The Paulson Plan

http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html

The Paulson Plan
by Amnon Portugaly
07 Oct 2008

There's one glaring weakness in Paulson’s Bailout Plan to save the U.S. financial system: It most probably won't work as intended. It also could make things worse. The Plan is a bailout of reckless bankers, lenders and investors and provides little direct debt relief to corporate borrowers. Lending and financing for the corporate sector is the main purpose of the financial system, not interbank lending.

By removing troubled assets from the balance sheets of the financial institutions, the Plan MAY enable the banks to lend again without lingering doubts about their solvency and viability. However, the Paulson Plan does not ENSURE that those banks and financial institutions that receive bailout aid will increase lending to Main Street.

Banks must have BOTH the capability to lend and the willingness to lend. The Paulson plan is aimed at restoring the banks ability to lend, at a huge cost to the American taxpayers. However, even with a healthy balance sheet the banks will not lend because of lingering doubts about the solvency of their customers, their ability of paying the loan and the viability of the economy. In short the banks’ potential customers – enterprises and individuals - also have broken balance sheets.

The Paulson plan does not address the root cause of the problem. The American consumer has no more purchasing power. For most middle class and workers, earnings since the mid-1970s have not kept up with the cost of living, while their real expenses for healthcare, education, housing, has grown much faster than the CPI, consequently their discretionary spending has decreased.

In order to bridge the earning gap and to keep their standard of living, middle class Americans turned to borrowing on a large scale. They turned their homes into ‘personal’ banks by refinancing home mortgages and taking out home-equity loans. But now, with the bursting of the housing bubble, Americans are reaching the end of their ability to borrow and lenders have reached the end of their capacity to lend. At the same time, Credit-card debt has reached dangerous proportions, and Banks are now pulling back. This debt based consumer economy is also to blame for the huge trade deficit.

Households in the US have too much debt, the price of their houses is plummeting, they are getting buried under rising debt servicing burdens, and their savings are evaporating. Unemployment has already jumped up and will continue to grow to rates approaching 10%.

Currently, there are several millions Americans without jobs, and several millions of American who lost their home or are going to lose their home. It seems that the government and congress do not care about these people and at the same time are going to inject $700 billion into the financial system.

Given the collapse of the corporate Commercial Paper market and the banking system reluctance to provide loans to the corporate sector, the only alternative is for direct lending to the business sector from the Fed.

This could include:

• Fed purchases of commercial paper from corporations and other forms of financing by the Administration to small businesses secured in appropriate ways.

• Use the first installment of the $350 Billion of the Paulson Plan and set up 10 banks in the US initially capitalized to the tune of $35 Billion each. Sell shares in these banks worth $35 Billion to private investors with warrants to buy out the government shares at say 5% interest on the original government investment.

With 10:1 leverage, each of these new banks will have some $700 Billion lending capability or some $7 Trillion in total, ten times the Paulson Plan. These banks having clean balance sheets could easily, along with many sound existing banks, provide the credit the economy needs, even allowing for the failure of other banks with broken balance sheets.