Former Treasury Secretary Henry Paulson Defends TARP

Arguing that a government infusion of cash into the financial markets was necessary to stave off a major economic depression, former Bush administration Treasury Secretary Henry Paulson recently defended his oversight of the $700 billion government bailout of the financial industry in late 2008.

“I didn’t want to be the treasury secretary that was presiding over the next Great Depression,” said Paulson, who was promoting his new book, On The Brink: Inside the Race to Stop the Collapse of the Global Financial System, at a February 23 event at the Max Palevsky Cinema on the Hyde Park campus.

“I happen to believe that it was valuable to have market balance. I have a history in business where you make tough decisions and make them quickly. Without (the Troubled Assets Relief Plan), the results would have been disastrous. We were a mere hours from financial collapse,” Paulson said in front of a packed university audience, many of them Booth students and faculty.

The event was moderated by Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance. Rajan asked the former Goldman Sachs Group, Inc. CEO about his reasons behind offering bailouts to places like American International Group, Inc. or Bear Stearns but not to Lehman Brothers Holdings, Inc., which has since declared bankruptcy.

According to Paulson, Lehman Brothers faced a solvency problem that could only be fixed by acquiring a private buyer. AIG, on the other hand, faced a liquidity problem, which was turned around with a quick infusion of government cash, Paulson said.

Further, AIG was also larger, and a failure of it would have had a greater impact on the American economy, Paulson said.

“Clearly, if AIG had gone down, it would have taken the financial system with it. This was about preventing a collapse, which would have been devastating. If the system would have collapsed, we would be in a far worse state,” Paulson said. Unemployment could have reached the 25 percent mark, as seen in the Great Depression, he said.

Given the bailouts, Rajan wondered about the future: “What else stops banks from going down and getting a bailout every time? Are we creating moral hazard? Are you creating banks which know they will never fail?”

“I’m the first to recognize that even if we have a perfect regulatory structure, regulators are not going to be able to find all the problems. Consequently, you need more market discipline. Unless investors, management, [and] lenders believe they are going to have to bear the consequences of their decisions, we are going to have problems,” Paulson said. “There are always going to be bank failures. There have been since the beginning of time. The question is how do we design something so nothing is too big to fail.”

Paulson’s suggestions, as he wrote them in a recent New York Times op-ed and reiterated at Chicago Booth, include creating “a systemic risk regulator to monitor the stability of the markets and to restrain or end any activity at any financial firm that threatens the broader market. Second, the government must have resolution authority to impose an orderly liquidation on any failing financial institution to minimize its impact on the rest of the system.”

That’s authority that neither Paulson nor his colleagues at the Federal Reserve or Federal Deposit Insurance Corporation had in 2008, he said. Further, the liquidation authority would help guard against moral hazard, as bank executives would be responsible for their company’s fate.

One move that Paulson did have the authority to make, and the one that had the largest impact on steering the economy away from the brink of collapse, he said, was putting mortgage giants Fannie Mae and Freddie Mac into conservatorship in 2008.

“Certainly, there would have been many, many more foreclosures,” he said. Still, going forward, he suggested a heavy restructuring of the companies.

“There is no doubt in my mind, and just about any other policy maker’s mind, no matter if you are Democrat or a Republican, that they were a failed structure. My own view is that they should be scaled way back, their mission shrunk. How do we exit this government intervention? In my view it needs to be exited, but it needs to be done very, very carefully.”

—Patrick Ferrell