Henry Paulson's conflict of interest.

Commentary about business and finance.
June 6 2006 11:43 AM

The Goldman Rule

Should new Treasury Secretary Henry Paulson be forced to sell his $700 million stake in Goldman Sachs?

George Bush with Henry Paulson. Click image to expand.
George Bush with Henry Paulson

Henry Paulson, who was recently nominated to be the next treasury secretary, is facing a lot of tough choices. Should the former CEO of Goldman Sachs continue to promote environmental causes in an administration that loathes them? What should he say about the dollar? Should he buy a condo in Washington, or a mansion? Then there's the trickiest question of all: What should he do with the mountain of money he's earned at Goldman Sachs over the years?

Not since Nelson Rockefeller served as vice president during the Ford administration has a senior government official arrived in Washington with such a high net worth. Paulson owns some 4.58 million shares in Goldman Sachs (including restricted stock) worth about $700 million at today's price and surely has millions more in other instruments.

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Conflict-of-interest laws say senior government officials can't hold on to investments that could benefit from decisions they might make. Meeting this requirement is comparatively easy for an upper-middle-class secretary of agriculture. Sell your stock in Archer Daniels Midland and direct your financial adviser to avoid it and similar stocks. But for a plutocrat who is about to become secretary of treasury, it's a much more difficult call. He can't choose the default mode that worked so well for former Federal Reserve Chairman Alan Greenspan, who put his cash into government bonds. Treasury secretaries are forbidden from buying government debt—after all, they issue that debt. (The T-bill strategy worked out remarkably well for Greenspan, who saw his net worth rise every time he slashed rates.) And putting the money in the simplest form of investment—a dollar-denominated savings account—would be both a poor investment for Paulson and a potential conflict of interest. After all, treasury secretaries frequently discuss currency exchange rates.

The most likely scenario is that Paulson will sell his Goldman shares and place the money in a blind trust. That would be a smart move, and a profitable one, since he'd gain some tax benefits. When you sell assets to conform to government ethics requirements, the U.S. Office of Government Ethics issues a certificate of divestiture (it's summarized here) that lets you defer capital-gains taxes triggered by the transaction. That will likely save Paulson several million dollars in the next few years. And when your annual salary is falling from $35 million to $183,000, every penny counts. The blind trust would also give Paulson an excuse to dump all his Goldman shares at once and diversify, just as things are getting choppy—something he couldn't do if he stayed on the job.

Once he sells, Paulson—or whoever will manage his blind trust—will have a new problem. In order to qualify for the certificate of divestiture, the cash must be invested in a diversified fund, such as a stock mutual fund. But Paulson's portfolio is so large that it doesn't make sense to put it into a mutual fund, or even into a whole bunch of funds. A nest egg of this size should be broadly diversified—some real estate and a few hedge funds, a few private equity funds, commodities, stocks from all over the world, a private island or two. And of course, all of these have the potential to be affected by Paulson's actions while he is in office.

Given recent activities in Washington, the notion of suggesting that we make exceptions to ethics rules seems highly dangerous. But here's a bold idea: Maybe we should just let Paulson keep his shares. That would be the simplest and least costly thing to do—for him and for the government. The transparency provided by Goldman's daily trading would act as a great inhibitor to favoritism.

What's the worst thing that could happen if Paulson held on to his Goldman stock? It's possible that a government in which the treasury secretary had a gigantic stake in Goldman might recklessly cut marginal income taxes on the very rich so that he and his fellow executives could keep more of their bonuses. Or he might push to cut income taxes on capital gains and dividends so that Goldman employees and clients would pay fewer taxes. He could help enact legislation to reduce and ultimately eliminate the estate tax so Goldman's private banking clients would be able to pass on as much cash to their heirs as they want. Why, such an administration might run up massive deficits so that the bond desks of Wall Street firms like Goldman would have plenty of material to buy and sell! Oh, wait—the Bush administration has already done all that.

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