Paulson Changes Course, Again

Yesterday, Hank Paulson, the Treasury Secretary, announced that the US government is no longer planning to buy toxic assets from trouble financial institutions, and instead, the money allocated to the TARP will only be used for the re-capitalization of various firms.  This move basically amounts to a decision only to treat symptoms of the disease rather than to cure the underlying ailment.  The market realized this and reacted on Wednesday.  Although equities rebounded today, problems will persist into the future.  The key issue here is that regulators need to take an approach that recognizes both short-term and long-term risks, which is what they were doing until Wednesday's announcement.  

While the banking system is still in desperate need of liquidity, there will come a time when these bad loans need to be taken off the books.  Otherwise, the long-term solvency of many firms will remain in doubt, and banks realize this danger: the gradual decline in LIBOR rates over the past 23 days has reversed itself as institutions realized that they may now need to raise greater amounts of capital in order to insure against yet another round of write-downs now that the implicit floor on these assets has been removed.  Paulson's original plan was by no means perfect, but it was beginning to work.  It was also starting to reassure lenders because they had slowly regained confidence that they could continue making loans without threatening their capital-asset ratios.  This unexpected announcement has engendered another round of uncertainty that will likely have continued negative effects in credit markets.  Clearly, we have not seen the end of this downturn, but in order to reverse it we need to see steady and clear signals from government leaders.  Sudden changes in course will only increase confusion and economic pain.