BT: Unravelling confidence game amid financial woes (23 Sep 2008)

Unravelling confidence game amid financial woes

By ROBERT SAMUELSON

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 Federal Reserve 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 US$85 billion rescue of largest US insurer American International Group (AIG).

But last week their hastily built defences seemed threatened, and so Mr 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 have lost that trust. Banks recoil from lending to each other; investors retreat. The ultimate horror is a financial panic. Mr Paulson aims to avoid that.

As is well-known, the crisis began with losses in the US$1.3 trillion market for sub-prime mortgages, many of which were securitised. With all US stocks and bonds worth about US$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 sub-prime securities. Moreover, many financial institutions were thinly capitalised. 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 per cent to the present 2 per cent. 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. Mr Bernanke created several new 'lending facilities' that allowed commercial banks and investment banks to borrow from the Fed. They received cash and safe US Treasury securities in return for sending securitised mortgages and other bonds to the Fed. In this manner, the Fed has lent more than US$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 JPMorgan Chase. Fannie Mae and Freddie Mac were taken over by the government; their sub-prime losses had also depleted their meagre capital. And now AIG has been rescued. How much all this will cost taxpayers is unclear. 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 Mr Paulson and Mr Bernanke could control the crisis. Practical problems also loomed. The Fed has financed its lending programme by reducing its massive holdings of 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, Mr Paulson suggested something resembling the Resolution Trust Corp of the savings and loan crisis. This new entity would buy sub-prime mortgage securities to stabilise the financial system. But questions remain. Which securities would be eligible? Just sub-prime? 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 US securities held by foreigners?

Objections to Mr Paulson's proposal abound. It would rescue some financial institutions from bad decisions. Some investors doubtlessly bought sub-prime securities at huge discounts and would reap massive profits by reselling to the government. That might trigger an angry public backlash. The programme would be huge and could burden future taxpayers. To which Mr 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? - The Washington Post Writers Group

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