Paulson: Credit turmoil to last a while

But the Treasury chief says the economy is strong enough to weather the storm.

When he wakes up in the morning, Treasury Secretary Henry Paulson admits that the first thing on his mind is the turmoil in the credit markets.

And, as an indication of how much time he's spending on it, Mr. Paulson in recent weeks has met with a range of mortgage officials from debt counselors to the companies that homeowners send their money to. He talks to Federal Reserve officials multiple times a day. He says his focus now is on developing a product for home­owners in danger of losing their houses – what he terms the "riskier area."

At a Monitor breakfast for reporters, the Treasury chief, a veteran observer of many Wall Street meltdowns, said the complexity of the markets and the global nature of the problem mean that "we need to expect this period of turbulence to go on for a while."

This is a crucial week for the credit markets. Some $120 billion of commercial paper needs to be reissued, a significant amount of it overseas. Half of that is asset-backed commercial paper, a product that has been very hard to get investors to add to their portfolios. Paulson says the funding of this part of the market is of special concern to him.

Despite the credit market issues, Paulson says the turmoil is taking place against a backdrop of a strong global economy. On Tuesday, he was quick to point to the continued rise in US exports and the slowing of imports. And, despite the recent drop in the employment numbers, he says, "We have in my judgment a healthy US economy."

Housing woes are slowing economy

Paulson admits the weakness in the housing market is providing a penalty to growth. That's also true of the turmoil in the credit markets – and last week he says he met with some of the nation's top CEOs to find out how the financial market was affecting their business. His conclusion: The economy is strong enough to weather the storm.

So far, the Fed is under the most pressure to act. Some investors would like to see the central bank aggressively drop interest rates by as much as a half of a percentage point next Tuesday.

"The Fed will cut by a quarter of a percent – but hopefully by half of a percent," says Jeffrey Kleintop, chief market strategist at LPL Financial Services in Boston. "If there is not aggressive action, if the inflation numbers make the Fed cautious, then there is more risk and the thought that the liquidity crisis is contained goes out the window."

Some investors urge federal action

But there are also other moves investors believe the Bush administration can take. For example, David Kotok, chairman of Cumberland Advisors, argues it is the role of the Fed to assist innocent victims who financed a home and were duped.

"Say you've got a working mom, living some distance from work, and she wanted a little house with some grass and a playground and took out a mortgage with a low teaser rate [a rate that would adjust after a period of time depending on the direction of interest rates]," explains Mr. Kotok. "Now, the mortgage payment has doubled, she needs some relief, perhaps through the tax code. That is not the Fed's job, but it could be the Treasury's job."

Mr. Kleintop sees the Treasury as acting like the stern old grandfather in terms of telling the nation's banks they need to be more willing to take some additional risk in order to provide liquidity. "This is the type of activity where bank managers can get fired if they take too much risk, but the Treasury has to say, 'We expect you to do this to provide liquidity.' "

However, there are others who believe any Federal involvement might only prolong the crisis or even make it worse in the future.

One of those is Bruce Bent, chief executive of The Reserve, a New York cash management firm with $62 billion under management. "The markets do wonderful things," says Mr. Bent.

He points to a hedge fund operated by Goldman Sachs that was hit hard by the devaluation of subprime loans this summer. It's still up and running, because of new capital injected by wealthy investors: Eli Broad, Hank Greenberg, and Goldman Sachs itself. "That's not really a stupid group of people," he says.

A market-based approach

Multiply actions like that – the give-and-take of the marketplace – and order can be restored to the mortgage markets, Bent says. Congress and the White House could cut the supply of credit even more, he says, if they impose new regulations that push good lenders out of the business.

Ironically, cash has been pouring into money funds in recent weeks as investors become more conservative. One investor in asset-backed commercial paper, Mark Simenstad, head of fixed-income mutual funds at Thrivent Financial for Lutherans in Minneapolis, says the coming weeks are pivotal.

"It will take a while for this to resolve itself," he says. "The next few weeks are fairly important to see whether these asset-backed [securities] programs can continue."

Administration's reform agenda

Paulson, in Tuesday's wide-ranging meeting with reporters, also laid out the reforms the administration hopes to accomplish in its remaining months. Among them:

•He encouraged the Senate to work with the House on reform of oversight of Fannie Mae and Freddie Mac, government-created corporations that were designed to boost homeownership in America. In recent weeks, "we've spent a lot of time talking" with these entities about how to "come up with products for homeowners that are in danger of losing their home." He said such initiatives could move forward in conjunction with regulatory reforms of those agencies under review in Congress. The House has moved its bill forward, and Paulson urged the Senate to follow suit.

•In an effort to boost prospects for reform of programs such as Medicare and Social Security, the Treasury is launching an effort to publish analytical papers on these challenges. "I want to depoliticize this," he said, affirming that the Bush administration is willing to talk with Democrats in Congress about securing future funding for the two programs with no policy options off the table.

•The administration wants to address the alternative minimum tax, which was designed to keep the wealthy from claiming too many deductions but is forcing a growing numbers of middle-class Americans to pay higher taxes. "We clearly need to patch the AMT," he said.

In the long run, he said, the US economy will be at a serious disadvantage to other nations if it maintains its current corporate tax rates. "The rest of the world has moved past us," Paulson said, realizing that high taxes on business will have a direct impact on job creation. The last thing the economy needs right now, Paulson said, is rising taxes.