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This morning Secretary of the Treasury Henry Paulson testified to the House Financial Services Committee. Key sections of his testimony and my reaction to it are presented below.

'...Before Congress provided these tools, we were facing a financial crisis without the authorities and resources necessary to meet the challenge. At the risk of oversimplification, the financial rescue package is about restoring confidence -- restoring the confidence of depositors and investors in our financial institutions, and restoring the confidence that our financial institutions need so that they will get back to normal lending practices.'

Confidence was decidedly not helped by the way the original plan was presented to the Congress. The essence of the original proposal was: 'Give me $700 billion, give it to me now, don't ask me where the money will go, or your economy dies.' However, once that step was taken, it was critical that something be done quickly to shore up confidence.

'This law has already allowed us to take decisive action to prevent the collapse of our financial system. But more needs to be done, and it is my responsibility to use the authorities Congress provided to protect and strengthen the financial system, and in so doing, protect the taxpayer.'

He does have a very good point here -- the key benefit from all the money that has been spent so far is the bad things that have not happened, rather than seeing much absolute good from the enormous amounts that have been spent. The financial system is still deeply troubled, but it has not collapsed.

As for protecting the taxpayer, by his steadfast refusal to conduct hard bargaining with the banks who are the recipients of the funds, he is doing an extremely poor job. Under the revised plan, the objective is to shore up the capital of the banking system. It is unconscionable that this money could be used to pay dividends to the common shareholders of JP Morgan Chase (JPM) or Goldman Sachs (GS).

It is even more unbelievable that this money could go to paying massive bonuses to top level executives of the banks that are getting the aid. The net present value of the preferred stock that the taxpayers got was about half the value of the preferred stock that Berkshire Hathaway (BRK.A) got just a few weeks earlier (when the system was actually in better shape, and thus should have been available on less advantageous terms to Berkshire).

'Let me summarize what the U.S. financial system has had to digest in just a few months' time. ... We have seen the failures, or the equivalent of failures, of Bear Stearns, IndyMac Bank, Lehman Brothers, Washington Mutual, Wachovia, Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG) -- institutions with a collective $4.7 trillion in assets when this year began. ... and market participiants around the world were speculating about which institution would be next to fall.

'... [I]n September, the financial system essentially seized up and we had a system-wide crisis. Our markets were frozen, banks had pulled back very substantially from interbank lending. Confidence in our financial system and a number of our financial institutions had been seriously compromised.'

It was the decision to let Lehman go under, rather than follow the playbook that was used in the case of Bear Stearns, that really caused the financial system to freeze up. It was the failure of Lehman, and its inability to make good on its commercial paper that caused several money market funds to 'break the buck.' Until that happened, the market had been able to absorb the string of bad news. Yes, there were many bailouts, but for the most part the taxpayer was protected.

Essentially the shareholders of Fannie and Freddie were wiped out, and the government took over 80% ownership of the companies. Management was replaced. The origional terms for bailing out American International Group were advantageous to the taxpayers. The new, revised terms are not quite so advantageous to taxpayers.

'Our objectives in asking Congress for a financial rescue package were to first stabilize a financial system on the verge of collapse ...

'During the two weeks Congress worked on the legislation, market conditions worsened significantly. Many Americans look at the stock market as an indicator of the economy, and during this period they saw tremendous volatility. The Dow Jones Industrial Average fell more than 700 points on one single day, and over 9 percent during the two weeks the legislation was debated ... stock market losses amounted to slightly more than $2 trillion.'

I would remind the Secretary that we still have a Constitution in the U.S. in which is up to Congress to decide how much money is spent and where it is spent. Two weeks is not a particularly long period of time given the amount spent, which approximates the entire direct costs of the Iraq war so far. Perhaps if Mr. Paulson had put forth a realistic proposal to begin with, things could have been expidited. This smacks of blaming Congress for the debacle, perhaps time would be better spent looking at yourself in the mirror, Mr. Secretary, if you are looking for a culprit.

'But we were focused on the credit markets because they provide our basic economic fuel ... Interbank lending rates relative to policy rates were at the highest level this decade, indicating banks' lack of confidence in one another and in the financial system. ... Investor concerns became most evident in the 'flight to quality' in the Treasury market, with short-term Treasury bill yields dropping to near zero.'

Indicators of credit stress have improved substantially over the last month, but are still nowhere near the levels that they were before the current wave of the crisis hit. The short-term bill is still trading near zero, currently at just just 7 basis points. This is the financial equivelent of banks just keeping their money in the vault or hiding it under a mattress. Money is changing hands much more slowly than it used to.

The technical term for this is 'velocity.' This is extremely important since nominal GDP is equal to velocity times the amount of money in circulation. The Fed has been desperately trying to increase the money supply to offest the decline in velocity. One good measure of this is the size of the Federal Reserve's balance sheet, which has more than doubled in the last month.

'... By the time legislation had passed on October 3, the global market crisis was so broad and so severe, we knew we needed to move quickly and take powerful steps to stabilize our financial system and to get credit flowing again. Our initial intent had been to strengthen the banking system by purchasing illiquid mortgages and mortgage-related securities. But by this time, given the severity and magnitude of the situation, an asset purchase program would not be effective enough, quickly enough. Therefore we exercised the authority granted by Congress in this legislation to develop and quickly deploy a $250 billion capital injection program, fully anticipating we would follow that with a program for troubled asset purchases.'

The original plan of buying troubled assets was, in a word, STUPID. It was clear from the outset that direct injections of capital was a far more effective way to use the money. I have no problem with the change of plan, and I am grateful that Chairmen Frank and Dodd slipped the ability to do so into the greatly improved bill that was passed, in fact I would go so far as to say that it was the single-most-important improvement of the entire bill, although one could make the case that the idea of actually having some oversight of how the money was spent was even more important. I just wish we had someone negotiating on the behalf of taxpayers when injecting this capital.

'There is no playbook for responding to turmoil we have never faced. We adjusted our strategy to reflect the facts of a severe market crisis always keeping focused on Congress' goal and our goal -- to stabilize the financial system that is integral to the everyday lives of all Americans.'

Au contraire mon Secrétaire -- do you think that the U.S. is the only country that has ever faced a banking crisis? Granted, given the size of our economy, this banking crisis is much bigger than others, but it is hardly unprecedented. In looking at previous situations abroad, it is clear that the best course was to follow the example of Sweden in the early 1990's. Eventually, by coming around to capital injection, we have a watered-down version of the Swedish plan.

There was more to the testimony, but this post is getting long enough as it is. If you wish to read the rest it is available at: http://www.treas.gov/press/releases/hp1279.htm. If time allows I will put up a simalar post regarding the Testimony of Fed Chairman Ben Bernanke in front of the same panel. His testimony can be found at: http://www.federalreserve.gov/newsevents/testimony/bernanke20081118a.htm

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Paulson Testimony Deciphered

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