Paulson's Change in Rescue Tactics
Plans Revamped After Scope of Bad Assets Became Clear, Stocks Plunged

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.

But if the government were to buy $10 billion in troubled assets, it would free up only $10 billion for lending.

"The facts as I know them changed," Paulson said in the interview. "We got a bigger impact per taxpayer dollar with the equity injection so we went that route. . . . The philosophy has stayed the same, but the tools we employed changed."

That would come with trade-offs, though. Through asset purchases, the government has considerable power to control exactly which assets get bought and which don't. With injections of preferred stock, the government has no explicit authority to ensure that banks use the new capital to increase their lending to ordinary families and businesses. There is a risk they could become "zombie banks," technically solvent but unwilling to make new loans.

Government officials said they have been deeply worried about that risk and intend to use their regulatory power to lean on the banks to take advantage of their new capital by making new loans.

As Paulson and his colleagues last week gelled around the idea of taking ownership stakes in banks, they set about trying to figure out the details. Bernanke had long been a proponent of having the government match those investments made into banks by private investors, which would allow the market to fulfill its role in directing capital. But with the markets for private investments in banks essentially shut down, that idea was a non-starter.

The Treasury wanted to set terms that would make the investments desirable to participating banks. And it didn't want the government to end up with seats on the boards of directors or other situations that would allow government meddling in private business.

Their solution mirrored the investments that billionaire Warren E. Buffett's company recently made in Goldman Sachs and General Electric, using a vehicle called a perpetual preferred stock that functions as capital but doesn't give its owner any control over the companies.

On Sunday morning, a key meeting took place among Paulson and his Treasury co-workers, Bernanke and his colleagues from the Fed, Sheila C. Bair of the Federal Deposit Insurance Corp. and John C. Dugan of the Office of the Comptroller of the Currency. The officials concluded they had little choice but to proceed. They would make the announcement Tuesday morning, so they would have time to figure out a myriad of details and get nine of the banks most crucial to the U.S. financial system to agree to the plan.

At a 3:00 p.m. meeting Monday in the same conference room where the government leaders had come together a day earlier, Paulson laid out the plan to the banks' chief executives. Though technically voluntary, it was presented as fait accompli. As some of the executives raised objections, the meeting, with a dozen large egos crammed around one long table, became tense.

Bernanke, who had not said much, chimed in. "I don't really understand why there needs to be so much tension about this," he said. Bernanke told them the government investments would be good for chief executives, good for the banks, good for financial markets, good for credit markets and good for the real economy. That eased some tension.

Still, the executives had to go back to their boards of directors before acquiescing to the deal. All nine did so by 7 p.m. Monday.

The actions, including the new guarantees for bank deposits and borrowing, came too late to prevent a rout in global credit markets that market insiders predict will take time to heal. It came too late to help Wachovia. "With Wachovia, it definitely would have made a difference," said Bair of the FDIC.

Congressional leaders were pleased with Paulson's reversal.

"I think this is the right move in the right direction, and I applaud the secretary of the Treasury for taking this step," Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) told reporters yesterday. Had the original rescue plan not included the authority to make cash injections, he said, Congress would probably be back seeking it now.

House Minority Whip Roy Blunt (R-Mo.), the lead House GOP negotiator on the bailout package, also expressed support for the new Treasury initiative, suggesting that House Republicans supported taking stakes in the banks and firms as a way to provide immediate capital while also creating "an almost certain guarantee" that the government would recoup its expenditures.

Staff writers Paul Kane and Binyamin Appelbaum contributed to this report.