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updated 11/12/2008 2:54:56 PM ET 2008-11-12T19:54:56
COMMENTARY

Listening to Hank Paulson's Nov. 12 speech, one is impressed both by his flexibility and a barely controlled underlying sense of panic.

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In a few short weeks, the Treasury Secretary has gone from a bailout plan focused solely on using $700 billion to buy up mortgage-backed securities to one that may not spend any money at all on mortgage-backed securities. Instead, as he announced Wednesday, much of the remaining money will be used to support consumer loan markets that have frozen up — credit-card debt, student loans, and auto loans. That's on top of direct equity injections for banks and money used to help reduce foreclosures.

The rapid change of direction reflects, in part, the fact that Paulson's original plan was not going to work. Buying up bad mortgage-backed securities only made sense if the current problems were a crisis of confidence in an otherwise sound economy. In that case, the government purchases could help restore investor trust and unclog the financial system.

But in fairly short order, it became clear to Paulson, Federal Reserve Chairman Ben Bernanke, and everyone else that financial institutions were being rocked by big losses that were not going to be helped by simply buying up bad securities. Instead, they needed more drastic medicine — to begin with, $250 billion in direct capital injections, with more to come.

The announcement of support for consumer loans was an acknowledgment that the economy's problems extend beyond mortgages and housing. In fact, as Paulson said: "…the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit-card receivables, auto loans and student loans, and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt."

This freeze-up in consumer loans is not an issue with the financial system. Rather, it reflects the dire straits faced by consumers and retailers. American households, struggling with debt and deep job losses, are pulling back with a vengeance. Retailers and auto manufacturers are being struck with the reality that the consumer spending boom which sustained them may not come back for years, if at all.

So Paulson is doing the right thing — but it's not likely to be enough. The government has to be prepared to keep the financial system functioning for months, or at least until the economy bottoms out. Paulson's big shift is only the down payment.

Copyright © 2012 Bloomberg L.P.All rights reserved.

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