The Terrible Scare Story Hank Paulson Told Congress

What does a Treasury secretary from a lame-duck Republican administration have to tell the leaders of a Democrat-dominated Congress to persuade them to fork over $700 billion to rescue Wall Street by buying toxic mortgage securities. Well, according to Sen. James Inhofe, Hank Paulson said something like this: "He said, ‘This is going to be far worse than the Great Depression in the '30s.'" (Recall that unemployment hit 25 percent back then vs. 6.5 percent currently.)

But now Paulson has scrapped Plan A. And a new University of Chicago study of a similar plan conducted by Japan in the 1990s concludes Paulson should have never gone that route. Here is what the study found:

"The U.S. financial system is in very fragile shape. As in the recent Japanese financial crisis, the shortage of capital is the fundamental problem that must be fixed. The U.S. bailout plan is similar to the Japanese approach in that it does not clearly identify the capital problem as critical and instead proposes using AMCs to remove distressed assets from bank balance sheets. When Japan used AMCs, their effectiveness was limited in part because they did not purchase enough assets. AMCs did not help recapitalization, either, and Japan had to come up with different mechanisms to use public funds for recapitalization. Both these risks are also present for the U.S. plan."

Me: Indeed, in an interview with CNBC, Paulson seemed to imply that $700 billion was not going to be enough money to make the asset-buy work. And good luck going back for more dough. The first bill barely passed. What's more, FBR Capital Markets estimates that Wall Street needs another $1-2 trillion in new capital, in the form of direct injections, to stablize. And it continues ...