Paulson's Change in Rescue Tactics

Treasury Secretary Henry M. Paulson Jr. eventually decided to invest directly in banks.
Treasury Secretary Henry M. Paulson Jr. eventually decided to invest directly in banks. (By Dominic Bracco Ii -- The Washington Post)
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By Neil Irwin and David Cho
Washington Post Staff Writers
Wednesday, October 15, 2008

Even as President Bush signed the $700 billion rescue plan for the financial system two Fridays ago, Treasury Secretary Henry M. Paulson Jr. was beginning to realize that the way he had planned to spend the money might not fix the meltdown in global markets.

Treasury officials were probing deeper into the books of the nation's banks and concluding that there were so many troubled assets that simply using government cash to buy them up -- the strategy Paulson had pitched -- wouldn't be enough to jump-start the markets. The troubled bank Wachovia alone had $312 billion in such assets.

At the same time, Treasury officials said they saw that global markets, which, rather than cheering the new government action, were becoming unglued. Already strained credit markets seized up, and the U.S. stock market was in the early stages of what would be an eight-day, 23 percent crash.

"As the markets deteriorated and as you looked at what was happening in this country and globally and looked at how frozen the markets were, it was clear that we needed to use a different tool, an additional tool," Paulson said in an interview yesterday.

Paulson and his colleagues turned their attention to a different approach: making investments in banks. That strategy, which many independent economists had preferred, was also authorized under the new law. Federal Reserve Chairman Ben S. Bernanke had privately urged that approach for weeks, but he vigorously endorsed Paulson's rescue package in part because he knew it left Paulson enough flexibility to change direction.

Some regulators argued yesterday that faster action to inject capital into banks, combined with the program announced this week to guarantee bank lending and many large deposits, could have prevented some of the chaos in the global financial markets last week. Speed could have even saved Wachovia, which is being bought at a bargain-basement price by Wells Fargo, top regulators said yesterday.

But during the debate over the rescue bill, Paulson told lawmakers he was reluctant to inject capital into banks in part because direct investments smacked of big-government nationalization. Aside from his free-market inclinations, emphasizing that option could have led some Republicans to vote against the bill.

Moreover, if he had called attention to the provisions in the bill that made cash injections an option, stockholders in banks could have concluded that the government was about to wipe them out, as it had investors in mortgage firms Fannie Mae and Freddie Mac and insurance giant American International Group, driving stock prices down and making the need for a bailout all the more urgent.

And he wasn't sure cash injections would work.

"There were some that said we should just go and stick capital in the banks, put preferred stocks, stick capital in the banks. And that's what you do when you have failures. You know, that's what happened in Japan," Paulson told the Senate Banking Committee when it was debating the rescue package in late September. "The right way to do this is not going around and using guarantees or injecting capital, and there's been various proposals to do that, but to use market mechanisms."

Those reservations evaporated last week as the financial system melted down. With initial bailout dollars capped at $250 billion and $700 billion in total, Paulson concluded that the most cost-effective way to get banks lending again would be to take advantage of the multiplier effect of expanding their capital bases.

If the government makes a $10 billion capital investment in a bank, that bank would be entitled to increase its lending by $100 billion or more.

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