Wednesday, October 1, 2008

The lack of detail that helped scupper the Treasury bail-out

As Hank Paulson seeks to resubmit his action plan to save the US financial system, Euromoney considers whether he was ever the right man for the job, asks the questions that he desperately needs to answer, and analyses the mistakes he has made which mean, whether his bill is eventually passed or not, he has failed as Treasury secretary.

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Q: Why was the bail out plan as originally presented so desperately short on detail?

Paulson wanted Congress to grant him extraordinary power and unprecedented levels of public funds. It was clear that the devil of the plan would be in the detail – but the details were devilishly difficult to come by.

Paulson’s draft proposal ran to just six sides of paper. It promised financial stability for our time. One’s thoughts ran to another public figure of impeccable background and imposing stature, waving a piece of paper after having flown back from a crucial meeting in Munich, promising an end to all our worries – almost exactly 70 years earlier.

Watching Paulson and Bernanke fumble over the details of the plan in front of the Senate banking committee on September 22 and 23 was embarrassing. It’s hard to imagine that Paulson ever turned up to a key client meeting as chairman and chief executive of Goldman Sachs with so little detail to hand.

The brief – one-and-a-half page – initial announcement of the Paulson plan used the word “illiquid” six times to describe the problem mortgage assets it would seek to remove from the system. Their illiquidity is not the issue: rather, the problem is their declining value. The lack of any clarity on how to identify, value and price these securities was staggering.

Introducing any bail-out plan to a Congress and US public disgusted at the excesses and failures of Wall Street and the US banks was never going to be easy. Paulson made it harder for himself by trying to present it as a way to do two utterly irreconcilable things at once: removing illiquid troubled assets from the banking system through a programme large enough to have maximum impact and restore market confidence, and simultaneously protecting the taxpayer to the maximum extent possible.

One of his staff needs to remind secretary Paulson of the old saying that you cannot ride two horses with one arse.

The truth was in there – “the ultimate taxpayer protection will be the market stability provided as we remove the troubled assets from our financial system” – but partly concealed behind the talk of reverse auctions.

Reverse auctions are a mechanism for a bidder to acquire assets at the lowest possible price. That would make this a good financial deal for taxpayers, suggesting that the Treasury really could operate like a value-investing hedge fund intent on making a killing in distressed assets. Unfortunately the killing would be of the US financial system because the application of a reverse auction to US banks’ problem assets today would, by crystallizing losses at the market-clearing level and inviting markdowns on remaining positions, bankrupt many participants across the system overnight by realizing losses in excess of capital.

It was left to Bernanke to give voice to the idea that assets might be acquired at hold-to-maturity prices, that is, at or around the level many banks hold them on their balance sheets. This would make Tarp a bad financial deal for taxpayers and mark the Treasury hedge fund down as a very strange new type of value investor seeking to buy at way above the market-clearing level. It is an approach that would, however, have a more credible chance of achieving the side benefit of saving the US banking system.

Buying using reverse auctions or at hold-to-maturity levels are two very starkly contrasting alternatives. It is hard to see how they could possibly be used together as two variant mechanisms for achieving broadly similar results.

The fact that the bail-out plan, as described in the initial legislative proposal sent up from the Treasury, failed to make clear or even discuss the mechanism for buying in troubled assets, raises the most troubling questions about Paulson’s suitability to do the job.

The mechanism for buying in the assets is not some dreary detail, to be worked out by functionaries later. It is the plan.

Why Hank Paulson has failed as Treasury secretary

Q: If you know so much, why didn’t you see the crisis coming?

Q: Every time you’ve spent money, you’ve said it would solve the problem. What’s different this time?

Q: If you’re going to cook up a plan, why not make sure it isn’t half-baked?

Q: Surely as a former investment banker, let alone Treasury secretary, you could have told SEC chairman Cox how ridiculous his short-selling restrictions were?

Q: Why was the bail out plan as originally presented so desperately short on detail?

Q: Did you forget that the negotiations were about politics as much as they were about saving the banking system?

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The lack of detail that helped scupper the Treasury bail-out

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