Hank Paulson, U.S. Treasury Secretary

By Maria Bartiromo

Treasury Secretary Henry "Hank" Paulson Jr. seems to be everywhere these days. He was front and center when the third week in October began with a financial bang as a consortium of banks, led by Citigroup (C ) and supported by Treasury, cobbled together a plan to address troubled mortgage-related assets in so-called structured investment vehicles (SIVs) and inject more liquidity into the credit markets. Then on Oct. 16 the former Goldman Sachs (GS ) chief delivered a tough address at Georgetown University in which he said the housing slump has turned out to be worse than anticipated and called for reforms across the mortgage industry. And on Oct. 19, Paulson was scheduled to host a meeting of the G-7 finance ministers and central bank governors. I talked with Paulson shortly after his Georgetown speech.

MARIA BARTIROMO:

What do you hope to accomplish with the SIV superfund?

HANK PAULSON:

I'd like to begin by saying we're proceeding on parallel tracks. In the short term, we're looking to minimize the impact of the housing downturn on the economy and to work through the broader issues that we see in the capital markets. In the medium term, we're going to need to address policy issues to prevent some of these excesses from happening again.

Let me go to the short term and start with the SIVs. As I've said repeatedly, it's going to take a while to work through some of the liquidity issues as certain assets are being repriced. One market where there continue to be significant liquidity issues is in asset-backed paper. The vast majority of the asset-backed paper in the structured investment vehicles are high quality. But as credit issues emerged on a portion of those securities, a cloud spread over the larger market. Now, it's going to take time for liquidity to return to that market because the complexity of these securities makes it more difficult for investors to gain an understanding of and have confidence in even the highest-quality asset-backed paper.

But the [superfund] will purchase only the highest-quality securities from the SIVs to facilitate this return of liquidity. The banks and investors will be on the board [of the fund]. And--this is critical--the proposed structure is not designed to address assets that have deteriorated in value because of credit impairment. It is designed to help accelerate a necessary market transition and to speed up the return of liquidity.

One fixed-income investor I spoke with says the problem for investors is that off-balance-sheet vehicles, like the SIVs, still find their way in a crisis onto balance sheets, impairing the banks. Are there sufficient barriers--regulatory, accounting, and otherwise--to prevent the movement of off-balance-sheet items onto the banks' books?

The issue that you just raised is one of the broader issues that we at the President's Working Group--the Fed, the Commodity Futures Trading Commission, and the Securities & Exchange Commission--are looking at, which is to say, what went wrong here and how can we make policy changes to reduce the likelihood that we'll have some of these problems in the future? So there will be a focus on transparency in accounting as it relates to SIVs and the off-balance-sheet liabilities of regulated financial institutions. There will be a focus on risk-management practices, particularly as they relate to liquidity of some of these instruments. And there will be work related to the rating agencies...and the transparency of the processes and potential conflicts of interest.

Last night at the New York Economic Club, Fed Chairman Ben Bernanke said this: "We have a situation today where... subprime mortgages or even prime, jumbo mortgages are not trading actively in a secondary market, and therefore it's very difficult to know what the appropriate price is when evaluating the assets of a special structured investment vehicle or even of a bank or an investment bank." What are possible solutions to the problem of how to value risk?

I can't say this strongly enough--with this AAA-rated paper, the highest-rated paper, most of the issues we're dealing with here are not credit issues, O.K.? Most of them are liquidity issues and...the mortgages that are backing up that paper are high-quality mortgages.

But who's going to ultimately buy this paper? Maybe putting those assets into this superfund gets us a clearer value, but where do they go next?

Just remember, Maria, a key to this is that sitting on the board and working with the banks are the ultimate investors. High-quality investors. So they're going to be there. They're going to see the assets that are going in. And so again, the idea is that, as part of speeding up the transition to liquidity, there will be an agreement on the part of not only the banks but also the investors on the quality of the assets. This will hopefully give confidence to the investors.

You said today that housing was the biggest threat to the economy. And you just came out with this SIV plan. Some people might say: "Look, now it's evident that Treasury is more worried about what has happened than we initially thought." Is this plan a sign that there are more problems ahead in the credit markets?

We've been very consistent in saying it's going to take a while to work through these issues, that certain of the asset classes--and certain of the markets--are going to return to normal before others. In my speech today, I said, yes, the housing market and some of the issues in the mortgage market are the biggest risk to our economy. But I also put it in context and said that this correction is happening against the backdrop of a strong global economy and a healthy U.S. economy, and I believe we will continue to see growth in the U.S. And so it was very much by coincidence that this SIV [plan], which we've been working on for some time with the private sector, happened to be announced around the time I made a speech on what was going on in the mortgage market and emphasized that we also have a short-term focus--that is, to help struggling homeowners maintain their homes and minimize, where appropriate, the impact of this housing downturn on the economy.

You say you've been working with the private sector for some time on this SIV plan. But some critics suggest that this plan was rushed out by the Administration without completely thinking through the consequences.

All I can say is we started this around Labor Day, but it came out of discussions that had been taking place for some time in the private sector. It sure is not my impression that it has been rushed. I don't want to make more of this than it is. I'm not saying that this is going to make all the problems go away. This is nothing more or less than a constructive initiative. We helped bring people together because investors and banks had expressed an interest in working together to speed up what is going to be a lengthy transition.

Yesterday Alan Greenspan told me he thinks we're going to see continued fallout in the financial markets and the economy from the housing slowdown into the fourth quarter and the first quarter. Do you agree?

I think I've said very clearly that not only is [the housing slump] the biggest risk, but it's lasting longer than a number of economists thought [who were] looking at the data late last year, and it's going to extract a penalty from our growth.

Maria Bartiromo is the anchor of CNBC's Closing Bell.

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