Paulson stakes his legacy on subprime bailout

It is impossible not to have an opinion about Henry Paulson. Some see laudable bipartisanship in Paulson’s approach to problem solving and feel he’ll go down as a good, if not great, Treasury secretary, destined to sit next to Robert Rubin in the Mount Olympus of Economics. Others, especially conservatives, see a man of small accomplishment with limited devotion to bedrock Republican free-market principles.

Who will the history books side with? Increasingly, it is becoming clear that Paulson, who has many small victories, has made one huge gamble upon which he has wagered his historical legacy: intervening in the debt markets.

He may have come to Washington with the idea that he would make real progress on our nation’s most challenging problems, but the DC reality disabused him of that relatively quickly. Paulson, 61, hasn’t brokered a deal on overhauling the Social Security or tax systems , nor has he significantly altered the US economic relationship with China.

Yet he has done something almost as good: quietly setting the stage for myriad future reforms , organising the staff and outside consultants to outline plans that will provide other Treasury secretaries with ample ammunition to make changes.

From the beginning of his term in July 2006, one of Paulson’s primary concerns has been the promotion of market competitiveness. He has taken a series of steps to revise the US regulatory system, most recently convening a 21-person panel that includes former Federal Reserve chairman Paul Volcker and former Securities and Exchange Commission chairman Arthur Levitt to scrutinise the accounting industry.

In July, Paulson assembled a group of economists, tax experts and business executives to discuss the corporate tax rate, and the consequences of international tax competition on the US economy. Speculation abounds that corporate tax cuts are on the way. Paulson has been the consummate organisation man as well.

He successfully lobbied Congress for the creation of a new assistant secretary position in charge of overseeing the process of examining foreign acquisitions of US corporations. Such an organisational change is a heavy lift but will have lasting dividends.

Paulson’s most memorable action will clearly be his foray into the debt markets. It is there that he has done the most to inflame his critics. Investors spent the summer waiting for the other shoe to drop as the subprime-mortgage market collapsed. The biggest fear has been that losses on mortgagebacked securities would undermine banks’ ability to raise funds.

These fears were realised in past weeks , as spreads on commercial paper skyrocketed, and genuine concern arose that banks would have to hold a “fire sale” of mortgage-backed assets as short-term money dried up. Paulson stepped up to the plate to address those fears. While his actions have been complex, a simple example can help illustrate both the problem and his solution.

Consider a bank that lends $200,000 to a somewhat questionable character (let’s call him ‘Kevin’ ) for 30 years to cover his mortgage, and raises the money itself by borrowing funds for three months. After three months, the bank plans to find another $200,000 to pay back the original loan.

But suppose Kevin’s prospects decline enough that there’s a serious question whether he will be able to repay the money. Then it might be that nobody will want to lend the bank the $200,000. In that case, the bank might have to try to sell Kevin’s mortgage to someone else. But since the mortgage isn’t worth much, the bank will take a big loss.

In response, Paulson has organised a ‘superconduit’ , which is essentially a group of banks — Citigroup , Bank of America and JPMorgan Chase & Co — that have agreed to create an entity to purchase mortgage-backed securities.

The entity will buy only the good stuff, and, hopefully, will be able to raise money from wary investors better than any individual bank could. If successful, Paulson’s plan will help the banks avoid having to hold a fire sale of such assets, since the new entity will be able to solve the short-term financing problem.

Critics fear no good can come of such meddling in markets. Banks such as Citigroup made stupid bets, the argument goes, and should be forced to pay the piper.

If the Treasury steps up to organise something that smells like a bailout, then nothing has been done to discourage the banks from making even stupider bets in the future. And the appearances of the bailout are less than ideal. The chairman of Citigroup’s executive committee, after all, is Paulson’s former Goldman Sachs colleague Rubin.

Would Treasury come to the rescue if some other less-connected financial institution were imperilled? All this will be moot, of course, if the superconduit works and debt markets calm down. If that occurs, then Paulson will go down as a great Treasury secretary. If the deal falls apart or proves to be too little too late, then Paulson will find out what it feels like to be a scapegoat in Washington.