Paulson Behind the Curve

By Sebastian Mallaby
Monday, December 10, 2007

Hank Paulson ranks among the Bush administration's many disappointments. When he left the top job at Goldman Sachs to take the helm at Treasury, Washington was abuzz: This man was a problem-solver; this man had clout; the president had practically begged him to accept the job, and Mr. Fix-It hadn't acquiesced just to warm a seat around the Cabinet table. But Washington can be a frustrating place. After 18 months, Paulson has made no serious impact on the issues that he cares about: entitlements, tax reform, China, trade, the environment.

Now Paulson's predicament is reversing itself. Having been prevented from acting on his chosen issues by Washington's constraints, Paulson is being forced by Washington to act on something he might rather leave alone -- the mess in the financial and real estate markets. He is being pressed into action partly because the mortgage meltdown threatens a recession and partly because the pain will be especially acute in election battleground states such as Florida and Ohio. At the end of his spell in government, Paulson's legacy will be determined by a question that he never sought to pose: When fate handed him an issue on which he was required to lead, did he lead constructively?

So far Paulson has lurched forward like a boy with his back to a fire hydrant. Until the summer, he favored letting the market sort itself out: People who couldn't afford their mortgages should "become renters," as he put it last week. Then the Treasury proposed helping a subset of these would-be renters by expanding the role of the Federal Housing Administration, which insures mortgages for poor families; so far, 35,000 homes have been refinanced under this initiative. Then, last week, Paulson brokered a deal with private mortgage lenders to help keep people in their homes. Today a Paulson-backed effort to restructure dud investments that are weighing down the banks is supposed to move into action.

It's not that Paulson's initial wariness of government solutions was wholly misguided. The political pressure to act reflects concern for homeowners. But as the blogger Tyler Cowen has written, there are better ways to target assistance to the deserving poor than by rescuing subprime borrowers. Given that they hold some responsibility for borrowing too much, subprime borrowers are not society's most unambiguously deserving group. And many of them are not poor, either.

Equally, the pressure to act comes partly from concern that the subprime mess is scaring investors away from whole classes of debt, with indirect effects on the economy. But if investor confidence is the problem, government meddling can backfire. The leading Democratic presidential candidates have proposed, variously, a moratorium on mortgage foreclosures, a freeze in loan rates and other measures to help homeowners at the expense of investors. This is hardly the best way to rebuild market confidence.

But while the pressure for government action is partially confused, it is partially legitimate. Market failures got us into this mess, and market failures could make the exit more painful than it need be. Paulson is coming around to this reality cautiously and grudgingly while the pressures around him are building at an altogether faster rate. Unless he gets out in front on this crisis, the fire hydrant will propel him forward willy-nilly.

Last week's deal with the mortgage industry illustrates Paulson's dilemma. It addresses a market failure: Left to their own devices, the service companies that collect mortgage payments are likely to kick people out of their homes even when doing so will cost investors money. This is partly because of a collective-action problem: One service company's decision to foreclose doesn't take account of the fact that this will depress the value of neighboring houses, triggering more defaults and losses. Then there is a legal perversion: Even if a service company recognizes that forgiving 10 percent of one mortgage will cost investors less than the expensive process of foreclosure, it may foreclose anyway for fear of investor lawsuits.

By sponsoring industry guidelines for identifying mortgage borrowers who deserve a break, Paulson aims to reduce the collective-action problem and create legal cover for leniency. Experts such as Douglas Elmendorf of the Brookings Institution regard Paulson's fix as theoretically elegant, but it is not going to be transformative even if it works as planned; Paulson himself concedes that it can only forestall a fraction of expected foreclosures. The same can be said for Paulson's initiative to restructure the dud investments at the banks. It is elegant but marginal.

The problem is that Washington in an election year is going to want more than action at the margins. Pretty soon the mortgage mess is going to create two camps. One will argue for more drastic intervention: a taxpayer bailout or an enforced cut in mortgage payments that socks it to the lenders. A second camp, worried about the perverse incentives created by bailouts and forgiveness, will call for a general fiscal stimulus instead: Last week Harvard's Martin Feldstein recommended that direction.

Paulson better hurry up and choose which of these options he is for -- or the choice may be made without him.

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