When Will Henry Paulson Learn?


Once again, we have good news and bad from Wall Street.

Henry Paulson has announced Citigroup and three other banks will begin issuing covered bond in an effort to rejuvenate commercial bank mortgage lending and the housing market.

Concurrently, Merrill Lynch announced it is taking yet another big write down on its subprime securities, selling paper with a face value of $30.6 billion to private equity firm Lone Star for $6.7 billion. It will dilute its common stock 38 percent through the sale of additional shares to make up the losses.

Paulson’s covered bonds would be backed by specific mortgages held by the banks. In essence, these would be large certificates of deposit. Though not necessarily insured, the bonds would be back by specific assets on the banks books, and the banks would to take steps to ensure these mortgages were good—not the junk Merrill Lynch, Citigroup and others have been hoisting on investors.

Whether the bond market accepts these securities—essentially whether insurance companies, pension funds and other fixed income investors take the plunge—comes down to trust in the banks. Recent events at Merrill Lynch, Citigroup and others indicate that such trust will require a bold leap of faith.

The basic problem at the big banks is compensation schemes that encourage bank executives to make risky bets that allow them to profit when things go well and to push the losses on bond and stockholders when things go sour. Upon taking over Merrill Lynch, John Thain increased executive bonuses, but established a risk management scheme. That hasn’t worked.

At Citigroup, CEO Vikram Pandit is selling off assets to cover losses, but he has not given back the $165 million he took from shareholders in his sale of the Old Lane hedge fund to his employer. The bank subsequently took more than $200 million in losses, yet the Citigroup bonus machine continues to payout to its executives.

USB is under investigation for fraud in the sale of auction rate securities.

It seems hard to find a major bank without some a record of sharp practices.

Mr. Paulson is trying to sell trust in the banks with his new covered bonds. It’s tough to sell trust in a Wall Street bank these days, because there is not much to trust.

An insurance company that buys Paulson’s covered bonds will likely be all right, but it is taking an imprudent risk. That should tell you something about the competence of its management, and it would be signal to dump its stock.

Paulson’s scheme to reopen the bond market to banks for mortgage lending will only work, if the commercial banks clean up the management practices that caused the subprime crisis, and massive losses imposed on shareholders and bond customers.

The federal government is imposing new a regulator on Fannie Mae and Freddie Mac, which will have authority to regulate executive compensation. The Federal Reserve has loaned hundreds of billions to Wall Street banks and securities companies without any real commitments for management reform. The asymmetry is puzzling.

Mr. Paulson will only get the mortgage market, housing crisis and economy turned around when he resolves the confidence gap on Wall Street. That requires systemic reform in the business practices and compensation structures. What’s good Fannie and Freddie would be good for Citigroup, Merrill Lynch and the others.

PETER MORICI is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.


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