3 Reasons Behind Hank Paulson’s Bailout Flip-Flop

Treasury Secretary Henry Paulson sold the $700 billion financial bailout to Congress by insisting that emergency cash was needed to get rotting mortgage and other assets off banks’ balance sheets. Now he’s telling a different story:

“Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets,” Paulson said in a speech today. “Our assessment at this time is that this is not the most effective way to use TARP [Troubled Asset Relief Program] funds.”

Instead, the Treasury secretary announced plans to use the bailout cash for a distinctly different approach to resolving the financial mess: injecting additional capital into banks (potentially expanding the initiative to include non-bank financial institutions), supporting the asset-backed securitization market, and looking at ways to prevent foreclosures.

Lawmakers on Capitol Hill will have smoke coming out of their ears over this change. Critics will call it another example of Paulson’s whack-a-mole response to the worst financial crisis since the Great Depression. Nevertheless, here’s a look at the key reasons behind Paulson’s decision to scrap his original plan to buy mortgage assets from banks:

1. Capital is quick: The process of selling these illiquid, difficult-to-value mortgage assets to the government would be tediously slow--the reverse auctions that were expected to be used take a great deal of time to set up. By comparison, acquiring equity stakes in financial companies is a more straightforward and expeditious process.

2. Cash is thinning out: While $700 billion is an unfathomable pile of money, Paulson’s pockets are already starting to look a little thin. More than $170 billion of bailout cash has already been committed to banks under the capital purchase program, according to ProPublica. Add to that the $40 billion that Treasury recently committed to troubled insurer AIG, and most of the bailout’s first installment of $350 billion is spoken for. “There isn’t enough money left over to buy enough of these troubled assets to really make a difference,” says Stephen Stanley, chief economist at RBS Greenwich Capital. So Paulson may think “it’s better [not] to do it at all than to do it half as big as it needs to be and have it not work.”

3. Paulson’s days are numbered: Although markets remain extremely unstable, the capital purchase program has been able to soothe certain credit indicators. This success--albeit tenuous--reduces the incentive for Paulson to undertake a new, complex program in the sunset of his federal government career. It’s much easier for him to simply “stay the course” with the capital purchase program and punt the troubled asset purchase issue to the Obama administration.