What Paulson Should Have Said

I’ve criticized Treasury Secretary Paulson for poorly explaining and marketing his plan. Here’s the statement I believe he should have given before the Senate Banking Committee. I’ve also criticized the plan itself, but I’ll leave my suggestions for a better plan for another time.

Chairman Dodd, Senator Shelby, members of the committee, ladies and gentlemen:

I come before you today because the United States and the American people are facing three financial crises: a housing crisis as home prices continue to tumble; a mortgage crisis as defaults and foreclosures continue to rise; and a banking crisis as banks contract their lending in the wake of losses on mortgages and mortgage-related securities.

All three crises require the urgent attention of Congress and the Administration, and we are committed to working with you to address each of these crises. But while the housing and mortgage crises are both critically important, it is the banking crisis that now demands our immediate attention.

As mortgage defaults and foreclosures have increased, the values of the mortgages and mortgage-related assets held by banks have plummeted, and the attempt by the banks to shed these assets in the marketplace have resulted in further price declines. This downward spiral has depleted the capital positions of some banks to the point of insolvency. In some cases, the insolvent institutions have been allowed to fail, and in some instances they have been purchased by stronger institutions. But in either case, we’ve witnessed a loss to our nation’s financial infrastructure.

While the majority of financial institutions are not insolvent, many banks find that their capital positions no longer support the provision of new loans. As a result, credit has been contracting for corporations, small business, municipalities, and consumers.

No one can predict with certainty the eventual impact that this contraction will have on the economy and on the lives of the American people. But some very frightening scenarios have now become plausible.

If the commercial paper market were to freeze further, large corporations would be unable to meet their payroll obligations. Large retailers would be unable to hold inventory on their shelves. Airlines would be unable to purchase fuel ahead of peak periods. If bank lending were to contract further, small businesses would be unable to maintain working capital, forcing them out of business. New business creation would come to a standstill. Farmers would be unable to finance the purchase of seed and fertilizer.

Imagine the country with no paychecks, barren shelves, fallow fields, no air travel, and hundreds of thousands of small business failures. Unemployment would skyrocket. A deep recession would ensue. And some scenarios would be more accurately characterized by the word depression.

But in addressing this problem, we also have an opportunity. The current banking crisis is not the first our country has experienced, and we have learned valuable lessons from previous experience. In particular, Chairman Bernanke and I are proposing a good bank / bad bank approach to our current crisis, in which the troubled mortgage-related assets are placed in a government entity, leaving the private-sector banks with fewer problem assets and a real chance to recapitalize and to increase their lending activities to the levels required to support our economy.

I use the term opportunity to describe this proposal because the values of these assets have been driven to levels that appear very attractive based on realistic assessments regarding the likelihood of future repayments. Taxpayers have an opportunity to acquire these assets at prices that are very likely to produce handsome returns in the future.

The press has referred to these mortgage-related assets as being toxic, and you may be wondering why we propose that US taxpayers should make a tremendous investment in toxic assets. Simply put, we do not believe these assets are toxic at all. These assets are the IOUs of the American people. They may be sliced, diced, and repackaged, but in the end they are still the promised payments of the American people. As such, we strongly object to characterizing them as toxic.

It is true that many Americans are having difficulty in these troubled times making all their payments when they are due. As a result, some of these payments will arrive late, and some will not arrive at all. But the default assumptions consistent with the valuations of these troubled assets suggest that the nation will experience levels of default and recovery rates that are unprecedented.

If these securities are so attractive, why should we offer to buy them from the banks? To be clear, many banks are happy to hold these assets on their books, fully expecting the payments to be made and/or for the assets to recover much of the value lost in recent months. But in that case, the banks would be using their capital to support these assets rather than to support new lending.

Ladies and gentlemen, this is not a bailout for the banks. This is an opportunity for us to motivate the banks to lend new money to businesses and consumers rather than simply sitting on the loans they had made previously. The goal of our proposal is not to provide money to Wall Street but rather to enable credit for Main Street. Our banking system is the mechanism by which credit reaches businesses and consumers. If Wall Street is using its remaining capital to hold troubled mortgage assets on its books, it can’t use that capital to provide credit to Main Street. If we can motivate Wall Street to sell these troubled assets to a newly-created government entity, Wall Street can use its capital to provide credit to the business and consumer sectors, thereby supporting the economy.

In particular, we propose the American people invest seven hundred billion dollars to purchase assets backed by the promises of the American people. Specifically, in coming weeks the Treasury would hold fixed-rate tenders for banks to exchange mortgage-related assets for US Treasuries bills and notes. The rate of exchange would be based on mortgage models, using conservative but not unreasonable assumptions about the default and recovery rates for the assets underlying these securities. We anticipate that these prices would be somewhat greater than the values at which many banks currently have these assets on their books. In this case, banks could expect to make a small profit by participating in the program. And of course, even banks that did not participate in the program would enjoy mark-to-market gains in the values of assets they held. But then of course they would still have the assets on their books, and they would be unable to use their capital to make new loans.

On the other hand, we expect the transfer values for these securities to be significantly lower than their value assuming realistic rates of default and recovery, in which case the US taxpayer would enjoy a significant return on this investment, which would be returned to the Treasury general fund. If Congress saw fit, profits from this investment could be used to reduce future taxes or to fund future Social Security or Medicare obligations.

If we do nothing, the outcome is not certain, but the risks are clear. In short, we run the risk of severely curtailing economic activity, perhaps to an extent not seen since the Great Depression. But with this proposal, we have an opportunity to clear the channels by which credit reaches businesses and consumers, a prerequisite for a healthy economy. And we have an opportunity for the American people to invest in their own IOUs at prices that are likely to result in significant returns on this investment.

While I deeply regret our present circumstances, I am also encouraged that Treasury, the Federal Reserve, the Senate, and the House have an opportunity to take quick and decisive action to restore confidence, protect our financial infrastructure from further damage, and promote the provision of credit to businesses and consumers necessary for a healthy economy. I look forward to answering your questions about this proposal and to working with you in the coming days to ensure its timely and effective implementation.