Paulson's Plan - Is it Right For America?

There has been much discussion about Henry Paulson’s Plan to invest $700 billion dollars of the tax payers’ money in US mortgage backed securities. Opinions are divided, some totally oppose it while others vehemently espouse it.

Here is my take on how we got to this situation and why America should adopt Paulson’s Plan.

The present mortgage market crisis was created when interest rates fell in 2002 and made mortgages affordable and available for lots of families who would not ordinarily have qualified for them based on their incomes. Further, many of the originators of these sub prime mortgages, banks and other lenders, had no intention of keeping these mortgages till maturity. They had found a business model of earning profits without carrying the risks associated with lending. What they did was package their sub-prime mortgages in to mortgage backed securities and sold them on to other banks. The executives of the purchasing banks did their calculations and found them quite profitable. This was great for their bottom line as well as their end of the year bonuses and purchasing these poor quality securities was, at that time, probably a no brainer. As rates eventually rose, more and more home owners could not afford the mortgage installments and had their properties foreclosed. This resulted in an over supply of properties on the market with consequent house price crash. The banks that had purchased these securities now had bad debts on their books as they had become non productive assets.

Paulson’s plan envisages purchasing these securities at near maturity rates, therefore, letting the banks off the hook. It also envisages freezing of rates for some home owners to prevent further foreclosures. Those opposed to the plan want the Fed to purchase the securities at the present market rate, which is not much of a help to any body. It would probably mean more bankruptcies in the financial sector as the weakest lenders would not have the liquidity to survive.

Over the past 6 months, 3 of the biggest names in finance, Bear Stearns, Merrill Lynch and Lehman Brothers have disappeared forever. These were household names with long histories. Can America afford to lose even more such institutions? Granted that the executives running these venerable institutions had made bad decisions, but does that mean that 150 year old organisations with solid brand equity be reduced to nothing? The better route would be to prevent more bankruptcies and force banks and other financial sector companies to be more transparent about their businesses, which is what the Paulson plan is about.

Consider also another perspective on Paulson’s plan.

America has spent 3 trillion dollars on the war in Iraq and some estimate that the final bill, including the health care of mentally and physically injured war veterans, will probably come to 5 trillion. Further, America spends close to 350 billion dollars net every year (after subtracting for exports to these countries) to finance imports from China and Japan. If America can spend so recklessly on countries that are never going to pay back any of that money, is there any reason why it should not spend on its own welfare?

My final argument on why America should support its financial sector is that this is one of the industries in which it is still competitive. Over the past century, America has lost its pre-eminence in many of its labour intensive industries - steel, automobiles, consumer electronics and textiles to name just a few, and eventually losing finance would add to that long list. I do not think that America should lose an industry which is not dependant on labour costs for its competitiveness. What needs to be done is to rescue it now and bring in tougher regulation to make the industry more transparent and accountable.

I would appreciate any comments you have on this article.