The Public Policy

It’s Paulson’s Own Mess

There is a way to clean it up.

By 9.24.08

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They said it was "too big to fail." This multi-billion dollar firm was now on the brink of bankruptcy. Although not a bank, the firm held complicated financial assets such as derivatives and traded with just about every big bank on Wall Street.

So company officials called on the administration of George W. Bush, hoping to get a lifeline. Big Wall Street executives, including former government officials, phoned the Bush Treasury Department to plead their case to save this company.

Treasury's response? "Not a chance!"

The company described above was not Bear Stearns or American International Group, although it had a lot in common with those firms that the government this year decided must be bailed out by taxpayers. It was Enron Corp., just before it went bankrupt in 2001.

Did Enron's failure somehow pose less of a systemic risk than that of Bear Stearns, AIG, or the thousands of other financial firms that could now be bailed out under the administration's new plan? Not really. Enron was the seventh largest public company in the U.S., employing nearly twice as many as Bear did prior to its bankruptcy.

And like Bear, Enron traded derivatives and other financial instruments with counterparties that were some of the biggest commercial and investment banks in the country, such as Morgan Stanley and Citigroup, which would have been heavily exposed to its losses And these instruments were concentrated in energy, a sector equally as important, if not more important, to our economy than housing is.

No, what was really different in 2001 was who was heading Treasury and other economic agencies. The Enron failure shows how much the Bush administration, as much as conservatives ripped it, has moved in an interventionist direction under Treasury Secretary Henry Paulson.

ACCORDING TO KURT EICHENWALD'S Conspiracy of Fools, an authoritative account of Enron's demise, Enron head Ken Lay was on speed dial to government officials looking for "a lifeline." He called then-Federal Reserve Chairman Alan Greenspan and then Treasury Secretary Paul O'Neill. And Robert Rubin, who had just gone on to become an executive at Citigroup after serving as the Clinton administration Treasury Secretary, phoned a Treasury aide to see if the Department could intervene to keep Enron from being downgraded by the credit rating agencies.

The responses? Nada, nada and nada. Enron's bankruptcy was complicated, but despite Lay and Rubin's dire predictions of what would happen if Enron failed, the economy kept growing in 2002 and 2003.

But Enron most likely would have had more luck if it had gotten into trouble after Hank Paulson left his post as CEO of Wall Street investment bank Goldman Sachs to become Treasury Secretary in 2006. With the exception of Lehman Brothers, Paulson is truly "Dr. Yes," having never met a Wall Street bailout he doesn't like: $29 billion here, $200 billion there, and now possibly upwards of $700 billion over there, and pretty soon even Washington starts to realize it's real money.

In terms of not just the bailout, but the unprecedented intervention in setting prices of company stock in mergers, picking new CEOs, and encouraging the abrogation of mortgage contracts, Paulson has gone where no Treasury Secretary -- Republican or Democrat -- has gone before on the road to socialism. In the way he has persuaded a GOP administration to betray what conservatives stand for, he is -- metaphorically speaking -- the late Dick Darman on steroids.

Darman's convincing of the elder Bush to raise taxes pales in comparison to these bailouts and the new $700 billion bailout scheme before Congress. If this "mother of all" bailouts passes, it will leave an albatross around conservatives' necks for years, allowing new arguments for intrusive regulations to prevent taxpayers from paying for business failures.

YET CONSERVATIVE CRITICISMS of Paulson so far (maybe until this week) have largely been muted because of two myths propagated by the media. One is he was a free-market believer until catastrophic economic events forced him to intervene. The other is that no matter how bad the financial industry woes are now, the economy would be much worse off but for his interventions. The first myth is demonstrably untrue, and the second is under contentious dispute.

Paulson did raise a lot of money for the GOP -- more than $100,000 in 2004 -- but has always been something of a political chameleon and has never been an ideological conservative of the fiscal or social type. As Robert Novak reported last year, he has also contributed to Bill Clinton, Bill Bradley, the feminist Emily's List, and "Wall Street's favorite Democrat, Chuck Schumer." And, in moves leading my organization -- the Competitive Enterprise Institute -- to oppose his nomination, Paulson supported and Goldman Sachs partnered with anti-property rights "green" groups.

As to the second myth, Paulson certainly isn't responsible for all the factors that have caused the credit crunch, such as the growth of the government-sponsored enterprises Fannie Mae and Freddie Mac. But far from saving the economy, there is ample evidence that the March bailout of Bear Stearns' creditors simply prolonged, postponed and added to the pain.

This is because "moral hazard," -- the ability to take risks knowing that someone will bail you out -- was increased, and firms didn't make the hard choices about restructuring. As Manhattan Institute scholar Nicole Gelinas, a chartered financial analyst, wrote in the Wall Street Journal, "the Fed, by being so quick to jettison the bankruptcy process, cut off a valuable source of new information to financial markets and blurred the critical distinction between sophisticated and unsophisticated investors." And in a recent paper presented at the prestigious Jackson Hole Symposium held by the Federal Reserve Bank of Kansas City, professors from the University of Pennsylvania's Wharton School and the University of Frankfurt conclude that, "Given the characteristics of the markets where Bear Stearns operated, it is quite possible that...no contagion would have occurred."

Yet Paulson has staunchly refused to provide financial firms any regulatory relief from one problem that experts, including the authors of the paper mentioned above, say is contributing strongly to the contagion: mark-to-market accounting. As I wrote last weekend in the Wall Street Journal, these recently imposed rules force even healthy banks to face "regulatory insolvency" because they have to value their loans based on any sick bank's fire sale, even if they have no plans to sell the loans and the loans are still performing. In fact, Paulson's proposed new mega-bailout may exacerbate this problem.

Yet Paulson, in a stunning statement at the New York Public Library in July, said basically that if the rules are good enough for Goldman Sachs, they're good enough for every community bank. Paulson said, "I think it's hard to run a financial institution if you don't have the discipline which requires you to mark securities to market."

If John McCain is looking for someone else on the Bush economic team to fire, the answer is right in front of him.

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About the Author
John Berlau is Senior Fellow for Finance and Access to Capital at the Competitive Enterprise Institute and blogs at OpenMarket.org.