Paulson Must Make Rescue Work After Bill Gives Him $700 Billion

By Scott Lanman and Christopher Stern

Sept. 29 (Bloomberg) -- Treasury Secretary Henry Paulson and congressional Democrats hammered out a consensus on spending up to $700 billion to rescue the financial industry. There isn't consensus on whether it would work.

Lawmakers reached agreement yesterday as House Republican leaders backed away from opposition to the proposal after it included plans to create insurance for mortgage-backed securities. The House and Senate are scheduled to vote on the bill early this week, although it wasn't clear last night that it has sufficient votes to pass the House.

Giving Treasury authority to buy so many distressed securities from lenders is without precedent, and it's unclear how the government will pay prices that strike a balance between protecting taxpayers and preventing more bank failures.

``This has a reasonable chance of pulling back from the brink and having some success, but it's far from certain that will be the case,'' said former Fed Governor Laurence Meyer, now vice chairman of consultant Macroeconomic Advisers LLC in Washington.

``The markets are going to love it because it's a massive subsidy of shareholders and unsecured creditors,'' said Nouriel Roubini, chairman of Roubini Global Economics and economics professor at New York University. ``But you're not resolving the two fundamental issues: You still have to recapitalize the banking system, and household debt is going to stay high.''

Immediate Cash

The bill gives Paulson $250 billion at the start to buy assets, increasing the amount to $350 billion upon ``written certification'' from the president that the secretary is ``exercising the authority'' to buy assets. The Treasury chief, or whoever succeeds him, may use the remaining $350 billion if Congress fails to reject a request for it within 15 days.

The proposed law lets Paulson buy assets ``at the lowest price that the Secretary determines to be consistent with the purposes of this Act.'' The bill doesn't require any specific method for the purchases beyond saying mechanisms such as auctions or reverse auctions should be used ``when appropriate.'' Treasury officials declined to discuss how the plan will be implemented.

Democratic and Republican leaders trust that Paulson can avert a collapse after Lehman Brothers Holdings Inc. filed for bankruptcy and the government was forced to take over American International Group Inc. Success hinges on whether he can help banks raise capital after $556 billion in writedowns and losses, and get credit flowing through the economy.

`Far Worse Pain'

``We have clearly seen a run of failures of financial institutions not like anything we've seen since the Great Depression,'' House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, told reporters yesterday. ``If we didn't do this, there would be far worse pain in the sense of the lending freezing up.''

``It's a fragile situation,'' Paulson said in an interview on CBS television's ``60 Minutes'' program broadcast yesterday. ``It's gotta do it, and we're going to make this work.''

The draft legislation was posted on the House Financial Services Committee's Web site yesterday. It includes a provision to give taxpayers equity stakes in the companies that benefit from the plan.

The bill has a section aimed at limiting the pay of executives at companies that take advantage of assistance by prohibiting tax deductions for officials that exceed $500,000, which is half the normal deductible limit. It also allows ``clawbacks'' of money already paid to executives at troubled companies and forbids so-called golden parachutes.

Community Banks

The legislation takes steps to let some 800 community banks that held preferred stock in Fannie Mae and Freddie Mac before the mortgage giants were taken over by the federal government on Sept. 7, make better use of losses for tax purposes than they would otherwise be allowed.

House Republicans offered early resistance to the Paulson plan. They complained that it put the country on the road to socialism and instead argued that elimination of the capital gains tax would spur a wave of investment that would render the bailout plan unnecessary.

House Minority Leader John Boehner of Ohio commissioned Virginia Representative Eric Cantor to draft a rival plan without telling Democrats or Paulson. The plan, which depended on self- funded insurance premiums, was abandoned after Democrats lashed out at Republicans at a White House meeting Sept. 25.

Limited Insurance

Ultimately, Republicans got none of the tax breaks they sought, though the bill includes a limited self-funded insurance program for companies that benefit from the bailout. Last night Boehner, the top House Republican, urged his colleagues to support the bailout plan.

Some House Republicans, such as Representative Mike Pence of Indiana, are still holding out. ``We now have a deal that promises to bring near-term stability to our financial turmoil, but at what price?'' Pence said in a letter to colleagues.

Pence called the plan ``the largest corporate bailout in American history'' and that it would ``nationalize almost every bad mortgage in America.''

Paulson, the 62-year-old former Goldman Sachs Group Inc. chairman, said such a strategy is necessary to stabilize financial markets. ``We will have turbulence and turmoil in our financial system for some time, but I believe that this is going to work,'' he said on ``60 Minutes.''

`Some Doubts'

Yet as members of Congress and their staffs worked late nights over the past week negotiating and writing compromise legislation, money markets failed to improve. ``It just raised some doubts in my mind whether this was going to be sufficient,'' said Meyer, who was on the Fed board when the Asian financial crisis struck in 1997.

Should the plan fail, ``there may have to be a more substantial participation by the federal government to buy mortgages,'' Frank said last night. Any alternative proposal would involve ``significant purchases directly of the foreclosed mortgages.''

Paulson and Federal Reserve Chairman Ben S. Bernanke, who will be on a five-member oversight board for the program, have signaled that their priority is shoring up the nation's banks even if it means they don't get taxpayers the cheapest prices for the devalued assets the government buys.

The proposal also sets the stage for an overhaul of financial regulation next year, something Frank is already planning. The draft bill requires the Treasury secretary to report to Congress and make recommendations by April 30 on whether to regulate additional participants in the financial markets.

``It'll give us some temporary respite from the earlier pressures,'' said Joseph Mason, a Louisiana State University finance professor who formerly worked in the bank-research division of the Office of the Comptroller of the Currency. ``If we don't use that respite to design more permanent policy, we will find ourselves back in the same place.''

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Christopher Stern in Washington at cstern3@bloomberg.net.