Back

For those who just couldn't wait, I did go bike camping this weekend. The trip went well, and I enjoyed the experience. It was nice to just be away from everything. But now I'm back in civilization watching the market fall nearly 800 points and congress choking on the $700B "King Henry" bill. I found an article from BusinessWeek about Mr. Paulson from 2006, not long after he was appointed Treasury Secretary. Probably dull as paint drying when reading it in 2006, but in light of where we are today it is fascinating. I realize that the problems of the current crisis go back further than 2006, and possibly back to the early 80s, and as such it's unfair to heap all the blame at Paulson's feet. But this article certainly makes it harder to sympathize with the guy.

Paulson was the former head of Goldman Sachs (a name frequently in the news these days). According to the article:

The appointment of Paulson, Mr. Risk, as Treasury Secretary is at once ironic and completely appropriate. According to conventional economic wisdom, the single biggest problem the U.S. faces is a massive accumulation of debt. Both liberal and conservative economists warn that the bulging trade deficit, now roughly 6% of gross domestic product, poses a danger of sending the dollar plunging and causing a financial meltdown. The federal budget deficit for 2006 will hit at least $300 billion. And current projections call for Social Security and Medicare to run up enormous deficits in the long run.

Yet Goldman actually has leveraged up faster than the U.S. government in recent years. In 1999, Goldman had about $1.60 in long-term debt for every dollar in net revenue. In the same year, the federal government had $3.10 in debt, mostly long-term, for every dollar in revenue. Today [2006] the government has about $3.70; Goldman, around $4.

Clearly, Paulson isn't scared by debt and risk-taking. That might make him the ideal person to grapple with the U.S. economic and fiscal situation, which is more similar to Goldman's than most economists will admit. Facing intense competition from around the world, the only way the American economy can thrive is through risk-taking.

Combine that with a theory put forth earlier this month:

All the Fed's alphabet soup of emergency liquidity facilities innovated over the past year were structured around repurchase agreements. Toxic waste securities were used as collateral for US Treasuries and dollar credit at 85 percent of face value. But as each facility expires, it has to be rolled over and increased to keep pace with the implosion of credit in the interbank markets. Well over half the balance sheet assets of the Fed have been loaned out in this way, perhaps a critical amount in excess of this estimate. Without recapitalisation, the Fed is at risk of failure in the midst of this crisis. Its Enron-style accounting for the toxic waste makes it very vulnerable to a default by any of the repo counterparties it oversees and limits its ability to enforce any constraints as well.

The Paulson plan will provide a one off opportunity for banks to take their toxic collateral back and sell it at a Paulson-determined price for cash. He issues Treasuries to finance the plan which increases the supply available. He selectively decides winners and losers, of course in making the scheme available and pricing assets, creating arbitrage opportunities and survivor bias in the process.

In the meanwhile, the removal of the toxic waste from the Fed balance sheet and redeposit of Treasuries and cash as the repos unwind gets the Fed off the hook for having hypothecated most of its assets against worthless toxic waste at Enron-styled false valuations.

If I'm right, the Paulson Plan recapitalises the Fed without ever publicly admitting that it was dangerously overextended.

Yikes. I feel like I should head back to the woods.