, Lehman’s problems are only an extreme version of the problems confronting all stand-alone investment banks, which now face not only losses on credit securities but existential questions about their future business models too. If Lehman’s debtholders suffer losses in a failure or takeover, the cost of funds for other investment banks could go up. Letting Lehman go would represent a policy decision that the market must decide whether the sector has a future.

So rapid has the pace of events been that it seems hard to believe it was just last Saturday, shortly after midday, that Mr Paulson addressed the Fannie Mae board in the conference room of the Federal Housing Finance Agency, with Mr Bernanke and James Lockhart, FHFA director, at his side. His tone was respectful but tough. The government was taking control of their company whether they liked it or not.

Three hours later, Mr Paulson gave the same message to Freddie Mac. Both companies conceded. The takeovers were announced at 11am on Sunday – the timing dictated by the desire to reassure worried foreign investors before the start of Monday trading in Asia.

Mr Paulson, despite all his time at Goldman Sachs, had just pulled off the biggest deal of his career. The initial reaction from the market was euphoric, with stocks surging and the yields on bonds issued by Fannie and Freddie plummeting – holding out the prospect of lower mortgage rates that could mitigate the US housing slump.

But within 48 hours the wider market was on the slide again, amid renewed fears not just about the viability of Lehman but also of commercial banks including Washington Mutual and – as the week progressed – AIG, the insurance group. The rollercoaster ride continued through Friday. While government bond yields this week went down, not up, traders say that was because a flight to safety overwhelmed the impact of the deal on the government’s balance sheet.

By Tuesday Mr Paulson was already turning his attention to the crisis at Lehman, even as he tried to explain to a surprised Congress and an anxious public how he had reached the decision to take over Fannie and Freddie. “This was the first time in my career that I had trouble sleeping,” the former Goldman Sachs chief told Bloomberg Television.

Mr Paulson’s first attempt to turn the tide at Fannie and Freddie two months ago by seeking blanket authority to invest in them had been accompanied by bluster. “If you have a bazooka in your pocket and people know it, you probably won’t have to use it,” he told the Senate Banking Committee on July 15.

But the initial gambit was flawed. It offered no encouragement for private investors to put in more equity – and the authority was to expire in 18 months time, providing little reassurance for investors in long-term debt. The market called his bluff.

Determined that nothing should go wrong with the second phase, Mr Paulson hired Morgan Stanley, the investment bank, and Wachtell-Lipton, a law firm, to advise the Treasury. After a short break in Beijing at the Olympics in the second week of August, Mr Paulson focused almost exclusively on Fannie and Freddie. People familiar with his schedule say it shows nearly nothing else – almost a single rolling meeting on Fannie and Freddie that never ended.

The Treasury chief met Mr Bernanke and Mr Lockhart in person every couple of days to hammer out the plan. On Friday August 29, he told Mr Lockhart he could not commit billions of dollars of taxpayers’ money unless the regulator took control of the companies.

The first that Fannie, Freddie and top members of Congress heard about it was a week later, on September 5. Mr Paulson called Barack Obama and John McCain, the presidential contenders, to tell them. Hours later the deal was done and the announcement made, to expert acclaim. “The Fannie-Freddie thing was shockingly well done,” says one prominent investor. “I haven’t always been that impressed with Paulson but I think this was very good.”

Experts say the deal exemplifies the skilful way in which Mr Paulson has contained systemic risks arising from a series of crises at financial groups over the past year. Yet some question whether he has been able to stay ahead of the curve in a strategic sense. For example, six months after the crisis at Bear, the US still does not have a special insolvency regime to deal with a failing investment bank – a framework that would make it much easier to manage the situation at Lehman.

Democrats meanwhile see a contradiction between Mr Paulson’s willingness sometimes to put public money on the table but not to spur mortgage restructuring and minimise foreclosures. Falling house prices are the underlying cause of all the fires he is fighting, they argue.

“I think Paulson has done an excellent job dealing with the evolving financial crisis,” says Doug Elmendorf at Brookings, a think-tank. “I wish he had been more energetic more quickly on the housing side.”

Even if he succeeds in keeping taxpayer money out of a Lehman deal, Mr Paulson is likely to face many more tough decisions on the use of public funds in the months ahead. In an ugly downturn, there are no good options for policy, only a series of choices between the lesser of two evils.

As Mr Paulson told CNBC this week: “All I can do is play the hands I have been dealt – and play them in a way that I think is going to be in the best interests of the American people.”