Paulson Turns US Treasury Into Gargantuan Distressed Debt Hedge Fund

The details of Hank Paulson's plan to save the world financial markets from a systemic meltdown are being hammered out in Washington.  The plan calls for the Treasury to buy $700 billion in distressed assets from financial institutions.  Originally, Mr. Paulson proposed only buying mortgage-related assets but has widened the scope of assets to include credit-card debt, car loans, and unsold Hummers.  The part about the Hummers is a joke, but who knows how a desperate car company will interpret the "other devalued assets" phrase in the landmark proposal?  I am aware that the plan currently does not allow car companies to participate.  However, "any financial institution" is eligible to puke assets, a standard which has already been lowered once from "any financial institution headquartered in the US."  Frankly, I'm certain that car companies are lobbying to be included, since it is unpatriotic that the US would favor foreign financial institutions over US car companies.  

I am still waiting to hear more details about the plan before I can make judgements as to whether this is the most terrifying idea to be hatched by this administration.  Although it is true that this will help banks remove problem assets off of their balance sheets, if the prices on the assets from the reverse auction are much lower than where banks have them marked, it will require them to raise more capital.  In some cases, it may leave a few banks insolvent.  Whether private capital will be more likely to pump money into insolvent institutions after they have rid themselves of toxic assets is a big question, particularly when there is so much other great distressed garbage to pick through.  If it turns out that these assets are worth less than what the government pays for them, then the taxpayer loses.  This seems like a lose lose either way.

However, if belief in the plan's success is strong enough to restore a measure of stability to the financial markets, then that is at least a temporarily positive outcome.  Frankly, as I discussed in my rant about Chris Cox's ludicrous ban on short-selling, this is a fabulous opportunity for banks whose shares hit 52-week highs on Friday to issue more stock and raise capital.  Do not be surprised if we get a rash of equity issuance before the ban expires.  

The biggest concern on some economists' minds is how will the world handle $700 billion in additional treasury issuance that will go to finance the mother of all hedge funds?  Although some supporters are claiming that Mr. Paulson will eventually make money for taxpayers, the Treasurer still has to borrow $700 billion from the world through issuing Treasuries to finance this endeavor.  Frankly, of all the bearish views that I have ever spewed about the equity and debt markets, I have never doubted that US Treasury securities would always be considered the safest investment in the world, UNTIL NOW.  I am legitimately worried that this plan could cause a currency crisis in the US similar to that experienced by emerging economies in the past.  It is not a coincidence that foreigners have been net sellers of US assets recently.  I suspect this trend will only continue.  

For other interesting commentary on Paulson's plan, check out Calculated Risk and Naked Capitalism.  I'll have more thoughts as the ultimate plan is unveiled.