Paulson’s plan still needs some work

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Hank Paulson, the US Treasury secretary, compared his powers over Freddie Mac and Fannie Mae to a bazooka. His new plan to buy up mortgage-backed securities is nothing short of a B-52 bomber. He will need to make some modifications to it before it flies, but Mr Paulson should also seek an even bigger weapon – a plan for the public recapitalisation of US banks.

As the value of mortgage-backed securities has fallen, some institutions find themselves with too little capital to support lending. Some are also unable to raise the money they need to finance the securities. By selling assets, to raise money, they have depressed prices further. This has weakened balance sheets, forcing them to dump yet more.

Mr Paulson’s plan is to buy up $700bn of these securities, to put a floor under the price and end this vicious spiral. It has deep inherent flaws. A central feature of the crisis is that no one knows what these assets are really worth: the Treasury has no greater insight than private investors. If the Treasury pays too little, it may well fail to solve the crisis. If it pays too much, it will inflict huge losses on taxpayers, for the benefit of a reckless and incompetent financial sector. Indeed, such a scheme inevitably directs most help at the most reckless banks.

Yet there are also avoidable mistakes. The current draft legislation would set up a huge fund answerable to the Treasury secretary. Any scheme should, instead, be run by an independent board – led by someone of the stature of Paul Volcker, former Federal Reserve chairman – and guided by a tight remit.

Bailing out Wall Street while Main Street is hit by foreclosures would be politically unacceptable, for good reasons. A package to help homeowners and small businesses is a political necessity. It is also a reasonable request, once such government bail-outs are in the offing. But these objectives should be met elsewhere. The new institution should focus on the financial crisis.

Such a body is, however, only a part of the solution. Even if the prices for the securities stabilised, some banks would remain undercapitalised. It may prove necessary for the authorities to be able to deleverage institutions directly, by injecting new capital, perhaps as preference shares, or by turning debt into equity on a large scale.

If the real problem is that banks are insolvent, Mr Paulson’s B-52 may well prove to have been an expensive and ineffective diversion. In any case, the US authorities need a nuclear option for recapitalising the financial system. What is more, they are likely to need such an alternative option quite soon.

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