The $700-billion bailout plan proposed by US treasury secretary Henry Paulson is bad in principle and will create more problems in the long term than the short term fixes it offers. By Shivshanker Verma

The day after he announced the $700-billion bailout plan, US treasury secretary Henry Paulson did a series of interviews to drum up support for the plan. Like most politicians, he blamed the excesses of Wall Street for the crisis.

Paulson talked about "bad lending practices", "irresponsible borrowing", "irresponsible lending", "overly complex securities" and "rating agency failures". At the hearing before the US Congress to present the plan, Paulson even said "it is embarrassing to look at this".

That was quite rich from Henry Paulson who was, until as recently as 2006, the CEO of the firm that was the most profitable during the boom - Goldman Sachs. He presided over the firm during those golden years when the huge explosion in credit derivatives brought unprecedented riches to Wall Street. He didn't realise the risks inherent in the system then, but does very clearly now.

Not only that, he left the firm for the government at the peak of the boom. In other words, he managed a perfect bailout for himself back in 2006. Now, he wants to offer a bailout to the rest of the world.

The bailout plan from Paulson has something for everyone to criticise, except maybe the bankers who will be the biggest beneficiaries.

It is bad in principle and will create more problems in the long term than the short-term fixes it offers.

A cartoon strip that appeared over the weekend in Los Angeles Times nicely sums up the worst part of the Paulson bailout plan. The strip is designed like an advertisements for muscle-building supplements with an image of Hank Paulson, dubbed 'The World's Most Economically Advanced Man', looking more like the Schwarzenegger of old.

It starts with a skinny Uncle Sam, enjoying a bit of a sun on the beach with his girlfriend, being bullied by the muscular Bad Mortgage Guy. To get even, Uncle Sam buys the $700-billion 3-page Paulson plan, which promises to make any 'scrawny, whining runt' into 'The World's Most Perfectly Developed Economic Stud'. 

Lo and behold! Uncle Sam is instantaneously transformed into a stud as promised. To get even with the Bad Mortgage Guy, he goes back to the beach and hands out, not a series of blinding punches but a heavy bagful of dollars to his tormentor. While Sam's girlfriend gushes he is a real man, Bad Mortgage Guy can't believe himself and exclaims 'what a guy!'

What a guy indeed! Every banker who raked in millions of dollars in bonuses over the last several years must definitely be thanking Paulson for his generosity.

Because of the bailout, bankers can now get away with the least pain for the stinking mess they created.

Shareholders, except the unlucky ones who were invested in the already failed banks like Lehman Brothers and Washington Mutual, will get some of their money back.

Hedge funds can renew their bets, if they haven't already done so, on financial stocks. Warren Buffett will make a pile from his $5-billion equity investment in Goldman Sachs and all will be well with the world again.

There is a fundamental difference between the proposed blanket bailout for all comers and the earlier bailouts of Bear Stearns, Fannie Mae, Freddie Mac and AIG.

Shareholders lost nearly everything, as in the case of Bear Stearns, or were left with just 20-per cent stakes in the other three companies. The top managers were bundled out in all the four firms and the businesses were sold off or restructured substantially. Everyone associated with the businesses paid a heavy price and that is a big disincentive, for some time at least, to others who may be tempted to do it all over again.

The way liabilities were taken over or guarantees extended in the earlier bailouts were different.

Being 'US government sponsored' entities, the liabilities of Freddie Mac and Fannie Mae were de facto government liabilities in any case and the US government was just formally acknowledging that fact by coming to the rescue of the two firms. In the case of AIG, the US Fed has only extended a loan and that too at a very high interest rate.

The loan has to be repaid by AIG over the next two years by selling off its assets and, if the asset sales fetch more money, the government stands to benefit the most as it now owns 80 per cent of the firm. The only risky transaction is the nearly $30 billion guarantee extended by the US Fed to cover the bad assets of Bear Stearns, taken over by JP Morgan.

Unlike these bailouts, Paulson's new plan did not originally have any concrete provision for acquiring equity stakes in firms to be bailed out. It only talked about a 'flexibility' to consider such options, if the need arises in the event of potential losses to the government. There was no requirement for a management change or business restructuring, or even a cap on executive pay and bonuses.

The plan simply envisaged the government taking over the bad assets and letting the firms and their managements remain as they are.

Paulson sought to become the ultimate hedge fund manager, least answerable to regulators and his own investors. Under pressure from US Congress, Paulson later yielded to some form of cap on executive compensation and a provision for the government to acquire equity stakes. However, there is no clarity on the basic rules to be followed either in the case of equity stakes or executive compensation.

Defenders of the Paulson Plan argue that it is not feasible to include an equity acquisition clause as the plan is open even to foreign financial institutions. The foreign banks may not participate if it involves a compulsorily stake acquisition by the US government, they argue.

But, that is the problem of foreign banks and the governments of their home countries. If they don't want the US government to become a big shareholder, let those governments handle the crisis themselves! Yes, if foreign banks are excluded and foreign governments don't come out with their own plans, the Paulson Plan will not be as effective. Still, that is less of a price to pay than embracing this sort of crony capitalism.

Within days of the bailout plan being announced, an email spoof mimicking the notorious 'Nigerian email scam' started going around. It read, 'I am ministry of the treasury of republic of America. My country has had crisis that causes need for large transfer of funds of $700 billion. If you would assist me in this matter it would be most profitable for you. After you send me bank account details, I will reply with detailed information about safeguards to protect the funds.'

The unfortunate souls who responded to the original Nigerian scam emails lost a lot of money and a few who landed in Nigeria to claim the bounty even lost their lives. But, Hank Paulson's offer is no scam. It is for real. Those who respond to his offer will be saved from bankruptcy, may even get to enrich themselves and thank good heavens for the blessings they don't deserve and never prayed for.

Hank Paulson's plan to save the world may save the world from financial Armageddon in the short term. It will indeed change the world, but for the worse. It will cause even bigger bubbles, and bigger and costlier bailouts, in future. Then the world will remember Hank Paulson, maybe as the man who promised to make anyone 'The World's Most Perfectly Developed Economic Stud' for just $700 billion!