"...there was too much leverage in the system, and a lack of awareness as to how much leverage there was..." ('NO...!?!...that cannot be "possibly true"...'-Edition)

Paulson sees faint light at end of financial tunnel

The US Treasury chief warns of some unpleasant shocks ahead, but he remains cautiously optimistic, writes Krishna Guha

The credit crisis is entering its later stages, but the proc­ess of deleveraging in the financial system still has further to (go, according to Hank Paulson, the US Treas­ury secretary.

"I am encouraged. I am feeling better about the mar­kets," he told the Financial Times, adding: "In terms of the capital markets, I believe we are closer to the end than the beginning."

Mr Paulson said he took "some comfort and satisfac­tion" from the amount of capital that was coming into the banking system, both in the form of equity infusions into banks and private capi­tal deployed to purchase assets such as leveraged loans.

"There have been plenty of examples through history of where astute investors have come in and taken advan­tage of distress in the mar­ket to make good profits," he said.

But he said the process was taking a long time, partly because of the com­plexity of some of the credit instruments involved, but also "because of the increase of'leverage in the system".

Before last summer's credit squeeze, many finan­cial institutions took on extra leverage in the form of debt to maximise profits at a time of cheap borrowing. But that has left them vul­nerable to losses, and a proc­ess of increasing the amount of equity, relative to debt, is seen as essential to recovery from the crisis.

Mr Paulson said one of the big lessons of the past months was that "there was too much leverage in the system, and a lack of aware­ness as to how much lever­age there was".

The deleveraging process, he said, was an important part of the repricing of risk, "I would say that this has still got further to go," he said, calling on US financial institutions to continue to raise more capital.

Mr Paulson said markets "feel much better than they did in March". But he said a number of markets were still not functioning as normal and there would be "some unpleasant surprises" along the way to recovery.

"These things do not move in straight lines. This is partly about the underlying economy. It is also partly about sentiment, and senti­ment can swing dramati­cally."

The US economy had had a couple of tough quarters, and "we are in a tough quar­ter now". Rising energy prices, along with health and food costs, presented "an additional headwind" to growth.

There was, he said, no quick fix.

"Energy, first and fore­most, is [about] the supply and demand situation," he said. "In addition, there have been a number of financial investors that have decided to increase their investment allocations to commodities in general."

The former investment banker said there was "obvi­ously speculation in all of these things". But he believed that investors were also making "longer-term asset allocations" to com­modities.

He was focused on getting tax rebates into the hands of consumers as quickly as pos­sible to support spending.

Mr Paulson acknowledged that housing remained "the biggest risk to the econ­omy". The administration was going to "great lengths in working with the private sector to avoid preventable foreclosures". But the US government did not want to impede a "necessary correc­tion" in house prices.

The Treasury was working with lenders and loan servic-ers to deal with the complex­ity created by what he called the "Gordian knot of securitisation" - the fact that loans are co-owned by many different investors, making it difficult to reach agree­ment on restructuring them.

Mr Paulson said the indus­try had "made a lot of progress". But it was now "a matter of executing better and executing quicker, and working on additional issues such as principal write-downs and second mort­gages."

Mr Paulson said the Treas­ury would unveil a series of new initiatives in the com­ing weeks. None would be "major breakthroughs", but each would be "productive".

This week the White House threatened to veto a bill that proposed allowing the Federal Housing Admin­istration to provide $300bn to $400bn (€194bn-€258bn, £152bn-£203bn) in credit guarantees to refinance restructured mortgages.

Asked about this, Mr Paul­son said: "We have got the same objectives. We are already doing a lot adminis­tratively at the FHA." But he added: "We believe that this bill is too prescriptive and goes too far in terms of shifting risk from lenders to taxpayers."

However, he would "look carefully" at a separate pro­posal from Sheila Bair, the banking regulator, to pro­vide low-interest govern­ment loans to help borrow­ers partly pay down un-affordable mortgages.