The Paulson Doctrine: An Uncertain Prescriptive for Uncertain Times

Unwittingly or not, Treasury Secretary Paulson has effectively created the Paulson Doctrine. The doctrine states that firms that he deems too big to fail (but we're not exactly sure where the line is drawn: (LEH)? No. (BSC)? Kind of. (MER)? Maybe. (AIG), (FNM) and (FRE)? Definitely.) get the U.S. Government (and the U.S. taxpayer) as new senior shareholders, while the others are either left to execute an orderly private markets Good Bank/Bad Bank restructuring (if they can, like Mellon in the late 1980s) or a hurried Chapter 11 Good Bank/Bad Bank restructuring (if they can't: see BCS/LEH circa 2008).

Sure, the headline reads that the Fed bailed out AIG, but was anyone other than Mr. Paulson pulling the strings? I doubt it. So what of this doctrine, and what does it mean for the global financial markets, the integrity of the U.S. regulatory regime and the U.S. taxpayer?

In the short run, the Paulson Doctrine helps the markets. It creates the liquidity-driven optionality only available through the U.S. Government's philanthropy, protecting against wholesale liquidations that could further depress asset prices and start a daisy-chain of events leading to a radical marking down of assets globally. As those of us from Wall Street know, once there is blood in the water markets get pushed further and further away from intrinsic value, and the only way back is through securing of liquidity (which generally occurs at a market bottom after total despair has set in). So rather than a radical restructuring taking place in an accelerated manner, out of sheer necessity, the U.S. Government and their well-heeled central bank brethren have decided to slow the pace of the correction to forestall an extremely painful fall-out.

But is this a good thing? Well, given the position of the U.S. as the debtor to the world and the political and market power wielded by China and Russia, in particular, Mr. Paulson's wielding of the Paulson Doctrine keeps these governments from dumping our dollar-denominated debt. We have little room to maneuver, thanks to President Bush's budget-busting spending habits, our debt-fueled consumption party, lousy financial disclosure and sheer greed.

This enables us to continue our profligate spending habits that got us in this mess in the first place. Better to defer pain for another day rather than sucking it up and squaring up, I guess. This is no different than the charades that are Social Security and Medicare - bail out Bill Gross, Putin and our other unfriendly financiers, and we'll pay for it all later. While I fundamentally believe that the U.S. Government's actions, particularly with respect to AIG, create real option value through the provision of liquidity, it sends a very, very bad message to those in dire need of a really, really good message: You make your own safety net. And that safety net is called prudent financial management.

You know who comes out looking really good in the mess of the last 96 hours? Barclays (BCS). They did exactly what they should do. Let the market come to them. Focus on their core goals and strategy. Put in an offer that gives them exactly what they need as a franchise for a price that implies a very short payback period and minimal portfolio risk. This is a company thinking about their shareholders. They didn't assume an uncertain pool of opaque assets (see this post about (BAC)/(MER)) to get what they really wanted (unlike BAC, who wanted the retail brokers but took everything else for a mere $50 billion). $250 million for the North American assets plus $1.5 billion for the headquarters building and two data centers. Kudos, John and Bob. Job well done. Ken Lewis? The jury's out, and will be for a long time. But would I want to be a BAC shareholder right now? No, I wouldn't.

I'm a pragmatist: the Paulson Doctrine has its place. But only if the market understands the rationale behind the doctrine and the breadth of its application. He is reacting just like a hedge fund manager whose illiquid asset portfolio is blowing up in his face. Investors (the U.S. taxpayer, in Mr. Paulson's case) have no transparency. Market participants have no idea how to plan. Redemption notices are starting to roll in. And the actions taken have been entirely reactive and inconsistent. This is neither the way to run a bailout nor to manage taxpayer funds. We need more transparency and better disclosure from our financial institutions. And we need the same from Mr. Paulson.

Comments

[blondino:]

hey,
and you know who's behind Barclay's? our friends in the middle-east. first you americans made 'em rich with outrageous oil prices & now they're fetching you up for pennies (you know, oil money)...add some more ingredients to the mixture, such as USSR & China who are also big lenders and there you have the world-famous circus...think first, always!

2008 Sep 17 07:05 AM

[sohony:]

paulson's remit is to look after his pals on wall street.

that's fine i guess but is there anyone out there whose remit is to look after the US taxpayer.

i'm not feeling very looked after right now.

paulson is not an elected representative so by US tradition he can look after his own personal interests, bail out his pals and represent the lobbyists who throw money at the republican party.

but where are our elected representatives in all of this?

oops i guess they've been paid off (see the above), isn't that how they raised the funds to get elected in the first place?

just one question: how many trillions will paulson and bernanke be able to give away to their pals on wall street before foreigners loss of confidence in the $, the treasury bond and the US balance sheet creates the huge sucking sound of dollar decline and interest rate expansion.

how rapidly and to what level will US debt be downgraded?

seekingalpha.com/artic...

look out below.

and oh yes, are there enough lobbying $s to pay off china, japan et al and convince them to keep buying our treasuries.....?

or do we have a better idea than bribing government decision makers to keep wall street afloat?

pray tell.....

2008 Sep 17 07:29 AM

[blondino:]

re: sohony
and only congress can stop him, so will they? wouldn't bet on that one...

2008 Sep 17 07:56 AM