US $1 trillion bailout is under threat from political skirmishes

By Stephen Foley in New York and Margareta Pagano in London
September 21 2008

Cracks are opening up in the remarkable political consensus that allowed the US government to promise a solution to the year-old credit crisis, with Wall Street becoming nervous that partisan battles could delay vital plans to clean up banks' toxic balance sheets.

Less than 48 hours after the Treasury Secretary Hank Paulson called together Congressional leaders from both sides of the aisle, Democrats are demanding that additional measures to boost the economy and prop up house prices be bolted on to legislation aimed at bailing out Wall Street.

Treasury and Congressional aides were huddled together over the weekend to finalise details of a government plan to buy, potentially, hundreds of billions of dollars of distressed mortgage assets – a scheme aimed at clearing out these assets and restoring confidence to the banking system.

Some analysts say the bail-out of the financial system could cost the US government up to $1 trillion, taking a heavy toll on the economy. This includes the rescue of Bear Stearns, Fannie Mae and Freddie Mac, as well as AIG.

Specific legislation will be needed to create a new government agency or government-sponsored vehicle to buy up assets such as collateralised debt obligations (CDOs), whose value has been deteriorating since Americans began defaulting on their loans in record numbers. With the ultimate collateral for these derivatives – US houses – still tumbling in value, there has been no market for the assets for over a year, and the freeze has triggered a chain reaction of disasters in the credit market that reached a crescendo in last week's historic events on the global markets.

Congressional leaders plan to have legislation drawn up early this week, galvanised into action by the panic on Thursday that threatened a modern-day repeat of Depression-era bank runs.

But leading Democrats said a Bill focused on Wall Street would be unacceptable unless accompanied by more help for homeowners. Barney Frank, chairman of the House Financial Services Committee, said the measures should include a second economic stimulus package with funding for infrastructure. A first stimulus package, containing $150bn (around £80bn) of tax rebates, buoyed consumer spending over the summer and kept the US out of recession.

Other Democrats have called for measures to prevent more home foreclosures. The leader of the Senate's Democrat majority, Harry Reid, said: "We must not forget Main Street as we address the crisis on Wall Street."

With Mr Paulson spending the weekend contacting chief executives across the banking industry to discuss a mechanism for the government to buy toxic assets, aides remained positive that a deal would be reached. Last night, however, he was also facing anger from some within his own Republican Party, as a number of congressmen questioned the cost of a taxpayer-funded rescue that some estimates suggest could run beyond $500bn. The Republican presidential candidate John McCain has strongly criticised the state's role in salvaging the US financial system. On Friday, he said: "The Federal Reserve should get back to its core business of managing our money supply and inflation. It needs to get out of the business of bailouts."

Ben Garber, an economist at Moody's Investors Service, said speed was of the essence. "I think the idea has a very solid chance of succeeding, but it is very difficult to gauge the exact effects on which institutions. What is important is that the government does not leave institutions hanging on too long with these distressed assets on their books."

Decisions on both sides of the Atlantic to ban short-selling of financial stocks temporarily were conceived to give the authorities a window in which to craft a longer-term rescue. Not only did the bans end a downward spiral in bank share prices – they sparked a rally which contributed to optimism that the world could yet avert a slump into recession.

But the ban on short-selling provoked a strong reaction in the UK, where many hedge funds and investors defended the practice, arguing that the equity markets will be less efficient as a result. On Friday, however, the FTSE 100 soared by more than 8.8 per cent to 5311.30 – the biggest daily gain in its 24-year history.

Dealers, though, remained adamant that short-selling should not be blamed for the sharp falls in HBOS's shares earlier in the week. Figures from dataexplorers.com, the stock-lending research house, confirmed that most of the HBOS share dealing last week had been conventional selling by fund managers.

Will the Government Bailout Work?

By Nomi Prins

Friday, like an electrical shock to a failed heart, federal money promises lifted the pulse of the financial markets. Unfortunately, Washington still doesn't know how much risk it's taking on.

Treasury Sec. Henry Paulson's multi-billion dollar market rescue includes four things to save the market: Creating a toxic waste fund for worthless mortgage assets, extending the Fed's discount window to investment banks, using a $50 billion Depression-era Exchange Stabilization Fund to guarantee money market investments, and installing a temporary ban on short-selling 799 financial stocks.

The stock market loves all of them, finishing Friday's trading session with a flourish. Even Bush came out of hiding to optimistically note that, "in the short run, adjustments can be painful…in the long run, I'm confident that our capital markets are flexible and resilient and can deal with these adjustments."

The waste-removal vehicle that Paulson is proposing is similar to the S&L crisis one; the Resolution Trust Corporation created in 1989 to assume over $125 billion in bad assets owned by insolvent savings and loan companies. Its primary goal was to sell them into the market slowly, giving the industry time to heal.

Will that work now? Not really. The packaged mortgage assets today are much more complicated than they were 20 years ago, and the entangled credit default products less transparent. Plus, S&Ls were regulated by the government, whereas the institutions that could benefit from such a fund today, like investment banks and hedge funds and insurance companies, are not.

As for a short-sale ban—this isn't the first time that SEC Chairman Christopher Cox has proposed one under a measure provided by the 1934 Securities Exchange Act. After four months of deliberating the role that short selling might have played in the pummeling of Bear Stearns' stock, he installed a 10 day short-sale ban, between July 21st and 29th. That didn't work for long.

But, sort of like with Sarah Palin and the bridge to nowhere, before he was against short selling, he was for it. Last year, the SEC removed a post 1929 stock market crash rule that only allowed short selling when the stock price's last tick was positive, which was designed to prevent the kind of short selling he's concerned about now.

Meanwhile, Central Banks around the world are lavishing cash on the financial industry to keep liquidity alive. Today, Japan, Australia, India and Indonesia pumped $42 billion into their money markets, a day after the US Federal Reserve pushed through an $180 billion package. The Bank of England, Swiss National Bank, and European Central bank lent $70 billion of cash to their markets.

But,

Here's the thing. Bear Stearns and Lehman Brothers didn't go bankrupt because of individual mortgage loans defaults and foreclosures. These were simply the catalysts at the bottom of a huge pyramid of leverage that ultimately uncovered the sheer lack of transparency in the financial markets. Without a clear understanding of the risks in our US financial system, including huge new conglomerate balance sheets like that of Bank of America-Merrill Lynch, this euphoria will soon give way to further disintegration.

Using terms like 'adjustment' and 'correction' makes it seem like this episode of financial destruction can be cured by the equivalent of a chiropractor visit. What we really need is something more drastic: a Glass-Steagall style wall.

Already, the US national debt has nearly doubled in the past eight years, and it will keep going up. If Congress really wants to alleviate this crisis, they need to not set themselves up for another round of handouts while making the public shoulder the risk of the entire banking community.

Here's a breakdown of the $555 billion running total of Wall Street aid to date: The Fed backstopped $30 billion of Bear Stearns risk in its sale to JPM Chase in March, is loaning $85 billion to AIG in return for an 80 percent equity stake, opened a $150 billion window for banks who could use risky mortgage securities as collateral, and extended the use of its discount window to investments banks who aren't supposed to have that privilege, since they're not regulated by the Fed. The Treasury has pledged to backstop Fannie and Freddie up to $200 billion, created an emergency $40 billion worth of T-bills to be auctioned to spot the Fed some extra cash, and is using a $50 Depression-era emergency fund to support the money market industry.

Nothing converts free-marketers to pseudo-socialists like fear and an international spotlight. But instead of discussing intense new regulation, the US government is just writing out checks. The New Deal didn't just include the Glass-Steagall Act of 1933, which disentangled riskier speculative investment banks from the more consumer-oriented commercial banks, it provided safeguards to the entire financial system. Today, Washington is using the ones that it didn't destroy. It would be much better if they were discussing how to resurrect the ones they did.