Hank Paulson's Mistake Explained

With a financial crisis looming in September, Hank Paulson went to Congress for $700 billion in bailout funds. He intended to use these to buy up toxic securities from a range of banks and hold them. Essentially, the idea was to create a "bad bank" owned by the governemnt. While this would have forced participating banks to declare large losses, it would have created certainty about their solvency by removing illiquid assets from their balance sheets. Paulson realized after receiving the first half of the monies that the policy wouldn't work with his plan - the assets had already proved unpriceable and the enormous, up-front costs were dramatically more than it had available.

He therefore decided that a better solution, albeit one that would be worked out bank-by-bank, would involve the government taking an equity stake in the major financial institutions and, where necessary, issuing insurance on the value of the illiquid assets, making up the difference if they all below an agreed floor price. Paulson reasoned that investors would know that the bank is secure, but that it would reduce the requirement for immediate capital.

The problem with the strategy that Paulson pursued is that the direct investment into financial institutions wasn't transparent and diluted equity holders. It also didn't do anything to stimulate lending, whereas a cleaner balance sheet might have provided existing banks with a fresh start. Moreover, the insurance issued against the existing portfolio, which has now been issued at AIG, Citibank and Bank of America, has the potential to put the government in significant risk for having liabilities well above those that are funded or budgeted, essentially forcing the government to order and supervise an orderly liquidation, as opposed to risking a disorderly one.