Proposed U.S. mortgage aid would do harm -Paulson

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"Most proposals I've seen would do more harm than good," he said in a speech to the Economic Club of Chicago.

Several leading Democratic lawmakers in Washington have proposed multibillion-dollar programs that would help troubled borrowers stay in their homes.

Paulson also had strong words of discouragement for homeowners who may be mulling whether to simply walk away from a home that has slipped in value. He said homeowners who could afford their mortgage should honour their obligations and that the Bush administration had no interest in bailing out housing speculators.

As for the economy, Paulson said he expected it to continue to grow this year, although he noted problems in the housing market continue to pose the biggest downside risk.

He fingered subprime mortgages as the catalyst for turmoil in the capital markets, which he compared to "a dry forest out there waiting for a match."

"We're working our way through this and there will be a policy response," he said, adding that the response will deal with mortgage originators, securitization, rating agencies, disclosure and valuation issues.

He added that while he has "great confidence" in the markets, a good number of them were not performing as they should.

STRONG DOLLAR IN USA'S BEST INTEREST

Paulson also touched on currency matters in response to questions from the audience at the Economic Club of Chicago. He said he believed a strong dollar was in the best interest of the United States.

In early Tokyo trading on Friday, the dollar fell below the psychologically important level of 105.00 yen and slid to 104.60 yen, its lowest since May 2005.

The dollar's slide followed Federal Reserve Chairman Ben Bernanke's warning to the Senate Banking Committee in Washington on Thursday that some small U.S. banks may fail because troubled real estate investments may drain their capital during the housing crisis. The dollar hit a lifetime low against the euro and a basket of currencies on Thursday.

As for China's yuan and other issues with China, Paulson told his Chicago audience that progress was being made.

"Frankly, if China does well economically, it benefits us in our economy," he said, adding that was not a popular sentiment, "but it's true."

The People's Bank of China, the central bank, on Friday set the mid-point of the yuan exchange rate against the dollar at 7.1058, its highest level since Beijing re-valued the Chinese currency in July 2005.

(Additional reporting by Patrick Rucker in Washington; Editing by Jan Paschal)

(Reporting by Karen Pierog)