Once Again, Paulson Misses the Point

In testimony before Congress last week, former Treasury secretary Henry Paulson said he was "proud to have been among the many public servants" who came together "to prevent a far more damaging meltdown of our financial system." It would be hard to list a lack of certitude among his weaknesses.

A more humble Paulson might have thanked Congress for allowing the very architects of our financial meltdown the opportunity to administer the system's return to health. Paulson then should have apologized for having done such a poor job of fixing something that he should never have been allowed to fix to begin with.

Indeed, if a frenzied rush to housing this decade lay at the heart of the nation's financial problems, it should be noted that throughout history these flights to the real have regularly occurred in concert with a weak currency. As a former Treasury head, it's passing strange that Paulson never once mentioned the dollar during his testimony, nor did he mention that its decline occurred on the watch of the Administration he served.

Paulson also failed to mention the bi-partisan, and decades-in-the-making collectivist crack-up on the part of our Washington minders who sought to make it easier for those who shouldn't be lending and borrowing to lend and borrow. With hindsight always 20/20, Paulson would have done better to express collective shame for the political class that enabled this financial debacle, along with horror that those who started the fire were allowed to try and put it out.

But try to fix what he helped break is what Paulson did, and the result is an emasculated banking sector that's been weakened by the very federal dollars billed as the system's savior. TARP was unconstitutionally imposed on the U.S. citizenry with a more sturdy banking sector the presumed result, but thanks to limits on compensation, hiring and the pursuit of profits, it's a safe bet that the financial institutions touched by TARP will never again be the same.

Paulson excused his actions by saying that absent federal intervention, "the world of 2009 would look very different from the world we live in today." Yes, it would, but the picture Paulson painted of Americans suffering "without their homes, their jobs, their businesses, their savings, and their way of life" seems a bit hysterical. It should also be said that Paulson's picture is unknowable considering Washington's aversion to failure.

For one, bank deposits are for good or bad (realistically bad) already federally insured, and as such the savings of Americans would hardly have disappeared. To the extent that Americans were able to borrow money they couldn't afford to pay back in order to achieve home ownership, it should be said that the loss of homes for those who fell into that category would have been a very desirable result. For the homebuilders previously eager to sell to anyone able to secure a loan, the failure of neighborhoods would have signaled the need for greater due diligence on their part. Know thy customer.

If by the failure of banks Paulson meant that investors and businesses would have suffered, this result too would have been desirable. Indeed, there's no law that says all investments should increase in value, and the collapse of securities loaded with bad loans would have been a strong, economy boosting signal that in the future, investors should be more careful.

For the businesses hurt by the collapse of their lending institutions, another positive signal would have been sent to our commercial class that they must take great care in choosing the firms they seek to do business with. And just as the failure of one's favorite restaurant creates the opportunity for another to increase share of wallet, so would the failure of certain banks have created an opportunity for prudent lenders - big and small - to increase their portfolios of profitable loans.

Paulson asserted that last fall lending confidence "was largely gone", and that absent bailouts, all financial institutions would have "suffered as widespread fear prevented investors from lending to any financial institution." Pure conjecture on his part since we never let the failures be, but even if completely true, the high rates of interest wrought by investor fear would have created incentives for financial and non-financial institutions alike to profitably lend against this fear.

Had the above been allowed to take place, only the businesses deemed the best risk by investors seeking profits would have received capital. Instead, the U.S. economy suffered another body blow as the very institutions and lending practices considered unworthy of more capital were supplied funds taken from a private sector that had already voted in favor of their bankruptcy. We'll never know, but it's not unrealistic to assume that a lot of good commercial concepts died for lack of capital last fall amid a federal frenzy to save the very institutions that had treated capital so poorly.

About Bank of America's attempt last December to exit its deal entered into to buy Merrill Lynch, Paulson testified that BofA's failure to complete the acquisition would have threatened "the viability of both firms". If so, if BofA really would have been materially harmed for not taking on Merrill Lynch, then why did he have to threaten BofA CEO Ken Lewis with his job to get him to complete the transaction?

If Merrill Lynch's failure on its own represented "systemic risk", how could the weakening of another financial institution in concert with Merrill somehow strengthen the nation's financial outlook? Notably, markets disagreed with Paulson's thinking as evidenced by a 27 percent decline in BofA shares since December 17th when Lewis's hand was forced (67% since October of 2008 when TARP was imposed) versus a 4 percent increase in the S&P 500.

Paulson concluded by urging Congress "to build a structure where regulators have clear accountability for market stability, institutional safety and soundness, and consumer and investor protection." In short, the very politicians and regulators so unequal to the existing crisis will be rewarded with more oversight.

What's increasingly apparent thanks to the above is that the regulatory class in Washington will create incentives for financial institutions to grow large enough such that they're part of a "protected" grouping of finance firms considered "too big to fail." Due to the greater empowerment of our systemic risk generators in Washington, the seeds of tomorrow's crises are already being planted in the name of harmful policies imposed to avoid them.

So yet again, Paulson misses the point. As a system of success and failure, the increasingly unknown ideal called capitalism would have - if left alone - rid the economy of the institutions engaging in unprofitable business practices in favor of those seeking profit. The only regulation we need is profit and loss, but since we're burdened by a hubristic political class that delights in the empowering nature of "crises", another opportunity to truly fix the financial system has passed.