Capital Markets

Time to Think Big

The Treasury, Fed, and Congress decide to spend a lot of money to stabilize markets.
Economist StaffSeptember 19, 2008

(See original story on Economist.com.) Until this week America’s authorities clung to the hope that they could tide over the financial system with a few loans until home prices stabilised and all the bad debts were accounted for. But the destruction visited on Wall Street in the past week has dashed those aspirations and forced policymakers to consider a more sweeping response. The bankruptcy of Lehman Brothers and AIG’s federal takeover have triggered a wholesale flight to safety that could turn illiquid institutions insolvent. Healthy corporations can no longer issue bonds. Banks can barely borrow from each other.

The federal government, having lent hundreds of billions of dollars to banks and investment banks and AIG, now thinks it must put permanent capital into the financial system to restore confidence and stop the vicious spiral. On the night of Thursday September 18th Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, met Congressional leaders. They discussed “a comprehensive approach to address the illiquid assets on bank balance sheets that are at the underlying source of the current stresses in our financial institutions and financial markets,” a Treasury spokesman said. “They are exploring all options, legislative and administrative, and expect to work through the weekend with Congressional leaders to finalise a way forward.”

And the next morning America’s financial regulators followed the example set by their British counterparts the day before and temporarily banned the short-selling of shares in financial institutions. Short-sellers have taken the blame for adding extra untoward downward pressure on the share prices of struggling banks. The Treasury also announced on Friday that it would put up $50 billion to back money-market funds, where cracks are also appearing. Hitherto seen by small investors as utterly safe, any loss of confidence in these funds, which are big buyers of short-term corporate debt, would be hugely damaging.

The authorities are considering two broad approaches to shore up the financial system. One is to create an institution to provide capital to weakened institutions. A proposal floated on Thursday by Charles Schumer, a Democratic senator, would recreate the Depression-era Reconstruction Finance Corporation to “provide capital to struggling financial institutions in exchange for an equity stake.” The banks would have to let judges write down delinquent mortgages to levels homeowners could afford. Such an institution could conceivably relieve the Fed of its politically compromising loans to Bear Stearns and AIG.

The problem is that such an approach might not have much impact until bad debts drove many institutions to the brink of failure and they had nowhere else to turn. By that point, the economy would be in dire straits and the financial system in chaos. Moreover, the Bush administration has opposed forcing lenders to write down their mortgages.

The Treasury’s preference is to buy the mortgage securities at the heart of the problem, thereby putting a floor under their prices and removing them from the banking system. (There is apparently no serious proposal to purchase the homes.) The Treasury already has the authority to purchase mortgage-backed securities underwritten by Fannie Mae and Freddie Mac but wants to be able to buy much dodgier mortgage securities which have become impossible to trade. The Fed could also purchase such securities by invoking its emergency powers.

This approach has its problems. As Mr Schumer noted, “most troubled mortgages have been sold into complex mortgage-backed securities, which have themselves been split into pieces and sold to thousands of investors around the world.” To modify these mortgages so that homeowners could stay in their homes, the government “would have to be able to gather all of the pieces of every security and put the proverbial puzzle back together. This would be incredibly difficult.”

Either approach would be difficult, controversial and extremely expensive. If the Treasury or Fed acted alone, it would infuriate both parties in Congress, already aghast at how much taxpayers’ money has been lent without their approval. Democrats in Congress are still suspicious of Mr Paulson for taking over Fannie Mae and Freddie Mac less than two months after playing down the possibility.

A bail-out plan would require staggering sums—as much as $500 billion—to provide meaningful support. As of June 30th, $10.6 trillion of home mortgages were outstanding (the vast amount current). Once authorised, the money may not be spent: mere knowledge of the fund’s existence might restore confidence. And banks don’t have to sell their mortgages to benefit; merely having a credible market price for those they hold could restore the confidence of investors. And if the Treasury is astute in its buying, it could even make money. After all, thanks to investors’ panicked flight to the safety of Treasury debt, it can now borrow for close to nothing. The Treasury would have to recognise that it could lose a lot of the money too: there’s a reason no one wants this paper. Still, even $500 billion, at 4% of GDP, is cheap compared to an average of 16% that banking crises around the world have cost in the past 30 years, according to the International Monetary Fund.

Congressional leaders, who plan to go into recess at the end of next week, had previously said that consideration of such an ambitious initiative would have to wait until after the election. This week’s events have concentrated their minds. Republicans recoil at the thought of bail-outs but don’t want to accept blame for a market meltdown less than two months from an election. The Dow Jones Industrial Average had been heading for another sickening fall on Thursday until news of the plans sparked a turnaround and sent it up by 4% on the day.

John McCain, the Republican candidate for the presidency, who had argued against aggressive bail-outs for homeowners earlier this year, has jumped on board, calling on Thursday for a “mortgage and financial institutions trustÂ…to work with the private sector and regulators to identify institutions that are weak and take remedies to strengthen them before they become insolvent.” He wasn’t specific about what this outfit would do. No matter: for politicians, doing nothing is apparently no longer an option.

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