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September 22, 2008
The Great Confidence Game
By Robert SamuelsonWASHINGTON -- It's doubtful that former Princeton University economist Ben Bernanke and ex-Goldman Sachs CEO Hank Paulson imagined what awaited them when they took charge of the Fed and the Treasury in 2006. Since then, they have put their agencies on a wartime footing, trying to avert the financial equivalent of an army's collapse. As in war, there have been repeated surprises. As in war, the responses have involved much improvisation -- for instance, the $85 billion rescue of American International Group (AIG). But last week their hastily built defenses seemed threatened, and so Paulson proposed a radical solution of having the government buy vast amounts of distressed debt to shore up the financial system.
It's all about confidence, stupid. Every financial system depends on trust. People have to believe that the institutions they deal with will perform as expected. We are in a crisis because financial managers -- the people who run banks, investment banks, hedge funds -- have lost that trust. Banks recoil from lending to each other; investors retreat. The ultimate horror is a financial panic. Paulson aims to avoid that.
As is well-known, the crisis began with losses in the $1.3 trillion market for "subprime" mortgages, many of which were "securitized" -- bundled into bonds and sold to investors. With all U.S. stocks and bonds worth about $50 trillion in 2007, the losses should have been manageable. They weren't, because no one knew how large the losses might become or which institutions held the suspect subprime securities. Moreover, many financial institutions were thinly capitalized. They depended on borrowed funds; losses could wipe out their modest capital. So the crisis spread.
Since August 2007, the Fed has done three things to prevent eroding confidence from becoming panic. The first was standard: cut interest rates. By April, the overnight fed funds rate had fallen from 5.25 percent to the present 2 percent. The aim was to promote lending and prop up the economy. By contrast, the second and third responses broke new ground.
If banks still avoided routine short-term loans -- fearing unknown risks -- then the Fed would act aggressively as the lender of last resort. Bernanke created several new "lending facilities" that allowed commercial banks and investment banks to borrow from the Fed. They received cash and safe U.S. Treasury securities in return for sending "securitized" mortgages and other bonds to the Fed. In this manner, the Fed has lent more than $300 billion.
Next, the Fed and the Treasury prevented bankruptcies that might otherwise have occurred. With the Fed's backing, the investment bank of Bear Stearns was merged into JP Morgan Chase. Fannie Mae and Freddie Mac, the mortgage giants, were taken over by the government; their subprime losses had also depleted their meager capital. And now AIG, the nation's largest insurance company, has been rescued.
How much all this will cost taxpayers is unclear. It could be many billions -- or nothing. For example, the Fed is charging AIG a hefty interest rate and expects to be repaid from the sales of the firm's businesses. But turning the Fed into a massive lending agency supporting specific firms and types of credit was a dramatic shift from its role of regulating interest rates and credit conditions. The official justification: Companies that lent to and traded with the salvaged firms wouldn't suffer further losses.
Unfortunately, these confidence-building exercises slowly lost their effect. As today's surprise followed yesterday's, it became less convincing that Paulson and Bernanke could control the crisis. Practical problems also loomed. The Fed has financed its lending program by reducing its massive holdings of U.S. Treasury securities. It could not do this indefinitely without exhausting all its present Treasuries. A danger: The Fed might then resort to old-fashioned -- and potentially inflationary -- money creation.
Against that backdrop, Paulson suggested something resembling the Resolution Trust Corp. of the savings and loan crisis. This new entity would buy subprime mortgage securities to stabilize the financial system. But hard questions remain. Which securities would be eligible? Just subprime? Suppose a weaker economy creates new classes of bad debt -- say credit card securities? What price would the government pay? Would government hold them to maturity or sell? What about U.S. securities held by foreigners?
Objections to Paulson's proposal abound. It would rescue some financial institutions from bad decisions. Some investors doubtlessly bought subprime securities at huge discounts and would reap massive profits by reselling to the government. That might trigger an angry public backlash. The program would be huge ("hundreds of billions," says Paulson) and could burden future taxpayers. To which Paulson has one powerful retort: It's better than continued turmoil and possible panic. But that presumes success and begs an unsettling question: if this fails, what -- if anything -- could the government do next?
Copyright 2008, Washington Post Writers Group
