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Inside Man

Hank Paulson sounds tough. His gravelly delivery starts out strong. The voice is that of a seasoned and fair-minded cop sorting out the ruffians, and the hard-boiled dialogue is straight from Raymond Chandler. Speaking of his plans to act immediately against some specific financial sector CEOs and their boards of directors, he says “Mr. President, ... we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”

As I say, a great opening. This is exactly what we need—a top-tier Wall Street dealmaker and experienced executive who knows how to bring major-league pressure to good banks gone bad, and who uses that knowledge to depose miscreants while safeguarding the public purse. We might have opened his book worrying about the fact that its author, the man who was charged with confronting Wall Street about the damage it caused to the economy and the country, used to run Goldman Sachs, but immediately he sounds like a big-time poacher turned gamekeeper. We can all sleep that little bit easier.

Or can we? This is only three lines into the book and something already sounds wrong. Haven’t we heard far too much lately about Wall Street attitudes and behavior to take Paulson’s statements so readily at face value? One sentence later and all is clear: Paulson is talking about his takeover of Fannie Mae and Freddie Mac, an important episode for people working at those Government Sponsored Enterprises, but largely a sideshow to the main business of 2008, which was the complete collapse and the unconditional bailout of the purely private firms—and the people who run them—that dominate Wall Street. Or, rather, the way in which the most “pro-market” people in our economy all became Government Sponsored and made out like bandits along the way.

Paulson sounds tough throughout the book and he has many growling moments that add to the theater. But on the substance that matters—when it came to his friends, associates, and even long-term Street rivals—he was weak. He had a soft and gentle touch. In his mind, no one was really to blame, and (almost) everyone could and would be saved, and at no cost to them—and never mind what that meant to taxpayers and ordinary citizens.

On the Brink is Paulson’s story, or at least a heavily vetted spin on his story. (He keeps no notes and never uses email—this is a smart guy.) The book focuses primarily on the period from September 2008 through the end of the Bush administration. Its author comes across in its pages as honest, overtaken by events, and swamped by odds beyond his control. But in reality he is a prime constructor of modern Wall Street, a man who worked long and hard—alongside his competitors—to bring you the risk-taking and crazy gambling of the 2000s.

That Paulson was also in charge when the Street crashed has its potential ironies, of course. And there is still a chance to save his reputation—that is what this book is all about–with a sophisticated web of misdirection. He seeks to make three closely connected points. If you buy them all, then Hank Paulson is a hero of mythic proportions. If you question even one, the whole house of cards around his reputation—and our current financial sector—starts to tremble like an investment bank facing its creditors.

And if we seriously dispute his interpretation on all three dimensions, then we are looking at something quite different. Far from being a hero (his view), or an unfortunate victim of events beyond his control (the mainstream consensus view), or even a man who was compromised by his deep Wall Street background but tried hard to use this knowledge to turn things around (a position favored by some Democrats), Paulson is something else entirely. He is an integral, if somewhat un-self-aware, component in the mechanism that not only shook down the American taxpayer in 2008-2009, but also set us up for repeated crashes—perhaps with even worse consequences—in the future.

Here are the issues. First, Paulson portrays himself as the thoughtful Wall Street insider who knew—somehow—that a crisis was coming. As he told President Bush, “If you look at recent history, there is a disturbance in the capital markets every four to eight years.” And he confides in the reader, “I was convinced we were due for another disruption.” This is a sensible insight and, if true, would qualify as prescient—although it’s too bad that Paulson turns out to be a procrastinator.

But before we get there—what exactly did Paulson know and when did he know it? This memoir is thin regarding his time at Goldman Sachs. We learn that he pushed out Jon Corzine, and that he built up the firm and internationalized it, but not much else. He talks about the development of financial instruments in and around the housing market in a very detached way, as if he were only an observer. There is no first-person involvement, no sense of the risks being taken and the rewards harvested. Paulson’s line is that he knew enough to be helpful but not enough to have engaged in any fraudulent transactions. Alternatively, he had no idea what was coming. He was just as much in the dark as everyone else running big Wall Street firms. The crisis that hit us was based just as much on his ignorance as it was on yours.

There is also no mention of his own mega-payday. When Paulson joined the Bush administration in July 2006, he was exempted from paying capital-gains tax on the sale of his half-billion dollar holdings of Goldman stock, which presumably saved him (and cost the taxpayer), at least $100 million. Paulson has to be very careful here, of course, because our securities law is tough on anyone who withholds material information when selling securities. So his notions about a future crisis have to be expressed in vague language. If he is more precise, people will start going through his various statements as CEO about the likely future of Goldman or the overall market.

But even at this level, he has a big p.r. problem. There is no mention anywhere in his book of how the crisis was built on the backs of consumers—abused and trampled upon by a banking sector that brags about “ripping the faces off” its customers. And Paulson does not discuss the need for consumer protection vis-à-vis financial products. It’s almost as if he is on a different planet.

Second, Paulson wants to convince you that, once he became secretary of the treasury, he worked hard to head off the growing crisis and prepared for it as much as possible. This is exceedingly hard to believe. All of his policy initiatives were small and late (his programs for homeowners are the best example). Slight pressure was put on lenders and their agents to restructure troubled mortgages—but there was no serious arm-twisting and no real incentive to make progress. If you ask sharp-elbowed financial sector representatives to be nice, it turns out they just ignore you. 

Paulson is from the deal-making side of investment banking. He deals with China by meeting lots of top policymakers, but there is no evidence this makes much difference, say, to China’s massively undervalued exchange rate. And there is also no evidence that Hank Paulson ever noticed. He likes to meet important people. His “best” ideas for financial policy and heading off a crisis are always about getting one firm to merge with another, and worrying about the “social issues” that ensue. Those issues are not really about society, of course; they are about who will rule in any merged board room. Still, house prices decline, financial firms enter into distress, and Paulson (and Geithner) fret mainly about whether Goldman can buy another firm or reasonably be bought up. 

The prose is flat, the chronology well known—almost cliché by now—but weirdly enough all this is fascinating and somewhat disturbing reading, because you know where it ends. The shakedown, when it comes, is so beautiful that it takes your breath away—rather like watching Nueve Reinas (Nine Queens), the brilliant Argentine financial scam movie.

Here's the set up. The core of the world's financial system teeters. Paulson doesn't want to do another bailout, he thinks. The politics stink, the economics are appalling, and Dick Fuld (the CEO of Lehman) is a difficult fellow. So Paulson lets Lehman fail. But it turns out that the bankruptcy of a major financial firm is an unspeakably messy affair. Paulson had been warned about this, including by the International Monetary Fund (not an ordinary event)—but he was oblivious. We can handle it ourselves, thank you, was Treasury’s attitude.

But they couldn’t. They were absolutely and completely unprepared. This was not a team that was expecting the unexpected; they were asleep at the wheel. Paulson thinks he hired the best people—mostly from Goldman, naturally—and honed them into a sharp-edged tool. The alternative view is that he and his people were incompetent bumblers who had no idea what they were doing or how dangerous modern financial markets have become. So here are the possible interpretations: either the former head of Goldman Sachs saw it all coming and prepared assiduously, or an old-fashioned deals guy—most definitely not a trader—was hopelessly out of his depth and floundered his way to the greatest financial crisis since 1929.

Finally, Paulson really needs you to believe that once the crisis broke, he did what was necessary to save the world’s financial system. As Mrs. Thatcher liked to say, “there is no alternative.” This part of the story has been told much better by Andrew Ross Sorkin in Too Big To Fail. But the great conceit in Paulson’s book is still fascinating. He wants to convince you that the only way to save the American financial system and—by implication—the world’s economy was by keeping Wall Street essentially intact. To be sure, he says that “the Wall Street I knew had come to an end.” But what he means is that the remaining investment banks—including Goldman Sachs—became bank holding companies and therefore, for the first time in history, acquired effective government backing. 

So leading financial institutions were saved, which is not by itself an unusual event in some countries. It happens with some regularity in places with serious governance issues and endemic corruption. But even in troubled middle-income countries, such as South Korea, Turkey, Argentina, or even Russia, it is extraordinary to keep management in place when providing such support. Perhaps a few financial executives might be deemed beyond reproach and unfortunate victims of a system-wide panic. But to keep them all, with their base pay and their bonuses and their pensions? That is essentially unheard of. Perhaps there is a poor and benighted country somewhere that saved its massively incompetent financial firms in this manner, but you can search the historical records long and hard for a parallel to what Paulson pulled off.

The fallacy here is complete. Since the entire system failed—in terms of the largest banks and quasi-banks—Paulson and his supporters, including his successor at Treasury, argued that we must treat everyone generously in order to have an economic recovery. But the United States always presses for a much harder approach toward failed bankers in other countries. And with good reason: when the whole system crashes due to reckless risk-taking, you should aim to re-boot with a different incentive structure and, immediately, with much more effective regulation.

It is not hard to save a financial system: you can just throw money at the problem, providing various kinds of unconditional guarantees. This is in effect what Paulson and his colleagues did. Banks will, of course, recover on that basis. If you put the balance sheet of the United States behind any group of firms, investors will stand up and salute. But the point is to save the financial system while not worsening the underlying problems. If “hubris” and “too big to fail” attitudes lurked before 2008, where are they now?

Paulson has the answer, and on this final point he has a moment of clarity, “The largest financial institutions [today] are so big and complex that they pose a dangerously large risk.” Exactly right. So On the Brink turns out to be an interesting and important book, but not at all for the reasons its author thinks. It is really a memoir of modern American power, an account of how we messed up and how our so-called leaders put it all back together—with the same underlying problems now made worse.

Simon Johnson is co-author of 13 Bankers, forthcoming March 30.

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