Moral Low Ground


Treasury Secretary Henry Paulson Warned Hedge Fund Managers About Fannie, Freddie Takeover in July ’08

Henry Paulson, the former Goldman Sachs CEO who served as Treasury Secretary under President George W. Bush, tipped off his Wall Street buddies— including at least five Goldman Sachs executives– that the federal government was preparing to seize control of secondary mortgage giants Fannie Mae and Freddie Mac.

This stunning revelation is the result of a Freedom of Information Act (FOIA) request by Bloomberg Businessweek. That publication found that Paulson talked up the two government-sponsored enterprises (GSEs) to New York Times reporters and editors on the morning of July 21, 2008, just hours before attending a meeting at the headquarters of hedge fund Eton Park Capital Management LP in Manhattan. There, over sandwiches and pasta salad, Paulson had a very different message for the luminaries of finance gathered around the conference room table.

According to Bloomberg Businessweek: 

Around the conference room table were a dozen or so hedge- fund managers and other Wall Street executives — at least five of them alumni of Goldman Sachs Group Inc. (GS), of which Paulson was chief executive officer and chairman from 1999 to 2006. In addition to Eton Park founder Eric Mindich, they included such boldface names as Lone Pine Capital LLC founder Stephen Mandel, Dinakar Singh of TPG-Axon Capital Management LP and Daniel Och of Och-Ziff Capital Management Group LLC.

After a perfunctory discussion of the market turmoil, the fund manager says, the discussion turned to Fannie Mae and Freddie Mac. Paulson said he had erred by not punishing Bear Stearns shareholders more severely. The secretary, then 62, went on to describe a possible scenario for placing Fannie and Freddie into ‘conservatorship’ — a government seizure designed to allow the firms to continue operations despite heavy losses in the mortgage markets.

Paulson explained that under this scenario, the common stock of the two government-sponsored enterprises, or GSEs, would be effectively wiped out. So too would the various classes of preferred stock, he said.

Less than two months later, both Fannie Mae and Freddie Mac went into conservatorship– they were seized by the government– under the new Federal Housing Finance Agency (FHFA). Following the federal takeover, both companies’ stocks plunged below $1/share, down from $14.13 for Fannie Mae and $8.75 for Freddie Mac on the day of the Eton Park meeting. The FHFA estimated the cost to taxpayers for rescuing the two GSEs at $124 billion through 2014.

It is important to stress that there is no evidence that anyone present at that meeting profited from the nonpublic market information shared by Paulson. But if this case doesn’t scream crony capitalism, I don’t know what would.

“You just never ever do that as a government regulator– transmit nonpublic market information to market participants,” William Black, an economics and law professor at the University of Missouri- Kansas City told Bloomberg Businessweek. “There were no legitimate reasons for those disclosures,” the former general counsel at Federal Home Loan Bank of San Francisco added.

This revelation begs the question of how many unwitting investors were bamboozled into buying Fannie and Freddie shares after hedge fund managers warned by Paulson of coming disaster.

Still, many legal experts concur that Paulson did nothing illegal. “I don’t think a government person is liable,” Phillip Kaplan, a litigation partner at Manatt Phelps & Phillips LLP told Bloomberg Businessweek. “He didn’t profit from the information or trade on it.”

“You can’t prosecute them for insider trading if they didn’t trade the shares,” concurred Adam Zagorin at the Project on Government Oversight. “You may not be able to even reprimand them. What the hell are the rules?” he told Bloomberg Businessweek. 

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