All the Devils Are Here [155]
There was one big problem Paulson missed, however. When he made his Camp David presentation, he didn’t mention any potential problems in housing or mortgages. That’s because Paulson didn’t suspect that housing or mortgages could be the catalyst for a crisis.
This was Paulson’s blind spot—though not because he was a free-market ideologue. Perhaps because he had spent his entire career on Wall Street, he thought the way others on Wall Street did and the way economists did: Housing prices hadn’t declined on a nationwide basis since the Great Depression! People always paid their mortgages! He didn’t see the boarded-up homes that were blackening neighborhoods like rotten teeth in places like Cleveland. His was a bloodless view, the world as seen from the perch of high finance.
Besides, why would Paulson suspect that Wall Street’s securitization process was deeply flawed? After all, Goldman Sachs had moved into this business on Paulson’s watch. Paulson was part of the machine, not outside it. That also meant, for all of Paulson’s worries about derivates, he didn’t understand the dangerous potential of credit default swaps on mortgages. (Though he’d later say, “If I had known some of the things that were happening, I wouldn’t have been able to sleep at night.”)
Paulson certainly wasn’t alone. Everyone else on Wall Street and in Washington shared his views. In late 2005, Bernanke said that home prices, rather than being in bubble territory, “reflect strong economic fundamentals.” In 2006, he said that he expected the housing market to “cool but not to change very sharply.” He went on to tell CNBC, “We’ve never had a decline in house prices on a nationwide basis. So what I think more likely is that house prices will slow, maybe stabilize.” As late as the spring of 2007, he said, “[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or the financial system.”
Another reason for Paulson’s blind spot, say people who worked with him, was that he had too much faith in regulators. “He thought the regulators were more capable than they were,” says a staffer. Paulson today concedes he’d put too much faith in regulation itself. During his time in office, Paulson would change his tune. “The system was so outdated and screwed up, you just couldn’t have imagined it,” he’d later say. A big part of the problem, of course, was that both the regulators and Paulson assumed that financial institutions were more competent than they were. Paulson spent his career at Goldman, which at least didn’t need anyone else to tell it how to protect its own bottom line. He had no idea that other firms weren’t as capable of looking out for their own interests. “No financial institution wants to blow itself up,” he’d later explain. “So I’ve always taken some confidence in the fact that their survival instinct would help protect the system. But I was shocked by how bad risk management was in some institutions. And many banks thought they were smarter than they were.”
By 2006, John Dugan, the comptroller of the currency, was fretting to other regulators about the growth in nontraditional—i.e., subprime—mortgages, according to several former Treasury officials. But here was a “disconnect,” says one official. “The people in the Treasury building who spent most of their time on housing were the economists. The people on the market side were the ones dealing with leverage. Even in this building, with a small senior staff,