WHEN: Today, Monday, January 12th at 3-5PM ET

WHERE: CNBC's "Closing Bell"

Following is the unofficial transcript of a CNBC interview with Treasury Secretary Hank Paulson today on CNBC's "Closing Bell" (3-5 PM ET).

All references must be sourced to CNBC.


MARIA BARTIROMO: The fed increasing its balance sheet by one and a third trillion dollars in a couple of months time. The fe-- the treasury injecting money from tarp, taking stakes in bank. Can we afford this as a country?

HANK PAULSON: Maria, we can afford it as a country. We're a rich country. And (COUGHING) if history teaches us any lesson, it is that when you have an historical problem like this, if we don't react to it quickly, and react to it with force quickly, the long-term economic clock-- consequences will be much more severe. Now, again, a good deal of this treasury issuance is going to be the fund investment programs that really aren't expenditures. For instance, the $250 billion bank capital investment program. This-- this is money that will come back into the treasury. And it will come back into the treasury with a profit. So all of it won't be spending. And again, I-- I think a big part of this success will be the-- the focus that the-- and the policy choices that the next administration makes, as it relates to their stimulus program. And I'm hoping that it will be-- relatively short-term, because, as you pointed out, we have long-term fiscal challenges. And one of the things that I started working on as soon as I came down here were the long-term fiscal challenges-- social security and health care challenges. And I think that if, in the first year, the next team in Congress starts to address some of these fundamental long-term problems, it will make investors and others around the world much more comfortable with some of the things we need to do in the short-term, to deal with a very-- present and real-- you know, ec-- economic-- downturn we have in this country.

MARIA BARTIROMO: But do you worry about foreigners becoming unwilling to lend? I mean, how do we know that they're continue buying our-- our debt? Who is gonna finance, and at what interest rates-- what we have right now?

HANK PAULSON: Well, Maria, right now, there's great demand for our treasury securities. And at very low interest rates. I've spent a great deal of time personally talking with investors overseas, talking with investors in the Middle East-- China, Japan. And I will say to you that everything they indicate to me is they feel comfortable with the things we're doing. They like the fact that we're dealing forcefully and stepping up to meet the challenges and to stabilize our financial system. And to protect-- their interests, and that we-- we as-- as a nation respect property rights and respect foreign investments.

MARIA BARTIROMO: Let me-- let me ask you this. Let me ask you to look back-- Secretary Paulson. I mean, throughout this upset, the trillions of dollars--


MARIA BARTIROMO: --lost in-- in wealth, in-- in market value--

HANK PAULSON: Yeah, right.

MARIA BARTIROMO: --the-- the banks having-- you know, some gone-- collapsed. Some people say some of the smartest people in the planet, the so-called geniuses that we thought, all did the same thing. Took on so much risk-- or didn't really understand the risks that they were taking on, or didn't understand the arcane world of-- of some of these securities. Do you agree with that?

HANK PAULSON: Oh, absolutely.

MARIA BARTIROMO: How is that possible?

HANK PAULSON: Well-- it was possible because we had excesses in the system building up for many, many years. And there were imbalances that built up for many years. And they existed for so long, people started to use phrases like stable disequilibrium to-- to--


HANK PAULSON: --to explain it. You know, actually morons (?) like that. And the degree of financial innovation and complexity became so great that it was difficult to understand how much leverage was embedded into the system. And I believe a big reason for the problem is that we have outdated and outmoded regulatory structures here and around the world, outmoded financial regulatory structures, and authorities-- outside of this country and-- and in this country. And so, there's plenty of blame to go along-- go around. And trust me, this is-- is building up over a long period of time.

MARIA BARTIROMO: How much of the risk taken on had to do with compensation? I mean, if you were a banker or a trader, you're getting 50 percent of the revenue. Of course you want a bigger balance sheet. Do you think compensation, the lure of more money in the paycheck, played into this?

HANK PAULSON: You betcha. Yeah, there-- there-- there's no doubt about it. And when I talked earlier, in the interview, about the-- a regulatory guidance that was put out by the four-- bank regulators-- where they dealt with lending, they also deal with compensation practices, in-- in that guidance. And so I believe, having the proper incentives for everyone that works in a financial institution, to incentivize long-term performance and performance that aligns management and traders and bankers with shareholders. And promotes teamwork and leads to building long-term value is-- is critical. And when you have compensation that's based upon short-term formulas, you're-- you're gonna get what you incent. And-- and you're gonna-- you're gonna get-- excessive risk-taking.

MARIA BARTIROMO: You're about to pass on the baton to Tim Geithner. What can you tell us about Geithner in terms of the differences between you and him when it comes to policy?

HANK PAULSON: Well, I think you should let Tim Geithner answer that question, when he's sitting in this seat. I can just tell you that-- that he-- is a man of enormous abilities, that I believe we're very fortunate to have someone coming into this position that enjoys the support not only of Congress but of the markets. And I think you're gonna find the markets are very comfortable with Tim. He's had a very senior job, treasury, in the past. He understands this department. He's an internationalist. And so, he is highly regarded around the world. He's very knowledgeable, about the challenges we're facing in the-- in-- in the financial markets. He's very knowledgeable about the steps that we've taken here and the programs we have. So I think, and-- and we've had a very good transition. So I-- I do think that we can do this without skipping a beat.

MARIA BARTIROMO: You have obviously overseen what has been one of the toughest periods in this country's history. What do you want your legacy to look like?

HANK PAULSON: Listen, I'm not-- right now (LAUGHTER) not worried about legacy. I want-- I-- I-- I've got more work to do, before I leave. When--

MARIA BARTIROMO: In two weeks--

HANK PAULSON: --and then-- then I'll say--


HANK PAULSON: Then I'll say in the next-- in-- in-- in the-- weeks after I leave, maybe I'll give some thoughts to things we did well, things we-- we-- we could have done better. But as I look at the things that I'm proudest of-- there-- there are a good number of things that have nothing to do with the-- the financial crisis. I think the ground bank breaking nature of the strategic economic dialogue with China, where we talked throughout the government about long-term critical issues, ranging from-- from health care to financial markets to energy and the environment. I dealt with the most pressing short-term issues. Foreign investment in the US, letting people around the world know that we welcome that. Streamlining the foreign investment in the US regulations, the (UNINTEL) regulations. Having many investments being made when I was here, where we didn't have really-- any issues surrounding them, and having-- foreign investors feel welcome. And then in terms of the-- credit crisis, as I look at this, we've dealt with historic events. We've had a lot come at us. We didn't have the authorities and all the tools we would have liked. And even if we sometimes use duct tape and bailing wire, I think we got the job done. And I think we stemmed a tide of-- or a cycle of collapsing institutions. And I think we injected stability into the financial system, and I believe that the steps we took there were proper. And I think with 20/20 hindsight, people will look back at the programs we did with the tarp, as saying, "Those were the right things to be done." And they'll look at the things we decided not to do and they'll say those were the proper decisions also.

MARIA BARTIROMO: No data (?), I remember speaking to you when you first came into office. And you had very important things on the agenda, foreign investment, China, continuing--


MARIA BARTIROMO: --that relationship. No doubt--


MARIA BARTIROMO: --some of those things had to get interrupted--


MARIA BARTIROMO: --by the unforeseen events.

HANK PAULSON: They-- they absolutely did. And-- there were-- there were several things I would like to have done more of. But we did-- we did a lot. And there were a number of things that I was pleased to be part of, and in terms of environmental protection under this president, and that I think were very, very important, particularly some of the programs with China and the work we did to develop the-- you know, the clean technology fund, the global $5 billion fund that's gonna fund-- clean technologies in developing countries, which is, I think, gonna be-- one of the keys to dealing with-- with the climate issues.

MARIA BARTIROMO: Secretary Paulson, I was with somebody from Lehman Brothers recently and understandably, he's upset--


MARIA BARTIROMO: --that his firm collapsed. But he said-- his theory was, you needed Lehman to fail in order to prove to Congress this was real, and that you needed money. You needed to create that tarp plan. True?


MARIA BARTIROMO: Did you need Lehman to fail?

HANK PAULSON: I-- we certainly didn't need Lehman to fail. We didn't need Lehman to fail. We didn't want Lehman to fail. I-- we worked with Lehman for many, many months. The New York fed-- Washington fed, treasury, many months. I had no authorities to do anything until we got the tarp. And again, we didn't have a buyer for Lehman Brothers. And it-- it would-- some of the potential buyers discussed making an acquisition. It was under the condition that they would leave (UNINTEL) behind-- a large number of assets that were worth less than they're on the books for. And so, even if they had been there, I think it would have been very difficult, impossible, for the fed to-- to fund them in a way in which-- let a buyer-- acquire the company and avoid-- it going through bankruptcy.


HANK PAULSON: Matter of fact, with Lehman, that-- from the-- the day we did the Bear Stearns transaction, we were talking privately and publicly about the lack of powers to intervene and deal with a financial institution that wasn't a bank, that faced bankruptcy.

MARIA BARTIROMO: But do you worry that-- you know, that-- that people feel like you and Tim Geithner, in-- in many cases, and in many cases, this was needed. Somebody needed to lead. But-- but almost engineered things so-- so one guy at Lehman said to me, "Look, I was-- I was in the room, when Dick Fuld was on the phone with Ken Lewis, saying, "I am looking forward to being your partner." And then Geithner comes along and says, "Wait a minute. You're not gonna go with Bank of America. We're gonna have Barclay's call you." And then B of A-- acquires Merrill.

HANK PAULSON: That-- that was-- let-- let me say this. The-- the facts are very clear. We did everything we could to get buyers, and get more than one buyer. And-- and I not only encouraged Dick Fold, I-- I called Ken Lewis myself, and I called the Barclay's people myself. And-- and Ken Lewis made it very clear what he might be prepared to do. And it was not-- and-- and it was something that didn't get done and couldn't have got done. And-- and with Barclay's right up until the end, we were talking to them, trying to en-- engineer a transaction. The fact is, Dick Fold, for many months, knew what he needed to do. We all knew what he needed to do. He tried to do it. He was unsuccessful in doing it. And there wasn't a buyer for his company, at a price above zero. There just wasn't.

MARIA BARTIROMO: A broad question about, you know, in some cases, what some people would call laissez-faire, free market--


MARIA BARTIROMO: --capitalism. Do you worry that because, you know, the FCC missed Madoff, and you know, the-- the banks took on all of this risk, that it's going to come back in the face of capitalism? And it-- it will make it look like we do need much more regulation, that free market capitalism maybe is the wrong way to go. Do you-- do you worry about that?

HANK PAULSON: Well-- I think the things we did were to preserve free market capitalism. They needed to be done to preserve free market capitalism. You know, when I came down here, in the first months, people were saying to me, "Hank, the Sorbanes-Oxley need to be repealed. Is there too much regulation?" And I said some things that were unpopular to many people. I said, "Sorbanes-Oxley is good legislation. We don't need it repealed. It can be implemented differently." So I've never been anti-regulation. But I do believe we need effective regulation, better regulation -- regulation, more authorities. The new administration will need more than just the tarp. There are additional authorities they will need, in my judgment, to do everything they are gonna need to do. And then, this country needs a updated regulatory system that works for today's world.

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