At a mid-2008 meeting with a dozen or so hedge-fund managers, Treasury Secretary Henry Paulson delivered information about Fannie Mae and Freddie Mac's fate that was different from his public message, according to a fund manager who attended. The Wall Street executives were capable of profiting from that disclosure.
Treasury Secretary Henry Paulson stepped off the elevator into the Manhattan offices of hedge fund Eton Park Capital Management. It was July 21, 2008, and market fears were mounting. Four months earlier, Bear Stearns had sold itself for just $10 a share to JPMorgan Chase.
Now, amid tumbling home prices and near-record foreclosures, attention was focused on a new source of contagion: Fannie Mae and Freddie Mac, which together had more than $5 trillion in mortgage-backed securities and other debt outstanding.
Paulson had been pushing a plan in Congress to open lines of credit to the two struggling firms and to grant authority for the Treasury Department to buy equity in them. Yet he had testified at a Senate hearing a few days earlier that giving the government new power to intervene made actual intervention improbable.
"If you have a bazooka, and people know you have it, you're not likely to take it out," he said.
On the morning of July 21, before the Eton Park meeting, Paulson had spoken to New York Times reporters and editors, according to his Treasury Department schedule. A Times article the next day said the Federal Reserve and the Office of the Comptroller of the Currency were inspecting Fannie and Freddie's books and cited Paulson as saying he expected their examination would give a signal of confidence to the markets.
At the Eton Park meeting, he sent a different message, according to a fund manager who attended. He delivered that information to a group of men capable of profiting from any disclosure.
Around the table were a dozen or so hedge-fund managers and other Wall Street executives — at least five of them alumni of Goldman Sachs, of which Paulson was chief executive and chairman from 1999 to 2006.
In addition to Eton Park founder Eric Mindich, they included such boldface names as Lone Pine Capital founder Stephen Mandel, Dinakar Singh of TPG-Axon Capital Management, and Daniel Och of Och-Ziff Capital Management Group.
After a perfunctory discussion of the market turmoil, the fund manager says, the discussion turned to Fannie Mae and Freddie Mac. Paulson described 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 would the various classes of preferred stock, he said.
The fund manager says he was shocked Paulson would furnish such specific information — to his mind, leaving little doubt that the Treasury Department would carry out the plan. The managers at the meeting were thus given a choice opportunity to trade on that information.
There's no evidence they did so after the meeting; tracking firm-specific short stock sales isn't possible using public documents. And law professors say Paulson himself broke no law by disclosing what amounted to inside information.
At the time, rumors about Fannie and Freddie were tearing through the markets.
The mandate of the government chartered firms is to buy mortgages from banks and repackage them into securities either for their own portfolios or to sell to others. The banks can then use the proceeds from those transactions to write new mortgages.
By mid-2008, delinquencies and foreclosures were soaring. In the first six months of 2008, the GSEs racked up combined net losses of $5.46 billion as they slashed dividends and marked down the values of their huge inventories of mortgage-backed securities.
On Wall Street, confusion reigned. UBS analyst Eric Wasserstrom on July 10 cut his share price target on Freddie to $10 from $28 a share. The next day, Citigroup analyst Bradley Ball reiterated a "buy" recommendation on the two GSEs.
At the time Paulson addressed the fund managers, the GSEs' shares were rallying, with Fannie Mae's nearly doubling in four days.
William Black, associate professor of economics and law at the University of Missouri-Kansas City, can't understand why Paulson felt impelled to share the Treasury Department's plan with the fund managers.
"You just never ever do that as a government regulator — transmit nonpublic market information to market participants," says Black, a former general counsel at the Federal Home Loan Bank of San Francisco. "There were no legitimate reasons for those disclosures."
Janet Tavakoli, founder of Chicago-based financial consulting firm Tavakoli Structured Finance, says the meeting fits a pattern.
"What is this but crony capitalism?" she says. "Most people have had their fill of it."
The fund manager who described the meeting left after coffee and called his lawyer. The attorney's quick conclusion: Paulson's talk was what the Securities and Exchange Commission would label material nonpublic information, and his client should immediately stop trading the shares of Fannie and Freddie.
Seven weeks later, the boards of the two firms voted to go into conservatorship under the newly created Federal Housing Finance Agency. The takeover was effective Sept. 6, a Saturday, and the companies' stock prices dropped below $1 the following Monday, from $14.13 for Fannie Mae and $8.75 for Freddie Mac on the day of the meeting.
Various classes of preferred shares lost upward of 85 percent of their value.
Paulson, now a distinguished senior fellow at the University of Chicago, declined to comment through a spokeswoman. The financial executives known to have attended the meeting also declined to comment.
A spokesman for one, GSO Capital Partners co-founder Bennett Goodman, said the firm's owner, Blackstone Group, doesn't believe market-sensitive information was discussed.
Richard Painter, a law professor at the University of Minnesota, says Paulson handed hedge-fund managers the kind of information they seek every day.
"There's a lot of government information out there, and the hedge funds are trying to get it," Painter says. "It's a huge problem that has to be addressed."