Money & Politics with Larry Kudlow

An Interview with Former Treasury Secretary Henry Paulson

Editor's Note: This is the unofficial transcript produced February 1, 2010 for The Kudlow Report - An Interview with Former Treasury Secretary Henry Paulson.

Tonight, on a special edition of THE KUDLOW REPORT live from Washington, DC, former Treasury Secretary Henry Paulson talks to us about his new book, "On the Brink: Inside the Race to Stop the Collapse of the Global Financial System."

We will talk to a free market man who engaged in perhaps the most systemic government intervention in US financial history.

Did it work? Were there other options? Why is there a populist political backlash against the bailouts? And is the long-term American economic future better or worse?

Mr. Paulson will give us some straight talk on what he was thinking and how it all turned out. This is a first government source account, inside account, straight from the horse's mouth. Fasten your seat belts, everybody, THE KUDLOW REPORT begins right now.

Tonight, we learn about Mr. Paulson's thinking behind all those decisions, taken in response to the financial crisis, and, ultimately, in the pursuit of long-run American prosperity. Here with me now in Washington, DC, the former Treasury man Henry Paulson.

Hank, thank you very much for doing this.

Mr. HENRY PAULSON: Larry, great to be here.

KUDLOW: First of all, let me say just as someone who read the manuscripts, they were Xeroxed for me, it was one hell of a book. I just want to say that. I loved it, I couldn't put it down. I read it in the course of three or four days.

Now, let me ask you this. You were here in this very spot in the spring of 2007. We interviewed.

Mr. PAULSON: Yeah.

KUDLOW: And the first stirrings of the crisis began more from reports about subprime mortgage failures and some bank issues. A month or two later, you had the BNP Paribas crisis, which triggered in France. OK. Then you take this narrative down to 2008. Let me ask you this: In '07, you said it was containable.

Henry Paulson
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Mr. PAULSON: Right.

KUDLOW: You were still an optimist on the economy. You were still an optimist on the financial system's health. Why wasn't it containable?

Mr. PAULSON: Larry, you know, one of the things that I recount in the book is, you know, the very first major meeting I had with President Bush, I asked for the topic to be about what I thought was the likelihood of having a credit crisis. And he asked me, he said, `Hank, what would--well, what would cause it,' and I said, `I don't know, and we--it's almost impossible to guess. Who would have guessed that the Russians would default and that would cause a crisis in '98? But after the fact, it will be obvious. There's just a lot of dry tinder out there and I'm not sure what's going to light the spark.' Now, why did we say it's contained? And I think...

KUDLOW: You said it, Mr. Bernanke said it, a lot of people said it.

Mr. PAULSON: Yeah. And I think...

KUDLOW: And then I said it after you said it.

Mr. PAULSON: I know it. I know it. And you're an optimist.

KUDLOW: I am an optimist.

Mr. PAULSON: Now, in terms of why I thought it was contained was, first of all, I was talking about subprime and we made the mistake of just simply saying the subprime was not big in relation to, you know, a $13-, $14 trillion US economy. And what was really going on is we were talking about housing overall, and, you know, since World War II, housing, residential home prices had generally gone up. And mortgages were just considered to be very safe investments. And so the kind of decline we saw was something that was not envisioned in any kind of model. It wasn't anything that many people that were close to it--you know, after the fact, it all seems obvious to all of us.

But the--and so when you had the kind of decline we saw in housing prices, that changed the behavior of those who, you know, of homeowners. And also the other thing you and I were talking about before the show is just this--all of this complexity.

KUDLOW: Mm-hmm.

Mr. PAULSON: And so when...

KUDLOW: These crazy bonds, collateralized debt obligations, credit defaults, what--mortgage-backed securities that were rated triple-A by a bunch of goofy raters that didn't know what they were talking about.

Mr. PAULSON: Yeah. And the level of complexity, OK, made--so when housing the prices declined, all kinds of complex products became suspect because people said, `Who understands them.'

KUDLOW: All right. So look, let's shift the narrative now. You maybe saw the first sparks of problems back in 2007. Let's call it midyear, to the argument's sake.

Mr. PAULSON: Right.

KUDLOW: Switch it to six or nine months later. March of 2008, Bear Stearnsfaces a run on the bank. You got to close, them and you sell them to JPMorgan . And as you note in your book, March to September 2008, probably the most extraordinary thing in the history of American finance, eight major financial firms failed, and that doesn't include putting Merrill Lynchinside the Bank of America . In a sense, Merrill would have been nine. And I think  we may have a full screen on what the eight were, if we put those things up.

But leaving that aside, here, Bear Stearns, IndyMac, Fannie, Freddie, Merrill Lynchacquired by Bank of America.Let's switch to page two on this. We've got to get-- AIG'sgot to come up on there. There's Lehman, AIG . And let's not forget, by the way, Washington Mutual--WaMu--Wachoviaand somewheres in there, did I mention IndyMac. That was in there as well. Now...

The Crisis: 1 Year Later - A CNBC Special Report - See Complete Coverage

Mr. PAULSON: And now what you had also happening was...

KUDLOW: That was an incredible jump shift. Incredible in the space of nine months to a year we had a total collapse of all these huge institutions. And yet it seems to come as a great surprise.

Mr. PAULSON: And that's--and that's the US alone because you had--if you look from September through the first part of October, we had six European nations have to come in and rescue a whole series of banks.

KUDLOW: But why? What happened? You had this, in effect, a rolling run on the bank. That's really what you had.

Mr. PAULSON: Right. Yeah.

KUDLOW: You can define it and make it complex...

Mr. PAULSON: Yeah.

KUDLOW: ...but basically you had a run on the bank--investors, depositors--for liabilities that were insured. Open market trading funds and all the rest of it...

Mr. PAULSON: Yeah.

KUDLOW: ...just took off. And all of a sudden you're in this incredible crisis. The credit markets freeze. You couldn't even have bank-to-bank, interbank trading. Money market fund went down, let's not forget that, whatever it was called, the reserve primary fund, that was another.

Mr. PAULSON: Right.

KUDLOW: What happened? Some--there's got to be some rational explanation to get from the middle of those seven into the autumn of '08.

Mr. PAULSON: Well, what you need to understand is what had happened before even the middle of '07, which is you'd had these excesses had been building up for some times. You'd had a--we had been overstimulating housing. So if you look at the combined weight of all of our policies in the US government...

KUDLOW: Wait. It's HUD-backed, unaffordable mortgage loans, Fannie and Freddie?

Mr. PAULSON: What you have--yeah, yeah, Fannie and Freddie, the FHA,various state programs.

KUDLOW: Community Reinvestment Act.

Mr. PAULSON: You know, mortgage interest deduction. I'm not saying of them were...

KUDLOW: Zero capital gains tax on home sales.

Mr. PAULSON: That's right. And so you had--so you had all of this going on, and then you had even more basic than this, you had these big global economic imbalances, structural imbalances, which stem from the fact that we, as a country, save not enough, both as a government and individually. Overreliant on debt. And so this--so you had these big structural imbalances. We have a tax system that penalizes savings and it really rewards consumption.

KUDLOW: Right.

Mr. PAULSON: And so you had these huge capital flows, global capital flows raining down through the banks. And so it was something--economists would talk about this, and they would talk about it, and I remember someone even using this term that was, you know, "stable disequalibrium," you know...


Mr. PAULSON: ...the oxymoron, almost. But--so you had these excesses and then you have, in 2007...

KUDLOW: Right. Before we get to those, though, I want to say...

Mr. PAULSON: Yeah.

KUDLOW: ...Hank, you were effusive in your praise of Ben Bernanke.

Mr. PAULSON: That's right.

KUDLOW: Effusive.

Mr. PAULSON: Right.

KUDLOW: In a number of pages. You call him the most brilliant guy, he's a nice man.

Mr. PAULSON: Yeah.

KUDLOW: He shows up on time for meetings. As I recall, you like that, too. But so many of us believe that the Fed's ultra-easy money, with Greenspan running the Fed in the early part of the decade, and Bernanke as intellectual co-pilot, ultra-easy money, ultra-low interest rates, negative real interest rates helped the housing bubble, the commodity bubble. And you know, as a former Wall Street veteran, you throw negative real interest rates at Wall Street traders looking for yield to please customers and whatever, that's like throwing blood into the water for sharks. And so they just took those—and then I want to ask you, that it comes around--what goes around, comes around.

After the Fed finally figures out that they were too easy and the inflation rate started rising to 5 or 6 percent, then they tightened the screws from pillar to post. And if you look at a chart, real interest rates were 4 or 5, 6 percent by the time we got to '07, '08. So they pumped the money in, they bubbled out the asset prices, then they clamped down on them with a huge liquidity squeeze. Why aren't you more critical of the rock 'n' roll monetary policy?

Mr. PAULSON: Because what I looked at, and this was--this was my view of the world, my view of the world was inflation was very low globally, there was--the world was awash in excess liquidity, and you saw--so, in this world, investors were reaching for risk and mispricing it. But to get to your basic question...

KUDLOW: How easy to misprice when the Fed has mispriced its own monetary policy?

Mr. PAULSON: Well, when the world's lost--but if you--but to get to your basic question, because--which I think is critical when you say why did you get this chain of bank failures suddenly, you had--remember, the crisis hit in the late July-August period of 2007. So before we got to Bear Stearns, this had been going on for some time. And the--it was taking its toll. And I think that given some of that accounting conventions and so on, the losses weren't realized.

KUDLOW: Something happened, Hank. Here's the thing that I'm--I don't want to dwell on this. I mean, your book, your narrative is...

Mr. PAULSON: Yeah.

KUDLOW: ...this was financial Armageddon, peering into the abyss.

Mr. PAULSON: Right.

KUDLOW: And you know what, I don't--I don't disagree. I think you're right. I'm not sure we need to talk about why the rest of the public today doesn't understand that. But I'll come back to that. But it seems like when these big banks, brokers, mortgage lenders, let's not forget Countrywide went down...

Mr. PAULSON: Yeah.

KUDLOW: ...something happened between Bear Stearns and, I don't know, Merrill Lynch, something happened so the system turned off. What was the event that happened?

Mr. PAULSON: Well, I would say that, but first of all...

KUDLOW: Turned a downturn into a catastrophe?

Mr. PAULSON: Well, first of all, again, this had been building up for a long time. These institutions were--there was a--I think they didn't adequately understand the need for liquidity cushions. There was a lot of focus on capital, which is important, but I think they didn't have adequate liquidity. I think it was a complexity of products. But again, they were--I was aware from August of 2007 right up through that period, how severe the problem was.

KUDLOW: Well, I'm not blaming you.

Mr. PAULSON: No, no.

KUDLOW: There's no perfect foresight in this game. I'm not blaming you.

Mr. PAULSON: No. But I was just saying...

KUDLOW: Nobody blames you.

Mr. PAULSON: No, I wasn't...

KUDLOW: The question is, though, in terms of how this thing hit...

Mr. PAULSON: No, I was--I was saying...

KUDLOW: ...what was it? We wake up in the fall of '08, Hank, and it's a total catastrophe.

Mr. PAULSON: See, I was--well, here's the point, I think.

KUDLOW: Something must have happened.

Mr. PAULSON: But here's the point I'm trying to make, which is I think--see, I saw it hitting in August of 2007, and it was beneath the surface. So it was building and building and the system was becoming more and more fragile.

KUDLOW: And you're still going to defend the Fed during this period?

Mr. PAULSON: And it was hard. We were working, yeah, with the Fed, during that period, we were working jointly with the Fed trying to get institutions to raise capital and trying to get them to raise capital while they still could raise some. And I was calling up bankers and saying, I don't know of a single CEO of a major bank or any bank who's ever got in trouble by having too much capital, raising capital. But they viewed it as a sign of weakness.

KUDLOW: All right. We're going to take a break here.

Mr. PAULSON: Yeah.

KUDLOW: I understand that. And I agree with, by the way, the capital issue, and I think that's a key part of this solution. All I'll say is this: Wouldn't it be nice to have a steadier monetary policy that didn't go on, let's take real interest rates. I mean, the inflation rate went to 5 percent for awhile, then it went back down, then it went to 6 percent for awhile in 2006 to 2008. They blew their targets. Wouldn't it be nice to have a central bank and policy that didn't fluctuate from a negative 4 percent real rate to a positive 4 or 5 percent real rate? Because I submit that that was an ocean that drowned--first it created the waters and then took the water out. This was a liquidity squeeze of the first magnitude. First, they pumped it up, then they deflated it. That's got to be part of the issue here.

Mr. PAULSON: Well, I have looked--I'm not trying to debate it. I just looked at, from my perspective and from a banker's perspective, I saw huge complexity, much of it unwarranted. I saw--and I saw big capital flows stemming from imbalances, and with the world awash in that kind of liquidity from the capital flows, and low inflation around the world. So that was, you got it from me, not an economist, not a monetary economist but a banker. And when we were working to put out the fire, you know, I could not have had better partners.

KUDLOW: Well, we'll get to the putting out the fire part. We're going to take a full break. We have Mr. Paulson here for the entire hour.

We're going to talk about mark to market accounting, where he's totally going to disagree with me. We're going to talk about the role of the dollar. We're going to talk about Lehman, we're going to talk about AIG. We're going to ask the former secretary whether he, in fact, put a gun to Ken Lewis' head to buy Merrill Lynch.

Of course, this is a dramatic book. Somebody's got to figure out the causes of this thing so we can somehow try to prevent it in the future.

Coming up, we'll even talk about some of the individual players.

I'm Larry Kudlow.

Treasury man Henry Paulson.

It's a great honor and a pleasure. It's a great read, folks, by the way.

You got to go online, buy it, Amazon, bookstores, whatever .

Hell of a read.

You're watching CNBC, first in business worldwide.

You can read the full transcript of the Paulson interview here.

You can begin watching the interview here - The Cause of the Collapse
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