The Trouble with Paulson's Bailout

The Treasury Secretary's $700 billion initial plan fails to give financial firms the incentive to reform and risks rewarding those who made the biggest mistakes

Is this really the best way to spend $700 billion? Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are pressing Congress to enact without delay their hugely expensive plan to vacuum up devalued mortgage-backed securities and other toxic assets. If the plan isn't passed, Bernanke warned the Senate on Sept. 23, "the economy will just not be able to recover in a normal, healthy way."

But there's growing concern that the plan offers a small bang for big bucks. Hard-won experience in the U.S. dating as far back as The Great Depression—and in other countries as diverse as Japan, South Korea, and Mexico—shows that the kind of approach that Paulson and Bernanke are pushing could fail to get the U.S. economy moving again. That is a scary prospect. Because if all $700 billion buys is a bunch of weak financial institutions that have enough money to survive but not thrive, there will be a wave of anger from the taxpaying public that will make today's mounting restiveness seem mild.

Forget the heated debate over whether failed bankers should be forced to disgorge their bonuses. That's chump change. The real problem with the plan, many economists argue, is that it attempts to be something that's a contradiction in terms: a free-market bailout. By scooping up securities with no strings attached, it fails to give financial firms the right incentives to get healthy. "It may not refloat the system," says Raghuram G. Rajan, a former chief economist of the International Monetary Fund who is a professor at the University of Chicago Graduate School of Business. Adds Rajan: "We should be putting more capital into the well-capitalized entities, not the people who made the biggest mistakes."

Strictly Voluntary

Given how rapidly circumstances are changing, the plan that Paulson and Bernanke pushed on Capitol Hill this week may not be the last word. Even if the plan passes more or less intact, the next Congress and Administration could change or even reverse it if economic and financial conditions fail to improve. Indeed, a new study by the International Monetary Fund finds many nations battling banking crises continuously revise their plans as one solution after another fails.

For now, Paulson and Bernanke seem to be trying hard to avoid any more huge takeovers after having swallowed Fannie Mae (FNM), Freddie Mac (FRE), and American International Group (AIG). Their rescue plan is strictly voluntary. The owners of the securities will choose whether or not they want to sell, with no coercion involved. This fits Paulson's long background as a creature of Wall Street—he's a former CEO of Goldman Sachs (GS)—which means he retains a strong aversion to exerting direct government control over financial markets.

The risk, though, of a free-market bailout is that the money will be spent inefficiently. The companies that get the biggest benefits will be the ones that accumulated the biggest globs of unwanted securities. As a result, the government could be propping up zombie firms that wouldn't survive under ordinary circumstances. These companies are unlikely to have enough funds to lend effectively. Instead, they will focus all their energy on simply surviving, while sucking up funds that would be better used elsewhere.

Paulson and Bernanke have been deliberately vague about how much the government would pay for securities. If it tries to pay as little as possible, most banks won't participate. But if it pays above-market prices, "that would be a massive transfer from the taxpayers to the banks," notes Charles Wyplosz, an economist at the Graduate Institute of International & Development Studies in Geneva.

In the best-case scenario for Paulson's plan, there is real, unrecognized value in the mortgage-backed securities sitting on financial institutions' balance sheets. He hopes that the government, by serving as a committed buyer, will be able to jump-start trading in those securities. Once it's clear to the marketplace that the disdained securities have considerable value, Paulson hopes, the uncertainty over financial institutions' net worth will be dispelled and they will be able to raise capital privately and resume normal lending.

If instead the Treasury purchase plan reveals that the securities really are as worthless as many fear, Paulson and Bernanke will need an urgent Plan B (or are we up to Plan X by now?). Super-low sales prices will force financial institutions to acknowledge they have been carrying assets on their books for more than they're worth. They'll have to write them down, which could leave many undercapitalized. At that point, the government will be forced to take them over and then close them or merge them into healthier institutions.

Public Ownership

What are the alternatives to the Paulson plan? One is for the government to focus less on buying bad assets and instead recapitalize the financial system by buying substantial stakes in selected companies. That amounts to picking winners and losers, a hated concept in free-market circles. But it would save money and give taxpayers some of the gains when banks eventually recover. In his Sept. 23 testimony, Bernanke resisted the idea of grabbing equity in companies that sell assets, arguing that this "punitive" measure might discourage them from participating. Daniel Alpert, a managing director at boutique investment bank Westwood Capital, says that's like worrying that a drowning man will spurn a lifeline.

Temporary public ownership worked in Sweden, where it was a key part of the nation's rapid recovery from a banking crisis in the early 1990s. "If you're taking all of the downside, you need to have some upside. That is what the man on the street would say," says Lars H. Thunell, who was named to run a Swedish government-backed company called Securum, which took over troubled companies and assets, and who is now CEO of the World Bank's International Finance Corp. in Washington. Bo Lundgren, head of the Swedish National Debt Office, says he has met with Fed officials twice this year to discuss the Swedish strategy. He said that for an intervention to work, it's not enough just to put in money. The government, he says, must "have complete control over what's done with the assets."

Other countries have eased banking crises by buying shares to directly inject capital into their banks—rather than just scarfing up bad assets. The U.S. itself did so under the auspices of the Reconstruction Finance Corp. in the early 1930s. The new IMF survey of 42 systemic banking crises from 1970 to 2007, which was published in early September, found that government purchases of assets (as in the Paulson plan) "appear largely ineffective." In a Sept. 23 interview, Luc Laeven, one of its authors, said he found "it's often more effective to directly inject capital into the institutions that you want to save." (Although published by the IMF, the paper does not represent the official position of the agency.)

"A Sense of Fairness"

Even aside from efficiency grounds, there's a fairness argument for not showering money indiscriminately on firms that got in trouble. Jeffrey Sachs, director of the Earth Institute at Columbia University, advised Russia on its transition from Communism before resigning in disgust over the rise of the oligarchs. Speaking from that experience, Sachs says: "There has to be a sense of fairness about anything that's done. Right now there is a profound and justifiable skepticism about the Treasury Dept. It seems like it's Wall Street bailing out Wall Street."

If history is any guide, it's likely the Paulson plan will gradually evolve into one that minimizes the cost to taxpayers by giving government a strong hand to rebuild the healthier firms and kill or merge the weak ones. Government is likely to grow more powerful in other respects as well. To counteract the deflationary impact of massive debt repayment, the government is likely to step up spending on things like public works projects, even though that will swell the federal budget deficit. Japan's massive spending on marginally useful roads and bridges is often ridiculed, but it's what kept the nation's unemployment rate low and prevented economic output from ever falling below its 1990 level, when the stock market peaked, argues Richard Koo, chief economist of Nomura Research Institute. Says Koo: "If you don't put this [government spending] in, the deficit will be larger and larger because the economy will be collapsing."

One often-mentioned option for the U.S. is a "Green Deal"—a modern-day successor to the employment and public works programs of the Depression-era New Deal, which would create a mix of high- and low-skilled jobs. Massachusetts Institute of Technology President Susan Hockfield isn't calling for a jobs program, but says that achieving an "energy revolution" would help the economy at the same time it eased global warming and reduced dependence on imported oil.

How things shape up will depend in part, of course, on whether Republican John McCain or Democrat Barack Obama wins the White House. But in coping with a financial crisis of epic proportions, either Administration is likely to be forced into a more interventionist stance than the U.S. has seen in years. Paulson's free-market bailout may seem in retrospect like the last gasp of a failed Wall Street culture.

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