Q&A With Henry Paulson

In the summer of 2006, Henry Paulson left the helm of Goldman Sachs to become the third Treasury secretary of the Bush administration. At the end of his first full year in Washington, Paulson sat down with NEWSWEEK Senior Editor Daniel Gross to discuss the price of oil, the housing market and his recent trip to China. Excerpts:

NEWSWEEK: Is it surprising to you that oil has reached $100 per barrel at a time when demand in the United Satesthe world's biggest consumer of oilis slowing?
Henry Paulson: Oil has been at a level that has seemed high for some time. I think what is noteworthy is that the economy has done as well as it has. We're using oil more efficiently, and it has a smaller overall impact on our growth. A big part of the oil story has to do with global demand and another part is the underinvestment in a number of the countries that have essentially nationalized oil production and are not managing resources efficiently.

Speaking of global growth, you just got back from China. What were you hoping to accomplish, and what did you accomplish?
These big meetings that take place twice a year are only part of the story, because we have a continuing dialogue. I think the significance of this meeting is that it came at a time when the Chinese leadership is in transition. It took place between the Party Congress and the National People's Congress that takes place in March. A big part of what we're doing is to keep this economic relationship on an economic even keel during a time of tension. My primary focus is to work to persuade the Chinese to move more quickly to open up their economy. It's the fastest-growing market for our exports. The thing that was most noteworthy to me is that our two countries agreed to work between now and our upcoming meeting in June in Washington to develop a 10-year plan whereby we can work together on energy efficiency, energy security and [the] environment, including climate. We're the two biggest emitters of carbon. We're both big importers of oil, and we have some common interests.

As an investment banker, you traveled to China several dozen times. How is it different than going as a private-sector person?
The advantage that I had in coming to this job was I knew a good number of their leaders quite well. I had worked with Ziang Jemin and knew Hu Jintao. I had had a chance to work with Chinese leaders not just on their financial-sector reform but on environmental issues, too. Having said all that, it's just enormously different to represent your country. One of the positive surprises for me has been the sense of pride and satisfaction I feel when I go to any foreign country representing the American people and the United States of America. It's just an absolutely terrific feeling.

Your trip was just before Christmas, when Americans were concerned about the quality and safety of toys from China. Did you discuss that?
The biggest accomplishment at this meeting by far was the progress that was made in import safety. The work that [Health and Human Services Secretary] Mike Leavitt had done with his Chinese counterparts is a good start on a model for what can be adopted around the world. We didn't have a system in place where you could simply scale it up. This is not an issue where you can inspect your way out of it. Quality has got to be built-in. When we set up these strategic economic meetings in the fall of 2006, and we looked at the various trade tensions and the issues that we had before us, no one had foreseen that import safety would be as big an issue. That's very analogous when you want to talk about what's happening in our capital markets and our economy.

That provides a good segue to one of the stories of 2007, the falling value of the dollar. It is very common to hear policymakers in Washington say we have a strong-dollar policy. What does it mean to say that? And what can you as the Treasury secretary do about it?
I'd begin with and say that given my background in the capital markets, it was very easy for me to say a strong dollar is in our nation's interest because I know it is. Our economy, like any other, has its ups and downs. But you know, I believe our economy is going to continue to grow, and its fundamental strength will be reflected in the currency markets. It's my job as Treasury secretary to advocate and fight for policies that are going to keep our economy strong, increase confidence and increase productivity. The [positive news] is the president's pro-growth policies, the fact that the revenues are coming in ahead of forecasts and that our deficit is now down to 1.2 percent of GDP. Fighting economic isolationism and protectionism to keep our country open to foreign investment and trade are all things I'm very committed to--and are reasons why our economy over any period of time has been as vibrant and strong as it has.

So if we have the right structural policies in place, the dollar will follow?
I'm not going to comment any more on the dollar.

What's been the biggest positive surprise in transitioning from Goldman Sachs to Washington?
I have been impressed with the quality of people I've worked with in Washington, people like [Commerce Secretary] Carlos Gutierrez, [Energy Secretary] Sam Bodman, [Secretary of State] Condi Rice--the whole range of people. It's quite fashionable for people outside of Washington to dump on senators and congressmen, and I would say that, again, the surprise has been on the upside. When you look at how hard they work, many of them working full weeks, flying home and being with their constituents, they may not be qualified to run companies, but there are many people who run companies who aren't qualified to do what they do. The other positive has been living in Washington. I live in an area where I can get on my bike, ride out to Rock Creek Park, and I'm 10 minutes from Treasury.

And the biggest negative surprise?
I knew when I came, there were big issues—there wouldn't be low-hanging fruit. So I knew that the most interesting and important issues were going to be very difficult, and we'd have to measure progress by whether I was able to advance the ball, to make it easier for those who come after you to solve issues. There was the paradox that the lesson of the last 20 to 30 years was that those countries that opened themselves up to competition, to trade and investment flows, benefited, while the others were left behind. I knew there was greater protectionist sentiment in almost every country, including ours. But to see it on a day-to-day basis, while I'm sitting in this seat, is discouraging. Regarding the longer-term structural deficit we had with entitlements, it's frustrating to talk to people on both sides of the aisle, have them behind closed doors say they recognize this is an important problem but not make more progress to solve it. When I looked at Social Security, and I give the president a lot of credit for trying to solve this issue, I tried to depoliticize it, so it'll be easier to deal with in the future.

Are you surprised by the credit problems we've seen in the financial markets?
When I came down here [in the summer of 2006], one of the first things I said to the president is that the history of the capital markets is that every five, six or seven years we have financial turmoil. I wasn't predicting it, but it had been about eight years since we had turmoil. I said to my cohorts, the next time we have a shock, hopefully it'll be after I'm here, because we'll be dealing with issues I haven't dealt with before in terms of the complexity of products and the degree of integration with global markets. At the time, everyone was focused on hedge funds, and we made the point that it's very difficult to determine what will be the spark that lights the dry forest. So it wasn't a surprise. But it's less important to figure out what it is than to get ready to deal with it.

So what went wrong on Wall Street? How can so many people who are paid so well to manage risk do such a bad job at it?
There were clearly a good number of mistakes that were made, there's plenty of blame to go around. But my job is to do everything we can do to get through this period with as little negative impact on the real economy and the American people as possible—and to help come up with some policy prescriptions that will hopefully make this less likely to take place in the future. So right now, as we work our way through this, I'm not looking to point fingers. I'm encouraging people to recognize losses, raise capital and go forward. When you look at what went on, you need to look at it against the backdrop of a world where there were big imbalances, relatively low inflation, what seemed to be a surplus of liquidity, and lenders and investors were reaching for yield in a whole variety of interests. And there was great complexity in the instruments. Clearly, there were poor underwriting standards. We're looking hard at a whole number of things. We need to look at the whole securitization process, the mortgage-origination process and the rating agencies. But again, my focus is on getting through this period.

One of the ways you've done so is by helping to organize a program whereby lenders will freeze interest rates for certain subprime borrowers. Tell us about the motivation behind that.
In the past, if a homeowner with a mortgage had a problem making the payment, often he'd get together with a lender and strike a deal, because foreclosures are very expensive to the lender and obviously not good for the homeowner and the community. Now investors in mortgages are scattered around the world, and that makes decision-making very complicated. In a market where home prices are stable and going up, that's manageable. We have this wave of resets coming, which really picks up this year, on adjustable-rate mortgages, and the underwriting quality is the poorest, because those were the ones originated late last year. So we went to the industry-mortgage servicers covering 90 percent of the market—together with investors and counselors—and came up with a way to handle this volume that would approximate what would have happened in normal market circumstances, and do so in a way that we avoid a market failure. There's nothing that I believe we can do to prevent the market from working, to prevent home prices from going down, given all the excesses we had. But we can certainly do some things to avoid needless foreclosures that are going to exacerbate the situation and hurt the economy and hurt homeowners.

Critics have charged that it will only help a minority of subprime borrowers.
The 1.8 million ARMs coming up for adjustments fall into three buckets. There are some people that have been unable to make initial payments, often they put little money in the home, and they were renters before. That's roughly 600,000. There's a second group that has been able to make their payment and are going to have trouble making the higher payment. Those people will get put very quickly into a fast-track modification, which will be for all intents and purposes an interest freeze. And then the other 600,000, those with higher credit scores, will have to go through a longer process. Some of them will be able to afford the higher rates, others will be able to refinance.