Henry Paulson, then-secretary of the Treasury, testifies before the Senate Banking Committee on July 15, 2008 about the outstanding debt held by Fannie Mae and Freddie Mac. Photographer: Joshua Roberts/Bloomberg
Henry Paulson, then-secretary of the Treasury, testifies before the Senate Banking Committee on July 15, 2008 about the outstanding debt held by Fannie Mae and Freddie Mac. Photographer: Joshua Roberts/Bloomberg

(Corrects Tavakoli’s Goldman Sachs job description in third paragraph.)

What should we make of the revelation last week -- courtesy of Richard Teitelbaum and Bloomberg Markets magazine -- that in July 2008 Treasury Secretary Henry Paulson shared some confidential musings with a group of plugged-in New York hedge-fund executives at the offices of Eton Park Capital Management LP?

According to the report, Paulson mapped out for the assembled honchos -- many of whom had ties, like Paulson, to Goldman Sachs Group Inc. -- a scenario to put the government-sponsored entities Fannie Mae and Freddie Mac into conservatorship. Seven weeks later, the government did exactly that, an action that wiped out the companies’ shareholders.

Was it nothing more than “crony capitalism” -- the idea that the rich always seem to get better information about the markets before anyone else -- as Janet Tavakoli, a former Goldman employee turned Chicago-based consultant, put it?

Or was it a way for Paulson to begin to disseminate into the market the momentous news that Fannie and Freddie could be taken over by the government and that their shareholders would be eviscerated, as argues William Poole, a former president of the Federal Reserve Bank of St. Louis?

“It seems to me, you’ve got to cut the guy some slack, even if he tipped his hand,” Poole told Teitelbaum. “How do you prepare the market for the fact that policy has changed without triggering the very crisis that you’re trying to avoid? What is he supposed to say without misleading these people?”

A Possible Scenario

Or was it something else entirely: The batting around of options for Fannie and Freddie with a bunch of smart guys, well in advance of any decision having been made? If it was the latter -- which my review of the Fannie and Freddie timeline leads me to conclude -- I’m not sure it’s so horrible that the Treasury secretary would be discussing possible scenarios before deciding what he was going to do.

There is no question that Paulson appears to have put these hedge-fund managers into an untenable situation. After Paulson made the suggestion at Eton Park that Fannie and Freddie’s shareholders could be wiped out, the executives had to choose between passing up a possible money-making opportunity (by shorting the shares of Fannie or Freddie) or risking prosecution for insider trading, should someone be able to prove definitively that by July 21 Paulson had already decided on a course of action.

According to Bloomberg Markets, it seems that none of the bigwigs at the meeting traded on the information that Paulson conveyed, although tracking specific short-sale transactions is impossible from public information. (Some of the men claimed they could not remember what Paulson said at the meeting, which I find beyond hard to believe.)

But at least one of the hedge-fund managers at the meeting claimed -- anonymously -- that Paulson had left him with the distinct impression that Fannie and Freddie would be put into conservatorship and that shareholders would be wiped out. “The fund manager says he was shocked that Paulson would furnish such specific information -- to his mind, leaving little doubt that the Treasury Department would carry out the plan,” Teitelbaum wrote.

But a review of the timeline of events leading up to the government’s Sept. 7 decision to take over Fannie and Freddie makes it pretty clear that by July 21 no decisions had been made, by Paulson or by anyone else, about the fate of the two entities.

The House of Representatives didn’t pass the Housing and Economic Recovery Act until July 23, two days after his Eton Park meeting. On July 26, the Senate passed the legislation. President George W. Bush signed the bill into law on July 30, giving Paulson the “bazooka” he had requested (but said he had no intention of using) for dealing with Fannie and Freddie.

Making the Decision

On Aug. 7, Paulson went to China for a week to attend the Olympics. He returned to Washington on Aug. 15. In his 2010 memoir “On the Brink,” Paulson recalled that Barron’s ran a lengthy article that weekend about “the poor prospects for the two GSE’s and predicted a government takeover that would wipe out the holders of the common shares.” He said he thought the article was “pretty accurate.” (His book made no mention of the Eton Park meeting.)

While Paulson was in China, the Fed, the Office of the Comptroller of the Currency, Morgan Stanley and BlackRock Inc., the asset-management behemoth, studied Fannie and Freddie’s books and concluded the two were badly undercapitalized. Paulson then thought the best course of action was to put the companies into receivership, which is akin to liquidation, not conservatorship, which is more like a corporate bankruptcy process where the companies remain intact and operating.

It wasn’t until Aug. 23, a day after Treasury had hired the law firm Wachtell, Lipton, Rosen & Katz LP to analyze the legal options between receivership and conservatorship, that Paulson made the decision that conservatorship for Fannie and Freddie was the way to go. It was more than a month after the Eton Park meeting.

Based on the evidence, Paulson did not divulge inside information on July 21 to the hedge-fund managers in New York. He shared with them one possible idea for solving the Fannie and Freddie problems. Since that was the solution that was eventually selected -- a month later -- in retrospect his conversation looks damning. But it wasn’t and it isn’t.

Which isn’t the same thing as saying we shouldn’t be upset about it. The whole episode should be seen as further confirmation that hedge-fund managers, private-equity moguls and the top executives of large banks have long received special access to government leaders at the highest levels to plead their cases, or just to get a whiff of whatever might be on their minds. When it comes to getting access to powerful people, it’s not what’s illegal that’s the crime, but rather what’s legal.

(William D. Cohan, a former investment banker and the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the writer of this article: William D. Cohan at wdcohan@yahoo.com.

To contact the editor responsible for this article: Tobin Harshaw at tharshaw@bloomberg.net.