The Real Reasons Why Hank Paulson Screwed Up

For Hank Paulson's detractors (and there are many), the U.S. Treasury Secretary's main mistakes in dealing with the 2009 financial crisis often boil down to: 1. Letting Lehman Brothers go bankrupt. 2. Relying on an ad hoc approach: one day the $700 billion bailout is about buying bad assets, the next it's about recapitalizing struggling banks (remember the quote from a Washington lawmaker accusing him of flying a $700 billion plane by the seat of his pants).

But is this really where the former Goldman Sachs chairman blundered?

First, Lehman Brothers: Did its collapse really play such a large role in ushering in the nuclear winter in credit markets? It's not that hard to imagine that, absent a Lehman going belly up, a different bankruptcy or dire event would have brought us to the same juncture. Remember too that Lehman was revealed to be in worse shape than anyone imagined: its bonds wound up fetching a paltry nine cents on the dollar. Its implosion spooked markets partly because investors saw how much rot had spread through asset books of financial companies.

Of course a countervailing argument is that letting a Lehman perish isn't smart because of the outsized effect on money flows. Fear and caution become ascendant to an irrational degree; overnight lending rates between banks skyrocket as everyone wonders where the next Lehman Brothers may be hiding. The system is too fragile to allow such a big company to fail.

But imagine the Treasury made a mighty 11th hour effort; there was no bankruptcy; Lehman was saved. Then what would we have today? For one, an even more entrenched corporate bailout culture. Loans would flow a bit more smoothly for a while, while the underlying weaknesses remained the same. The financial system would still be highly susceptible to small shocks.

Now what about the second Paulson criticism: Does he deserve to be pilloried for being too quick to change direction? This seems misplaced. Steadfastness may be a virtue for a 50-year marriage; its value is much less clear for a complex, fast-changing crisis that has global ramifications. Should we favor hardheadedness and inflexibility over what may be a smarter, pragmatic approach that happens to look a bit messy?

So how did Paulson screw up? The best answer to that question comes from contrasting the American and British responses to the crisis. Paulson failed to:

1. Aggressively recapitalize and resolve uncertainty around struggling banks. The Treasury Secretary and Fed should be coordinating efforts to audit banks to determine who's really insolvent and who simply needs more capital to weather hard times. The insolvent companies need to be merged with healthier rivals or unwound. This would go a long way toward restoring confidence in the industry. This requires the political will to grab the bull by the horns; Bush's free-market ideologues have been reluctant to do so.

2. Strike hard bargains in return for bailout funds. Britain did this more effectively. The U.S. government should offer money on conditions close to what the private sector would demand: preferred stock, board seats, maybe a top-level reshuffle (throw out a president or two -- or three or four). When Barclays saw what the British government wanted in exchange for assistance, it promptly began looking elsewhere for capital. The benefits to knuckling down are many, including: 1. Lessening moral hazard risk. 2. Creating more opportunities for taxpayers to benefit from providing the rescue funds. 3. Necessitating fewer bailouts, meaning less government involvement and less money being paid out by an overburdened Treasury. 4. Encouraging private capital to move off the sidelines to recapitalize banks (private capital no longer has to compete with a government that offers sweetheart deals). That then helps establish a floor price for bank valuations -- and that, of course, is a necessary prelude to any long-term recovery.

Forget Lehman. Forget the ad hoc policy. These are the real failures Hank Paulson should answer for.