A break in the clouds

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Sep 22nd 2008 | WASHINGTON, DC
From Economist.com

But questions abound over a $700 billion rescue plan for Wall Street

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THE threat of impending financial disaster concentrates political minds wonderfully. On Thursday a group of congressional leaders heard Hank Paulson, the Treasury secretary, and Ben Bernanke, the Federal Reserve chairman, describe a dire economic scenario if they did not approve a more sweeping remedy for the financial crisis. Student and car loans, not just mortgages, would all be harder to get. The economy would sink into a severe recession.

So by Sunday September 21st support was coalescing around the Treasury’s rescue proposal: that Congress authorise it to buy up to $700 billion in mortgage and other assets in an effort to resolve the root of the financial crisis, which is the huge amount of illiquid and uncollectable mortgage debt on financial institution balance sheets. (One senator predicted $1 trillion would be needed.) Passage this week, before Congress breaks for the election, seems likely.

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Democrats in Congress have several priorities in negotiations. They want the government to modify the mortgages it owns so that homeowners can avoid foreclosure; they want the Treasury to receive shares or senior debt from companies that sell it troubled assets so that taxpayers can share in the industry's upside; and they want limits on executive compensation for firms selling assets to the programme. This last condition may be the most contentious. If “it's punitive…institutions aren't going to participate,” Mr Paulson noted.

Mr Paulson’s plan is stunning in its brevity (two-and-a-half pages) and audacity. It would authorise him to purchase any “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages,” implying the right to take over derivative positions. A fact sheet later distributed by the Treasury broadened it to include “other assets, as deemed necessary to effectively stabilise financial markets.” The government could, in effect, buy anything it wanted: student or car loans, loans, equities, entire companies.

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The Treasury secretary’s decisions “may not be reviewed by any court of law or any administrative agency.” He would report to Congress three months after the programme begins and every six months thereafter. It is now conventional wisdom that recent events have guaranteed a heavier regulatory hand for government in the economy. Mr Paulson’s programme raises the prospect of it becoming a huge player in the allocation of capital as well. The ability to buy assets expires after two years, but its management of those assets would continue.

Mr Paulson said that the lack of oversight gives future administrations “flexibility to run this any way they would like to run it.” And some experts say decisions must not risk being tied up in lawsuits, or confidence could suffer. But the great discretionary power seems to fly in the face of the original rationale for the programme, which was for a systematic rules-based approach to resolving the crisis rather than ad-hoc bail-outs. Future administrations could find a $700 billion fund a potent tool for various policy goals. A counter-proposal by Chris Dodd, the Democratic chairman of the Senate Banking Committee, envisions an oversight board comprising the chairmen of the Federal Reserve, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and two members named by congressional leaders, one from each party. The Fed chairman would chair the oversight board. It also requires monthly reports to Congress and the creation of an inspector-general over the programme.

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To acquire mortgages the Treasury plans to use “reverse auctions”. But as Lou Crandall of Wrightson ICAP, a research firm notes, “Auctions work well when you have a group of bidders for a single set of identical assets. They work less well when you have a single bidder for a group of disparate assets.”

Another problem is that it would reward the least deserving institutions the most. “Banks that stayed clear of this debt or sold such debt at cut-rate prices earlier this year in an effort to move beyond the crisis would receive no direct gain from such a programme,” notes Doug Elmendorf of the Brookings Institution, a think-tank, while banks who had the most junk and had dragged their feet on writing it down would benefit most.

Mr Paulson has rightly noted that the cost of the programme should be well below $700 billion since some of the mortgages will be repaid. But it may be optimistic to expect it to turn a profit. Indeed, profit is inconsistent with the point of such a programme which is to socialise losses that would otherwise cripple the financial sector and toss millions of people out of their homes. The lack of an upside for taxpayers is one reason that some scholars, like Mr Elmendorf, favour the taking of direct stakes by the government in financial firms instead.

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Profit is possible, of course. The market prices of many mortgage securities today reflect not just the likelihood of default, but a steep liquidity premium, because the paper no longer trades. The Treasury could conceivably buy something above market value but below fair value and hold it to maturity. But it could deepen the financial crisis by forcing institutions to recognise the assets’ deeply distressed prices.

Even if the programme is designed perfectly, it is no sure thing it will end the crisis. It does address the root problem, defaulting mortgages, and Mr Bernanke has long worried that bad debt would fuel a vicious circle of crippled lenders, constricting credit, weakening growth and more defaults. But that is not what happened last week. Losses on Lehman debt forced several money-market funds to “break the buck” (lower their net asset value below the sacred $1 per share), triggering a flight out of short-term commercial paper. Banks, forced to contemplate redeeming hundreds of billions of dollars in maturing commercial loans, began hoarding liquidity. Interbank lending froze. This generalised loss of confidence was many steps beyond the root cause of the crisis. Announcement of bail-out plans helped ease things, but the effect was purely psychological.

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For this reason, ad hoc responses will still be critical, such as last week’s federal guarantees for money-market funds, Fed loans to banks to buy asset-backed commercial paper and, on Sunday, approval of the remaining two big independent investment banks, Morgan Stanley and Goldman Sachs, to become Fed-regulated bank holding-companies whose investment bank units can now borrow from the Fed on the same terms as other banks.

It could be some time before the Treasury is able to buy mortgages en masse, and longer still before that starts to affect the broader financial system and economy. In the meantime, the crisis could claim other victims.