Hank Paulson helped organise a rescue of Bear Stearns and let Lehman Brothers fall into bankruptcy. Subsequent financial turmoil is now blamed on Paulson’s inconsistency, and many observers—including Congressman Barney Frank and just about everyone who worked at Lehman—are perplexed by the different outcomes. But in his argument interview with the New York Times today, Paulson plainly explains the difference: Bear Stearns had good collateral to back up the loan guarantees from the Federal Reserve while Lehman was holding nothing but junk.
The Times reports Paulson as taking a strictly legal position: the Fed couldn’t guarantee Lehman liabilities because the law didn’t permit it to extend loans that were not secured by good collateral.
In the interview, however, Mr. Paulson said the main issue was whether it was legal. Under the law, the Fed has the authority to lend to any nonbank, but only if the loan is “secured to the satisfaction of the Federal Reserve bank.” When pressed about why it was legal for the Fed to lend billions of dollars to Bear Stearns and A.I.G. but not Lehman Brothers, Mr. Paulson emphasised that Lehman’s bad assets created “a huge hole” on its balance sheet. By contrast, he said, BearStearns and A.I.G. had more trustworthy collateral.
But interpreting this as pure legalism seems implausible. Paulson has shown an amazing willingness to interpret laws in innovative and flexible ways. The Treasury and the Fed have done a lot that no one ever imagined they would or could. Why should we suddenly believe Paulson got all narrowly legalistic on Lehman.
It’s a far better bet to say that Paulson means what he’s been saying all along: that he believes that the various bailout measures he’s taken will not come at taxpayer expense. Although we’ve castigated that as overly optimistic and wrong for technical reasons, it has a certain appealing internal logic. Temporary capital injections—in the form of buying distressed assets or buying preferred equity—can be looked at as investments rather than subsidies if they are expected to earn a positive return. Hank is willing to socialize risk so long as the potential for profit is also socialized.
But if a company is truly insolvent and its assets mostly worthless junk, a government bailout is nothing more than a subsidy to creditors and managers. And that bridge from privatized profits to socialized losses is one that Paulson is apparently unwilling to cross.
Also, over at Portfolio, we debate the merits of not bailing out Lehman with Felix Salmon.