Paulson’s Balancing Act: Step In, but Stand Back

By: Wall Street Journal

October 15, 2007

When Henry Paulson was named Treasury Secretary last year, the former head of Goldman Sachs Group Inc. was seen as an ally of Wall Street, someone who could navigate a financial crisis.

Now, with Treasury brokering a $100 billion effort by Wall Street banks to fix a troubled corner of the debt markets, Mr. Paulson is showing himself to be such an ally — up to a point.

Mr. Paulson’s desire to involve Treasury in a private-sector problem stems from his view banks could otherwise be forced to dump billions of dollars in mortgage-backed securities and other assets onto the market, setting off a ripple effect that could exacerbate the credit crunch and harm the broader economy. Mr. Paulson is eager to avoid that and to find a way to facilitate an “orderly” disposition of assets, a person familiar with his thinking said.

Treasury officials, aware that they could be criticized for rescuing banks from their bad bets, view their role as facilitating a discussion between competitors unlikely to come together on their own, said the person familiar with the matter. They made it clear to market participants that no government financing was on the table: This was to be a strictly private-sector solution.

The plan under discussion would provide a way for banks to pool and make more secure billions of dollars in short-term debt, backed by shaky subprime mortgages, that they are having trouble selling.

Still, Treasury’s involvement is prompting criticism from those who say the government is rewarding banks for risky behavior by helping them avoid a huge financial hit. That, critics say, encourages similar behavior in the future.

“There’s at least a question as to whether the organization of a large group of banks into a large consortium is the most effective way to change the practices of banks going forward,” said Dan Tarullo, an economic adviser to former President Clinton and now a professor at Georgetown Law School.

The government has stepped in before, most notably with the 1998 rescue of Long-Term Capital Management, a huge hedge fund that ran into trouble. In that case, negotiations were led not by Treasury but by the Federal Reserve of New York, which helped persuade market participants to prop up the fund. Government money wasn’t involved in the bailout.

Mr. Tarullo and others say the current situation is different. While the bailout of LTCM was a one-shot deal, the banks involved in the discussions this time will face continuing questions relating to how they manage risk and liquidity.

John Makin, a visiting scholar at the conservative American Enterprise Institute and a principal at hedge fund Caxton Associates LLC, put it more succinctly: Treasury’s involvement “stinks,” he says, in part because of Mr. Paulson’s close ties to Wall Street. Mr. Paulson and his domestic finance adviser, Robert Steel, are both former Goldman executives.

Mr. Paulson’s behind-the-scenes efforts suggest a willingness to use the government’s power to help resolve a situation that he and other Treasury officials feared could spiral out of control. In his public statements, he has said that the U.S. economy is able to handle the financial-market volatility and that the markets are simply engaging in a “repricing” of risk.

The surprising Treasury-orchestrated effort got its start this summer. Mr. Paulson and other top officials at the department were concerned about a type of short-term financing emerging as a particular source of distress in the financial markets.

In conversations with market participants, it was becoming increasingly clear to Treasury that the market for asset-backed commercial paper — a popular funding instrument with exposure to subprime mortgages and other home loans — was troubled. The stress was hurting huge funds affiliated with Wall Street banks, which were finding it difficult to sell commercial paper in the wake of the mortgage meltdown.

By mid-September, Mr. Paulson decided it was time to act. In a rare move, Treasury convened a Sunday meeting of bankers and other market participants on Sept. 16, with the goal of determining whether there were “market-based solutions that could help reduce the possibility of a disorderly solution in the marketplace,” according to a person who attended the meeting.

Those meetings, which have continued throughout September and October, provided the framework to develop a “superconduit,” a fund backed by some of the world’s biggest banks that would issue short-term debt and serve as a buyer of assets currently held by structured investment vehicles, of SIVs, affiliated with the participating banks.

SIVs are independent of the banks that create them and issue their own short-term debt, including asset-backed commercial paper.

The decision to develop a conduit came together during that Sept. 16 meeting. For several hours, bankers from New York, dressed in casual attire, and Treasury officials, donning suits, sat in a large conference room at Treasury, hashing over market conditions. The meeting was kicked off by Mr. Steel and Anthony Ryan, Treasury’s assistant secretary for financial markets. Before going to Treasury, Mr. Ryan was a partner at Grantham, Mayo, Van Otterloo & Co., a Boston investment firm.

The conversation quickly zeroed in on the credit markets and the market for asset-backed commercial paper. Mr. Ryan asked the group how they saw that marketplace evolving, and a consensus view soon emerged: An “unorderly unwind” in the course of the next year would be damaging to the financial markets.

From there, the group talked about ways to avoid that scenario, and, in a series of phone calls and meetings over the past three weeks, settled on the idea of a conduit that would be backed by the big banks. The goal is to reassure investors and make them more willing to buy its short-term debt.

Write to Deborah Solomon at

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