Paulson Tries to Calm Investors, Says Stability Will Return

Aug. 21, 2007 -- Treasury Secretary Henry Paulson today paired a sober outlook with measured confidence, saying it "will take some time" before the market emerges out of the current credit crunch and restores itself back to health.

"We've had some bad lending practices," Paulson said on CNBC. "This is going to take a while to play out."

Though he warned the end is not immediately in sight for the credit crunch that has slowed the market ever since the collapse of the subprime mortgage market earlier this year, Paulson added that the economy remains fundamentally strong and will eventually rebound from its current difficulties.

"Economic growth will be less than it ordinarily would have been," Paulson said. But he nonetheless added, "I expect the economy to continue to grow and create jobs."

This morning the Federal Reserve also pumped another $3.75 billion into the financial system, the latest in a series of maneuvers that has pumped over $100 billion into the market since last week.

Saying he has "great confidence" in the Federal Reserve, Paul said these maneuvers will help investors focus on the principal problem on hand -- the repricing of risk.

"As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk," Paulson said. "This will play out over time and liquidity will return to normal when the market has a better understanding, investors have a better understanding, of the risk-return trade off."

Stocks fell in early trading Tuesday after Paulson's remarks.

The market has slowed down ever since investment banks and hedge funds began to realize earlier this year that they were over-invested in risky high-yield subprime loans, used for home mortgages given to individuals with poor credit. With home values stagnant, these owners will be unable to refinance their loans when higher interest rates kick in beginning later this year, raising the specter of large-scale defaults on these loans.

Several funds had problems, but it was not until the well-respected investment bank Bear Stearns revealed problems that the market woke up. Last month Bear Stearns announced that one of its hedge funds, which had been highly exposed to subprime mortgages, was essentially worthless, while another had lost 90 percent of its value.

A host of other major banks and hedge funds, including Paulson's former employer Goldman Sachs, have also seen significant devaluations of some of their funds.

Investors have looked to withdraw their money from their beleaguered funds – the equivalent to a run on the bank – and banks have not always had the cash readily available for them. The Federal Reserve's maneuvers over the past two weeks were designed to pump liquidity into cash-starved banks looking to satisfy investors and sustain the current credit problems.

Paulson and investors on Wall Street are hoping that the price of risk will stabilize soon so that normal market activity can recommence.

Paulson also met behind closed doors this morning with Federal Reserve Chairman Ben Bernanke and Senate Banking Committee Chairman Christopher Dodd, D-Conn.

Dodd, who is also a presidential candidate, spoke to reporters after the meeting and said that he urged both the Federal Reserve and the Treasury to "use all the tools at their disposal to keep the market working."

"It's important to be vigilant but also it's time to act," said Dodd, who added that he thinks the Federal Reserve "acted responsibly" by pumping liquidity into the market last week.

He continued to urge the Bush administration to lift the portfolio caps on the government-sponsored mortgage companies Freddie Mac and Fannie Mae. "This would have a positive effect I think on dampening down interest rate caps."

But on CNBC this morning Paulson said that raising those caps "doesn't do much of anything," and the Bush administration has signaled it will not raise those caps.