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By Root 3614 0

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?’”

Paulson also embarked on a hugely ambitious project to revamp the regulatory system. In the spring of 2008, when he rolled out a 228-page blueprint, observers said it would be the most radical overhaul of the laws in eighty years. Among other things, he advocated merging the SEC and the CFTC, getting rid of the OTS, imposing stricter rules on the leverage that investment banks could employ, setting up a federal Mortgage Origination Commission—which would finally institute rules for subprime originators—and giving the Fed the power to serve as a systemic regulator that could “go wherever in the system it thinks it needs to go for a deeper look,” as Paulson explained at the time.

Yet the blueprint did not make much mention of the issue that was causing Paulson such deep concern: regulation of over-the-counter derivatives. Some would see this as evidence that Paulson—Goldman’s former CEO, after all, who had never worried about the dangers of derivatives while running the firm—was as reluctant to force the industry to change as his predecessors had been. But Paulson would later insist that wasn’t true, and that he wanted changes in the regulation of derivatives. He and Geithner had gotten the industry to document its existing trades and to agree on a set of operational rules. These fixes would prove critical in the crisis that was coming. But Paulson didn’t feel they were sufficient. In fact, derivatives were a deeply frustrating issue for him, because he felt more oversight was necessary, but he also knew he wasn’t going to get a legislative solution in the waning years of the Bush administration. Besides, other regulators worried that if they took on more oversight of derivatives, their agencies, already stretched on budgets, staff, and capability, would be blamed if something went wrong.

Instead, Paulson began using the President’s Working Group—the same group that Rubin had used to keep Brooksley Born away from derivatives regulation—as a way of “persuading, jawboning, and sometimes pressuring industry participants to take actions they were reluctant to take,” as he later put it. Paulson and Geithner quietly