Amid meltdown, a conversion for Paulson

Treasury Secretary Henry M. Paulson had a stern message for more than two dozen of the nation’s most powerful hedge fund managers gathered in the third-floor conference room near his office.

Paulson told them it was time to begin regulating the opaque realm of hedge funds, reversing his long-held opposition. “You should not be thinking about how to fight it but how to make it work,” he recounted telling them at the meeting last month.

They were stunned. One manager recalled muttering as he walked out: “What happened to the Hank Paulson we knew?”

With his 30-month tenure nearing its end, Paulson is leaving behind a legacy of federal interventionism that few would have expected from this former head of the investment giant Goldman Sachs Group Inc.

When he arrived in Washington as one of Wall Street’s most successful bankers, he was skeptical of government meddling.

But as a regulator facing the worst financial crisis in nearly a century, he engineered a series of massive federal intrusions into the markets while persuading reluctant bank executives and influential politicians to fall in behind him.

His evolution in thinking has extended even beyond these government programs to a set of new beliefs that he has yet to trumpet publicly or, in most cases, even share privately with colleagues on Wall Street and in the White House.

While they, too, have changed some of their views on regulation, Paulson disclosed that he has traveled an even greater distance.

“My thinking has evolved a lot to the point where I’ve seen regulation up close and personal,” he said in a series of interviews.

It wasn’t just the crisis that changed him. It was every bit as much sitting behind the desk where he fashioned new regulation.

“I’ve realized how flawed it is and how imperfect, but how necessary it is,” he added.

Even though President Bush has been warning the next administration in speeches not to over-regulate the markets, Paulson said he will unveil proposals in coming weeks urging President-elect Barack Obama and the new Congress to endow the federal government with broad new authority to take over any failing financial institution, not just banks.

A Republican, Paulson would bring government into some of Wall Street’s most private quarters. He said banking regulators should have a major say in how financial firms compensate their executives and that the Federal Reserve should have the power to regulate any financial company it considers crucial, including hedge funds and private-equity firms.

He added that the policy statement he crafted on hedge funds in January 2007, which stated they should not be regulated, was wrong.

In reshaping his philosophy, he has had to feel his way even as the once-familiar financial landscape shifted around him. Some senior government officials who worked with him said he invented much of the government’s response on the fly.

In reflecting on his term, which comes to an end in January, Paulson said his biggest regret was not seeing the extent of the financial crisis as it developed. But he defended every major action he took.

“We were always behind. We saw the problem, but it took us a while to see the severity of the problem,” he said. “But even if we had been more clairvoyant, we wouldn’t have been able to do much differently than what we have done.”

Paulson had long believed that free markets work only if companies, no matter how big or vital to the financial system, could pay for their mistakes by failing. Nothing is as powerful a motivator as the possibility of a collapse, he would say.

Wall Street giant Lehman Bros. Holdings Inc. failed not because of Paulson’s convictions about how free markets should work, but because he could not arrange a deal to save the firm, even with taxpayer money.

The fallout from Lehman’s bankruptcy filing Sept. 15 was severe. The firm had relationships with a wide range of hedge funds and financial firms. Some could not get their money back. Suddenly, investors on Wall Street could no longer be assured that their money was safe in any investment bank.

Just a day later, Paulson dropped publicly any pretense that large firms would be allowed to fail. Along with Timothy F. Geithner, president of the Federal Reserve Bank of New York, Paulson put together an $85-billion loan for the insurance titan American International Group Inc.

Before the end of the week, Paulson headed to Capitol Hill to ask for the authority to spend $700 billion on an unlimited number of banks and financial firms whose troubles could put the entire financial system in jeopardy.