Paulson's Explanation Leaves More Questions

Second-guessing mounts over Henry Paulson's handling of the Treasury bailout fund, along with his answers for where and how the funds are being applied

By Jane Sasseen

To hear Treasury Secretary Henry Paulson tell it these days, the most effective use by far of Uncle Sam's $700 billion rescue fund is to rebuild the capital in U.S. banks and other financial companies by taking big equity stakes in those that the Treasury deems strong enough to survive the current turmoil. As the crisis has deepened, Paulson has abandoned earlier plans to buy up the troubled mortgage assets gumming up the balance sheets of banks.

Following a surprising turnabout announced on Nov. 12th—which he stoutly defended in a contentious hearing before the House Financial Services Committee on Nov. 18—Paulson now argues that the equity purchases in banks and other financial firms clearly represent the best bang for the government buck. "An emphasis on capital seems to us a better strategy," he said at the hearing. "When the situation changed, we changed the strategy. We didn't implement a flawed strategy."

But if Paulson thought that his announcement would bring some clarity to the Treasury's nascent rescue program, it has done exactly the opposite. The shift, along with the tense battles over whether some of the funds should go to bail out the struggling auto giants or homemakers facing foreclosures, has only heightened the confusion in Washington and on Wall Street about how Treasury plans to spend the rescue money and what criteria it's using to decide who gets a slice of the pie. "You came to us with a plan, then suddenly one day we woke up and found that $700 billion would be used for a different purpose," said Representative Gary Ackerman (D-N.Y.). "You appear to be flying a $700 billion plan by the seat of your pants."

"Bait and Switch"

The congressional ire was bipartisan—and it went well beyond ideology. Conservative Representative Jeb Hensarling (R-Tex.) spoke for many of the plan's original opponents as he too fretted over the change. "It felt like a bait and switch," he said.

There's more than just politics at stake, of course. The sense that policymakers are struggling to get ahead of the markets' woes, and have frequently switched course or backtracked on earlier declarations about what needed to be done, has damaged investor confidence and created even more jitters in the markets. "There's no question that there's a sense they're jumping from plan to plan," says Rod Dubitsky, the head of asset-backed securities research at Credit Suisse. "They appear to be extremely reactive; as a result, we find ourselves continually behind the curve."

Dubitsky believes that the Treasury should have stuck to its original intent and bought up mortgage assets; not only would that improve mortgage markets, he argues the government would then be positioned to finally develop a more standardized national approach to loan modifications, and to do a more effective job of managing the often deteriorating real estate that's now piling up on the market due to the wave of foreclosures.

Scrambling to Help Homeowners

Throughout the crisis, Paulson and other policymakers have often downplayed the need to tackle one or another aspect of the crisis—only to have it emerge later as a larger problem that must be addressed.

Through the early part of the year, Administration officials repeatedly argued that voluntary industry efforts to rework troubled mortgages held by homeowners facing sharply higher monthly payments when their adjustable-rate mortgages reset would be enough; now, they are scrambling to come up with more extensive foreclosure mitigation programs that will stem the still rapid growth in foreclosures.

In early September, they strongly resisted pleas to help troubled insurer AIG (AIG)—only to announce an $85 billion government bailout days later when private alternatives evaporated. Treasury has since hiked its aid to more than $150 billion.