Why The Paulson Program Doesn’t Work

One senior banker described the new Paulson, Bernanke & Co. plan as "the privatization of profits and socialization of losses."

There are a number of reasons why the government’s plan to pull toxic assets out of banks and brokers and into a huge radioactive Superfund site will not work. On the surface the financial companies will be rid of bad paper, and, perhaps, the government can carry the junk long enough to sell it back into the market.

One question that few people have asked is who gets the deal of the century. Banks? Savings and loans? Credit unions? Brokerage firms? What about hedge funds?

If hedge funds are not included and have to mark their bad paper to the market rate that the government is paying, these operations may have to liquidate huge positions in other investments. A series of big sell-offs like that will not usually help the market recover.

What about foreign banks? Barclays (BCS) has a lot of offices in the US, and a lot of capital. Goldman Sachs (GS) has offices in London and a lot of money in UK banks. Someone will have to draw the line on who gets saved and who does not.

When the public banks, brokerage firms, and insurance companies sell their assets to the government, will they have to take huge losses? Under accounting rules, "yes." Unless Citigroup (C) has already written its bad paper down to exactly what it will get at an auction to determine what the government will pay, the bank will need to book the loss that day. Big losses may mean a new need for capital and more dilution.

Over the weekend Congressmen can bicker with Henry Paulson, Ben Bernanke, John Mack, and Jamie Dimon. The representatives from Akron, Ohio and Battle Creek, Michigan will want to make sure the local one-branch banks are in on the deal. By Monday, the market will wake up to the fact that the solution is not easy and that it harms almost as many entities as it helps.

At the end of the line, someone will have to pay for all of the mistakes. The new plan only means that fewer firms will carry that burden.

Douglas A. McIntyre