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. Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, met Congressional leaders towards the end of the week. And on Saturday September 20th Mr Paulson sent a preliminary plan under which the federal government would be authorised to purchase up to $700 billion of "residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages" originated or issued on or before Wednesday. It could buy them from any financial institution headquartered in the United States.
America's financial regulators had already taken some steps to restore order to the markets. On Friday it followed the example set by their British counterparts and temporarily banned the short-selling of shares in financial institutions. Short-sellers have taken the blame for some of the instability. The Treasury also announced that it would provide guarantees of $50 billion to money-market funds, where cracks are also appearing.
At the same time, the Federal Reserve announced two measures aimed at easing strains in money markets. It will buy short-term debt issued by Fannie Mae and Freddie Mac from primary dealers. In a sign of the acute stress in markets this week, this paper has been trading at spreads of almost three precentage points above government debt of comparable maturity despite the de facto nationalisation of the mortgage agencies two weeks ago. The Fed will also extend loans to banks to buy asset-backed commercial paper from money-market funds that face redemptions.
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. 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.
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.”
The bail-out plan's large size is designed 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. At 5% of GDP, $700 billion would be larger than the net amount spent on the savings-and-loan clean-up in the early 1990s which came to around 3% of GDP. The final price tag of this bailout should be less since the government would eventually recoup some of the money owed on the mortgages. Even 5% of GDP is cheap compared to an average of 16% that banking crises around the world have cost in the past 30 years, according a recent staff study of 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. It jumped by another 3% Friday. The Treasury and the Fed would like Congress to pass enabling legislation this week.