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Hank Paulson: Why Fannie and Freddie remain a big threat

Hank Paulson

FORTUNE — To commemorate the five-year anniversary of the financial crisis, former Treasury Secretary Hank Paulson has written a new prologue to his memoir On the Brink, which chronicles the dark days of 2008. As head of the Treasury, Paulson, now 67, had the herculean task of saving the global banking system when problems in the subprime mortgage market sent waves of losses to the furthest reaches of the financial markets.

In order to prevent financial Armageddon, Paulson had to achieve bipartisan support for radical bailout plans including the takeover of the mortgage giants Fannie Mae and Freddie Mac and the Troubled Asset Relief Program, (un)popularly known as TARP. Brokering rescue deals with Washington D.C. was no small feat given how sour relations had grown between Democrats and Republicans. Just two months before Lehman Brothers filed for Chapter 11, Nancy Pelosi, the Democratic Speaker of the House, described then-president George W. Bush as “a total failure” who used criticisms of Congress to divert attention from the fact that he had “no ideas.” When Lehman did go bankrupt, the ensuing chaos became a huge thorn for both presidential candidates Barack Obama and John McCain.

Amid this charged political climate, Paulson fought hard to keep politicians focused on rescuing the banking system. The former head of Goldman Sachs (GS) got down on one knee and begged Pelosi to support TARP. And in his memoir he mentions getting physically ill more than once as politics slowed down his ability to act, even while Wall Street’s meltdown gained momentum.

Looking back on the days and months after September 15, 2008, Paulson tells Fortune that he was tremendously frustrated with Congress because “it was so obvious to me that we were on the brink of catastrophe.” But he gives credit to lawmakers for giving broad powers to the Treasury, not once but twice. “Now I understand that it took great political courage for members of both parties to act against their own political interests and for Congress to act as fast as it did,” Paulson says.

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In a wide-ranging interview, Paulson addresses the role the politics played in the financial rescue and the current recovery, the big risks posed by Fannie and Freddie, and what still needs to happen to stave off another catastrophic event in the global financial system.

What was the mood in Washington D.C. like when you arrived at Treasury in 2006?

The political environment was poisonous, particularly between the administration and the Democrats. I was concerned about that rift before accepting the job — which I was offered three times before I was persuaded to take it — and I came in with the understanding that I wouldn’t be partisan and could hire for the Treasury regardless of a person’s political affiliation.

Do you think politicians would have acted to prevent a systemic breakdown had they understood the risks, or would it still have taken the threat of another Great Depression to force them to find bipartisan solutions?

It took a near catastrophe to get Congress to act. When Ben Bernanke and I went to Congress to ask for approval for TARP, Barney Frank said in our first meeting that this was going to be politically difficult to pass. Whether or not we got approval, the economy was still going to turn down, and no politician gets credit for preventing a disaster the public never sees.

But that bipartisanship also happened because a lot had been done to build relationships before the crisis. I had developed a relationship of mutual trust with President Bush, so when the time came, he turned to me as his war-time general and was prepared to make tough decisions even if they were unpopular. I was fortunate to have a year before the crisis hit to work with members of both parties to get things done, much in the same way I would with clients at Goldman.

Is partisan gridlock stymying the economic recovery and harming growth?

You bet. Economic growth is still too slow, and unemployment too high, and this is in part because we’re dealing with a disturbing, longer-term trend of declining economic competitiveness. Even in the 10-year bubble from 1997 to 2007, median family income was flat, when Americans were borrowing at historically high levels and taking on unsustainable levels of debt to maintain an unaffordable standard of living.

What it takes to restore economic competitiveness and get growth above 3% a year is to have bipartisan reform in areas like entitlement systems, immigration policy, and the tax code so that we can get the revenues we need and create jobs.

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Absent another crisis, what needs to happen for Congress to tackle economic reform in a constructive way?

The reforms we desperately need will only happen if the Administration and members of Congress from both parties are willing to compromise.

President Bush encouraged me to compromise to cut deals. The stimulus bill was structured as a refundable tax credit, which is anathema to Republicans, but we compromised so that it could be passed.

We started working to reform Fannie and Freddie in late 2006, and President Bush authorized me to break ranks with some of the Republican diehards — who were largely right regarding their views on the GSEs — because they were insisting on reforms that just couldn’t get done. It’s better to compromise and get some important things done, rather than clinging to ideological views and getting nothing done at all.

Why has it been so hard to reform the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac?

Fannie and Freddie are a big part of the incentive structure that vested interests want to protect, along with the mortgage interest tax deduction and state housing programs. Those strong vested interests include homeowners, real estate brokers, homebuilders, and investors.

Bond investors also have a strong vested interest in the status quo. When we stepped in to put the GSEs into conservatorship, there was $5.4 trillion in Fannie and Freddie securities held globally — $1.7 trillion were held by central banks around the world; $3.4 trillion held in the U.S., where they flowed like water through our financial system. Community banks, pension funds, and money market funds all held GSE securities. Even though there was no explicit government guarantee, they were treated almost like the equivalent of Treasury bonds.

Imagine if [a GSE] auction had failed and how a price drop would have impacted confidence in their securities. It was unthinkable. Fortunately, we were able to stabilize Fannie and Freddie before Lehman came unglued — that was essential. The GSEs were nine times bigger than Lehman.

How would you reform the GSEs?

We need to work toward a system where government subsidies don’t set the terms for the market. We have to dramatically rein in the missions of the GSEs by not only eliminating their ability to hold mortgages, but limiting the mortgages they can ensure. You can do that by limiting the mission to first-time homebuyers, by the size of the mortgage Fannie and Freddie can back, borrower income, or all of the above.

Importantly, we need to make sure there is no implied government-backed guarantee on Fannie and Freddie corporate debt.

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What happens if nothing changes at Fannie and Freddie?

Without the discipline of a private market, we are in danger of creating another speculative housing bubble, which would again result in massive losses and economic hardship when it bursts.

Do you think the banks should be broken up?

[There is now] increased concentration in the financial system. But today, the big banks are better regulated, better capitalized, and have better risk management. I’m very supportive of the Fed’s proposal for the largest banks to have higher capital requirements. Big capital and liquidity cushions are our best defense against failure. Importantly, thanks to Dodd-Frank, regulators now have resolution authority that gives them the tools to liquidate any large, failing financial institution.

We have bigger problems to solve right now than the banks including Fannie and Freddie and the shadow banking system, meaning money-market funds and the repo market, which provides short-term wholesale financing to industrial companies and banks.

What makes the Treasury Secretary role so important?

When I came in, I underestimated was how much could be done to make a difference every day. But there’s always an economic issue somewhere; and the Treasury secretary’s role should be to serve as the primary advisor and spokesman for all domestic and international economic issues.

Today’s world is one of increasing economic integration and one where we’re almost certain to have economic and political volatility. Everything from the environment to trade to national security issues has an economic component.

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What did you do after you left Washington?

I came back to Chicago, where I spent most of my career and my family has kept a home and maintained our permanent residence next to my mom’s house. One of the reasons I wanted to work at Goldman Sachs was because the firm had a strong Chicago office.

I’m working with the Nature Conservancy where I’ve launched and chair the Latin American Conservation Council, which is comprised of business and government leaders from the U.S. and Latin America, working on major conservation challenges in Central and South America.

And I’m setting up the Paulson Institute, a not-for-profit headquartered at the University of Chicago that focuses on U.S.-China relations with a big emphasis on sustainable economic development. We are a think and do tank. Our programs support Chinese mayors on issues like energy efficiency and sustainable development, Chinese CEOs on responsible executive leadership, investment between the U.S. and China, and conservation, particularly of Chinese coastal wetlands.

Why focus on China?

One of the big economic phenomena of the next 20 to 30 years will be having 250 million Chinese people move from country to city. That migration will drive global economic and environmental outcomes.

I’m also writing a book on China that should come out mid-next year. It focuses on my 25 years working with China. It’s called Dealing with China. It’s a narrative of 20 years of getting things done as an investment banker, as Treasury secretary, and as a conservationist.

How would you define your legacy?

Others will define my legacy. I’m pleased to have established a strategic economic dialogue with China that helped reset U.S. relations with that country. I’m proud of how we responded to an unprecedented financial crisis, working within an outmoded, balkanized regulatory system without the necessary authorities. We worked within the executive branch and with Democrats and Republicans to put in place capital market stabilization programs that successfully staved off disaster and were carried over into the next administration. For the most part the capital market programs the Obama administration needed were already in place, and they managed and adapted them very well.