EXTRA CREDIT: Paulson Faces Tough Crowd On Subprime Strategy

NEW YORK -(Dow Jones)- Treasury Secretary Henry Paulson may never have had to deal with this sort of pressure before he moved from the helm of Goldman Sachs.

His briefing Thursday on the government's plan to prevent a housing crisis was defending more than just a strategy that can't possibly address the full implications of the subprime market's collapse.

At stake was his personal credibility as a Treasury Secretary with the industry smarts to conjure a market-driven response to the biggest threat to the U.S. economy in almost a decade.

So far, Paulson has yet to enjoy a clear success in tackling this crisis, either from the political angle - the issue of keeping people in their homes - or from the capital markets angle that should arguably be his forte.

Informal Opposition

Though the Treasury's plans on both of these angles enjoys considerable industry support in public - the loan modification deal is backed by the American Securitization Forum - they have drawn widespread informal opposition from market participants.

The government's strategy to avert a mass of foreclosures in the coming year among subprime borrowers is already facing staunch criticism from those who say it won't reach the most embattled homeowners, who can't afford their mortgages at even the current "teaser" interest rate.

And within minutes of the government's briefing Thursday, ratings agency Standard & Poor's - charged with its own share of complicity in the subprime mess - said that the plan to freeze mortgage reset rates for five years could lead to further downgrades to the securities they back.

Paulson's capital market salve is no closer to fruition. Indeed, several weeks after he announced the plan to create a Super SIV, a structured investment vehicle sponsored by three Wall Street heavyweights and administered by an asset manager, the project is still grounded, amid talk of a lack of demand. Instead, banks such as U.K. banking giant HSBC Holdings (HBC) have led the way in taking their tainted investments in these vehicles back onto their balance sheets.

A Long And Winding Road

Paulson himself was clearly on the defensive against such charges Thursday, reiterating that there is "no silver bullet" to dispatch the mortgages crisis. Moreover, he described it as part of an "evolving" policy, thereby reminding everyone that this problem is far from over.

Indeed, this is a problem unlike any that faced his predecessors. William Kline, senior fellow at the Petersen Institute for International Economics, argues that, even if there were a silver bullet, the financial technology involved in the subprime crisis has blurred the target.

In 1989, when then-Treasurer Nicholas Brady intervened in the Latin American debt crises with his loan restructuring plan, there was nothing like the risk dispersion that's been created via synthetic and structured debt deals. "In a sense, Paulson is dealing with a less transparent problem than either the Latin crisis or the LTCM crisis," said Kline.

Crucially,the subprime mortgages crisis is impervious to Paulson's greatest strength. His ties to the market as a 32-year veteran of Wall Street and former Goldman Sachs CEO can't muster the massive consensus he needs for a swift resolution. For this, he must prevent a storm of litigation among the myriad small- and medium-sized institutions holding mortgage-backed securities and the structured products they underpin.

When Long Term Capital Management collapsed back in 1998, then New York Fed Chairman Bill McDonough could run through a rolodex of the leading banks and talk them down from a fire sale of redeemed assets.

"If all these mortgages were held by the 15 largest banks, they could all agree to freeze rates," said Kline.

Instead, they are held by investors around the world, listed on balance sheets from major pension funds to the smallest local governments.

But it is premature to judge Paulson too harshly on these counts. His two most recent predecessors, John Snow and Paul O'Neill, commanded little respect on Wall Street, nor did they enjoy a long or smooth tenure in the administration.

Treasury may nevertheless have gained a better handle on this crisis by now had it been a little swifter to act.

"It would've been better if the Treasury had more ambitious plans outlined earlier," said Douglas Elmendorf, senior fellow at Brookings Institute in Washington. "But I'm pleased at all the steps that they have taken."

Officials will have plenty of time to hone their approach. The clear subtext to Thursday's conference is that the market strain will not ease any time soon. Lending conditions have seized nastily heading into the year end, with soaring rates on one-month lending between banks, and there's no reason to assume that they will fall back in the new year.

"Maybe this will help relax financial markets a bit, but they're still worried about the unknown losses held by financial institutions," Elmendorf said.

It's this massive unknown quantity - even after the string of large-scale writedowns announced by Wall Street firms over the past earnings season - that needs ultimately to be addressed by officials serious about solving the capital markets problem.

"We need to have these positions valued appropriately. " said Joseph Mason, Associate Professor of Finance at Drexel University's LeBow School of Business.