It's doubtful that 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 (their "counterparties") will perform as expected. We are in a full-blown crisis because investors and financial managers—the people who run banks, investment banks, hedge funds, insurance companies—have lost that trust. Banks recoil from lending to each other; investors retreat. The ultimate horror is a financial panic; everyone wants to sell and no one wants to buy. Paulson's plan—still lacking essential details—aims to avoid that calamity.
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. AIG is a case in point. Although most of its businesses—insurance, aircraft leasing—were profitable, it had written "credit default swaps" (CDS) on some subprime mortgage securities. These contracts obligated AIG to cover other investors' losses. In 2008, AIG's mounting losses on its CDS contracts resulted in a downgrade last week of the company's credit rating and a need to post more collateral to its CDS "counterparties." AIG didn't have the cash.
Since August 2007, when the crisis first broke, the Fed has done three things to prevent eroding confidence from morphing into a self-fulfilling panic. The first was standard: cut interest rates. The overnight fed funds rate dropped 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 remained reluctant to make routine short-term loans—fearing the unknown risks—then the Fed would act aggressively as lender of last resort. Bernanke created several new "lending facilities" that allowed banks and investment banks (such as Goldman Sachs) 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 Bear Stearns was merged into JPMorgan 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 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 (mortgages, corporate bonds) was a dramatic shift from its familiar role of regulating interest rates and credit conditions.The justification: intervention prevented a disastrous chain reaction. Securities didn't get dumped on markets, depressing prices; companies that lent to and traded with these firms didn't suffer further losses.
The trouble with these confidence-building exercises was that the more of them that occurred, the less effect they had. As today's surprise followed yesterday's, it became less convincing that Paulson and Bernanke understood or could control the crisis. There were also possible practical problems. 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 would then resort to old-fashioned—and potentially inflationary—money creation.
Against that backdrop, Paulson suggested something like the Resolution Trust Corp. that was used in the savings and loan crisis to dispose of distressed real estate. This entity would buy subprime mortgage securities to stabilize the financial system. But hard questions remain. Which securities would be eligible? Just subprime? How about alt-A (mortgages with low documentation)? Suppose a weaker economy creates new classes of bad debt—say credit card securities? Might they become eligible? What about U.S. securities held by foreigners? What price would the government pay? Would the government hold them to maturity or sell them?
Objections to Paulson's proposal abound. It would rescue some investors and financial institutions from bad decisions and erode a useful discipline—the fear of losses. Some investors (how many no one knows) 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 the alternative of continued turmoil and possible panic. But that presumes that the program succeeds and raises the most unsettling question: If this fails, what—if anything—could the government do next?