Nightmare on Wall Street

A Compendium of Articles and Editorials on the US Financial Meltdown

Give me $700 billion, or I'd hate to see anything bad happen to

that nice economy of yours

A month of financial madness September-October2008

The financial crisis Sep 18th 2008

From The Economist print edition “THINGS are frankly getting out of hand and ridiculous rumors are being repeated, some of which if I wrote down today and re-read tomorrow, I’d probably think I was dreaming.” So said an exasperated Colm Kelleher, Morgan Stanley’s finance chief, during a hastily arranged conference call on September 16th. The carnage of the past fortnight may have an unreal air to it, but the damage is all too tangible—whether the seizure of Fannie Mae and Freddie Mac by their regulator, the record-breaking bankruptcy of Lehman Brothers (and the sale of its capital-markets arm to Barclays), Merrill Lynch’s shotgun marriage to Bank of America or, most shocking of all, the government takeover of a desperately illiquid American International Group (AIG). The rescue of the giant insurer was justified on the grounds that letting it fail would have been catastrophic for financial markets. As it happened, even AIG’s rescue did not stop the bloodletting. On September 17th shares in Morgan Stanley and the other remaining big investment bank, Goldman Sachs, took a hammering. Even though both had posted better-than-expected results a day earlier, confidence ebbed in their stand-alone model, with its reliance on flighty wholesale funding. An index that reflects the risk of failure among large Wall Street dealers has climbed far above its previous high, during Bear Stearns’s collapse in March (see chart). It is a measure of the scale of the crisis that, by the evening of September 17th, all eyes were on Morgan Stanley, and no longer on AIG, which only 24 hours before had thrust Lehman out of the limelight. After its share price slumped by 24% that day, and fearing a total evaporation of confidence, Morgan attempted to sell itself. Its boss, John Mack, reportedly held talks with several possible partners, including Wachovia, a commercial bank, and Citic of China. As contagion spread far and wide, on September 18th central banks launched a co-ordinated attempt to pump $180 billion of short-term liquidity into the markets. HBOS, Britain’s biggest mortgage lender, also sold itself to Lloyds TSB, one of the grandfathers of British banking, for £12.2 billion ($21.9 billion) after its share price plunged. The government was so anxious to broker a deal that it was expected to waive a competition inquiry. Financial panics have been around as long as there have been organized economies. There are common themes. The cause of today’s crunch—the buying of property at inflated prices in the hope that some greater fool will take it off your hands—has featured many times in the past. And the withholding of funds by institutional investors is merely the modern version of an old-fashioned bank run. The same, and yet different But each has its own characteristics, which makes it difficult for students of past crises to apply lessons. Ben Bernanke, the chairman of the Federal Reserve, may be a scholar of the Depression, but the vastness and complexity of the financial system, and the speed with which panic is spreading, create a daunting task. Though they are putting on a brave face, officials could be forgiven for feeling at a loss as one great name buckles after another and investors flee any financial asset with the merest whiff of risk. Even the politicians have been stunned into inactivity. Congress probably will not pass new financial

legislation this year, admitted Harry Reid, the Senate majority leader, because “no one knows what to do.” At times, the responses appear alarmingly piecemeal. Amid a fresh clam our against short-sellers—Morgan Stanley’s Mr Mack accused them of trying to wrestle his stock to the ground—the Securities and Exchange Commission, America’s main markets regulator, brought back curbs on “naked”, or potentially abusive, shorts. It also rushed out a proposal forcing large investors, including hedge funds, to disclose their short positions. Calstrs, America’s second-largest pension fund, said it would stop lending shares to “piranhas”. As in August 2007, when the crisis began in earnest, money markets were this week seizing up. The price at which banks lend each other short-term funds surged, leaving the spread over government bonds at a 21-year high. A scramble for safety pushed the yield on three-month Treasury bills to its lowest since daily records began in 1954—the year President Eisenhower introduced the world to domino theory. Aptly enough, the crisis is spreading from one region to the next. Asian and European stockmarkets suffered steep falls. Japan was fretting that Lehman’s potential default on almost $2 billion of yen-denominated bonds would send a chill through the “samurai” market. Russia suspended share trading and propped up its three largest banks with a handy $44 billion, as emerging markets lost their allure. Another weak spot is the $62 trillion market for credit-default swaps (CDSs), which has given regulators nightmares since the loss of Bear Stearns. It did not fall apart after the demise of Lehman, another big dealer. But it remains fragile; or, as one banker puts it, in a state of “orderly chaos”. CDS trading volumes reached unprecedented levels this week, and spreads widened dramatically, as hedge funds and dealers tried to unwind their positions. But as margin requirements rise, few participants are taking on much risk, according to Tim Backshall of Credit Derivatives Research. The turmoil will embolden those calling for the opaque, over-the-counter market to move onto exchanges. Nerves on Wall Street would be jangling less if a central clearinghouse, planned for later this year, was already up and running. The CDS market may have figured in the government’s calculations of whether to save AIG, given that its collapse would have forced banks to write down the value of their contracts with the insurer, further straining their capital ratios. But officials also had an eye on Main Street. Some of AIG’s largest insurance businesses serve consumers; its failure would have shaken their confidence. As it was, thousands lined up outside its offices in Asia, with some looking to withdraw their business. Consumers are already twitchy in America, where bank failures are rising and the nation’s deposit-insurance fund faces a potential shortfall. The failure of Washington Mutual (WaMu), a troubled thrift, could at the worst wipe out as much as half of what remains in the fund, reckons Dick Bove of Ladenburg Thalmann, a boutique investment bank. WaMu was said this week to be seeking a buyer. No less worrying are the cracks appearing in money-market funds. Seen by small investors as utterly safe, these have seen their assets swell to more than $3.5 trillion in the crisis. But this week Reserve Primary became the first money fund in 14 years to “break the buck”—that is, to expose investors to losses through a reduction of its net asset value to under $1—after writing off almost $800m in debt issued by Lehman.

Any lasting loss of confidence in money funds would be hugely damaging. They are one of the last bastions for the ultra-cautious. And they are big buyers of short-term corporate debt. If they were to pull back, banks and large corporations would find funds even harder to come by. Coming to a bank near you At some point the Panic of 2008 will subside, but there are several reasons to expect further strain. Banks and households have started to cut their borrowing, which reached epic proportions in the housing boom, but they still have a long way to go. By the time they are finished, the pool of credit available across the markets will be smaller by several trillion dollars, reckons Daniel Arbess of Perella Weinberg Partners, an advisory boutique. A recent IMF study argued that the pain of deleveraging will be felt more keenly in Anglo-Saxon markets, because highly leveraged investment banks exacerbate credit bubbles, and are then forced to cut their borrowing more sharply in a downturn. Furthermore, it is far from clear, even now, that banks are marking their illiquid assets conservatively enough. Disclosures accompanying third-quarter results, for instance, showed a lot of disparity in the valuation of Alt-A mortgages (though definitions of what constitutes Alt-A can vary). “Level 3” assets, those that are hardest to value, will remain under pressure until housing stabilizes—and that may be some time yet. Jan Hatzius of Goldman Sachs expects house prices in America to fall by another 10%. Builders broke ground on fewer houses than forecast in August, suggesting the housing recession will continue to drag down growth. The pain is only now beginning in other lending. “We may be moving from the mark-to-market phase to the more traditional phase of credit losses,” says a banker. This next stage will be less spectacular, thanks to accrual accounting, in which loan losses are realized gradually and offset by reserves. But the numbers could be just as big. Some analysts see a wave of corporate defaults coming. Moody’s, a rating agency, expects the junk-bond default rate, now 2.7%, will rise to 7.4% a year from now. Like many nightmares, this one feels as if it will never end.

Beyond crisis management Bold ideas for solving America’s financial mess

EVERY financial crisis involves a tug of war between the tacticians and the strategists. The tacticians dash from skirmish to skirmish trying to control a crisis, deciding in each case whether taxpayers should bail out a distressed bank, firm or country. The strategists call for a more comprehensive approach to resolving the mess—often involving new government bodies to recapitalize banks or take over troubled assets. The present crisis in America conforms to this pattern. So far, the government’s response has been ad hoc and focused on crisis containment. The tacticians at the Federal Reserve and the Treasury have put plenty of taxpayers’ money on the line—whether through the huge expansion in the central bank’s liquidity facilities, the loan to Bear Stearns in March, or the government takeover of Fannie Mae and Freddie Mac, the mortgage giants, and, now, of AIG, a huge insurer. But they have focused on staving off catastrophe one bailout at a time. Now the strategists are pushing back. From across the political spectrum people are arguing that it is time for America to shift to a more systematic approach. In the past week Barney Frank, the leading Democrat on financial matters in the House of Representatives, Paul Volcker, a former chairman of the Fed, as well as writers of the editorial pages of the Wall Street Journal, have suggested that Congress may need to create a new agency to deal with the mess. All have pointed to the Resolution

Trust Corporation (RTC), a government body set up in 1989 to deal with the fallout of the savings and loan (S&L) bankruptcies. Americans focus on the RTC because it is the country’s most recent example of a comprehensive government plan to deal with a financial crisis. Between 1980 and 1994 almost 1,300 specialized mortgage lenders, known as thrifts, failed. Their combined assets amounted to more than $600 billion. By 1986 these failures had bankrupted the Federal Savings and Loan Insurance Corporation, the federal insurer for the thrift industry. At first the government tried to muddle through by trying to recapitalize the insurer. But the S&L mess escalated. In 1989 Congress created the RTC, an entirely new organization, to dispose of the failed thrifts’ assets in a way that minimized downward pressure on financial and property markets. The RTC is not a perfect parallel for today’s needs. It was set up—years after the S&L crisis began—to deal with the aftermath of widespread bank failures. Those who advocate comprehensive action today want to minimize the mess, not just clean up afterwards. Their proposals vary, but many who cite the RTC envisage an institution that buys troubled mortgage-backed securities (not only from failing institutions), putting a floor under their price. Some propose that the putative new agency should manage and write down the underlying mortgages, in effect combining the functions of the RTC with a Depression-era institution, called the Home Owners’ Loan Corporation, which bought and restructured defaulting mortgages. Details are in short supply, but intellectual momentum is building for a broader solution. Not a moment too soon, suggest the results of a new study by Luc Laeven and Fabian Valencia, two IMF economists.* They examined all systemically important banking crises between 1970 and 2007, creating a database on how much financial crises cost and how they are resolved. The evidence is clear. Tactical crisis containment is expensive and frequently inadequate. In most financial meltdowns a comprehensive solution was required, and the sooner it was provided the better. The study looks at 42 crises in all, spanning 37 countries. Like America today, most governments began with ad hoc crisis management. In 74% of cases, for instance, governments pumped emergency loans into failing banks or guaranteed their liabilities. An equally common tactic has been regulatory forbearance. Governments allowed banks to hold less capital than was normally required or softened their rules in other ways. These tactical responses, however, often did not work and ended up increasing the overall bill from a crisis. “All too often”, the economists conclude, “central banks privilege stability over cost in the heat of the containment phase.” No such thing as a free crunch Sooner or later most governments realize the need for a comprehensive solution to the crisis, involving public funds. This can take different forms, from bank recapitalization to forgiveness of all the underlying debts. In three-quarters of the cases, governments shored up bank capital by, for instance, injecting preferred stock. About 60% of the time, governments set up institutions to manage distressed assets. The evidence from these attempts is sobering for proponents of an RTC II. Some institutions worked well. In the early 1990s, for instance, Sweden successfully set up an asset-management company to take over and sell the bad loans from its biggest banks. But, in general, the paper argues, such government-owned asset-management firms are ineffective—often because politicians try to push them around.

On average, the study finds that government attempts to stanch systemic banking crises over the past three decades have cost 16% of GDP. That average hides enormous variation, much of which depends on how crises were handled. America’s mess, even if it has already led to the demise of famous Wall Street firms, is far from finished. That is why the international lessons are worth taking seriously. Resolving a financial mess is cheaper, quicker and less painful if governments take a rounded approach. For the moment, the bailout tacticians are in overdrive. But the strategists’ moment is approaching. * “Systemic Banking Crises: a new database”. IMF Working Paper. September 2008.

What next? Global finance is being torn apart; it can be put back together again

FINANCE houses set out to be monuments of stone and steel. In the widening gyre the greatest of them have splintered into matchwood. Ten short days saw the nationalization, failure or rescue of what was once the world’s biggest insurer, with assets of $1 trillion, two of the world’s biggest investment banks, with combined assets of another $1.5 trillion, and two giants of America’s mortgage markets, with assets of $1.8 trillion. The government of the world’s leading capitalist nation has been sucked deep into the maelstrom of its most capitalist industry. And it looks overwhelmed. The bankruptcy of Lehman Brothers and Merrill Lynch’s rapid sale to Bank of America were shocking enough. But the government rescue of American International Group (AIG), through an $85 billion loan at punitive interest rates thrown together on the evening of September 16th, marked a new low in an already catastrophic year. AIG is mostly a safe, well-run insurer. But its financial-products division, which accounted for just a fraction of its revenues, wrote enough derivatives contracts to destroy the firm and shake the world. It helps explain one of the mysteries of recent years: who was taking on the risk that banks and investors were shedding? Now we know. Yet AIG’s rescue has done little to banish the naked fear that has the markets in its grip. Pick your measure—the interest rates banks charge to lend to each other, the extra costs of borrowing and of insuring corporate debt, the flight to safety in Treasury bonds, gold, financial stocks: all register contagion. On September 17th HBOS, Britain’s largest mortgage lender, fell into the arms of Lloyds TSB for a mere £12 billion ($22 billion), after its shares pitched into the abyss that had swallowed Lehman and AIG. Other banks, including Morgan Stanley and Washington Mutual, looked as if they would suffer the same fate. Russia said it would lend its three biggest banks 1.12 trillion rubles ($44 billion). An American money-market fund, supposedly the safest of safe investments, this week became the first since 1994 to report a loss. If investors flee the money markets for Treasuries, banks will lose funding and the contagion will suck in hedge funds and companies. A brave man would see catharsis in all this misery; a wise man would not be so hasty. The blood-dimmed tide Some will argue that the Federal Reserve and the Treasury, nationalizing the economy faster than you can say Hugo Chávez, should have left AIG to oblivion. Amid this contagion that would have been reckless. Its contracts—almost $450 billion-worth in the credit-default swaps market alone—underpin the health of the world’s banks and investment funds. The collapse of its insurance arm would hit ordinary policyholders. At the weekend the Fed and the Treasury watched Lehman Brothers go bankrupt sooner than save it. In principle that was admirable—capitalism requires people to pay for their mistakes. But AIG was bigger and the bankruptcy of Lehman had set off vortices and currents that may have contributed to its downfall. With the markets reeling,

pragmatism trumped principle. Even though it undermined their own authority, the Fed and the Treasury rightly felt they could not say no again. What happens next depends on three questions. Why has the crisis lurched onto a new, destructive path? How vulnerable are the financial system and the economy? And what can be done to put finance right? It is no hyperbole to say that for an inkling of what is at stake, you have only to study the 1930s. Shorn of all its complexity, the finance industry is caught between two brutally simple forces. It needs capital, because assets like houses and promises to pay debts are worth less than most people thought. Even if some gain from falling asset prices, lenders and insurers have to book losses, which leaves them needing money. Finance also needs to shrink. The credit boom not only inflated asset prices, it also inflated finance itself. The financial-services industry’s share of total American corporate profits rose from 10% in the early 1980s to 40% at its peak last year. By one calculation, profits in the past decade amounted to $1.2 trillion more than you would have expected. This industry will not be able to make money after the boom unless it is far smaller—and it will be hard to make money while it shrinks. No wonder investors are scarce. The brave few, such as sovereign-wealth funds, who put money into weak banks have lost a lot. Better to pick over their carcasses than to take on their toxic assets—just as Britain’s Barclays walked away from Lehman as a going concern, only to swoop on its North American business after it failed. The center cannot hold Governments will thus often be the only buyers around. If necessary, they may create a special fund to manage and wind down troubled assets. Yet do not underestimate the cost of rescues, even necessary ones. Nobody would buy Lehman unless the government offered them the sort of help it had provided JPMorgan Chase when it saved Bear Stearns. The nationalization that, for good reason, wiped out Fannie’s and Freddie’s shareholders has made it riskier for others to put fresh equity into ailing banks. The only wise recapitalization just now is an outright purchase, preferably by a retail bank backed by deposits insured by the government—as with Bank of America and Merrill Lynch, Lloyds and HBOS and, possibly, Wachovia with Morgan Stanley. The bigger the bank, the harder that is. Most of all, each rescue discourages investors from worrying about the creditworthiness of those they trade with—and thus encourages the next excess. For all the costs of a rescue, the cost of failure to the economy would sometimes be higher. As finance shrinks, credit will be sucked out of the economy and without credit, people cannot buy houses, run businesses or as easily invest in the future. So far the American economy has held up. The hope is that the housing bust is nearing its bottom and that countries like China and India will continue to thrive. Recent falls in the price of oil and other commodities give central banks scope to cut interest rates—as China showed this week. But there is a darker side, too. Unemployment in America rose to 6.1% in August and is likely to climb further. Industrial production fell by 1.1% last month; and the annual change in retail sales is at its weakest since the aftermath of the 2001 recession. Output is shrinking in Japan, Germany, Spain and Britain, and is barely positive in many other countries. On a quarterly basis, prices are falling in half of the 20 countries in The Economist’s house-price index. Emerging economies’ stocks, bonds and currencies have been battered as investors fret that they will no longer be “decoupled” from the rich countries.

Unless policymakers blunder unforgivably—by letting “systemic” institutions fail or by keeping monetary policy too tight—there is no need for today’s misery to turn into a new Depression. A longer-term worry is the inevitable urge to regulate modern finance into submission. Though understandable, that desire is wrong and dangerous—and the colossal success of commerce in the emerging world (see article) shows how much there is to lose. Finance is the brain of the economy. For all its excesses, it allocates resources to where they are productive better than any central planner ever could. Regulation is necessary, and much must now be done to improve the laws of finance. But it must be the right regulation: an end to America’s fragmented system of oversight; more transparency; capital requirements that lean against booms and flex with busts; supervision of giants, like AIG, that are too big and too interconnected to fail; accounting that values risks better and that everyone accepts; clearing houses and exchanges to make derivatives safer and less opaque. All that would count as progress. But naive faith in regulators’ powers creates ruinous false security. Financiers know more than regulators and their voices carry more weight in a boom. Banks can exploit the regulations’ inevitable blind spots: assets hidden off their balance sheets, or insurance (such as that provided by AIG) which enables them to profit by sliding out of the capital requirements the regulators set. It is no accident that both schemes were at the heart of the crisis. This is a black week. Those of us who have supported financial capitalism are open to the charge that the system we championed has merely enabled a few spivs to get rich. But it helped produce healthy economic growth and low inflation for a generation. It would take a very big recession indeed to wipe out those gains. Do not forget that in the debate ahead.

Investment banking--Is there a future? The loneliness of the independent Wall Street bank

IN THE early years of this decade, when banks did quaint things like making money, the mantra on Wall Street was: “Be more like Goldman Sachs”. Bank bosses peered enviously at the profits and risk-taking prowess of the venerable investment bank. No longer. “Be less like Goldman Sachs” is the imperative today. Of the five independent investment banks open for business at the start of the year, only Goldman and Morgan Stanley remain. Doubts about the sustainability of the model are rife. In earnings conference calls on September 16th, the chief financial officers of both firms had to bat away analysts’ questions about their ability to survive on their own. Spreads on their credit-default swaps, which protect against the risk of default, soared as investors digested the implications of Lehman Brothers’ demise (see chart). Universal banks, which marry investment banking and deposit-taking, are in the ascendant. Bear Stearns and Merrill Lynch found shelter in the arms of two big universal banks, JPMorgan Chase and Bank of America. Barclays, a British universal bank, is picking at the carrion of Lehman Brothers. The mood at Citigroup, seen until now as one of the biggest losers from the crisis, is suddenly bullish: insiders talk up the stability of its earnings and the advantages of deposit funding. Regulatory antipathy to universal banks has also eased. Although the 1933 Glass-Steagall act, which separated investment banks and commercial banks, was repealed in 1999, the universal model is still viewed with suspicion in America. Among measures announced on September 14th, the Federal Reserve temporarily suspended rules restricting the amount of money that banks can lend to their investment-banking affiliates. Many are skeptical that this rule makes much practical difference.

Even if the investment-banking arms of universal banks nominally have to raise money separately, their parents’ ratings still make their funding cheaper. By the same token, if they get into trouble, the effects ripple through the entire balance sheet. Even so the suspension, and the dramatic reshaping of Wall Street, represents the final repeal of Glass-Steagall. Can Goldman and Morgan Stanley survive as independents? In normal times, the question would seem ludicrous. Both banks had profitable third quarters, with Morgan Stanley beating expectations comfortably. Rivals’ disappearance should allow them to grab new business and has already helped to increase pricing power: Morgan Stanley hauled in record revenues in its prime-brokerage business. Both have reduced their most troubling exposures; both can call on decent amounts of capital and strong pools of liquidity. And both can marshal strong arguments that they are better managed than their erstwhile peers. The problem, of course, is that these are not normal times. Although the firms condemn the rumor-mongering, stories that Morgan Stanley was looking for a partner continued to swirl. As The Economist went to press, Wachovia, an American bank, and Citic of China were among the names in the frame. Three doubts hang over the independent model. The first concerns the risk of insolvency. Investment banks have higher leverage than other banks (in America at least), which worsens the impact of falling asset values. They do not have the safety-valve of banking books, where souring assets can escape the rigors of mark-to-market accounting. And they lack the stable earnings streams of commercial and retail banking. In other words, they have less room for error. Goldman’s reputation for risk management is excellent, Morgan Stanley’s a bit patchier. But asking investors to take valuations and hedging processes on trust is getting harder by the day. The second, related doubt concerns their funding profile. As a group, the pure-play investment banks have relied heavily on short-term funding, particularly repo transactions in which counterparties take collateral as security against the cash they lend. Both survivors say they are nowhere near as exposed to the risk of a sudden dearth of liquidity as Bear Stearns was. They could also argue that retail deposits can be as flighty as the wholesale markets: just ask Northern Rock and IndyMac, both of which suffered rapid withdrawals. Even so, a further shift towards longer-term unsecured financing will be the price of survival for Morgan Stanley in particular. That would increase costs, which in turn raises the third doubt, profitability. As well as dearer funding and lower leverage, the investment banks face the prospect of weakened demand for their services. As and when the market for structured finance revives, it will be smaller and less rewarding than before. Demand for many services will not go away, but in a world of scarcer credit, universal banks will be tempted to use their lending capacity to win juicier investment-banking business from companies. “Don’t give me the bone,” says one European bank boss. “Leave some meat on it.” By these lights, universal banks appear to offer clear advantages to both shareholders and regulators. Yet some of those advantages are illusory. For regulators, larger, diversified institutions may be more stable than investment banks but they pose an even greater systemic risk. “The universal bank is the regulatory equivalent of the super-senior mortgage-backed bond,” says one analyst. “The risks may look lower but they do not go away.” And deposit funding is cheaper than wholesale funding in part because those deposits are insured. Measures to protect customers may end up allowing banks to take on risks that endanger customers. For shareholders, too, the universal bank may offer false comfort. A model that looks appealing in part because assets are not valued at market prices ought to ring alarm bells. Sprawling

conglomerates are just as hard to manage as turbo-charged investment banks. And shareholders at UBS and Citi will derive little comfort from the notion that the model has been proven because their institutions are still standing. If the independent investment banks survive, they will clearly need to change. But they are not the only ones.

Looking for the bright side Are there any signs that this could be a buying opportunity?

WHEN Winston Churchill lost the 1945 election, his wife remarked that the defeat might be a blessing in disguise. “At the moment”, replied the great man, “it seems quite effectively disguised.” It is possible, when investors view recent events in retrospect, they will see them as a turning point for markets. But if there are immediately bullish implications, they seem to be quite effectively disguised. The American authorities sacrificed Lehman Brothers “to encourage the others”, only to find the others were simply encouraged to deny funding to weak-looking institutions. Risk aversion reached extremes this week as the money markets froze. Overnight dollar rates doubled in the interbank market while the rate paid by the American government for three-month money fell to its lowest in more than 50 years. In addition, the caning the authorities gave to shareholders in Fannie Mae, Freddie Mac and AIG, however hard to argue with, will make it tough for financial institutions to raise new equity. Wall Street did not even bother to rally after the AIG deal as it had after previous government interventions. Bad news seems to be coming from all sides, leaving Hank Paulson, America’s treasury secretary, increasingly resembling a one-armed wallpaper hanger as he valiantly seeks to cope with the mess. Another problem emerged this week; a $65 billion money-market fund, Reserve Primary, suspended redemptions and warned that it would “break the buck”, i.e, repay investors at less than face value. That could cause a flight out of other money-market funds. Meanwhile, credit spreads over risk-free rates have widened sharply and emerging markets have taken a hammering. The “great deleveraging” is working its way through the markets, as institutions, unable to roll over their debts, are forced to sell assets. The resulting fall in prices raises doubts about the solvency of other businesses, giving the spiral another downward lurch. So what good news can be found in the midst of all this gloom? The first, curiously enough, is that sentiment is very depressed. The latest poll of global fund managers by Merrill Lynch found that risk appetite is at its lowest level in over a decade. Such extremes are normally a bullish sign. The second is that the government is not the only buyer. After Merrill Lynch’s sale to Bank of America, HBOS, a British mortgage lender, has also sought refuge within a bank, Lloyds TSB. That suggests executives see value in today’s prices. Whether this is out of shrewd bargain hunting, state arm-twisting or over-ambitious empire-building remains to be seen. The third is that the inflation threat has receded, thanks to the sharp fall in commodity prices. Eventually, that will allow central banks to cut interest rates. In addition, it will relieve the pressure on consumer demand and corporate profit margins. The fourth factor is that central banks are also willing to undertake quite extraordinary market-support measures, including the Fed’s decision to accept equities as collateral against lending at its discount window. That would have been unthinkable 18 months ago.

The fifth issue is that valuations in equity markets have improved substantially. In Britain on September 17th, the yield on the FTSE All-Share index was higher than the yield on ten-year gilts. This has happened only once before since the late 1950s—in March 2003, which proved to be the start of a long rally. However, it would be a brave investor that acted on those bullish signals today. Those who believed that the Bear Stearns collapse in March marked a turning point in the credit crunch were disappointed. The Vix, or volatility index, a measure of market preparedness for shocks, has been lower than in past peaks—though it shot up on September 17th. While the money markets are frozen, other financial institutions may get into trouble. Buyers will be tempted to wait until asset prices fall further, a strategy that worked for Barclays, which was able to choose the slice of Lehman Brothers it desired. And the economy will surely have been harmed by this week’s turmoil; consumer sentiment will have been hit and banks will inevitably prove even more cautious about their lending. A recession seems more likely than it did at the start of the month. Perhaps there will be no climactic sell-off to signal the end of the bear market. Instead share prices may simply bounce around in a choppy range near today’s values. It is quite plausible that those who buy shares today will look smart in five years’ time. It is much less certain they will look smart six months from now.

Saving Wall Street--The last resort

The American government’s bailouts are less arbitrary than they appear SIX months after the American government supported the sale of Bear Stearns to JPMorgan Chase, leading to the end of one of Wall Street’s “Big Five”, it tried to make it clear last weekend that there would be no further bail-outs, and let Lehman Brothers fail. Two days later, that line in the sand had all but blown away. The Treasury’s decision on September 16th to take over American International Group (AIG), one of the world’s biggest insurers, in exchange for an $85 billion credit line from the Federal Reserve, was momentous. More so than allowing Lehman Brothers, which was even bigger than Bear Stearns, to go bust the day before; more so, even, than the takeover of Fannie Mae and Freddie Mac, the big mortgage agencies, just over a week before. With AIG, the stakes were higher for both the financial system and the authorities’ credibility. Fannie and Freddie always had implicit federal backing, so when they tottered, the federal government had little choice but to make that support explicit. Bear Stearns was a regulated investment bank whose demise was so sudden that its collapse could have caused a maelstrom. AIG is an insurer, not a bank, and as such had neither federal backing nor much federal oversight. Yet it quietly built itself into a juggernaut in the global financial system by using derivatives to insure hundreds of billions of dollars of corporate loans, mortgages and other debt. Holders of these assets ranged from the world’s biggest banks to retired people’s money-market funds. Allowing AIG to fail could have panicked small investors, forced banks to take steep write-downs, and introduced a terrifying new phase to the financial crisis. To some, the institution-by-institution approach to bailouts seems haphazard. “Mr Secretary...you’re picking and choosing. You have to have a set policy,” Richard Shelby, the leading Republican on the Senate banking panel, complained to Hank Paulson, the treasury secretary.

In fact, back in July Mr Paulson had argued in favor of a formal mechanism to take over and wind down non-banks, such as investment banks and insurers, in an orderly way, much as already exists for retail banks. But Congress was only prepared to consider that as part of a bigger regulatory overhaul under the next president. That forced Mr Paulson, Ben Bernanke, the Fed’s chairman, and Timothy Geithner, the president of the New York Fed (the three are virtually joined at the hip) to pursue rescues ad hoc. Yet a certain logic has governed their actions. It is possible to detect a pattern of sorts emerging in Mr Paulson’s interventions. First, establish if a firm is so large or so entangled within the financial system that its unexpected failure could be catastrophic. If the answer is “no”, as the authorities concluded it was in Lehman’s case, encourage a private sale but commit no public money. If the answer is “yes”, as with Bear, Fannie and Freddie, and AIG, then make sure that taxpayers get first claim on the assets, common and preferred shareholders pay a steep price, and management is replaced. Mr Paulson argues that the approach combines pragmatism with an intense focus on moral hazard, or letting people pay for failure. “I don’t believe in raw capitalism without regulation. There’s got to be a balance between market discipline, allowing people to take losses, and protecting the system,” he says. Assuming the markets eventually right themselves, the bailouts may hasten healthy consolidation. American economic growth has been heavily dependent on borrowing and leverage for the last decade. AIG had used its unregulated status to supply cheap credit protection to regulated entities. But that business thrived in a period of easy credit and low defaults. When those conditions ended, it produced enough losses to nearly bankrupt AIG. Lehman’s bankruptcy and AIG’s failure suggest Wall Street has too much leverage and too much capital devoted to products of questionable economic utility. The bailouts will facilitate a deleveraging. The Fed expects AIG to repay its loan by selling off its healthy businesses, while winding down its derivatives book. Mr Paulson wants Fannie and Freddie to reduce much of their mortgage portfolios. “The necessary shrinking of the financial system is taking place in real time,” says Kenneth Rogoff of Harvard University. It could go too far. If the cycle of falling asset prices, insolvency and credit constriction is excessive, the government may have to step in and buy up bad assets en masse, as has often occurred in other financial meltdowns (see article). Even without such drastic action, the economy and the financial system are becoming dependent on the taxpayer. Bank of America was in a position to buy Merrill Lynch in part because the Federal Deposit Insurance Corporation, which guarantees deposits, insulates a large share of the bank’s funding from crises of confidence. With federal backing comes federal oversight. Even the most free-market policymakers will be reluctant ever to see another company get as large and interconnected as AIG without tougher regulation. Just as the Fed insisted on more oversight of investment banks when it agreed to lend to them in March, it will now have the authority to inspect the books of AIG any time it chooses. This poses risks to the Fed. Thrust to the fore during the crisis, its role in the financial system has expanded. It has so far balanced these responsibilities with its attention to inflation. On September 16th it defied market hopes for lower interest rates and kept its short-term target at 2%. It judged that for now, expanding its loans to banks and securities dealers, and broadening the collateral it accepts from banks, addresses the crisis better than looser monetary policy would, though it may yet decide further rate cuts are necessary.

Still, the Fed has lent so heavily to the most beleaguered financial firms that it is running out of bonds. The government has promised to help with a special issuance of Treasury bills, which, through the machinations of reserve management, will result in a larger Fed balance sheet but no impact on interest rates. The Fed needs to be sure it does not become a crutch for insolvent financial firms, distorting credit allocation and risk taking. For the time being, though, that concern is far less important to it than keeping the financial system intact.

Emerging markets--Beware falling BRICs Emerging countries are not the havens some people thought

SO MUCH for decoupling. In the wake of Lehman Brothers’ failure, emerging markets have suffered one of their biggest sell-offs in years. On September 18th Russia’s main bourses suspended trading in shares and bonds for a third day in a row after the largest one-day stock market fall for a decade; the central bank poured billions into big banks and the money market in a forlorn bid to calm fears. JPMorgan’s emerging-markets bond index fell by more than 5% in the week to September 16th, giving up in a few days all the gains it had made this year. Prices of Argentina’s credit-default swaps, a gauge of credit risk, rose to their highest-ever level. Unexpectedly, the People’s Bank of China cut its benchmark lending rate by 27 basis points on September 15th, to 7.2%, the first cut for six years. These actions reflected a variety of concerns, such as a darkening economic mood in China and political worries in Russia. But they all have something in common: investors may be changing their minds about emerging markets. For the past few years, China, Brazil and others, with their high growth rates and large current-account surpluses, began to seem like desirable alternatives to developed markets. For part of last year, the MSCI emerging-markets index was even trading at a higher multiple of earnings than the index of rich-world shares. That is changing as investors lose their appetite for risk. Merrill Lynch’s most recent survey of fund managers found that they are now holding more bonds than normal for the first time in a decade (indicating a flight to safety). They also have smaller positions in emerging-market equities than at any time since 2001. In the past three months, says Michael Hartnett of Merrill Lynch, emerging-market funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the previous five years. Reuters Reuters The ruble in the rubble Falling oil and commodity prices are partly to blame. When these were rising, money poured into Brazil and Russia, which became targets of the “carry trade” (investors borrow in low-yielding currencies and buy high-yielding ones). Now oil prices are falling (dipping almost to $90 a barrel this week), they are undermining the carry trade and forcing Russia to prop up the ruble. Indebted investors are also being forced by their banks to sell as falling prices reduce the value of their collateral. Lower oil and commodity prices ought to benefit China and India, by lowering import bills and assuaging worries about inflation. Yet India’s foreign-exchange reserves fell by $6.5 billion in the

first week of September as the central bank sold dollars to slow the fall of the rupee. In China, worries are growing about weakening export demand (growth in export volumes has fallen by almost half over the past year to 11%) and falling property prices, which seem to play a role similar to equity prices elsewhere. In the past three months, property sales in big cities were 40-50% lower than a year ago, according to figures tracked by Paul Cavey of Macquarie Securities. An agent for one of Hong Kong’s largest property companies says “confidence ended this week with the fall of Lehman.” All these countries have the comfort of huge foreign-exchange reserves. On September 16th the new governor of India’s central bank said he would continue to cushion the rupee’s fall; he also raised the interest rate Indian expatriates can earn on deposits at home and let banks borrow a bit more from the central bank. China’s interest-rate cut shows that its government, too, has room for maneuver. But the cut will have little direct impact on the economy because lending is limited by quotas. It was intended to boost confidence at a time of falling share and house prices. Too bad that among emerging-market investors, confidence is in short supply.

Accounting--All’s fair The crisis and fair-value accounting

SO CONTROVERSIAL has accounting become that even John McCain, a man not known for his interest in balance sheets, has an opinion. The Republican candidate for the American presidency thinks that “fair value” rules may be “exacerbating the credit crunch”. His voice is part of a chorus of criticism against mark-to-market accounting, which forces banks to value assets at the estimated price they would fetch if sold now, rather than at historic cost. Some fear that accounting dogma has caused a cycle of falling asset prices and forced sales that endangers financial stability. The fate of Lehman Brothers and American International Group will have strengthened their conviction. In response America’s Financial Accounting Standards Board (FASB), and the London-based International Accounting Standards Board (IASB) have not budged an inch. So, for example, banks will have to mark their securities to the prices Lehman receives as it is liquidated. The two accounting bodies already act cheek by jowl, and America will probably soon adopt international rules. Are they guilty of obstinately pursuing an abstract goal that is causing mayhem in financial markets? Banks’ initial attack on fair value was self-serving. In April the Institute of International Finance (IIF), a lobbying group, sent a confidential memorandum to the two standard-setters. This said it was “obvious” markets had failed and that companies should be allowed to suspend fair value for “sound” assets that had suffered “undue valuation”. Even at the time this stance lacked credibility; Goldman Sachs resigned from the IIF in protest at “Alice in Wonderland accounting”. Today it is abundantly clear that those revelations were not a figment of accountants’ imagination. For example, in July Merrill Lynch sold a big structured-credit portfolio at 22% of its face value—less than what was entered on its balance sheet. Bob Herz, FASB’s chairman, argues that fair value is “essential to provide transparency” for investors. Yet not all criticism of fair value can be so easily dismissed. The credit crunch has raised three genuinely awkward questions. The first of these concerns “procyclicality”. Bankers say that in a downturn fair-value accounting forces them all to recognize losses at the same time, impairing their capital and triggering fire sales of assets, which in turn drives prices and valuations down even more. Under traditional accounting, losses hit the books far more slowly. Some admire Spain’s system, which requires banks to make extra provision for losses in good times, so that when loans turn sour their profits and thus capital fall by less.

It is too soon to know if prices exaggerate the ultimate losses on credit products. Some people argue that swift write-downs in fact help to re-establish stability: Yoshimi Watanabe, Japan’s minister for financial services, says Japanese banks exacerbated their country’s economic woes by “avoiding ever facing up to losses”. But the principle defense of standard-setters is that enhancing financial stability is not the purpose of accounting. Over to the regulators In other words, if procyclicality is a problem, it is someone else’s. Already central banks have relaxed their rules on what they will accept from banks as collateral, which has helped to support the prices of risky assets. And the mayhem in the swaps market has shown the importance of on-exchange trading, so that trading remains orderly in times of stress. Ultimately, though, responsibility for interposing a circuit-breaker between market prices and banks’ capital adequacy falls on bank regulators, not accountants. They are already examining “countercyclical” regimes, which would force banks to save more capital in years of plenty. They could go further by suspending capital rules during times of stress if they think asset prices have overreacted. Europe’s national regulators already use some discretion when defining capital adequacy. There is a precedent in pension regulation, where corporate schemes are marked to market but the cash payments companies make to keep them solvent are smoothed over time. Banks’ financial statements could be modified to show assets at cost as well as fair value, so that if regulators or investors wanted to use traditional accounting to form a view, they could. Even if they leave procyclicality to bank regulators, standard-setters still have a lot on their plates. The second—and immediate—question is how to value illiquid (and sometimes unique) assets. A common solution is to use banks’ own models. But some investors are concerned that this gives banks’ managers too much discretion—and no wonder, because highly illiquid (or “Level 3”) assets are worryingly large relative to many banks’ shrunken market values. Such is the complexity of many such assets that it may not be possible to find a generally acceptable method. The best answer is to disclose enough to allow investors to form their own views. This week IASB gave new guidance that should help in this regard. The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only “available for sale” it is marked to market on the balance sheet, but losses are not recognized in the income statement. If it is to be “held to maturity”, or is a traditional loan, it can be carried at cost, subject to impairment. This is a dog’s breakfast. Different banks can hold the same asset at different values. According to Fitch, a ratings agency, at the end of 2007, Western banks carried about half of their assets at fair value, but the dispersion was wide: from 86% at Goldman Sachs to 27% at Bank of America (see chart). The obvious solution is to use fair value for all financial assets and liabilities. This is exactly what both FASB and IASB propose. In parallel they want to clean up the income statement, so that changes in the value of assets or liabilities are separated clearly from recurring revenues and costs. For low-risk banks, this would make little difference: both HSBC and Santander report that the fair value of their loan books is slightly above their carrying value. But it could mean big losses for riskier institutions. When Bank of America bought Countrywide, a big mortgage lender, it was forced, under another quirk, to mark its troubled acquisition’s loans at fair value, wiping out Countrywide’s equity. Bankers are therefore likely to resist the idea of fair value for loans fiercely:

one executive calls it “lunacy”. Here standard setters’ quest for intellectual consistency will run into a political quagmire. Marks out of ten Has accounting had a good credit crunch? The last year has shown that standard-setters are now truly independent and focused on investors’ needs rather than the wishes of management, regulators and the taxman. Reforms to IASB’s governance should bolster this independence. That is to be welcomed. For all fair value’s flaws, banks ought not to have license to carry their dodgy credit exposures at cost. At the same time the fair-value revolution is incomplete. Regulators may need to abandon the traditional, mechanistic link between accounting and capital adequacy rules if they really want to try to fight banking crises. That is no bad thing either. Investors and regulators should be able to share a market-based language to describe financial problems, even if they disagree about what needs to be done.

European banks--Cross-border contagion HBOS’s troubles give everyone a bit extra to worry about

JOHN PIERPONT MORGAN, it is said, whiled away the time while orchestrating a plan to avert the financial crisis of 1907 by steadfastly playing solitaire. A century later, the game du jour involves toying with dominoes. Funds and traders are casting about for the next banks to fall (and enthusiastically selling their shares). So far most of the falling stones have been American. But some European banks are also teetering. The latest is HBOS, a well-capitalized but weakly funded British bank that will lose its independence. On September 18th HBOS, Britain’s biggest mortgage lender, said it had agreed to be taken over by Lloyds TSB, another of the country’s leading banks. There was government pressure, but both sides denied there had been a bailout. Any hint of one would infuriate shareholders of Northern Rock, another British mortgage lender that was nationalized last year. They were largely wiped out. Worries about the wholesale markets intensified, not just for HBOS, but all European banks, on September 16th, when Reserve Primary, a money-market fund, froze withdrawals for a week. Its troubles caused huge surges in the cost of borrowing money overnight (see chart). “I don’t want to sound alarmist, but the liquidity squeeze we’re experiencing now is worse than it was in August 2007 [at the start of the credit crunch],” observes one trader. Although the shortage of money is most acute for dollar-denominated loans, some of Europe’s biggest banks are also exposed to this market because they generally do not have dollar deposits and rely largely on money and capital markets to fund their investment banks. Among those affected are Barclays, Royal Bank of Scotland, Deutsche Bank and UBS, all of which saw huge jumps in the price of insuring their debt against default. This reflected not just the spike in rates they have to pay to borrow dollars (with some smaller outfits said to be paying as much as 12% for three-month money, according to money-market traders). There was also the worry that they face losses on loans and derivatives contracts with firms that are either bankrupt, such as Lehman, or suddenly less than creditworthy, such as AIG. Arturo De Frias of Dresdner Kleinwort estimates that European banks may end up with losses of about $31 billion on short-term loans to Lehman.

Just as big a concern for banks in Britain and Europe is whether the hotchpotch of regulatory systems across the continent could cope with a bank failure. The American authorities have been nimble enough, yet their agility has not quelled the panic. Their European counterparts are still arguing about who should be in charge and what should be done. The trials of HBOS, which owns the Halifax, a building society, highlight a particular uncertainty faced by British banks. Even as the bank’s share price and bond spreads weakened this week, the Bank of England dithered over whether to renew its facility for letting British banks swap mortgages for funds. It announced an extension on September 17th, after news of HBOS’s talks with Lloyds had leaked out. British banks are also lobbying against parts of a long-overdue proposal by the authorities to deal with ailing banks. For other European banks, there is trepidation not about whether their governments or central banks are willing to support them, but whether they can. Some of Europe’s biggest banks, such as UBS, ING and Fortis, are based in some of its smallest countries such as Switzerland, the Netherlands and Belgium. If one were to fail, the fallout might well make America’s recent upheavals look orderly.

Derivatives--A nuclear winter? The fallout from the bankruptcy of Lehman Brothers

WHEN Warren Buffett said that derivatives were “financial weapons of mass destruction”, this was just the kind of crisis the investment seer had in mind. Part of the reason investors are so nervous about the health of financial companies is that they do not know how exposed they are to the derivatives market. It is doubly troubling that the collapse of Lehman Brothers and the near-collapse of American International Group (AIG) came before such useful reforms as a central clearing house for derivatives were in place. A bankruptcy the size of Lehman’s has three potential impacts on the $62 trillion credit-default swaps (CDS) market, where investors buy insurance against corporate default. All of them would have been multiplied many times had AIG failed too. The insurer has $441 billion in exposure to credit derivatives. A lot of this was provided to banks, which would have taken a hit to their capital had AIG failed. Small wonder the Federal Reserve had to intervene. The first impact concerns contracts on the debt of Lehman itself. As a “credit event”, the bankruptcy will trigger settlement of contracts, under rules drawn up by the International Swaps and Derivatives Association (ISDA). Those who sold insurance against Lehman going bust will lose a lot. But Lehman had looked risky for some time, so investors should have had the chance to limit their exposure. The second effect relates to deals where Lehman was a counterparty, i.e, a buyer or seller of a swaps contract. For example, an investor or bank may have bought a swap as insurance against an AIG default, with Lehman on the other side of the deal. That protection could conceivably be worthless if Lehman fails to pay up. Until the Friday before its bankruptcy, Lehman would have posted collateral, which the counterparty can claim. After that day, the buyer will have been exposed to price movements before it could unwind the contract. The third effect will be on the collateralized-debt obligation (CDO) market, which caused so many problems last year. So-called synthetic CDOs comprise a bunch of credit-default swaps; a Lehman default may cause big losses for holders of the riskier tranches.

Insiders say the biggest exposure may be in the interest-rate swaps market, which is many times larger than those for credit derivatives. In a typical interest-rate swap, one party agrees to exchange a fixed-rate obligation with another that has a floating, or variable, rate exposure. Depending on whether floating rates rise or fall, one will end up owing money to the other. Again, those banks that dealt with Lehman should have been fine until Friday, when the bank was still posting collateral. But not afterwards. Although there are ISDA rules to cover such events, the sheer size of Lehman in the market (its gross derivatives positions will be hundreds of billions of dollars) makes this default a severe test. There will inevitably be legal disputes as well. The good news is that the swaps markets did not utterly seize up after it went bust on September 15th. But the reaction may be a delayed one. Mr Buffet’s WMD could leave behind a cloud of toxicity.

AIG’s rescue--Size matters Why one of the world’s biggest insurers needed a government rescue

EVEN by the recent standards of Wall Street bailouts, that of American International Group is colossal. At its peak the insurance firm was the world’s largest with a market value of $239 billion. Its assets are bigger than those of either Lehman Brothers or Fannie Mae. Yet size alone does not explain the rescue. Nor do the images of customers queuing to cancel their policies as far away as Singapore. AIG posed a systemic risk because of its investment bank, tucked away behind the dull business of writing insurance contracts, which has lost it both a fortune—and now its independence (see chart). At one stage, this unit contributed over a quarter of profits. It has played the role of schmuck in one of finance’s most dangerous games by writing credit-default swaps (CDSs), a type of guarantee against default, with a giant notional exposure of $441 billion as of June. Of this, $58 billion is exposed to subprime securities which have already generated huge mark-to-market losses. For regulators, the real horror story may be the $307 billion of contracts written on instruments owned by banks in America and Europe and designed to guarantee the banks’ asset quality, thereby helping their regulatory capital levels. How much pain taxpayers will ultimately bear is an open question. The official line is that AIG only suffered a liquidity crisis. As subprime losses mounted, it had to put up more collateral with its counterparties, in turn prompting credit-rating downgrades, which in turn triggered more margin calls. It is probable that operating cash flow was drying up too as big risk-sensitive commercial customers stopped doing business with the insurer. On September 16th the Federal Reserve extended a two-year, $85 billion credit facility at a penal rate. The government will get a 79.9% stake in the company in return. The idea is that this buys time for AIG to improve its liquidity in an orderly way. The bail-out’s structure should also avoid a technical bankruptcy, which could force the unwinding of many of those CDS contracts. Yet might the government be taking over a company that is insolvent as well as illiquid? Extrapolating from AIG’s own test, but adjusting fully for mark-to-market losses and stripping out goodwill and hybrid capital, even at the end of June AIG might have had about $24 billion less book equity than it needed to be safely capitalized. And some of its equity may be “trapped” within its insurance subsidiaries, whose capital positions are ring fenced by insurance regulators. That might leave the holding company that taxpayers have backed in a far worse state. On September 17th Eric Dinallo, New York’s insurance regulator, vouched for the solvency of AIG’s insurance subsidiaries but was more circumspect on the company overall.

Ultimately, though, AIG may turn out be worth something after all: in June it had $67 billion of tangible equity, a much bigger buffer relative to assets than existed at Lehman or Bear Stearns. And, says Andrew Rear of Oliver Wyman, a consultancy, AIG’s insurance assets will attract a lot of interest. That raises the chances of their being sold at a premium, raising cash for the holding company. If the government holds on long enough, perhaps even AIG’s CDS contracts might make money.

Massive Shifts on Wall St.--Troubled Investment Bank to File for Bankruptcy

Lehman Brothers announced early Monday morning that it will file for bankruptcy, becoming the largest financial firm to fail in the global credit crisis, after federal officials refused to help other companies buy the venerable investment bank by putting up taxpayer money as a guarantee. The failure of the nation's fourth-largest investment firm offers a profound test of the global financial system, and government and private officials had been bracing Sunday night for an upheaval in a range of financial markets that have never before experienced the bankruptcy of such a large player. To keep cash flowing normally through these markets, the Federal Reserve announced new lending procedures, while 10 major banks combined to create a new $70 billion fund. After a marathon series of negotiations over the weekend, Federal Reserve and the Treasury stepped aside to allow a wrenching transformation of Wall Street to proceed. After galloping to the rescue of other major financial institutions in recent months, the federal government drew the line with Lehman Brothers, ignoring pleas from would-be buyers of the company who insisted on receiving federal backing for its troubled assets. Leaders of the Federal Reserve and Treasury Department decided that Lehman was unlike the investment bank Bear Stearns, whose sudden collapse in March threatened the world financial system, or Fannie Mae and Freddie Mac, whose potential insolvency did the same. In betting that Lehman could be allowed to fail without catastrophic consequences, New York Federal Reserve President Timothy F. Geithner, Fed Chairman Ben S. Bernanke, and Treasury Secretary Henry M. Paulson Jr. were making it clear that struggling financial firms cannot count on a bailout. The decision not to intervene carries the risk that the ripples of Lehman's failure will prove impossible to contain. What worries regulators and Wall Street is a massive, multitrillion-dollar lattice of interlocking financial instruments known as derivatives. The most worrisome to bankers are "credit default swaps," in essence a form of insurance against corporate failures. If the financial firms themselves fail, the value of the insurance they have written will be tested as never before. So would the market for "triparty repo" -- a form of debt that funds all sorts of financial firms and is held in the money market mutual funds of ordinary Americans -- which is also looking at potential losses from the Lehman bankruptcy. It was that fear that led the Fed specifically to broaden the types of collateral it will accept at its lending window for investment banks, so that cash can keep flowing through the repo market. Even with that move, they are were steadying themselves for a tumultuous week in that market. The steps the Fed announced last night, Bernanke said in a statement, "are intended to mitigate the potential risks and disruptions to markets." "Bankruptcy is a perfectly natural thing, but you hope that the firm is in a position so that it can be an orderly bankruptcy and not cause other problems," said Susan Phillips, dean of the George Washington University School of Business and a former Federal Reserve governor.

Government officials drew a sharp contrast with the threat posed by the difficulties of Bear Stearns. In that situation, in March, Fed and Treasury leaders were convinced that its abrupt demise would have caused extensive damage across the financial system resulting in economic distress in the United States and beyond. For that reason, senior federal officials strongly encouraged J.P. Morgan Chase to buy Bear Stearns and backed $29 billion worth of its risky assets to make the deal happen. Several firms, especially Bank of America and the British bank Barclays, wanted control of Lehman's investment banking and asset management businesses. However, they wanted no part of billions in shaky real estate and other investments on Lehman's books, and wanted either taxpayers or other financial firms to assume part of that risk. But other companies decided they didn't want to take over the distressed assets, leaving only the good ones for Bank of America or Barclays. They concluded that they would rather risk potential problems in the financial markets on Monday than plow their limited cash into a venture that would be expected to have poor returns. And the Fed and Treasury refused to make government money available. On Capitol Hill, key lawmakers either declined to comment on the Lehman's fate or did not return calls. A spokesman for Sen. Charles E. Schumer (D-N.Y.), for whom the day's events represent a hometown crisis, said Schumer, who chairs the Joint Economic Committee, was withholding comment until the status of Lehman Brothers became clear. Lehman confirmed early Monday that its holding company intends to file for Chapter 11 with the U.S. bankruptcy court for the Southern District of New York, and will make motions that would allow the firm to continue to pay employees and to keep its operations running. Lehman also said it is exploring a sale of its broker-dealer operations, and confirmed it remains in advanced talks with "a number of potential purchasers" for its investment-management division, which includes Neuberger Berman and Lehman Brothers Asset Management. Those two subsidiaries will conduct business as usual and will not be subject to the bankruptcy case, Lehman said. Customers of Lehman and Neuberger Berman can continue to trade in their accounts, the company said. Lehman's rank-and-file employees were unsure what they would find when they went to their offices Monday morning. "There's no word. It's not clear what's happening or what's going to happen," said a Lehman bond trader who spoke on condition of anonymity because of the sensitivity of the situation. On Friday, "we thought the options were clear, that either we got bought or we got sold off in small pieces. Nobody thought it was actually going to go to bankruptcy." Lehman's dissolution has been gradual, over several months. If Bear Stearns experienced a run on the bank, Lehman has experienced a walk on the bank. That means that its various business partners have had time to bolster themselves for potential losses, and, in the view of these government officials, the risks to the system as a whole are therefore less. It likely means the end of a Wall Street titan, a firm with 24,000 employees and 158 years of history. Lehman Brothers dates back to 1850, to a general store that Henry Lehman and two siblings opened in Montgomery, Ala. The brothers accepted cotton for cash and started a trading business on the side. A century ago, the firm helped arrange financing for Sears Roebuck. It expanded globally through the twentieth century and became one of the top investment banks. A decade ago, chief executive Richard S. Fuld Jr. faced down rumors that the firm was on the brink of insolvency and put Lehman on an aggressive expansion course. In 2001, with its trading floors destroyed by the terrorist attacks

in New York, he regrouped quickly, and the firm managed the first initial public offering to come to market after the attacks. Fuld's aggressive and competitive nature is not uncommon on Wall Street, but friends and rivals have said the intensity with which Fuld expresses those traits are unmatched. Lehman, which was outmuscled in merger advising and other traditional investment banking businesses, seized on the mortgage market as an area it could dominate in recent years. Lehman, the number one underwriter of mortgage-backed bonds last year, amassed a giant portfolio of properties and mortgage-related securities. But the value of the assets began to sink last year amid a spike in mortgage defaults by homeowners with subprime credit. Lehman shares have fallen from a high of $86.18 in February 2007, when the company's stock market value was approaching $50 billion, to Friday's closing price of $3.65, which left the firm with a market capitalization of $2.5 billion. "Six months to the day since Bear Stearns went under, I'm viewing our experience in a whole new light," said John Ryding, a former Bear Stearns economist. "We were lucky to be first. We got out with $10 a share, which looked really bad at the time, but it looks a whole lot better than what Lehman shareholders are likely to get."

Weekend Merger Struck With Bank of America September 15, 2008;

Bank of America struck a $50 billion deal yesterday to buy Merrill Lynch, a merger that will unite the nation's largest consumer bank with one of its most celebrated investment banking firms, according to sources familiar with the negotiations. Both boards approved the deal and it was being reviewed by lawyers late last night, the sources said. Bank of America will pay about $29 for each share of Merrill Lynch stock, which closed at $17.05 on Friday. A formal announcement is expected this morning. The acquisition came at the end of a historic weekend in New York. Senior federal officials and Wall Street executives cloistered themselves at the Federal Reserve Bank of New York and urgently discussed how to minimize the damage to global financial markets from the looming bankruptcy of investment bank Lehman Brothers. Merrill Lynch's chief executive, John Thain, had been among the Wall Street chieftains who had been summoned to the extraordinary session to help fashion a rescue for Lehman. But as the weekend went on, it became increasingly clear that Merrill Lynch could be badly injured by a Lehman bankruptcy and needed to find its own way to ride out the gathering storm. Initially, Bank of America had been a leading suitor for Lehman, but backed out after federal regulators refused to put government money behind the deal. Merrill Lynch is in better shape financially than Lehman, and Bank of America views the company as a better fit. Merrill Lynch's crown jewel is the nation's largest retail brokerage. Bank of America views that business as a good addition to its own consumer financial businesses. The company already was the nation's largest retail bank, credit card company and mortgage lender. Now it will become the nation's largest retail brokerage, too. Arguably no other American company sits closer to the heart of the consumer economy.

For Bank of America, which is based in Charlotte, Merrill Lynch also offers the prestige of owning one of the nation's great investment banks. Bank of America has struggled to build its own operation. Chief executive Ken Lewis declared last fall that he had "all the fun I can stand," as he announced that the company would slow its efforts to grow its own investment bank. It now appears the firm never relinquished the underlying ambition, and Bank of America will now be a major player on Wall Street. Bank of America is in a position to buy Merrill Lynch because until now the company has been a bit player on Wall Street. Instead it has set its sights on consumers, running the nation's largest retail bank, a business that remains highly profitable. That gave it the cash to go shopping for an investment bank, continuing a long tradition of opportunistic acquisitions. Merrill Lynch was one of the largest producers and sellers of complex securities at the heart of the economic crisis. Merrill Lynch sold collateralized debt obligations, which are securities that package a large number of mortgage bonds and other debt, to investors around the world. But Merrill and other Wall Street banks created many more of these complex securities than they could sell. As mortgage defaults started to rise, the value of the CDOs plummeted, forcing Merrill to write down their value. The mounting losses threatened Merrill's survival. Merrill's shares dropped 36 percent last week, reducing its market value by $15 billion, to $26 billion. Bank of America was one of the few bidders to show up at what turned out to be a historic fire sale. The company initially sought direct government support if it were to buy Lehman, but instead chose to buy Merrill Lynch. Sources familiar with the company's thinking compared the choice to fighting a fire. Executives felt that Merrill Lynch could be saved, but Lehman was lost already. Bank of America, by contrast, remains relatively strong because its core banking business is healthy. During the marathon New York meetings, federal regulators also assisted another one of the nation's biggest financial institutions, American International Group, the largest insurer in the country. AIG had too been battered by the mortgage meltdown. Leaders of AIG were scrambling to pull together a sweeping restructuring plan to save their firm, said sources who spoke on condition of anonymity because of the fluid nature of the unfolding events. The plan is likely going to include selling subsidiaries to raise cash, according to sources familiar with the restructuring. AIG sells a type of insurance known as credit default swaps to cover losses on investments in certain kinds of securities. AIG made a big business of selling these swaps to cover losses in securities backed by mortgages. As the mortgage market has melted down, AIG has been on the line to cover more of the losses, eating away at the firm's capital. Over the past nine months, AIG has posted $18.5 billion in losses. Last week, its shares fell sharply on fears that it would have to raise tens of billions of dollars more capital to offset losses. The company's shares fell 31 percent alone on Friday. After the market closed Friday, Standard & Poor's warned that it might lower its ratings on AIG's debt. S&P ratings are used by investors around the world to judge the safety of certain kinds of debt.

Lowering the rating would probably force AIG to pay more for loans and could force the company to come up with more collateral to back some of its complex insurance policies.

Possible financial crisis fix sends stocks soaring The stock market finally found reason to rally Thursday, and Congress promised quick action as the Bush administration prepared a plan to rescue banks from the bad debt at the heart of the worst crisis on Wall Street since the Great Depression. Details of the plan were still being worked out, but Treasury Secretary Henry Paulson emerged from a nighttime meeting on Capitol Hill to say he hoped to have a solution "aimed right at the heart of this problem." As word of a government plan began to reach Wall Street earlier in the day, the Dow Jones industrial average jumped 410 points, its biggest percentage gain in nearly six years. The rebound also came after an infusion of billions of dollars by the Federal Reserve and world governments aimed at getting nervous banks to stop hoarding money and lend again. Stocks had fluctuated throughout the day, without severe swings in either direction, until CNBC reported the administration might back a new agency to take bad assets off the books of struggling financial institutions, much like it did in the aftermath of the savings and loan crisis of the 1980s. After the discussions Thursday night, Paulson said the goal was to come up with a "comprehensive approach that will require legislation" to deal with the bad debts, or illiquid assets, on bank's balance sheets. He did not provide any details, but the plan taking shape called for Congress to give the administration the power to buy distressed bank assets. Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, said that probably would not mean creating a new government agency. "It will be the power — it may not be a new entity. It will be the power to buy up illiquid assets," Frank said. "There is this concern that if you had to wait to set up an entity, it could take too long." Frank said his committee could begin drafting legislation as early as Wednesday. Paulson, Fed Chairman Ben Bernanke and other officials planned to work through the weekend on a solution. House Speaker Nancy Pelosi said that once the administration had presented its proposal, "we hope to move very quickly" to come to an agreement. There was no immediate word how much the rescue plan might cost. The banks still standing are staggering under the weight of billions of dollars of bad loans and mortgage debt arising from the wave of home foreclosures in the United States, and lending has tightened around the world in response. Before the sun rose on Wall Street on Thursday, the Fed said it would boost by as much as $180 billion the amount of cash it would supply to foreign counterparts that are short on dollars. For banks in the United States, the Fed supplied $105 billion in short-term loans later in the day. But, at least initially, those efforts did little to unfreeze the global credit markets. Banks remained extremely reluctant to lend money.

The No. 2 official at the International Monetary Fund, John Lipsky, said the past few days were "searing manifestations of a financial crisis that has expanded to historic proportions." He predicted the turbulence would continue for "some time to come." British financial regulators also banned short-selling the stock of financial companies listed on the London Stock Exchange. U.S. regulators tightened rules on short-selling Wednesday. Christopher Cox, chairman of the securities and Exchange Commission, told lawmakers the SEC may put in a temporary emergency ban on all short-selling — not just the aggressive forms it already has targeted, according to a person familiar with the matter, speaking on condition of anonymity because no final decision had been made. The ban might apply to stocks of selected financial companies, to all financial companies or even possibly to all public companies. Short-selling, which has been practiced on Wall Street for decades, is not illegal per se. The Fed said it had authorized the expansion of swap lines, the process by which it supplies reserves to other central banks, to include amounts up to $110 billion for the European Central Bank and up to $27 billion for the Swiss National Bank. The Fed also said new swap facilities had been authorized with the Bank of Japan for as much as $60 billion, $40 billion for the Bank of England and $10 billion for the Bank of Canada. For more than a year, investors around the world have watched with growing alarm as the U.S. economy, the world's largest, has struggled to right itself amid massive home foreclosures, many of them from mortgages issued to homeowners with bad credit. The turmoil has swallowed some of the most storied names on Wall Street. Three of its five major investment banks — Bear Stearns, Lehman Brothers and Merrill Lynch — have either gone out of business or been driven into the arms of another bank. The Dow's gain of nearly 4 percent on Thursday sent the average back above 11,000 and nearly erased its losses from a day before. But as the uncertainty wore on, investors continued to flock to Treasury securities, considered a haven in times of crisis, and the price of gold rose yet again. And worries about even the safest investments intensified as Putnam Investments abruptly closed a $15 billion money market fund because institutional investors had pulled their cash. Bush canceled out-of-town fundraising trips to Alabama and Florida to stay in Washington and huddle with Paulson and the heads of the Fed and the Securities and Exchange Commission. In an appearance earlier in the day, the president acknowledged "serious challenges" in the markets and said: "The American people can be sure we will continue to act to strengthen and stabilize our financial markets and improve investor confidence." The credit troubles reverberated around the globe. Asian stocks closed lower. European stocks rose but struggled to hold on to the gains. Russia closed its stock exchanges for a second day, and President Dmitry Medvedev pledged a $20 billion injection into financial markets. In the United States, investors worried for another day about the health of the banks still standing. Earlier in the week, venerable Lehman Brothers was forced into bankruptcy, and Merrill Lynch was driven into the arms of Bank of America. On Thursday, Morgan Stanley scrambled to strike a major deal or raise more cash that will reassure investors and prevent more damage to its battered stock. Its CEO, John Mack, reached out to

China's Citic Group overnight about a possible investment, according to a person familiar with the talks. Morgan Stanley is also considering a combination with retail bank Wachovia Corp. and an investment from Singapore Investment Corp., one of the world's biggest sovereign wealth funds, said the person, who spoke on the condition of anonymity because the discussions were still ongoing. On Capitol Hill, lawmakers in both parties became increasingly vocal about their concerns with the Bush administration's handling of the current crisis. Administration officials refused to attend a closed-door briefing with House Republicans this morning, leaving their congressional allies in the dark about the government's $85 billion emergency loan to insurer American International Group, House GOP leader John A. Boehner said. And Sen. Chris Dodd, D-Conn., the Banking Committee chairman, was irritated that Paulson twice canceled appearances he was to have made before the panel this week.

To Plan B, With All Deliberate Speed In an effort to restore investor confidence, ease the anxieties of election-year voters and get out ahead of a financial crisis that threatens to spin out of control, Washington is moving toward creation of a new government entity to . . . . Well, that's the question, isn't it: to do what? Judging from the sobering statements of administration and congressional leaders last night, there is a strong political instinct at the White House and on Capitol Hill to do something. Everyone agrees that there's a better solution than having the Treasury and the Federal Reserve continue to do these ad-hoc, midnight rescues, stretching their balance sheets and their legal authority. And everyone agrees that we had better do something quickly, before there's even more of a run on the money markets and the stock market does another nosedive. As it now appears, the mission of the new entity would probably be as buyer of last resort for securities that are now almost impossible to sell but are weighing heavily on the balance sheets of banks, investment banks, pension funds, insurance companies and even hedge funds. Once the government takes these securities off the books of these institutions, new investors presumably would be willing to come in with additional capital to restore them to financial health. The aim would be for the government to eventually make money by buying only those securities priced well below the value of the underlying assets and waiting for the markets and the economy improve. Alternatively, there's the idea put forward yesterday by Sen. Chuck Schumer (D-Wall Street). Schumer would have the new agency inject capital directly into struggling financial institutions, in exchange for a government ownership stake and a promise to renegotiate troubled mortgage loans rather than pushing them to foreclosure. The obvious downside, of course, is that his plan would blur the line between public and private ownership and put the government in the position of deciding which enterprises to save and which to sacrifice. But it's a solution that's particularly attractive to Wall Street. (SHADES OF INDONESIA AND THE IMF!!) Once the mission is nailed down, there's still a question of how to structure the agency and how much money to give it. (SON OF IBRA) The simplest approach would be to create a new office within the Treasury, reporting directly to the secretary of the Treasury. Or you could create a new independent agency with its own director and an independent board. That's the way its been done in the past.

But the more modern variation would be to create a public-private entity and require that half the capital come from elsewhere -- private equity funds, hedge funds, pension funds, even sovereign wealth funds. These investors would get the same deal as the taxpayers, participating equally in all the risks and the rewards. The government would need to borrow less money and reduce its risk. As for funding levels, you can figure it could be anywhere from $200 billion to $500 billion, on top of the money already committed for Fannie Mae, Freddie Mac, AIG and Bear Stearns. That's a pretty good indication of how serious a problem we have on our hands. On a less serious note, finding someone with experience to run this new agency ought to be a piece of cake, given the large number of unemployed Masters of the Universe who now spend their days perfecting their golf swings. On Wall Street, losing $30 billion of your shareholders' money is never a disqualification for the next job -- hey, it could happen to anyone, right? But getting Stan O'Neal or Jimmy Cayne through confirmation hearings might be a problem. Maybe now that Hank Paulson has gotten used to working nights and weekends cleaning up after his former colleagues on Wall Street, he'd be willing to re-up for another tour of duty here in Washington. Finally there is the all-important question of what to call this new agency. Democrats like Schumer like the ring of the old New Deal agency, the Reconstruction Finance Corp., while Republicans take their model from the Resolution Trust Corp. set up by President George H.W. Bush to dispose of assets taken over from failed savings and loan institutions. Then again, given our great success with government-sponsored enterprises, maybe we could call it something catchy, like Rescue Ray or Vulture Mac.

Stocks soar as investors bet on gov't rescue plan Wall Street extended a huge rally Friday as investors stormed back into the market, relieved that the government plans to restore calm to the financial system by rescuing banks from billions of dollars in bad debt. The Dow Jones industrials rose about 370 points, giving them a massive gain of about 780 over two days, and Treasurys fell as money flowed into equities. The plan to rescue banks from billions of dollars in soured debt has reassured investors who worried that a continuum of bad bets on mortgages would hobble more financial companies and cause even further damage to the banking system and the overall economy. "If a solid plan is put in place, it's definitely going to be a positive in easing the pain," said Stephen Carl, principal and head of equity trading at The Williams Capital Group. He added, though, that the set-up of any plan will determine how successful it is. A new government ban on short selling, or placing bets that a stock will fall, likely added to the market's gains as traders adjusted their positions. "A big chunk of this is scaring all the shorts to cover their bets," said Joe Battipaglia, market strategist at Stifel, Nicolaus & Co. Treasury Secretary Henry Paulson, speaking about the rescue plan, said a bold approach is needed to remove troubled assets from the books of financial firms. He offered few details, but said he would working through the weekend with congressional leaders. The government's fix could help resolve a yearlong credit crisis that intensified this week, pummeling the stock market and forcing lending to grind to a virtual standstill. Wall Street suffered massive losses Monday and Wednesday, and credit markets seized up following this week's bankruptcy of Lehman Brothers Holdings Inc. and the bailout of teetering insurer American International Group Inc.

Analysts said it was the first government response decisive enough to restore confidence in the markets. "Everything they had done had been a Band-Aid approach, at the margins," said Jay Mueller, economist at Strong Capital Management. "Now we're dealing with the root problem." The government took other steps Friday to restore stability to the financial system. The Federal Reserve said it will expand its emergency lending and let commercial banks finance purchases of asset-backed paper from money market funds. The Fed injected another $20 billion in temporary reserves into the U.S. financial system. The central bank also will buy short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. And to help calm investors' anxieties, the Treasury Department has decided to use a Depression-era fund to provide guarantees for U.S. money market mutual funds. Money market mutual funds are typically considered safe, but many investors have been fleeing them, fearing that the funds' holdings included souring corporate debt. To help limit the freefall in financial stocks, the Securities and Exchange Commission on Friday enacted a temporary ban on the short-selling of nearly 800 financial stocks. Short-selling is the common practice of betting against a stock by borrowing shares and then selling them in the open market. A short-seller's hope is the stock will fall; if it does, the stock can be bought back at the lower price. Those cheaper shares can be returned to the lender, allowing the investor to pocket the profits. Traders can lose, however, if the stock rises. Wall Street observers have disagreed over the extent to which pressure from all those bets that a stock will fall shaped investor sentiment and strangled some financial stocks, like those of Lehman Brothers last week. Some say the fundamental problems with overleveraged financial companies warranted the pessimism while others say the short selling was a death knell for some financial names. "The federal government has been petitioned by Wall Street to take evasive action in the money markets, the stock and bond markets, to avoid a complete meltdown of the credit system," said Battipaglia. "Once the credit system melts down, the economy falls. We can hand-wring about if this is the proper thing for the government to do, or if Wall Street pulled the panic button too soon, but that's something for the historians to sort out." It's difficult to quantify how much of the market's gains reflected short sellers who are forced to step in and cover their bets by buying now rising stocks that had predicted would fall. While that appeared to play some role in the advances Thursday and Friday, the Nasdaq composite index — dominated by big technology stocks, not financials — showed big gains along with the Dow and the Standard & Poor's 500 index. According to preliminary calculations, the Dow rose 368.75, or 3.35 percent, to 11,388.44 after having been up as much as 463.36. Friday was a quarterly "quadruple witching" day, which marks the simultaneous expiration of options contracts, an event that often adds to volatility and heavy volume. Broader stock indicators also surged Friday. The S&P 500 index rose 48.57, or 4.03 percent, to 1,255.08, and the Nasdaq composite index rose 74.80, or 3.40 percent, to 2,273.90. Even with Friday's big gains, stocks didn't end the week with much change after the whipsaw sessions. The Dow slipped 0.29 percent, the S&P 500 rose 0.27 percent and the NASDAQ added 0.56 percent.

Treasury prices dropped as investors poured money back into stocks. The yield on the 3-month Treasury bill — a safe investment to which investors have rushed this week — rose to 0.95 percent from 0.07 percent late Thursday. Yields move opposite from price. The yield on the benchmark 10-year Treasury note shot up to 3.81 percent from 3.53 percent late Thursday. The stock market's enormous swings during the week reveal how anxious investors have been about the tightness in the credit markets the possibility that other financial companies might succumb to the difficulties in the markets. Moves Thursday by the Fed and other major central banks to inject billion into global money markets perhaps helped forestall steeper selloffs but didn't diffuse the Sturm und Drang and overall loss of confidence hammering the markets as big financial companies including Lehman and AIG stumbled. The only lasting move in a week of intense volatility came late in Thursday's session when reports emerged that the government was considering a plan that would shift soured debt off financials' books. A wobbly market rocketed higher, giving the Dow a 410-point gain for the session. The dollar rose against most other major currencies in Friday trading, while gold prices jumped. Light, sweet crude rose $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange. While stocks rose broadly, the financial sector was one of the strongest gainers. The two remaining independent investment banks logged big advances as fears dissipated that they would be felled by cash shortages and toxic debt. Goldman Sachs Group Inc., jumped $21.80, or 20 percent, to $129.80, while Morgan Stanley jumped $4.66, or 21 percent, to $27.21. Advancing issues outnumbered decliners by about 7 to 1 on the New York Stock Exchange, where volume came to a heavy 2.1 billion shares compared with 2.45 billion shares traded Thursday. The Russell 2000 index of smaller companies rose 30.06, or 4.15 percent, to 753.74. Overseas stock markets soared. Japan's Nikkei stock average jumped 3.8 percent, and Hong Kong's Hang Seng index surged 9.61 percent. In Europe, Britain's FTSE 100 jumped 8.84 percent, Germany's DAX index advanced 5.56 percent, and France's CAC-40 rose 9.27 percent.

Reckless? You’re in Luck By FLOYD NORRIS

Allow me to propose a simple principle that the next president and Congress could follow as they devise a new financial regulatory regime to replace the one that failed so badly: If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated. The regulators need to know what risks are being taken, and by which institutions, in time to act before a crisis develops. Had the government bothered to do that in years past, it might not have faced the decisions it faced this week. First, it let one big firm go down, and then it became scared enough to nationalize another one to keep it afloat. Now, showing no sign of embarrassment over how badly they failed before, the current crop of regulators seem to be unified in their determination not to let the markets force them to make a similar choice on some other big financial institution. The result is a campaign against those who bet that the financial system was crumbling.

If the government is forced to decide whether to save another firm, it will face the same question it faced with A.I.G. and Lehman Brothers. Would this failure cause systemic damage to the financial system? Lehman did not measure up because its chief executive, Richard S. Fuld Jr., simply was not reckless enough as he ran Lehman into the ground. Had he had the foresight to make a lot more bad bets in the derivatives market, the government would have feared financial chaos and might have nationalized Lehman, just as it nationalized A.I.G., Fannie Mae and Freddie Mac. Or it would have subsidized a takeover, as it did for Bear Stearns. The Paulson-Bernanke Doctrine is not “too big to fail.” It is “too reckless to fail.” If you get your company into enough trouble to threaten the financial system, Ben Bernanke, the Federal Reserve chairman, and Henry Paulson, the Treasury secretary, won’t let you collapse. It may be that they miscalculated. Lehman’s default caused a money market fund to suffer losses, and scared investors into pulling their money from similar funds. If those funds cannot find buyers for their assets, there could be more defaults, and perhaps more failures. The Paulson-Bernanke Doctrine was born not of theory or ideology, but instead from improvising as each new crisis erupted. The Fed’s briefing on the nationalization of A.I.G. did not start until 9:15 p.m. on Tuesday night, which is not a sign of carefully thought-out decisions. When they met with Congressional leaders Thursday night to seek a plan to get cash to banks before they fail, it was almost as late. If these nationalizations smack of socialism, it is closer to the Marxism of Groucho than of Karl. The Cox Proviso to the Paulson-Bernanke Doctrine is that the rules will change, and change again, if that is needed to avoid another failure. On Wednesday morning, Christopher Cox, the chairman of the Securities and Exchange Commission, announced new rules on short-selling. The market plunged anyway, and that night he was back with a news release saying he would ask the commission to force short sellers to publicly disclose their positions. “The enforcement division will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities,” he added. By Thursday night, after Senator John McCain denounced him for not doing enough about short selling, he was talking of banning the practice. Had the S.E.C. gone over the records of Lehman and Bear Stearns with the vigilance it now promises for the shorts, we might not be in this mess. But that was then, and it is clear that anyone betting against the big banks now is fighting not just the Fed, but the S.E.C. and Treasury as well. It is a sad commentary that the authorities are most worried about a market that they were unwilling to do anything about when it was growing and growing. That market is credit-default swaps. The people who developed that market hired good lobbyists, who got the law written to keep regulators away. Alan Greenspan, then the chairman of the Federal Reserve, thought it would be wrong for regulators to try to, as he frequently said, “outguess the market.” Now the country dares not risk letting the market work its magic. Credit-default swaps are a way of transferring the risk of owning a bond. If I own a bond issued by General Motors, and have also purchased a credit default swap on G.M., then I am covered if G.M. defaults. I can recover my losses on the bond from the institution that sold the swap to me.

There are now many more credit-default swaps outstanding than there are bonds for them to cover. They became a way to gamble with almost no money down. For a small fee, my hedge fund can bet that a company will go under. And your hedge fund can collect that fee, and produce instant profits. Years down the road, you may have to pay, but big companies rarely default anyway, so the risk is minimal. Or so people thought. One way to think of the swaps market is as insurance that is issued by companies that do not have to keep reserves and may be totally unregulated. I can’t legally buy fire insurance on your house, since I have no stake in it, and letting me have insurance would give me an incentive to burn it down. But I can buy a credit-default swap on G.M. even if a G.M. default would not cost me a penny. That brings up “counterparty risk.” If my hedge fund bought a G.M. swap from A.I.G., and sold one to your hedge fund, then my fund has laid off the risk. If G.M. defaults, I will have the money to pay you as soon as A.I.G. pays me. But if A.I.G. has taken lots of those positions — and it did — then who knows which banks and funds and investors will be in trouble if A.I.G. cannot honor its obligations? My fund may have a perfectly matched book, but it is suddenly in deep trouble if a counterparty is defaulting. Since no one keeps track of all the moving parts, no one knows just who may get into trouble if one participant fails. The theory that beguiled legislators and regulators was that the market could regulate itself. Each bank would be careful to deal only with counterparties it could trust, and so the whole system would be trustworthy. But even if you believe that, remember that most swaps are good for five years. Not long ago, A.I.G. was a Triple A company, whose credit was viewed as sterling by everybody. It is worth remembering that A.I.G.’s credit standing did not fall even after it was caught helping other companies rig their financial statements. Nor was it hurt by evidence it had fudged its own numbers. Discovering that a company is run by people with what we might call flexible integrity should have been a red flag. But who would have looked? The insurance subsidiaries were regulated by state insurance departments, and activities of the parent were not their focus. Had anyone suggested an aggressive audit to see what other games A.I.G. was playing, I am sure that neither the Fed nor the Treasury would have thought they had jurisdiction. Now they say the national interest required them to step in. “A disorderly failure of A.I.G.,” the Fed said, “could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.” That may sound outrageous, but it is probably true. By the time A.I.G. was on the verge of failure, the government’s options were limited. In letting Lehman default, the authorities wanted to send the message that they were not going to bail out somebody every weekend, and that the damage from a big brokerage failure could be contained. They may have been wrong on both counts. I doubt anyone in government thought to wonder if a money market fund would have to “break the buck” because it owned Lehman debt. But that did happen. It is not easy to forecast the reverberations of one big failure, and the Fed may not have done it well. But the biggest errors in Washington were made long before A.I.G. arrived at the Fed with its hat in hand, and long before short sellers began to think the banks were in trouble.

How Will Banks Fare in the Bailout?

Sept. 22nd Here are the industry winners and losers that could emerge as the grand plan takes shape The details still have to be worked out for the $700 billion fund the U.S. government will create to take distressed mortgage-related assets off banks' hands in hopes of thawing the country's frozen credit system. The most obvious beneficiaries of the plan will be members of the "shadow banking system," including such surviving investment banks as Merrill Lynch (MER)— which has agreed to be acquired by Bank of America (BAC)— and Morgan Stanley (MS), but even more conservative commercial banks that don't have much to purge from their balance sheets are expected to gain as the effects of the program spread through the economy. A major question that will determine how helpful the bailout is: the price the government is willing to pay, which could turn out to be as low the 22 cents on the dollar that Merrill Lynch got for $30 billion in assets it sold to private equity firm Lone Star in July. The financial companies that are holding distressed assets don't even necessarily have to sell them to the U.S. Treasury in order to benefit from what many are calling the "mother of all bailouts." A financial company might decide not to sell its distressed assets in the belief that there's more value in holding onto them until the market recovers somewhat and prices for the assets increase, predicts Gerard Cassidy, senior equity analyst at RBC Capital Markets (RY) in Portland, Me. THE BUYER OF LAST RESORT As Merrill Lynch's transaction with Lone Star showed, the discount on these assets has two components: credit risk, which is based on the likelihood of defaults on the underlying mortgages, and lack of liquidity discount, which stems from a dearth of potential buyers, says Cassidy. By stepping in as the buyer of last resort, the U.S. government will be pumping liquidity into the banking system, which is expected to boost the value of these securities, he says. As a result, the liquidity discount in the price of the assets should narrow substantially as market participants recognize there's a big buyer providing liquidity, which could help attract more buyers, Cassidy adds. One group that isn't likely to get any relief from the bailout are hedge funds that hold a large quantity of the distressed debt products, says Jack Ablin, chief investment officer at Harris Private Bank (BMO) in Chicago. "Here's a case where hedge funds, as unregulated entities, have no recourse at the table," unlike the banking lobby and mutual-fund industry group Investment Company Institute, both of which will likely have some influence over the legislation that ultimately materializes, he says. He also believes the hedge funds were directly targeted by the Securities & Exchange Commission's ban on shorting more than 800 financial stocks, which took effect on Sept. 22 and is due to last through Oct. 2. GM MAY BE A LOSER Other losers may include companies such as General Motors (GM), whose affiliated financing arm GMAC likely has exposure to toxic securities but may not qualify for the government bailout because it's not strictly a financial firm, says Ablin. "You certainly get into odd territory with GMAC," he says. "It's almost entirely owned by a private equity fund [Cerberus Capital Management]. So do you want to bail out [Cerberus chairman] John Snow?" Commercial banks, most of which have kept their balance sheets free of toxic assets, will probably benefit indirectly as the increase in market liquidity will help push their borrowing costs lower, says John Jay, senior analyst at the Aite Group, an independent financial services research firm in Boston. "If [its funding costs] go low enough, their senior managers will start to look for businesses to lend money to." In the end, their profit margins are expected to grow as the differential between their borrowing costs and lending rates widens.

The shares of some financial players have had a strong run in spite of the market's attempts to paint them with the same brush as the rest of the industry, says Jocelyn Drake, an equity analyst at Schaeffer's Investment Research in Cleveland. PNC Financial Services (PNC), Wells Fargo (WFC), and Hudson City Bancorp (HCBK) all steered clear of toxic assets and their shares hit one-year highs last week before Treasury Secretary Henry Paulson announced the plan on Sept. 18. The shares posted further gains after the announcement. SKELETONS IN THE CLOSET Schaeffer's tends to base its stock picks on technical performance and the degree of pessimism directed at them. Market pessimism —which is reflected in analysts' ratings, the level of short interest and the ratio of options betting on lower prices for certain stocks vs. bets on higher prices—can give you a sense of how much investing money is sitting on the sidelines waiting for the right signals to come into the market. "There are still some skeletons that could come out of the closet [for the financial industry] and hinder the group," says Drake. But she's betting that as certain stocks continue to buck the trend and outperform their peers, sidelined investors will cave in and start to buy these stocks so as not to miss the boat. There are also a couple of homebuilder stocks that Drake expects to benefit as liquidity returns to the housing market and inventory begins to move. She likes Meritage Homes (MTH) and Toll Brothers (TOL), both of which have been in an uptrend since the beginning of this year. She takes the drop in mortgage rates after the government bailout of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) was announced two weeks ago as a positive sign, which she believes will help stoke demand for houses.

U.S. taxpayers should expect heavy losses

It looks as if we got through the weekend without another scramble to save a troubled financial company with a trillion-dollar balance sheet. But that does not mean U.S. taxpayers are out of danger. No, sir. No, ma'am. Because lawmakers are at work on a bailout fund that would buy the kind of distressed assets (defaulted mortgages, for example) that have ignited this firestorm. Treasury Secretary Henry Paulson Jr. has called the fund the "troubled-asset relief program." I'll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don't soil your Guccis).

And depending on how TARP is operated, and how the assets are valued before taxpayers are required to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it. Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren't visited upon TARP. Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let's assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar. So what's a fair price that we TARPistas should pay for the assets? If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents. Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again. Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor? You know the answer to that. And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage that drove us into this ditch. Such is our lot today: They break it. We own it. Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned. If government regulators and political leaders want to earn back some trust, they could do two things. First, they could provide us with some transparency about whom precisely we are backing in the recent bailouts. Take, for example, the rescue on Tuesday of American International Group, once the world's largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers? Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer's financial prospects, loomed so big on balance sheets that they now drive every bailout decision. The deal to save AIG involves a two-year, $85 billion loan from taxpayers. In exchange, the new owners - us - get 80 percent of the company. If enough of AIG's assets are sold for good prices, we may get our money back. Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the AIG deal. AIG had written $441 billion in credit insurance on mortgage-related securities whose values have declined;

if AIG were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami. So, the $85 billion loan to AIG was really a bailout of the company's counterparties or trading partners. Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions - counterparties to AIG's derivatives contracts - benefited from the taxpayers' $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan? And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed? We'll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes. AIG's financial statements provided a clue to the identities of some of its credit-default-swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses. Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk. Got that? Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight. Warren Buffett was not engaging in hyperbole when he called these things "financial weapons of mass destruction." "The last eight years have been about permitting derivatives to explode, knowing they were unregulated," said Eric Dinallo, the New York State superintendent of insurance. "It's about what the government chose not to regulate, measured in dollars. And that is what shook the world." And it will continue.

Will the bailout work?

As the U.S. government steps to the center of the financial crisis, crafting plans to take ownership of up to $700 billion worth of bad mortgages, a pair of simple questions rises to the fore: Will this intervention finally be enough to restore order? And what will this grand rescue cost U.S. taxpayers?

The Treasury Department, as overseer of the American financial system, has in recent weeks unleashed an astonishing array of initiatives in a bid to stave off catastrophe. It took over the country's largest mortgage finance companies and put untold billions of taxpayer dollars on the line to prop up other lenders.

Now, although the details are still being worked out, the government is dispensing with rescuing one company at a time, and instead taking on a vast pile of bad debt in one gulp. If it all comes to pass - if Uncle Sam becomes the repository for the radioactive leftovers of bad real estate bets - will the crisis lift? Will the fear that has kept banks clinging to their dollars, starving the economy of capital, give way to free-flowing credit?

There are many skeptics of the Treasury's proposal, though there is wide agreement that some kind of broad intervention is necessary.

"It goes a long way. It ameliorates it very substantially," said Alan Blinder, an economist at Princeton and a former vice chairman at the Federal Reserve, who has said for months that the government must step in forcefully to buy mortgage-linked investments. "We're deep into Alice in Wonderland's rabbit hole," he said.

But significant skepticism confronts the initiative. Under a proposal circulating Saturday, the Treasury could spend as much as $700 billion to buy mortgage-linked investments, then sell what it can as it works out the messy details of the loans. But no one really knows what this cosmically complex web of finance will be worth, making the final price tag for the taxpayer unknowable. One may just as well try to predict the weather three years from Tuesday.

Some question the prudence of adding to the nation's overall debt at a time when the Treasury relies on the largess of foreigners to cover the bills. Most broadly, what are the longer-term costs of the government stepping in to restore order after so many wealthy financiers have become so much wealthier through what now seem like reckless bets on real estate - bets now covered with public dollars?

Also, what message does that send to the next investment bank caught up in the next speculative bubble and contemplating the risks of jumping in while wondering who is ultimately on the hook if things go awry?

Many economists say such questions are beside the point. The United States is gripped by the worst financial crisis since the Great Depression.

Before Thursday night, when the Treasury secretary, the Federal Reserve chairman and leaders on Capitol Hill proclaimed their intentions to take over bad debts, the prognosis for the American financial system was sliding from grim toward potentially apocalyptic.

"It looked like we might be falling into the abyss," Blinder said.

As the details of the government's plans are hashed out, no hallelujah chorus is wafting across Washington, down Wall Street or through the glistening condos of the United States. Too many households are having trouble paying their mortgages. Too many people are out of work. Too many banks are bloodied.

Still, the prospect that the government is preparing to wade in deep - perhaps sparing families from foreclosure and banks from insolvency - has muted talk of the most dire possibilities: a severe shortage of credit that would crimp the availability of finance for many years, effectively halting economic growth, both in the United States and around the globe.

"The risk of ending up like Japan, with 10 years of stagnation, is now much lessened," said Nouriel Roubini, an economist at the Stern School of Business at New York University. "The recession train has left the station, but it's going to be 18 months instead of five years."

If the plan works, it will attack the central cause of American economic distress - the continued plunge in housing prices. If banks resumed lending more liberally, mortgages would become more readily available. That would give more people the wherewithal to buy homes, lifting housing prices or at least preventing them from falling further. This would prevent more mortgage-linked investments from going bad, further easing the strain on banks. As a result, the current downward spiral would end and start heading up.

"It's easy to forget amid all the fancy stuff - credit derivatives, swaps - that the root cause of all this is declining house prices," Blinder said. "If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it."

For many Americans, the events that have transfixed and horrified Wall Street in recent days - the disintegration of supposedly impregnable institutions, government bailouts with 11-figure price tags - have been less stunning than inscrutable. The headlines proclaim that the taxpayer now owns the mortgage finance giants Fannie Mae and Freddie Mac, along with the liabilities of a mysterious colossus called the American Insurance Group, which, as it happens, insures against corporate defaults. Much like the human appendix, these were organs whose existence was only dimly evident to many until the pain began.

And yet these institutions are deeply intertwined with the American economy. When the financial system is in danger, it stops investing and lending, depriving ordinary people of financing for homes, cars and education. Businesses cannot borrow to start and expand.

"Wall Street isn't this island to itself," said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute. "Even people with good credit histories are having a very hard time getting loans at terms that make sense. If that gets worse, we're going to be stuck in the doldrums for a very long time, because that directly blocks healthy economic activity."

Financial Regulation 101: The human factor

When the credit crisis ends, the inevitable post-mortems may reach two unsatisfying conclusions: Banks had a lot of regulators but not much regulation, and there is little that regulators could, or should, have done differently to avert the crisis or blunt its impact.

There is no shortage of agencies supervising financial institutions. The U.S. Federal Reserve, because it has the keys to the Treasury and can make almost unlimited capital available to banks when they are starving for it, is considered to have the most important role in the United States.

Other significant players in the ensemble cast include the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Securities and Exchange Commission.

The European financial system has a byzantine regulatory system of its own. The European Central Bank, which governs the euro countries and political and economic iconoclasts like Britain and Switzerland, serve a function similar to the Fed's, and national Parliaments and quasi-independent agencies are involved, too.

The authorities in the field point to several reasons that all those entities were unable to limit the damage from bad debts and bad decisions. They converge on a crucial reality that is hard to regulate around: The human mind is both remarkably creative and infuriatingly fallible.

In this realistic but somewhat depressing context, what may well emerge is a regulatory philosophy that any institution that poses a risk to the system, whether it's called a bank or something else, will face tighter regulation and more ample disclosure requirements - not so much to avert the inevitable crisis, but to make it easier to make an informed investment decision and for rescuers to get information once the crisis hits.

Bank regulation is like a game of cat and mouse in which the mouse is smarter, earns more money and gets to make the first move. Institutions hire bright people to devise ways to exploit loopholes in the system to try to increase profits and stay ahead of competitors and regulators alike. They often succeed, and their success can cost a fortune.

"Coming up with structures to get around regulations has been a strategy of businesses for years, and that's not going to change," said Jaime Peters, who follows banks for the research firm Morningstar.

The principal regulation that American financial-service businesses tried to get around for most of the 20th century was the Glass-Steagall Act. A response to the proliferation of bank failures during the Great Depression, the 1933 law prevented deposit-taking institutions from owning investment banks and limited the ability of banks to operate across state lines.

At least in theory. The formation of holding companies that owned consumer and investment banks, as well as subsidiaries in multiple states, weakened Glass-Steagall, Peters said. So did the flourishing in the 1970s of mutual funds and money-market funds that became substitutes for conventional checking and savings accounts.

Picking up the story in the 1980s, Gary Gorton, a professor of finance at the Yale University School of Management, noted that technological advances had enabled bankers to concoct derivative instruments and so-called structured products like the notorious securitized mortgage loans. As he put it, "The banking system isn't the banking system anymore."

These developments rendered Glass-Steagall all but moot, and the act was repealed in the 1990s. That has led some observers to try to lay the credit crisis at the doorstep of the U.S. Congress, but others see it as an acceptance of the reality that bankers were a step or two ahead of regulators.

Financial innovators may have an incentive to continue bending the rules: the fact that the otherwise risky bets they make are not all that risky for them. If they win, they are rewarded with huge bonuses; if they lose, they get fired, at worst, and try again somewhere else.

Lawrence Harris, a professor of finance at the University of Southern California, said he expected regulators to continue to be "behind the ball." He sees no practical alternative.

"One way to improve things is to pay them more," he said. "You'll get better people, but they will still be subject to political pressure. And if you give them tenure, they'll become little gods unto themselves."

Political pressure - this is where Washington may bear some blame for the present mess, in his view. The mortgage leviathans Fannie Mae and Freddie Mac were encouraged to sacrifice safety to keep their great loan machines running at top speed, he said.

"Everyone in the administration and Congress wanted money to go into the housing industry," he said. "There was a lot of pressure on them to look the other way when receiving undocumented paper that they knew, or should have known, wasn't going to be good. They didn't feel they were all that exposed to risk."

As government affiliates that benefited from a Treasury guarantee on their debt, Fannie and Freddie were always special cases. In Europe, there is nothing special about the state authorities taking vigorously active roles in the affairs of big business, ostensibly in the public interest.

The credit crisis has intensified calls there, by lawmakers and others, for an overhaul of the way banks are regulated. Opinions vary widely on how to do it; some favor steps that would safeguard the financial system but otherwise give banks freer rein, while others want to monitor lenders more closely and curtail some of their activities, especially the riskier ones.

"Is the job of a regulator to ensure market stability or to keep the market from moving in the wrong direction?" said Jonathan Herbst, a partner at the Norton Rose law firm in London, framing the debate.

The more activist solution tends to be favored on the Continent. Jean-Claude Trichet, president of the European Central Bank, indicated in a recent speech that limits on leverage - the amount that can be borrowed for every unit of equity on the books - may need to be imposed on financial services companies. Regulators in Switzerland have already called for such strictures.

Until now, the more laissez-faire approach to supervision has been preferred in Britain, whose common-law legal history has evolved into a system that emphasizes broad guiding principles over an extensive list of rules and regulations. This is now under discussion, however.

"The idea is that you have greater flexibility," said Peter Snowdon, another partner at Norton Rose. "It's more future-proof."

It may also be more lawyer-proof, which is why the U.S. Treasury secretary, Henry Paulson Jr., is thought to favor such an approach. Having a looser set of principles, paradoxically, may provide a more secure regulatory framework than a set of explicit rules that legal eagles can navigate around or through.

One fact that is often ignored amid the urgent calls for action to protect the public is that there is not all that much, at least so far, to protect the public from.

Investors in several institutions, like Lehman Brothers, Bear Stearns and Countrywide Financial in the United States and Northern Rock in Britain, have seen the value of their holdings wiped out or nearly so. Pension funds are included in that group. But depositors with balances up to, and often above, mandated ceilings have lost no money, even when the accounts were at banks whose holding companies have gone bust.

That reality is one factor that persuades some observers that wholesale changes in bank regulation are unnecessary and may do more harm than good. So is the futility that regulators face in trying to anticipate what bankers will do next.

Peters, at Morningstar, still expects the attempt to be made. Investment banks are subject to little regulation other than the brutal kind that can be inflicted by the markets, but they may come under tighter supervision as the price for having gained access to government borrowing facilities.

An updating of accounting rules makes more sense to Gorton, the Yale professor. A good first step might be devising uniform rules for calculating the value of exotic assets.

"An accounting system that originated in the Middle Ages can't keep track of things like derivative instruments," he said.

Harris, at the University of Southern California, recommends measures to eliminate conflicts of interest. Highlighting one example central to the unraveling of the subprime mortgage market, he noted that agencies that rated the quality of debt instruments were paid by the issuers of that paper. That led to overly generous ratings, which contributed to an inability of banks to gauge the risks they were taking.

Instead of trying to compel banks to take fewer, or at least more sensible, risks, some authorities contend that it might be more fruitful to make people who do business with them - depositors, borrowers, investors - more aware of what those risks are.

"The loss of confidence was, in many ways, due to a lack of transparency and understanding, with both sellers and buyers of products forgetting the golden rule of 'don't sell or buy a product you don't understand,"' said Hector Sants, chief executive of the Financial Services Authority, the main financial regulator in Britain.

Harris is a big believer in full disclosure. Credit crunches and bank failures are a cost of doing business in a liberal economy, but that cost can be reduced by trying to make available all pertinent facts needed to make sound decisions.

"The most important thing that regulators can do is make sure there's complete information so people can understand what they're buying and be aware of the risks," he said. "If you ask for more regulation, there is an excellent chance you will end up with a worse problem. The best regulator is fear, and fear works when people are well informed. Sunlight is the best disinfectant."

Crashing banks and golden parachutes

Friday, September 19, 2008 With America's financial system teetering on a cliff, the compensation arrangements for executives of the big banks and other financial firms are coming under new scrutiny. Bankers' excessive risk-taking is a significant cause of this financial crisis and has contributed to others in the past. In this case, it was fueled by low interest rates and kept going by a false sense of security created a debt-fueled bubble in the economy. Mortgage lenders blithely lent enormous sums to those who could not afford to pay them back, dicing the loans and selling them off to the next financial institution along the chain, which took advantage of the same high-tech securitization to load on more risky mortgage-based assets. Financial regulation will have to catch up with the most irresponsible practices that led banks down this road, in hopes of averting the next crisis, which is likely to involve different financial techniques and different sorts of assets. But it is worth examining the root problem of compensation schemes that are tied to short-term profits and revenue, and thus encourages bankers to take irresponsible levels of risk. The banks recognize that pay is a problem. "Some firms" used "compensation incentives that exacerbated the weaknesses and contributed to the market turmoil," admitted the Institute of International Finance, a lobby group for big banks. One direct way to address this problem is for bankers to have more of their own money at risk in the bets they are making. The regulator of Fannie Mae and Freddie Mac set an example when the government took over the mortgage finance companies last week, barring them from paying their former chief executives severance packages worth millions that were stipulated in their contracts. It is proper for the federal government to intervene in executive compensation or exit pay when it takes over a bank. When the government assumed a huge ownership stake in American International Group, it fired the chief executive. But that was a drastic measure. Banks' boards of directors, encouraged by their shareholders, must look hard at reforming the pay of top bankers. The core problem is this: Bankers get stellar rewards in the good times and don't have to give money back when their strategy sinks the bank a few years down the road. They might miss a bonus, or even get fired - and float down to earth on the "golden parachute" negotiated in the flush years.

One way to change this would be for banks to hold a big chunk of bankers' pay in escrow, to be doled out over several years. A bigger share of a bankers' pay could be made in restricted stock that can only be sold over a fairly long period of time. Golden parachutes could depend on good performance through the executive's tenure. Now, there's a concept.

The fleecing of America World leaders converge on a battered New York this week for the United Nations General Assembly and my advice to them is: Think Damien Hirst. It's not that I expect them to dwell on the British artist's giant tanks of dead sharks, zebras and piglets at a time when the U.S. economy is being socialized to the tune of $700 billion ($2,000 for every person in the country) as a result of a giant mortgage-related Ponzi scheme. It's that the Hirst bull market in the midst of the most convulsive week for financial markets since 1929 says something important about the global economy and America's declining place in it. In case you missed it, Hirst sold 223 works last week for just over $200 million, well above Sotheby's pre-auction estimate. Oliver Barker, the auctioneer, identified the Russians as major buyers. Sotheby's took a preview of the sale to New Delhi, where it received a number of pre-auction bids. Jose Mugrabi, a New York dealer, told my colleague Carol Vogel that Hirst is a "global artist" who can defy "local economies." For local, read American. Yes, folks, the cash is elsewhere. Asians have been saving rather than spending. Their consumers are in better shape. Their banks are in better shape. The China Investment Corp. (CIC), a sovereign wealth fund, is sitting on $200 billion (and a 9.9 percent stake in Morgan Stanley) while China's central bank is managing another $1.8 trillion in reserves. And what have we heard from the new centers of wealth and power - China, India, Brazil, Russia, the Gulf states - about America's financial agony over the past week? Zilch. Well, not quite. When asked about the crisis, Luiz Inácio Lula da Silva, the Brazilian president, said: "What crisis? Go ask Bush." Thanks, Lula. Brazil is sitting on $208 billion of its own in reserves, so perhaps Lula would say his flippancy is justified. But I don't think it is. Remember the last financial crisis in 1998? With the Russian economy in a free fall, Moscow officials scurried to the U.S. Treasury to secure vital American support for $17.1 billion in new International Monetary Fund loans. That steadied things. The world has changed in the past decade. There's been a steady transfer of wealth away from the United States in a shift most Americans have not yet grasped. But there has been no accompanying transfer of responsibility. New powers are free-riding as if it were still the American century.

It's not. Imagine if Hu Jintao, the Chinese president, had declared this week: "China has a deep interest in the stability of the U.S. economy and the dollar. We stand ready to help in the essential return of confidence to financial markets. Talks with the U.S. Treasury are ongoing." Or perhaps the BRIC countries (Brazil, Russia, India and China) might have put out such a joint statement. Let's be clear: This is an American mess forged by the American genius for newfangled financial instruments in an era where the mantra has been that government is dumb and the markets are smart and risk is nonexistent. The responsibility for undoing the debacle is chiefly American, too. But toxic mortgage-backed securities were pedaled by plenty of foreign banks. And the decision to pour $85 billion of U.S. taxpayers' money into the rescue of American International Group (AIG), the insurance giant, followed appeals from foreign finance ministers to Henry Paulson, the Treasury secretary, to save a global company. Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, told me: "Paulson said he was getting calls from finance ministers all around the world saying, you have to save AIG. Well, they should have been asked to contribute to the pot." Frank has a point. (He should coach Barack Obama for the debates on how to put economics in plain language.) As Frank said on the Charlie Rose show, "I don't think the European Central Bank should be free to spend the Federal Reserve's money and not put any in." I know, you reap what you sow. Nobody loves to help the Bush administration. World central banks did inject billions in concerted action to help stabilize money markets, but the U.S. has essentially been on its own. Now foreign banks with U.S. affiliates will want a slice of the $700 billion bailout. That doesn't make sense until the burden of this rescue starts reflecting a globalized world. I asked Frank why Paulson and Ben Bernanke, the Federal Reserve chairman, did not get more foreign support. "I think it's a perverse pride thing," he said. "We don't ask for help. We're the big, strong father figure. But let's be realistic: We're no longer the dominant world power." It's time for a responsibility shift. Call it the Hirst reality check. If he can sell a formaldehyde-pickled sheep with gold horns for millions while Lehman goes under, perhaps it's time for everyone to help a little when Americans get fleeced.

Some hard truths about the bailout The fifth major federal bailout this year - after Bear Stearns, Fannie Mae, Freddie Mac and American International Group - is in the works. American taxpayers have every right to be alarmed and angry. This crisis could have been avoided if regulators had enforced rules and officials had dared to question risky lending and other dubious practices. If done right, this bailout could succeed where the others have failed and remove the threat of a system-wide financial collapse. But the cost will be enormous. So will the risk of losses in the long run - on top of the risks already incurred. The new plan would commit taxpayer money to buy hundreds of billions of dollars of troubled loans and other mortgage-related securities from banks and Wall Street firms. It is based on the reasonable premise that as long as institutions are stuck with those assets, the flow of credit, the economy's lifeblood, will be constrained, or as in the past week, all but frozen. Congress, with one eye on last week's volatile Dow and the other on November's election, could authorize the plan as early as this week.

It is painfully clear that the financial system will not rebound on its own from the excessive lending and borrowing of the Bush years. Lawmakers and administration officials must be prepared to tell Americans some hard truths: What is this going to cost the taxpayers and who decides? It's generally believed that many of the troubled assets that the government would buy will, in time, be worth more than they can fetch in today's chaotic markets. That's far from a sure thing. The assets are tied to housing, so their value will depend on how far prices fall and how long it takes before housing rebounds - all big unknowns. For those reasons, it's important for Americans to know who is going to decide what is the right purchase price for these assets. Americans also need to know how the process will be monitored to ensure that taxpayers' interests are protected. If the government gets the price right, the upfront outlay could be recouped when it later sells. If it overpays, the taxpayer is stuck with the loss. How will Congress balance the bailout of Wall Street and the needs on Main Street? Congress must do more to provide direct help to struggling families. Lawmakers should use the bailout legislation to extend unemployment benefits, bolster food stamps and provide aid to state and local governments to provide other services. The administration and lawmakers also need to tell Americans that the era of easy money is over and that there are more tough times to come. Whose taxes will have to go up? How will the government help to create jobs? How will the most vulnerable Americans be protected? Finally, Americans need to be told a more fundamental truth: This crisis is the result of a systematic failure by the government to regulate the activities of bankers, lenders and other market players. The regulatory failure was grounded in the Bush administration's belief that the market, with its invisible hand, works best when it is left alone to self regulate and self correct. The country is paying the price for that delusion.

Bad Bank Rescue September 21, 2008

With truly extraordinary speed, opinion has swung behind the radical idea that the government should commit hundreds of billions in taxpayer money to purchasing dud loans from banks that aren't actually insolvent. As recently as a week ago, no public official had even mentioned this option. Now the Treasury, the Fed and congressional leaders are promising its enactment within days. The scheme has gone from invisibility to inevitability in the blink of an eye.

This is extremely dangerous.

The plan is being marketed under false pretenses. Supporters have invoked the shining success of the Resolution Trust Corporation as justification and precedent. But the RTC, which was created in 1989 to clean up the wreckage of the savings-and-loan crisis, bears little resemblance to what is being contemplated now. The RTC collected and eventually sold off loans made by thrifts that had gone bust. The administration proposes to buy up bad loans before the lenders go bust.

This difference raises several questions:

The first is whether the bailout is necessary. In 1989, there was no choice. The federal government insured the thrifts, so when they failed, the feds were left holding their loans; the RTC's job was simply to get rid of them. But in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice. It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks. There are cheaper ways to stabilize the system.

In the 1980s, the government did not need a strategy to decide which bad loans to take over; it dealt with anything that fell into its lap as a result of a thrift bankruptcy. But under the current proposal, the government would go out and shop for bad loans. These come in all shapes and sizes, so the government would have to judge what type of loans it wants. They are illiquid, so it's hard to know how to value them. Bad loans are weighing down the financial system precisely because private-sector experts can't determine their worth.

The government would have no better handle on the problem.

In practice this means the government would make subjective choices about which bad loans to buy, and it would invariably pay more than fair value. Particularly if the banks and their lobbyists have any say in the matter. Billions in taxpayer money would be transferred to the shareholders and creditors of banks, and the banks from which the government bought most loans would be subsidized more than their rivals. If the government bought the most from the sickest institutions, it would be slowing the healthy process in which strong players buy up the weak, delaying an eventual recovery. The haggling over which banks got to unload the most would drag on for months. So the hope that this "systematic" plan can be a near-term substitute for ad hoc AIG-style bailouts is illusory. I agree

Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks' bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level (through the sale or issuance of government ‘recapitalization’ bonds that back non-performing loans at a discount ratio and are tradable on the capital markets at whatever price the market may set). The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Congress and the administration may not like the sound of these ideas. Taking bad loans off the shoulders of the banks seems like a merciful rescue; ordering banks to raise capital (real Tier 1 capital) or buying equity stakes in them (as per above) that sounds like big-government meddling. But we are in the midst of a crisis, and it shouldn't matter how things sound. The Treasury plan outlined on Friday involves vast risks to taxpayers, huge complexity and no guarantee of success. There are better ways forward.

Present at the crash

On the subway, a stranger in a suit knowingly eyed my Lehman Brothers ID badge in its Bear Stearns holster. With a look of detached curiosity, he expressed his condolences. This is not the way I thought my Wall Street career would begin. During college, I was an intern at Bear Stearns. There, I toiled at the lowest levels of Wall Street, fetching coffee, moving boxes, filing papers. In my final summer at Bear, I was promoted to intern in the marketing department of the asset management division. There, I worked on some hedge funds that invested in stuff called "mortgage-backed securities." Several months later, the hedge funds went down the tubes, dragging Bear Stearns behind them. After I graduated from college, Lehman Brothers hired me to help settle trades in complex derivatives, the very derivatives that led to the company's demise. I helped resolve trading issues involving tens - hundreds - of millions of dollars. And now? Now from my desk here in the trenches, my colleagues and I watch CNBC reports on the collapse of Wall Street. Over the months, we have watched our stock price plummet 99.8 percent, from $65 per share to 15 cents. The news provides grist for the rumor mill. I trade notes with my colleagues here. Though some more senior people have lost their entire life savings, the steady stream of bad news and uncertainty are also difficult for those of us at the bottom of the Wall Street food chain. It is dizzying. Most of the time, in the office and out, I feel like I am on display, an object of pity or fascination. Friends and family send frequent expressions of concern and empathy by phone, e-mail and text message. Even though I had little - nothing, actually - to do with the real estate losses that led to Lehman's problems, or the hedge funds that precipitated Bear's demise, the only conclusion I can draw is that I'm a jinx. Prospective employers will take one look at my résumé and call security to escort me out the door lest my mere presence infect their otherwise healthy businesses. Meanwhile, I sit at my desk. "Your password will expire in nine days," my computer informs me. "Would you like to change it?" Each time, I click "No."

Krugman: Crisis endgame By Paul Krugman

Friday, September 19, 2008 PRINCETON, New Jersey: On Sunday, U.S. Treasury Secretary Henry Paulson tried to draw a line in the sand against further bailouts of failing financial institutions; four days later, faced with a crisis spinning out of control, much of Washington appears to have decided that government isn't the problem, it's the solution. The unthinkable - a government buyout of much of the private sector's bad debt - has become the inevitable. The story so far: The real shock after the feds failed to bail out Lehman Brothers wasn't the plunge in the Dow, it was the reaction of the credit markets. Basically, lenders went on strike: U.S. government debt, which is still perceived as the safest of all investments - if the government goes bust, what is anything else worth? - was snapped up even though it paid essentially nothing, while would-be private borrowers were frozen out.

Thus, banks are normally able to borrow from each other at rates just slightly above the interest rate on U.S. Treasury bills. But Thursday morning, the average interest rate on three-month interbank borrowing was 3.2 percent, while the interest rate on the corresponding Treasuries was 0.05 percent. No, that's not a misprint. This flight to safety has cut off credit to many businesses, including major players in the financial industry - and that, in turn, is setting us up for more big failures and further panic. It's also depressing business spending, a bad thing as signs gather that the economic slump is deepening. And the Federal Reserve, which normally takes the lead in fighting recessions, can't do much this time, because the standard tools of monetary policy have lost their grip. Usually the Fed responds to economic weakness by buying up Treasury bills, in order to drive interest rates down. But the interest rate on Treasuries is already zero, for all practical purposes; what more can the Fed do? Well, it can lend money to the private sector - and it's been doing that on an awesome scale. But this lending hasn't kept the situation from deteriorating. There's only one bright spot in the picture: interest rates on mortgages have come down sharply since the federal government took over Fannie Mae and Freddie Mac, and guaranteed their debt. And there's a lesson there for those ready to hear it: Government takeovers may be the only way to get the financial system working again. Some people have been making that argument for some time. Most recently, former Fed Chairman Paul Volcker and two other veterans of past financial crises published an op-ed in The Wall Street Journal declaring that the only way to avoid "the mother of all credit contractions" is to create a new government agency to "buy up the troubled paper" - that is, to have taxpayers take over the bad assets created by the bursting of the housing and credit bubbles. Coming from Volcker, that proposal has serious credibility. Influential members of Congress, including Senator Hillary Clinton and Representative Barney Frank, the chairman of the House Financial Services Committee, have been making similar arguments. And on Thursday, Senator Charles Schumer, the chairman of the Senate Finance Committee (and an advocate of creating a new agency to resolve the financial crisis) told reporters that "the Federal Reserve and the Treasury are realizing that we need a more comprehensive solution." Sure enough, Federal Reserve Chairman Ben Bernanke and Paulson met on Thursday night with congressional leaders to discuss a "comprehensive approach" to the problem. We don't know yet what that "comprehensive approach" will look like. There have been hopeful comparisons to the financial rescue the Swedish government carried out in the early 1990s, a rescue that involved a temporary public takeover of a large part of the country's financial system. It's not clear, however, whether policymakers in Washington are prepared to exert a comparable degree of control. And if they aren't, this could turn into the wrong kind of rescue - a bailout of stockholders as well as the market, in effect rescuing the financial industry from the consequences of its own greed. Furthermore, even a well-designed rescue would cost a lot of money. The Swedish government laid out 4 percent of gross domestic product, which in America's case would be a cool $600 billion - although the final burden to Swedish taxpayers was much less, because the government was eventually able to sell off the assets it had acquired, in some cases at a handsome profit.

But it's no use whining (sorry, Senator Gramm) about the prospect of a financial rescue plan. Today's U.S. political system isn't going to follow Andrew Mellon's infamous advice to Herbert Hoover: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." The big buyout is coming; the only question is whether it will be done right.

Brooks: The post-Lehman world By David Brooks

Friday, September 19, 2008 A few years ago, real estate was all the rage. Earlier this year, the business magazines were telling us to invest in Lehman Brothers and Merrill Lynch, because those stocks were bound to zoom. Now another herd is on the march. We're in a paradigm shift, its members say. The current financial turmoil marks the end of the era of wide-open global capitalism. Today's gigantic government acquisitions signal a new political era, with more federal activism and tighter regulations. This observation is then followed by a string of ethereal gottas and shoulds. We Americans gotta have smart regulation that offers security but doesn't stifle innovation. We gotta have rules that inhibit reckless gambling without squelching sensible risk-taking. We should limit excesses during booms and head off liquidations when things go bad. It all sounds great (like buying a house with no money down), but do you mind if I do a little due diligence? In the first place, the idea that America's problems stem from light regulation and could be solved by more regulation doesn't fit all the facts. The current financial crisis is centered around highly regulated investment banks, while lightly regulated hedge funds are not doing so badly. Two of the biggest miscreants were Fannie Mae and Freddie Mac, which, in theory, "were probably the world's most heavily supervised financial institutions," according to Jonathan Kay of The Financial Times. Moreover, there is a lot of lamentation about Clinton-era reforms that loosened restrictions on banks. But it's hard, as Megan McArdle of The Atlantic notes, to see what these reforms had to do with rising house prices, the flood of foreign investment that fed the credit bubble and the global creation of complex new financial instruments for pricing and distributing risk. In other words, maybe there is something more going on here than just a bunch of laissez-faire regulators asleep at the wheel. But even if it is true that America needs more federal activism, I'm a little curious about what we're going to need to make the system work. Surely, we're going to need lawmakers who understand what caused the current meltdown and who can design rules to make sure it doesn't happen again. And yet there's no consensus about what caused this bubble. Some people blame the Fed's monetary policies, but some say the Fed had only a marginal effect. Some argue a flood of foreign investment allowed us to live beyond our means, while others say bad accounting regulations after Enron created a chain reaction of losses. We don't even have a clear explanation about the past, yet we're also going to need regulators who understand the present and can diagnose the future.

We're going to need regulators who can anticipate what the next Wall Street business model is going to look like, and how the next crisis will be different than the current one. We're going to need squads of low-paid regulators who can stay ahead of the highly paid bankers, auditors and analysts who pace this industry (and who themselves failed to anticipate this turmoil). We're apparently going to need an all-powerful Super-Fed than can manage inflation, unemployment, bubbles and maybe hurricanes - all at the same time! We're going to need regulators who write regulations that control risky behavior rather than just channeling it off into dark corners, and who understand what's happening in bank trading rooms even if the CEOs themselves are oblivious. We're also going to need regulators who can overcome politics and human nature. As McArdle notes, cracking down on subprime loans just when they were getting frothy would have meant issuing an edict that effectively said: "Don't lend money to poor people." Good luck with that. We'd need regulators who could spot a bubble and squelch a boom just when things seem to be going good, who can scare away foreign investment and who could over-rule popularity-mongering presidents. (The statements by the two candidates this week have been moronic.) To sum it all up, this supposed new era of federal activism is going to confront some old problems: the lack of information available to government planners, the inability to keep up with or control complex economic systems, the fact that political considerations invariably distort the best laid plans. This doesn't mean there's nothing to be done. Martin Wolf suggests countercyclical capital requirements. Everybody seems to be for some updated version of the Resolution Trust Corp., though disposing of complex debt securities has got to be more difficult than disposing of commercial real estate. It's just that there's a big difference between dreaming of some ideal regulatory regime and actually putting one into practice. Everybody says we're about to enter a new political era, rich in global financial regulation. The herd might just be wrong once again.

Radical change for Goldman and Morgan Monday, September 22, 2008

Goldman Sachs and Morgan Stanley, the last two independent investment banks on Wall Street, will transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night, a move that fundamentally reshapes an era of high finance that defined the modern Gilded Age.

The firms requested the change themselves, even as Congress and the Bush administration rushed to pass a $700 billion rescue of financial firms. It was a blunt acknowledgment that their model of finance and investing had become too risky and that they needed the cushion of bank deposits that had kept big commercial banks like Bank of America and JPMorgan Chase relatively safe amid the recent turmoil.

It also marks a turning point for the high-rolling culture of Wall Street, with its seven-figure bonuses and lavish perks for even midlevel executives. It effectively returns Wall Street to the way it was structured before Congress passed a law during the Great Depression separating investment banking from commercial banking, known as Glass-Steagall.

By becoming bank holding companies, the firms are agreeing to significantly tighter regulations and much closer supervision by bank examiners. Now, the firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking.

For decades firms like Morgan Stanley and Goldman Sachs thrived by taking bold bets, often using enormous amounts of debt to juice their profits, with little outside oversight.

But that brash model was torn apart over the last several weeks as investors lost confidence in the way they did business. Over several harrowing days, clients started pulling their money, share prices plunged and these banks' entire enterprise, once considered the gold standard on Wall Street, was brought to the brink.

In exchange for subjecting themselves to more regulation, the companies get access to the full array of the Federal Reserve's lending facilities. It should help them avoid the fate of Lehman Brothers, which declared bankruptcy last week, and Bear Stearns and Merrill Lynch — both of which were acquired by big bank holding companies.

The decision also raises questions about whether the Federal Reserve will seek to regulate hedge funds, many of the largest of which closely resemble investment banks like Goldman.

Just a year ago investment banks, the titans of global finance, considered bank regulation a millstone to be avoided at all costs. Commercial banks have to subject themselves to restrictions on how much money they can borrow and what kinds of businesses they can be in. Lobbyists for firms like Goldman spent years fending off closer supervision of their business.

As bank holding companies, the two banks, which have seen their shares lose about half their value this year, will have to reduce the amount of money they can borrow relative to their capital. That will make them more financially sound but will also significantly limit their profits. Today, Goldman Sachs has $1 of capital for every $22 of assets; Morgan Stanley has $1 for every $30. By contrast, Bank of America's has less than $11 for every $1 of capital.

JPMorgan acquired Bear Stearns this spring in a fire sale brokered by the federal government, while Bank of America has agreed to buy Merrill Lynch for $50 billion.

As bank holding companies, Morgan and Goldman will have greater access to the discount window of the Federal Reserve, which banks can use to borrow money from the central bank. While they have had access to temporary Fed lending facilities in recent months, they could not borrow against the same wide array of collateral that commercial banks could. The discount window access for investment banks is expected to be phased out in January.

It will take time for Goldman and Morgan to transform into fully regulated banks, because they cannot quickly reduce how much money they borrow relative to their assets. The Fed and the Securities and Exchange Commission have had examiners at investment banks since March, giving regulators significant insight into their businesses.

Both banks already have retail deposit-taking businesses, which they plan to expand over time. Morgan Stanley had $36 billion in retail deposits as of Aug. 31 and Goldman Sachs had $20 billion in deposits.

"We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources," Lloyd Blankfein, the chairman and chief executive of Goldman, said in a written statement Sunday night.

John Mack, the chairman and chief executive of Morgan Stanley, said: "This new bank holding structure will ensure that Morgan Stanley is in the strongest possible position — with the stability and flexibility to seize opportunities in the rapidly changing financial marketplace."

In recent days, Morgan Stanley had sought other ways to bolster its capital, and had been in advanced talks with China's sovereign wealth fund and others about raising billions of dollars, people briefed on the matter said Sunday night. It had also been talking about a merger with Wachovia, a large commercial bank based in Charlotte, North Carolina.

With their transition to operating as bank holding companies, those talks are likely to take a different form, because now Morgan can buy a commercial bank.

Will the bailout work? September 21, 2008

As the U.S. government steps to the center of the financial crisis, crafting plans to take ownership of up to $700 billion worth of bad mortgages, a pair of simple questions rises to the fore: Will this intervention finally be enough to restore order? And what will this grand rescue cost U.S. taxpayers?

The Treasury Department, as overseer of the American financial system, has in recent weeks unleashed an astonishing array of initiatives in a bid to stave off catastrophe. It took over the country's largest mortgage finance companies and put untold billions of taxpayer dollars on the line to prop up other lenders.

Now, although the details are still being worked out, the government is dispensing with rescuing one company at a time, and instead taking on a vast pile of bad debt in one gulp. If it all comes to pass - if Uncle Sam becomes the repository for the radioactive leftovers of bad real estate bets - will the crisis lift? Will the fear that has kept banks clinging to their dollars, starving the economy of capital, give way to free-flowing credit?

There are many skeptics of the Treasury's proposal, though there is wide agreement that some kind of broad intervention is necessary.

"It goes a long way. It ameliorates it very substantially," said Alan Blinder, an economist at Princeton and a former vice chairman at the Federal Reserve, who has said for months that the government must step in forcefully to buy mortgage-linked investments. "We're deep into Alice in Wonderland's rabbit hole," he said.

But significant skepticism confronts the initiative. Under a proposal circulating Saturday, the Treasury could spend as much as $700 billion to buy mortgage-linked investments, then sell what it can as it works out the messy details of the loans. But no one really knows what this cosmically complex web of finance will be worth, making the final price tag for the taxpayer unknowable. One may just as well try to predict the weather three years from Tuesday.

Some question the prudence of adding to the nation's overall debt at a time when the Treasury relies on the largess of foreigners to cover the bills. Most broadly, what are the longer-term costs of the government stepping in to restore order after so many wealthy financiers have become so much wealthier through what now seem like reckless bets on real estate - bets now covered with public dollars?

Also, what message does that send to the next investment bank caught up in the next speculative bubble and contemplating the risks of jumping in while wondering who is ultimately on the hook if things go awry?

Many economists say such questions are beside the point. The United States is gripped by the worst financial crisis since the Great Depression.

Before Thursday night, when the Treasury secretary, the Federal Reserve chairman and leaders on Capitol Hill proclaimed their intentions to take over bad debts, the prognosis for the American financial system was sliding from grim toward potentially apocalyptic.

"It looked like we might be falling into the abyss," Blinder said.

As the details of the government's plans are hashed out, no hallelujah chorus is wafting across Washington, down Wall Street or through the glistening condos of the United States. Too many households are having trouble paying their mortgages. Too many people are out of work. Too many banks are bloodied.

Still, the prospect that the government is preparing to wade in deep - perhaps sparing families from foreclosure and banks from insolvency - has muted talk of the most dire possibilities: a severe shortage of credit that would crimp the availability of finance for many years, effectively halting economic growth, both in the United States and around the globe.

"The risk of ending up like Japan, with 10 years of stagnation, is now much lessened," said Nouriel Roubini, an economist at the Stern School of Business at New York University. "The recession train has left the station, but it's going to be 18 months instead of five years."

If the plan works, it will attack the central cause of American economic distress - the continued plunge in housing prices. If banks resumed lending more liberally, mortgages would become more readily available. That would give more people the wherewithal to buy homes, lifting housing prices or at least preventing them from falling further. This would prevent more mortgage-linked investments from going bad, further easing the strain on banks. As a result, the current downward spiral would end and start heading up.

"It's easy to forget amid all the fancy stuff - credit derivatives, swaps - that the root cause of all this is declining house prices," Blinder said. "If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it."

For many Americans, the events that have transfixed and horrified Wall Street in recent days - the disintegration of supposedly impregnable institutions, government bailouts with 11-figure price tags - have been less stunning than inscrutable. The headlines proclaim that the taxpayer now owns the mortgage finance giants Fannie Mae and Freddie Mac, along with the liabilities of a mysterious colossus called the American Insurance Group, which, as it happens, insures against corporate defaults. Much like the human appendix, these were organs whose existence was only dimly evident to many until the pain began.

And yet these institutions are deeply intertwined with the American economy. When the financial system is in danger, it stops investing and lending, depriving ordinary people of financing for homes, cars and education. Businesses cannot borrow to start and expand.

"Wall Street isn't this island to itself," said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute. "Even people with good credit histories are having a very hard time getting loans at terms that make sense. If that gets worse, we're going to be stuck in the doldrums for a very long time, because that directly blocks healthy economic activity."

Giant Investment Banks Grasp for Government Safety Net Monday, September 22, 2008

The Federal Reserve approved the conversion last night of the two remaining investment titans on Wall Street, Goldman Sachs and Morgan Stanley, into bank holding companies, offering them broader government protection in exchange for tighter regulation and constraints on their once fabulously profitable business.

With the federal government continuing its rapid and radical reshaping of the U.S. financial system, the two investment banks agreed to transform themselves in an effort to escape the financial turmoil that last week put their existence in jeopardy.

The move, approved by the Fed with unusual haste, gives Goldman Sachs and Morgan Stanley greater latitude to borrow from the Fed and access to stable sources of funding -- namely, deposits from ordinary people and businesses. But the firms are also accepting regulation by the Fed that will make it far more expensive for them to borrow huge sums of money -- long an essential ingredient in their investment strategy -- and restrict what sorts of business activities they can engage in.

This development completes a sweeping transformation of Wall Street. Now extinct are the specialized trading houses that broke off from larger financial companies during the Great Depression, enterprises that once prized their independence of regulation and exploited their agility to make fortunes. Over the past 30 years, these firms even surpassed commercial banks as the prime funding source for corporate America.

The conversion of investment banks into the kind of banking companies that once were their rivals will have profound and long-lasting implications for the economy.

Seven months ago, there were five major independent investment banks, selling stocks and bonds, advising companies on mergers and engaging in ever more arcane financial engineering. Since then, Bear Stearns was bought in a fire sale by commercial bank J.P. Morgan Chase, Lehman Brothers went bankrupt, and Merrill Lynch agreed to be bought by Bank of America.

Now, the two biggest, strongest and most prestigious of those firms will become traditional commercial banks, too. The firms concluded that it was worth it to accept the safety net of government protection, even though it will probably lead to much more scrutiny by Fed regulators into what businesses they can engage in.

The change is likely to make easier, and could intensify, both companies' efforts to link up with commercial banks. Now that Goldman Sachs and Morgan Stanley have committed to using deposits to fund their operations, they have a tremendous incentive to gain access to the largest possible networks of bank branches.

In trying to save themselves, Goldman Sachs and Morgan Stanley are agreeing to surrender some of the activities that drove their profitability over the past decade. The two companies made massive bets while putting little money on the table. And they invested vast sums in a wide range of commercial enterprises.

As bank holding companies, Goldman and Morgan will be forced to put more money on the table when they make investment bets. Goldman Sachs, for example, currently holds about $1 for every $22 in investments. Morgan Stanley's ratio is even more dramatic. By contrast, Bank of America, which will soon be the nation's largest bank holding company, holds about $1 for every $11 in investments. And Goldman and Morgan will be sharply limited in their ability to make equity investments in non-financial companies.

"The marketplace won't give them leverage, the regulators won't give them leverage and so now we have formal confirmation that the model of freestanding investment banks is kaput," said Ed Yingling, president of the American Bankers Association.

Currently, the Fed has about a half-dozen examiners in Goldman and Morgan combined. By contrast, major bank holding companies host dozens of examiners, who monitor and restrict the firms' activities.

It's too early to tell what restrictions the Fed will put in place. The Fed must now send in its examiners and assess the companies' businesses, which are in flux.

Conventional banks, such as Bank of America and J.P. Morgan, have weathered the financial crisis much better than investment firms, despite incurring vast losses of their own. One key is that their deposits offer a steady source of funding, unlike the short-term debt that investment banks have relied on. That left them susceptible to runs, as Bear Stearns and then Lehman Brothers experienced.

It is in many ways a move to the business model used by banks in Europe, where large firms engage in both investment banking and commercial banking.

Also yesterday, the Treasury Department issued a major caveat to its Friday announcement that it would guarantee investments in money-market mutual funds, emulating the long-standing federal guarantee of deposits in bank accounts. The Treasury said yesterday that it would only guarantee existing investments in money-market funds.

The caveat came after loud pressure from the banking industry, which worried that a guarantee on new investments would encourage customers to pull money from bank accounts because money-market funds, which pay higher interest rates, would now be seen as equally safe. Both banks and banking regulators were concerned about how an exodus of deposits could impact already-struggling banks.

As banks fall, a bid to curb short sellers Traders who have sought to profit from the financial crisis by betting against bank stocks were attacked on two continents Thursday. The U.S. Securities and Exchange Commission is considering a temporary ban on short sales of some or all shares and an announcement could be made as early as Friday morning. Earlier Thursday, the commission scrambled to put together an emergency rule to force major investors to disclose their short sales daily. In Britain, regulators announced new rules to bar short selling. Short selling ( a bet that a stock price will decline) is the practice of selling stock without owning it, hoping to buy it later at a lower price, and thus make a profit. It has often been blamed for forcing prices down in times of market stress, but the level of anger has intensified as the U.S. government has been forced to bail out major financial institutions and the leaders of some investment banks have asked for action to protect their shares. Both the commission and the New York State attorney general promised to intensify investigations into short selling abuses. "They are like looters after a hurricane," said Andrew Cuomo, the New York State attorney general. "If you pass a rumor in a normal marketplace, people are calm, they check it out, they do their due diligence. When you get the market in this frenzied state and they are on pins and needles, any false information is much more impactful." Senator John McCain, the Republican presidential candidate, said the commission had "kept in place trading rules that let speculators and hedge funds turn our markets into a casino" and the commission's chairman, Christopher Cox, had "betrayed the public's trust." Speaking at a rally in Cedar Rapids, Iowa, McCain said, "If I were president today, I would fire him." The White House immediately said it supported Cox, who has said he would resign at the end of the Bush administration. Cox said he had moved against short sellers and was doing all he could to stem the financial crisis. "Now is not the time for those of us in the trenches to be distracted by the ebb and flow of the current election campaign," Cox said in a statement released by the commission. "It is precisely the wrong moment for a change in leadership that inevitably would disrupt the work of the SEC at just the wrong time."

Cox is a former White House aide to President Ronald Reagan and a former Republican congressman from California. Some conservative columnists and commentators supported him as a running mate for McCain. Writing in The American Spectator magazine earlier this year, Quin Hillyer said that conservatives would rally to a Cox selection and called him "the best choice, bar none." In recent weeks, Cox has also stepped up his criticism of short sellers, particularly those who engage in "naked" short selling. While short sellers are supposed to borrow shares before selling them, naked shorts do not borrow. That saves the cost of borrowing, though the trader is still vulnerable to losses if the share price rises. Opponents of short selling say that it can force share prices down and destroy confidence in a company that might otherwise survive. Regulators have long thought that the practice was crucial for efficient markets to function, but earlier this year the SEC imposed temporary limits on short selling of some financial stocks. Financial share prices rallied when those limits were announced but fell during the period in which the rule was in effect. Share prices for many financial companies shot up Thursday after plunging the day before in the wake of the government decision to take control of the American International Group, a large insurance company, to prevent it from collapsing. Financial shares were especially hard hit Wednesday, with Morgan Stanley plunging 24 percent, to $21.75, and its chief executive, John Mack, blaming false rumors spread by short sellers. On Thursday, Morgan Stanley regained part of that loss, rising 3.7 percent to close at $22.55. The latest moves against short sellers began Wednesday. In the morning, Cox announced new rules to prevent brokerage firms from selling a stock short if they previously had sold the stock short without having borrowed it. That night, he said that he would propose more rules, to force large short sellers to disclose their positions. The rules were needed, he said, "to ensure that hidden manipulation, illegal naked short selling or illegitimate trading tactics do not drive market behavior and undermine confidence." Details of the possible new disclosure rule were not released, and it is not clear how much authority the SEC has over hedge funds, which have successfully sued to prevent the commission from forcing them to even register with it. Institutional investors, including some hedge funds, provide details of stocks they own every three months but do not disclose short positions. Cox said he wanted daily disclosure of short positions, which he said would be made public, though he did not say how quickly. By late Thursday, the commission was considering a temporary ban of some or all short selling. Cox told reporters in Washington late Thursday that he had discussed the ban with other senior administration officials but no decision had been made yet. Richard Baker, the president of the Managed Funds Association, a hedge fund trade group, said the funds would comply with any rules but said that disclosure of their trading positions should not be made so quickly that it would harm them in the market. Cox also said the commission would intensify its investigations of short selling by hedge funds and would demand their records on trading in certain securities. In Britain, the Financial Services Authority said that beginning Friday it would bar traders from taking new short positions in listed stocks of financial companies, and that starting next week, investors would have to disclose their short positions if they were at least 0.25 percent of a company's outstanding shares. This week, the British bank Lloyds TSB took over HBOS, a mortgage lender, after HBOS's stock tumbled. That fall was widely blamed on short sellers, and Prime Minister Gordon Brown of Britain vowed to clean up the financial system.

To obtain shares to sell short, traders often borrow them from institutional investors, who receive small fees for the loans. But public pension funds in New York and California said Thursday that they would stop lending shares of some financial companies. The New York State comptroller said the state's Common Retirement Fund would temporarily stop lending the shares of 19 banks and brokerage firms to short sellers. "This speculative selling has put downward pressure on the entire stock market and threatens to drive our national economy deeper into decline," Thomas DiNapoli, the comptroller, said in a statement. "My action is intended to bring stability and rationality back to our equity markets." The suspension removes 105 million shares from the fund's securities lending program. It will last until market conditions stabilize, a spokesman said. New York City's comptroller announced the same move, as did California officials. "We're pulling them back because of the unfortunate predators that are out there right now, trying to be greedy," said Patricia Macht, an official of Calpers, the California Public Employees' Retirement System. The California State Teachers' Retirement System took a similar step. "We were just trying to stem the bleeding," said Ricardo Durán, a spokesman for that fund.

More regulators move to curb short-selling

More financial regulators across the globe are following the lead of the United States and Britain to curb the short sales of financial stocks in a move aimed at returning stability to financial markets. On Sunday, the Australian Securities and Investments Commission said in a statement that it had expanded a curb announced Friday, which had outlawed "naked" short sales, to include a ban on the more traditional form of "covered" short-selling of all traded stocks. Also Sunday, the Financial Supervisory Commission of Taiwan placed a ban on the short-selling of 150 stocks for two weeks starting Sept. 22. Supervisors from Germany, France and Belgium curbed short sales of financial companies late Friday to defend banks from trading that has been blamed for pushing down share prices and worsening the market crisis. Short-selling is a tactic designed to profit from falling share prices. It has been favored in particular by hedge funds and has been blamed for some of the huge gyrations in world stock markets in recent sessions. Short-sellers borrow shares of the stock and sell them. If the price drops, they buy shares at the lower price to cover the borrowed ones, pocketing the difference. So-called naked short-selling occurs when sellers do not even borrow the shares before selling them and then look to cover positions immediately after the sale. Analysts were not convinced that curbing short sales would necessarily help stabilize the shares of financial companies. "It should give the market some breathing room, but is not the answer to reopening the money markets long-term," RBC Capital Markets said in a research note published Friday. "Paradoxically, weak financial institutions that benefited from increased financial market volatility could now see a temporary reduction in revenues." The chairman of the U.S. Securities and Exchange Commission, Christopher Cox, on Friday announced a list of 799 financial stocks on which short-selling was banned until Oct. 2. The Financial Services Agency in Britain also banned investors last week from taking new short positions in financial shares or adding to existing ones. The ban will remain in force until Jan. 16 and will be reviewed after an initial period of 30 days, the agency said.

The German financial regulator BaFin said late Friday that it had suspended short-selling of shares in 11 financial companies - including Deutsche Bank, the insurer Allianz and the exchange operator Deutsche Börse - to try to protect them from speculators until the end of the year. The French and Belgian regulators barred most investors from overnight short positions in banks and insurers to "avoid all abusive arbitrage," according to coordinated statements. The measures are effective Monday and will be in place for three months. Market makers, liquidity providers and block sales are exempt. Similar steps were taken last week in Ireland, Canada, Switzerland and Portugal. Consob, the Italian stock market regulator, said it would increase scrutiny of short-selling and might tighten the rules on such sales.

U.S. weighs bailout of foreign banks, too Monday, September 22, 2008

The financial crisis that began in the United States spread to many corners of the globe. Now, the U.S. bailout looks as if it is going global, too, a move that could raise its cost and intensify scrutiny by Congress and critics. Foreign banks, which were initially excluded from the plan, lobbied successfully over the weekend to be able to sell the toxic U.S. mortgage debt owned by their American units to the Treasury, getting the same treatment as United States banks. On Sunday, the Treasury secretary, Henry Paulson Jr., indicated in a series of appearances on morning talk shows that an original proposal introduced on Saturday had been widened. "It's a distinction without a difference whether it's a foreign or a U.S. one," he said in an interview with Fox News. The prospect of being locked out of the bailout set off alarm bells among chief executives of overseas banks whose American affiliates also hold distressed mortgage-related assets, like Barclays and UBS. The original text provided access to the $700 billion bailout for any financial institution based in the United States. As the day wore on, some raised their concerns with the Treasury Department, arguing that foreign institutions were both big employers and major players in the American capital markets. By Saturday evening, the language had been changed to allow any financial institution "having significant operations" in the United States. While Paulson has agreed with that argument, the Bush administration is also leaning on foreign governments to pitch in with bailout programs of their own as needed. "We have a global financial system and we are talking very aggressively with other countries around the world, and encouraging them to do similar things, and I believe a number of them will," Paulson said on Sunday. The request is expected to be discussed during a conference call among Group of 7 finance ministries scheduled for Sunday evening, a European official said. Allowing foreign banks to participate in the federal rescue package has not yet drawn widespread scrutiny in Congress, where a number of lawmakers, including Senator Christopher Dodd, Democrat of Connecticut, have acknowledged that millions of U.S. citizens do business with UBS, the Royal Bank of Scotland, and many other foreign-based banks in the United States. But a number of lawmakers are wary that such an extension may worsen what could ultimately turn out to be a trillion-dollar bailout for Wall Street. "I'm skeptical of the bailout, the whole bill is only a couple of pages long," said Representative Scott Garrett, Republican of New Jersey, who is a member of the House Financial Services Committee.

As for the participation of foreign banks, Garrett said: "I have a concern with it, they probably should be treated differently, but Congress is really not getting any say." Christopher Whalen, a managing partner at Institutional Risk Analytics, said that Paulson needed to justify why a wider bailout was in the national interest. "Can you imagine the Congress floating a bailout for Deutsche Bank or UBS? It is the responsibility of the German or Swiss government," he said. "We shouldn't be bailing them out." While politicians in the United States may emphasize the benefits for banks based overseas, the definition of what is a European or U.S. bank has blurred in recent years with the growth of global giants like HSBC, Barclays and Deutsche Bank. Deutsche Bank, for example, became a major player in the United States with its acquisition of Bankers Trust in 2001. It has written down more than $11 billion in investments linked to the subprime crisis. Barclays, meanwhile, is on course to buy a significant portion of the North American operations of Lehman Brothers, the 158-year-old firm that filed for bankruptcy protection last week, helping to set off the global financial panic that forced Washington to act. Gaining access to the relief was a top priority for European foreign financial institutions with banking operations in the United States, according to officials in industry and government. They argued that the reputation of Wall Street and the U.S. government would suffer immensely if properly licensed foreign banks in the United States were shut out of the system. "Who would open a bank again in the United States?" asked one executive of a major European bank who has been following the discussions. At the same time, it was unclear how much European governments would bow to the Treasury Department's encouragement to set up national programs to deal with their own vast mortgage problems. Real estate markets in Britain, Spain and Ireland have been particularly hard-hit as their own housing market bubbles — which grew in tandem with America's — have collapsed. Other governments have struggled to get budget deficits under control in the last few years. The German government, for example, has discouraged talk of a stimulus package, and British officials said Sunday that they were not working on a plan like that of the United States. Robert Kelly, at the Bank of New York Mellon, said every European central bank would probably be scrutinizing the American bailout proposal. "I would expect every finance minister is looking closely at what is happening in the United States, trying to hypothesize what the impact will be, and is thinking about the tools the Fed and Treasury have used," he said. "I would not be surprised, and probably expect, some of those tools to be used in Europe as well." If the plan is approved in Congress and is signed into law, the benefits would be large for European banks with licensed operations in the United States, which incurred major losses from mortgage-linked securities. UBS, the Swiss giant, has been among the hardest-hit institutions in the world; both its chairman and chief executive left amid more than $40 billion in write-downs. Even so, it still retains roughly $20 billion more in potential exposure to the troubled U.S. housing market. If a battle does develop in Congress over foreign participation, UBS, among others, is poised to make just these arguments. Officials at the Zurich-based giant point out the bank employs more than 30,000 Americans, is listed on the New York Stock Exchange, and owns two broker-dealers registered under United States laws, UBS Securities and UBS Financial Services, better known to Americans as the former Paine Webber unit. "These are Americans who work in New York," said one executive who requested anonymity because the U.S. plan was still in development. "And they are working for a bank that was incorporated in the United States." One senior Wall Street executive said he believed that the

proposal would apply to other institutions with regulated U.S. entities. Credit Suisse, for example, includes the old First Boston Corporation, though that name was dropped years ago. He said the biggest issue being debated was what securities would be included in the proposal, and how the actual mechanism to buy them would work. In Asia, the plan to purchase distressed assets drew little reaction over the weekend. Asian banks generally have not invested significant assets in U.S. mortgage-backed securities. The bigger question in Asia, bankers said, lies in how the American legislation will affect HSBC, the large British-based bank with significant operations in Asia. The bank's U.S. subsidiary was a large buyer of mortgages over the last decade, and kept many of these mortgages on its books instead of trying to repackage and resell them as mortgage-backed securities. Richard Lindsay, a spokesman for HSBC, said that senior management was still evaluating the situation and said it was a "positive step forward but it won't solve the problems of an overleveraged industry."

Three views of a financial rescue plan Monday, September 22, 2008

The Bush administration is working with Congress to fill in the details of its plan to take the bad mortgage-related debt off the books of banks and financial institutions and stabilize the financial markets.

With Congress scheduled to begin its election-year recess at the end of this week, the administration has little time to pull the plan together. While the negotiations are going on, The New York Times asked three economists to offer their thoughts about the administration's actions.

Steven Schwarcz, professor of law and business, Duke University School of Law:

"The proposal by the Treasury to use government money to purchase mortgage-backed securities held by financial institutions should defuse the financial crisis, but at a cost to taxpayers that unfortunately will be much higher than if the government had acted when markets first began to collapse. It is, however, along with Treasury's Sept. 7 announcement that it will purchase securities issued by Fannie Mae and Freddie Mac, the first serious attempt by government to cure the underlying financial disease and not merely treat its symptoms.

"To cure the disease, government must focus on treating the loss of confidence in the financial markets. The American International Group, Bear Stearns, Lehman and potentially other financial institutions are in trouble, not because of problems with economic fundamentals, but because of falling prices of mortgage-backed and other securities, requiring these institutions to mark their securities down to the collapsed market prices or triggering insurance obligations on these securities. That, in turn, has created a downward death spiral of collapsing prices.

"A market liquidity provider of last resort is needed to correct these market failures by investing directly in securities of panicked financial markets, thereby stabilizing prices and dampening the downward death spiral that can lead to market collapse. This type of targeted market investment should generate minimal costs, and certainly lower costs than those of a lender of last resort to financial institutions — the Fed's traditional role.

"Whatever entity the Treasury is contemplating to purchase mortgage-backed securities held by financial institutions, the fact that it will directly purchase securities will set an important precedent for creation of a market liquidity provider that can act proactively, not merely reactively, after the damage is done.

"By acting at the outset of a market panic, a market liquidity provider can profitably invest in securities at a deep discount from the market price and still provide a "floor" to how low the market will drop. Had a market liquidity provider been in existence when the subprime crisis started, the resulting collapse of the credit markets would almost certainly have been restricted in scope and lessened in impact, and we would not now be facing the need to try to save AIG and other institutions."

Douglas Elmendorf, senior fellow at the Brookings Institution in Washington:

"The Treasury's new plan for stabilizing the financial system has already made a sharp impression on financial markets and the public consciousness. Yet little has been revealed about how the plan will work.

"The Resolution Trust Corporation of the early 1990s provides scant guidance on how to proceed. That company was designed to sell assets the government had acquired by honoring deposit insurance at savings and loans. But the objective now is to buy assets. The challenge is picking the best means of doing so. What should the government buy, from whom, in what quantity and at what price?

"The Treasury plans to purchase mortgage-related debt, which lies at the heart of the crisis. Yet this approach has significant disadvantages.

"First, mortgage-backed securities and derivatives of these securities are not all alike. Reverse auctions within broad debt classes would be risky, because current holders would try to unload the lowest-quality securities within each class. Relying on the judgment of hired investment firms to pick prices and quantities has the potential for inefficiency, unfairness and abuse.

"Second, buying troubled debt provides the most help to firms that made the worst investments. Banks that stayed clear of bad debt or cut their losses early would receive little or no gain, while banks with the weakest balance sheets would reap the biggest rewards. Not only is this unfair, it would dampen the impetus for restructuring the financial sector to give a smaller role to institutions and business models that have failed.

"Third, taxpayers would take on significant risk but see limited potential gain — in contrast with the rescues of Fannie Mae, Freddie Mac and AIG, where taxpayers got large equity stakes.

"An alternative approach is to make equity investments in a wide range of financial institutions. If the government offered each bank an investment equal to a given percent of its market value in exchange for a corresponding equity stake, the problems I listed above would be avoided. And because the government would be a minority shareholder, it would not directly manage or control these banks. This approach raises its own concerns that would need to be addressed, but it is a more promising starting point."

Vincent Reinhart, resident scholar at the American Enterprise Institute:

"Political leaders recognize that more than improvisation is needed to cope with the collapse of the housing market and the financial market crisis in its wake. Before they turn to the details of draft legislation, however, they had better settle on what they are trying to accomplish.

"Helping households in distress is a retail business, requiring decisions on a mortgage-by-mortgage basis. Similarly, negotiating with individual financial firms about their mortgage holdings takes time and infrastructure. Such negotiations put the government at a decided disadvantage because the other side in the transactions has more information about each asset.

"In both cases, politicians will have trouble establishing boundaries for assistance. While about one in 15 households with mortgages is now late in making payments, many more have suffered wealth losses. Builders, too, are in distress. And there are tens of thousands of financial institutions in the country, almost all of which have some impaired loans on their books.

"The unpleasant reality is that time is short, resources are stretched and many of the nation's urgent needs are unmet. Because government funds are not unlimited, legislation should focus on the immediate problem of the strains in financial markets.

"Providing aid to large financial firms is distasteful, especially when remembering their excesses and the time when their managers were considered masters of the universe. But those firms hold the larger economy hostage. As long as they are unwilling to support market functioning and make new loans, spending will sag and asset prices will slide.

"The Congress should authorize the Treasury to purchase asset-backed securities in the secondary market and mortgages through auctions. For assets where it might not have all the information it needs, the Treasury could demand a slice of equity in the selling firm as well. As has been the case since its inception, the Federal Reserve can act as fiscal agent, making some of the purchases directly and supervising outside managers where special expertise is needed.

"The election calendar narrows the window of action and provides reason to keep the draft legislation simple. The assets acquired this year will certainly not be sold before a new administration and Congress are in power. Thus, it is neither necessary nor appropriate to make decisions on what to do with those mortgage assets."

A Prescription for Recovery

By Robert H. Dugger, September 22, 2008;

This week, Congress is expected to commit hundreds of billions of taxpayer funds to a revitalization program to halt our financial hemorrhaging. Twenty years ago, in the midst of another financial crisis, I was part of a banking industry effort to solve the savings and loan problem. The result of that effort was the Resolution Trust Corporation, which, under Bill Seidman's masterful leadership, cleaned up the S&L mess in 48 months.

The situation then was very different. The S&L problem involved only one sector of the economy and was just 3 percent of gross domestic product. We were not so dependent on foreign savings, and the crushing pressure on our federal budget from tax policies and entitlements was far off. This crisis is many times larger than that created by the S&Ls. We are deeply dependent on savings from other countries, and our fiscal resources are limited and shrinking.

One lesson is clear: If Congress commits money without firm principles to guide its use, the cost to taxpayers will be far higher and the economy will remain weaker longer. Before the 1989 legislation, efforts to stem losses growing inside the S&L industry lacked firm principles; as a result, they did not remove the swelling tumor of losses and in some instances actually helped it grow.

Here are five principles Congress needs to impose now:

· Put individual taxpayers first. The program needs to focus on keeping taxpayers in their homes, strengthening their local economies and protecting their savings. It has to help Americans broadly, not just a few, and certainly not the managers who got us into this mess.

· Minimize taxpayer costs over the long term. Short-term thinking created this crisis. Only long-term efforts will end it. The S&L crisis was limited to the financial sector. It was best addressed on an aggressive basis, bank by bank. This meant that least-cost resolutions were the way to go and that the RTC should buy and sell assets quickly, which it did. But the current situation is systemic. It involves our entire economy. This means the revitalization program should buy distressed assets early and plan to hold them for a long time. The goal is to make the economic adjustment as shallow as possible, to limit the injury to families, jobs, homes and savings.

· Avoid creating an interim program. This program must not be like the S&L "rescues" of the mid-1980s, which merely enabled the problems to grow. The program needs to have the capacity, flexibility and scope to address the vast size of the current crisis. Congress should put no dollar or time limit on our national commitment. Yes, markets will want dollar figures. If numbers must be given, let them be in statements about the program -- and let them be big. Do not shy away from saying that the United States is prepared to commit a trillion dollars over the next 10 years to halt this meltdown here and now.

· Remember global investors, whose confidence we must regain. This crisis is an economic heart attack, but not a fatal one. We must assure global investors that we are fully prepared to cover American losses. No one suggests that this will be easy. The budget choices being forced on us will be profoundly difficult. But we have the strongest democracy and the most durable legal and financial systems in the world. We have the capacity to absorb losses and the ability to reshape our economy. Foreign investors need evidence that we are committed to the changes necessary for recovery. When they see that, they will buy our private assets again.

· Do not hesitate. Bill Seidman's greatest lesson was action. It is far better to deal with a few assets, even without knowing quite what to do, than to do nothing while trying to work out the details. Whoever is in charge of the revitalization program must not hesitate to buy the assets that institutions offer -- these will be what is burdening the institutions and clogging our credit system the most. There are many strategies for buying assets and infusing capital that can protect the program from paying too much and ensure that taxpayers benefit from price increases as recovery occurs. The key is to get the assets in-house quickly and learn how to manage them effectively.

The writer is a managing partner of a global hedge fund and chairman of the Partnership for America's Economic Success. As policy director of the American Bankers Association, he led a panel of bankers in developing a plan that became the RTC

The shadow banking system is unraveling Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders. Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-fulfilling and destructive run on its -liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that -prevent runs. A generalized run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realized the toxicity of its investments and its very short-term funding seized up. The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits. The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders. The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds. The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shakeout of the bloated hedge fund industry is likely in the next two years. Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk. We are observing an accelerated run on the shadow banking system that is leading to its unraveling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close. The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the Euro zone, the UK and most advanced economies. European financial institutions are at risk of sharp losses because of the toxic US securitized products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitization; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the

recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings. Thus the financial crisis of the century will also envelop European financial institutions.

In Bailout, Seeing a Need for a Penalty As economists puzzle over the proposed details of what may be the biggest financial bailout in American history, the initial skepticism that greeted its unveiling has only deepened. Some are horrified at the prospect of putting $700 billion in public money on the line. Others are outraged that Wall Street, home of the eight-figure salary, may get rescued from the consequences of its real estate bender, even as working families give up their houses to foreclosure. Most economists accept that the nation’s financial crisis — the worst since the Great Depression — has reached such perilous proportions that an expensive intervention is required. But considerable disagreement centers on how to go about it. The Treasury’s proposal for a bailout, now being negotiated with Congress, is being challenged as fundamentally deficient. “At first it was, ‘thank goodness the cavalry is coming,’ but what exactly is the cavalry going to do?” asked Douglas W. Elmendorf, a former Treasury and Federal Reserve Board economist, and now a fellow at the Brookings Institution in Washington. “What I worry about is that the Treasury has acted very quickly, without having the time to solicit enough opinions.” The common denominator to many reactions is a visceral discomfort with giving Treasury Secretary Henry Paulson Jr. — himself a product of Wall Street — carte blanche to relieve major financial institutions of bad loans choking their balance sheets, all on the taxpayer’s bill. There are substantive reasons for this discomfort, not least concerns that Mr. Paulson will pay too much, thus subsidizing giant financial institutions. Many economists argue that taxpayers ought to get more than avoidance of the apocalypse for their dollars: they ought to get an ownership stake in the companies on the receiving end. But an underlying source of doubt about the bailout stems from who is asking for it. The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress. “This administration is asking for a $700 billion blank check to be put in the hands of Henry Paulson, a guy who totally missed this, and has been wrong about almost everything,” said Dean Baker, co-director of the liberal Center for Economic and Policy Research in Washington. “It’s almost amazing they can do this with a straight face. There is clearly skepticism and anger at the idea that we’d give this money to these guys, no questions asked.” Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college. Some are suspicious of Mr. Paulson’s characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress’s failure to act. This time, it is financial Armageddon supposedly on the doorstep.

“This is scare tactics to try to do something that’s in the private but not the public interest,” said Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at the Carnegie Mellon Tepper School of Business. “It’s terrible.” In part, Mr. Paulson’s credibility has been dented by his pronouncements in previous weeks that the crisis was already contained. Some suggest this was a well-intentioned effort to stem panic. But the aftermath complicates his quest for the bailout. “If you view your public statements as an instrument of policy, people don’t believe you anymore,” said Vincent R. Reinhart, a former Federal Reserve economist and now a scholar at the conservative American Enterprise Institute. The biggest point of contention is over whether and how taxpayers would benefit if the bailout succeeded in righting the financial system, sending banking stocks upward. In Mr. Paulson’s plan, the Treasury would have the right to buy as much as $700 billion worth of troubled investments, with the taxpayer recouping the proceeds when those investments were sold over coming years. But many economists — Mr. Elmendorf among them — argue that taxpayers should get more out of the deal, securing stock in the banks that make use of the bailout. The government could then sell off that stock at a profit when conditions improve. A similar approach was used successfully in Sweden in the early 1990s when its financial system melted down. Others argue that any bailout must pinch the people who have run the companies now needing rescue, along with their shareholders, addressing the unseemly reality that executives have amassed beach houses and fat bank accounts while taxpayers are now stuck with the bill for their reckless ways. “It absolutely has to be punitive,” Mr. Baker said. “If they sell us the junk, then we own the company. This isn’t a way to make these companies and their executives rich. This should be about keeping them in business so the financial system doesn’t collapse.” Other questions center on how to value what the Treasury aims to purchase — an issue that goes to the heart of the crisis itself. The financial system got to its dangerous perch by betting extravagantly on real estate. When housing prices began plummeting and borrowers stopped making payments, financial institutions found themselves with huge inventories of bad loans. Not simple loans, but complex investments created by pooling millions of mortgages together and then slicing them into pieces. These were the investments that Wall Street bought, sold and borrowed against in cooking up the money it poured into housing. The trouble is that these investments are so intertwined and complex that no one seems able to figure out what they are worth. So no one has been willing to buy them. This is why banks have been in lockdown mode: with mystery enshrouding both the value of their assets and their future losses, banks have held tight to their remaining dollars, depriving the economy of capital. Now, the Treasury aims to clear the fog by buying up these investments. But their value is as mysterious as ever. “There’s a tendency for people to think these are stocks and bonds and you know what the price is,” said Bruce Bartlett, a former White House economist under President Reagan. “The problem is people are operating in a world in which nobody knows what the hell is going on. There’s some naïve assumptions about how this would function.”

If Mr. Paulson pays the market rate — whatever that is — that presumably would not be enough to persuade banks to sell. Otherwise, they would have sold already. For the plan to work, Treasury has to pay a premium. “It’s a straight subsidy to financial institutions,” said Martin Baily, a former chairman of the Council of Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings Institution. “You’re essentially giving them money.” Mr. Baily favors the basics of the Paulson plan, albeit with some mechanism that would give the government a slice of any resulting profits. And yet he remains troubled by the dearth of information combined with the abundance of zeroes in the bailout request. “I’d like a clearer statement of what we were afraid was going to happen that requires $700 billion,” Mr. Baily said. “Maybe they don’t want to talk about it because it would scare everybody, but it’s a bit much to ask.”

A Fine Mess By WILLIAM KRISTOL

Published: September 21, 2008 A friend serving in the Bush administration called Sunday to try to talk me out of my doubts about the $700 billion financial bailout the administration was asking Congress to approve. I picked up the phone, and made the mistake of good-naturedly remarking, in my best imitation of Oliver Hardy, “Well, this is a fine mess you’ve gotten us into.” People who’ve been working 18-hour days trying to avert a meltdown are entitled to bristle at jocular comments from those of us not in public office. So he bristled. He then tried to persuade me that the only responsible course of action was to support the administration’s request. I’m not convinced. It’s not that I don’t believe the situation is dire. It’s not that I want to insist on some sort of ideological purity or free-market fastidiousness. I will stipulate that this is an emergency, and is a time for pragmatic problem-solving, perhaps even for violating some cherished economic or political principles. (What are cherished principles for but to be violated in emergencies?) And I acknowledge that there are serious people who think the situation too urgent and the day too late to allow for a real public and Congressional debate on what should be done. But — based on conversations with economists, Wall Street types, businessmen and public officials — I’m doubtful that the only thing standing between us and a financial panic is for Congress to sign this week, on behalf of the American taxpayer, a $700 billion check over to the Treasury. A huge speculative housing bubble has collapsed. We’re going to have a recession. Unemployment will go up. Credit is going to be tighter. The challenge is to contain the damage to a “normal” recession — and to prevent a devastating series of bank runs, a collapse of the credit markets and a full-bore depression. Everyone seems to agree on the need for a big and comprehensive plan, and that the markets have to have some confidence that help is on the way. Funds need to be supplied, trading markets need to be stabilized, solvent institutions needs to be protected, and insolvent institutions need to be put on the path to a deliberate liquidation or reorganization. But is the administration’s proposal the right way to do this? It would enable the Treasury, without Congressionally approved guidelines as to pricing or procedure, to purchase hundreds of billions of dollars of financial assets, and hire private firms to manage and sell them, presumably at their discretion There are no provisions for — or even promises of — disclosure, accountability or

transparency. Surely Congress can at least ask some hard questions about such an open-ended commitment. And I’ve been shocked by the number of (mostly conservative) experts I’ve spoken with who aren’t at all confident that the Bush administration has even the basics right — or who think that the plan, though it looks simple on paper, will prove to be a nightmare in practice. But will political leaders dare oppose it? Barack Obama called Sunday for more accountability, and I imagine he’ll support the efforts of the Democratic Congressional leadership to try to add to the legislation a host of liberal spending provisions. He probably won’t want to run the risk of actually opposing it, or even of raising big questions and causing significant delay — lest he be attacked for risking the possible meltdown of the global financial system. What about John McCain? He could play it safe, going along with whatever the Bush administration and the Congress are able to negotiate. If he wants to be critical, but concludes that Congress has to pass something quickly lest the markets fall apart again, and that he can’t reasonably insist that Congress come up with something fundamentally better, he could propose various amendments insisting on much more accountability and transparency in how Treasury handles this amazing grant of power. Comments by McCain on Sunday suggest he might propose an amendment along the lines of one I received in an e-mail message from a fellow semi-populist conservative: “Any institution selling securities under this legislation to the Treasury Department shall not be allowed to compensate any officer or employee with a higher salary next year than that paid the president of the United States.” This would punish overpaid Wall Streeters and, more important, limit participation in the bailout to institutions really in trouble. Or McCain — more of a gambler than Obama — could take a big risk. While assuring the public and the financial markets that his administration will act forcefully and swiftly to deal with the crisis, he could decide that he must oppose the bailout as the panicked product of a discredited administration, an irresponsible Congress, and a feckless financial establishment, all of which got us into this fine mess. Critics would charge that in opposing the bailout, in standing against an apparent bipartisan consensus, McCain was being irresponsible. Or would this be an act of responsibility and courage?

How the Fannie and Freddie Created the Financial Crisis: Kevin Hassett

The financial crisis of the past year has provided a number of surprising twists and turns, and from Bear Stearns Cos. to American International Group Inc., ambiguity has been a big part of the story.

Why did Bear Stearns fail, and how does that relate to AIG? It all seems so complex.

But really, it isn't. Enough cards on this table have been turned over that the story is now clear. The economic history books will describe this episode in simple and understandable terms: Fannie Mae and Freddie Mac exploded, and many bystanders were injured in the blast, some fatally.

Fannie and Freddie did this by becoming a key enabler of the mortgage crisis. They fueled Wall Street's efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime-mortgage pools. In addition, they held an enormous portfolio of these toxic mortgages themselves.

In the times that Fannie and Freddie couldn't make the market, they became the market. Over the years, it added up to an enormous obligation. As of last June, Fannie alone owned or guaranteed more than $388 billion in high-risk mortgage investments. Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home.

The problem was that the trillions of dollars in play were only low-risk investments if real estate prices continued to rise. Once they began to fall, the entire house of cards came down with them.

Turning Point

Take away Fannie and Freddie, or regulate them more wisely, and it's hard to imagine how these highly liquid markets would ever have emerged. This whole mess would never have happened.

It is easy to identify the historical turning point that marked the beginning of the end.

Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They were enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late 2004, the chief accountant of the SEC told disgraced Fannie Mae chief Franklin Raines that Fannie's position on the relevant accounting issue was not even ``on the page'' of allowable interpretations.

Then legislative momentum emerged for an attempt to create a ``world-class regulator'' that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.

Greenspan's Warning

The clear gravity of the situation pushed the legislation forward. Some might say the current mess couldn't be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie ``continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,'' he said. ``We are placing the total financial system of the future at a substantial risk.''

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.

Different World

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, this Ponzi scheme of a ‘market’ would likely have not existed.

But the bill didn't become law, for a simple reason: It died in committee due to partisan politics and an unbridled lobbying effort on behalf of the two institutions. It was rightly observed at the time that this: ``Is a classic case of socializing the risk while privatizing the profit.''

Mounds of Materials

Now that the collapse has occurred, the roadblock built by the incompetent politicians who once again succumbed to the influence of industry lobbyists is unforgivable. Many who opposed the bill doubtlessly did so for honorable reasons. Fannie and Freddie provided mounds of materials defending their practices. Perhaps some found their propaganda convincing.

(This article cut off here as it deteriorated into a ‘blame game’ piece trying to pin it all on the Democrats who supposedly were the only ones who accepted lobbyists’ money to stop legislation against Fannie & Freddie))

Op-ed in the Financial Times �September 24, 2008

The Price of Salvation

The government plans to bail out the banking sector by buying up to $700bn (for now) of "impaired assets" … but at what price? Pay too little, and the banks will not have sufficient capital to remain solvent; pay too much, and the wealth of the American taxpayer will be unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury secretary, said the government would pay "fair market value", which, many pointed out, would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the current market with a "fire sale" and proposed paying "hold–to–maturity" prices. But what does this mean?

There are five different prices that the government theoretically might pay for a mortgage-backed security (MBS):

P1. The par value of the security (largely irrelevant at this point).

P2. The current book value on the holder's balance sheet: because of the accounting rules for banks, and because banks today have a strong incentive to overvalue these assets, these book values may be artificially high.

P3. Fair market value (FMV) in a market free of government intervention: Until September 17, this was set by actual transactions between buyers and sellers, such as Merrill Lynch's sale in July at 22 cents on the dollar. However, for most securities it was impossible to determine the FMV, because there were few comparable transactions.

P4. FMV with government intervention: Since the bailout was announced, the prices of MBS have drifted upward, on the assumption that the government has an incentive to pay artificially high prices (the point of the bailout being to pay prices high enough to ensure banks' solvency).

P5. Model value: The people who buy MBS on behalf of the government will use their own models of long–term cash flows to estimate their value.

The banks would like to get P2, since that would leave their capital levels where they are, but this amounts to paying whatever price the banks have decided their assets are worth, which is obviously foolish.

An ordinary fund manager would pay P3, but if that were the entire transaction, it would defeat the purpose of the bailout; banks could sell at P3 today, but cannot absorb the collateral damage to their balance sheets. As Bernanke acknowledged in Tuesday's Congressional testimony, the plan is to pay more than current market prices, which is

another way of saying that Treasury will be overpaying to save the banks.

Bernanke's comments can be interpreted in two ways. He could be saying the government's liquidity and capacity to bear risk will create a new market equilibrium, and that Treasury will pay the new market price (P4). Alternatively, his "hold–to–maturity" price could be the output of a long–term cash flow model (P5). The two are not necessarily exclusive.

But either possibility raises problems. First, the valuation models that produce hold–to–maturity prices are highly sensitive to their assumptions, and can be used to justify virtually any price, removing any constraints on overpayment. Second, in either case it will be impossible to determine P3, the price absent government intervention, and hence the real amount of overpayment – making it impossible to know how much wealth has been transferred from taxpayers to banks. Third, what if neither P4 nor P5 is high enough to ensure bank solvency? In that case the bailout would fail to accomplish its most important task: to recapitalize the banks.

But there is another solution. Given the need to (a) take these "toxic" assets off the hands of the banks and (b) make sure that they get more money than they would get on the open market, the answer is to separate the two parts of the transaction. In the first step, Treasury would pay FMV for the securities; in the second step, after assessing the bank's resulting condition, Treasury would do a capital injection by buying newly issued preferred shares.

In order to determine FMV in the first step for a given tranche of securities, a portion of the debt could be auctioned to the private sector. Any debt bought by the private sector will have no further recourse to the government, i.e., it is "bailout free". Properly designed, this auction will indicate P3, the fair market value in a free market. The government would then acquire the securities not bought by the private sector, at the price established in the auction. With their MBS gone, it will be easier to assess banks' solvency and determine the appropriate terms for a government recapitalization.

By explicitly identifying the FMV of the assets and distinguishing the asset purchase from the capital injection, this mechanism provides transparency to the operations of the proposed fund and limits the risk of overpayment. More fundamentally, it provides the much–needed assurance that the overall plan is fair to the American taxpayer and not simply a handout to the banking sector.

OFF THE CHARTS

Out of the Shadows and Into the Harsh Light By FLOYD NORRIS

September 27, 2008 THE credit default swaps market — a market that for years was kept out of view and away from any regulation — has suddenly turned into a political hot potato in Washington. The chairman of the Securities and Exchange Commission said this week that regulation was needed immediately, while the secretary of the Treasury said efforts were already under way to get things under control, and urged caution. Such swaps, which enable lenders to a company to purchase what amounts to insurance that will protect them if the company defaults on its debts, have grown exponentially in recent years, with the nominal amount of debt guaranteed rising to more than $62 trillion at the end of last year from $631 billion in mid-2001. The sudden interest in the market stems from two separate but related developments. The collapse of a major firm in the market could set off a chain of problems, a fact that has scared the Treasury Department this year.

In addition, speculators who think a financial firm will fail can buy credit-default swaps. They will profit if they are right. But even if the firm is not in trouble, an increase in the price of those swaps may scare other investors, and send the company’s stock down. That prospect has alarmed the S.E.C. As the political debate was growing, the International Swaps and Derivatives Association, a trade group, reported that the amount of outstanding credit-default swaps declined in the first half of 2008, something that had never happened before. The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be insured. The huge total reflects the way the market is structured, as well as the fact that someone does not need to actually be owed money by a company to be able to buy a credit-default swap. In that case, the buyer is betting that the company will go broke. Within that huge market, many contracts offset one another — assuming that all parties honor their commitments. But if one major firm goes broke, the effect could snowball as others are unable to meet their commitments. In regulated futures markets, contracts are centrally cleared. If you buy an oil futures contract on Monday, and sell it on Wednesday, you have made your profit (or taken your loss) and you no longer have any stake in whether oil prices rise or fall. But if you buy a credit-default swap on Monday from one firm, and sell an identical swap on Wednesday to another firm, you still face the potential of risk if the party that sold the swap to you is unable to pay when a default occurs, perhaps years later. “One of the major reasons that the government helped out in the Bear Stearns situation,” Treasury Secretary Henry M. Paulson Jr. testified at a Senate hearing this week, “was to avoid throwing it into bankruptcy with all the credit-default swaps.” Mr. Paulson said the Federal Reserve Bank of New York was working to develop protocols for that market to deal with a failure of a big player, and indicated that he did not see a need for legislation. But Christopher Cox, the S.E.C. chairman, said Congress should act. “Neither the S.E.C. nor any regulator has authority over the C.D.S. market, even to require minimum disclosure to the market,” he testified. “The market is ripe for fraud and manipulation,” he added. The S.E.C. is investigating possible fraud, although no charges have been brought, and is looking for cases where someone may have purchased credit-default swaps to drive up their price and persuade others that a company was in trouble. The swaps market has been exempt from regulation since it began to grow, thanks to legislation the industry sought. The industry argued that regulation would drive business overseas, and that no regulation was needed because ordinary investors did not trade in the market. In announcing the decline in the amount of swaps outstanding, Robert Pickel, the chief executive of the trade group, said it reflected industry efforts “to reduce risk by tearing up economically offsetting transactions, and demonstrates the industry’s ongoing commitment to reduce risk and enhance operational efficiency.” The accompanying charts show the growth of the amount of credit-default swaps outstanding, and show how those totals compare with the total amount of outstanding loans from banks and others to corporations and foreign governments. Even with the decline, the swaps volume is more than three times the debt total.

Cash for Trash (excellent commentary)

By PAUL KRUGMAN Some skeptics are calling Henry Paulson’s $700 billion rescue plan for the U.S. financial system “cash for trash.” Others are calling the proposed legislation the Authorization for Use of Financial Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq. There’s justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’ money on behalf of a plan that, as far as I can see, doesn’t make sense. Some are saying that we should simply trust Mr. Paulson, because he’s a smart guy who knows what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of

the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he knows what he’s doing? He’s making it up as he goes along, just like the rest of us. So let’s try to think this through for ourselves. I have a four-step view of the financial crisis: 1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments. 2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years. 3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs. 4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.” The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis? Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital. Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan? The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place. That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.) But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal. I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now. But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be

railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.

Can the U.S. learn any lessons from Sweden's banking bailout?

Monday, September 22, 2008

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?

It does to Sweden, which was so far in the hole in 1992 - after years of imprudent regulation, shortsighted macroeconomic policy and the end of its property boom - that its banking system was, for all practical purposes, insolvent.

But unlike the United States, whose Treasury has made a proposal to deal with a similar situation; Sweden did not just bail out its financial institutions by having the government take over the bad debts. It also clawed its way back by pugnaciously extracting equity from bank shareholders before the state started writing checks.

That strategy kept banks on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. Even the chairman of Sweden's largest bank got a stern answer to the question of whether the state would really nationalize his bank: Yes, we will.

"If I go into a bank," Bo Lundgren, Sweden's finance minister at the time, said, "I'd rather get equity so that there is some upside for the taxpayer."

The tumultuous events of the last few weeks have produced a lot of tight-lipped nods in Stockholm. And for all the differences between Sweden and the United States, Swedish officials say there are lessons to be learned from their own nightmare that Washington may be missing. Lundgren even made the rounds in New York in early September, explaining what the country did in the early 1990s.

A few American commentators have proposed that the U.S. government extract equity from banks as a price for the bailout they are likely to receive, as Sweden did. But it does not seem to be under serious consideration yet in the Bush administration or in Congress.

That's despite the fact that the U.S. government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and American International Group, the insurance giant.

Putting taxpayers on the hook without offering anything in return could be a mistake, said Urban Backstrom, a senior Swedish Finance Ministry official at the time. "The public will not support a plan," he said, "if you leave the former shareholders with anything."

The Swedish crisis had strikingly similar origins to the American one. Norway and Finland went through related experiences, and they also turned to a government bailout to escape the morass that bad policy had created.

Financial deregulation in the 1980s fed a frenzy of real estate lending by Swedish banks, which spent too little time worrying whether the value of collateral might evaporate in tougher times. Property prices exploded.

The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden's currency, the krona, resulted in an incredible spike in overnight interest rates at one point to 500 percent. The Swedish economy contracted for two years straight after a long expansion, and unemployment, at 3 percent in 1990, quadrupled in three years.

After a series of bank failures led to ad hoc solutions, the moment of truth arrived in September 1992, when the government of Prime Minister Carl Bildt opted for a clear-the-decks solution.

With the full support of the opposition center-left, Bildt's conservative government announced that the Swedish state would guarantee all bank deposits and creditors of the nation's 114 banks. Sweden formed an agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. In a similar situation later in the decade, Japan made the mistake of dragging the process out, officials in Sweden and elsewhere note, delaying a solution for years.

Then came the imperative to bleed shareholders first.

Lundgren, the former finance minister, recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden's largest bank. Wallenberg, the scion of the country's most famous family and steward of large chunks of its economy, heard from the finance minister that there would be no sacred cows.

The Wallenbergs turned around and arranged a private recapitalization, obviating the need for a bailout at all. SEB turned a profit the next year, 1993.

"For every krona we put into the bank, we wanted the same influence," Lundgren said. "That ensured that we did not have to go into certain banks at all."

By the end of the crisis, the Swedish government had seized vast swaths of the banking sector, and the agency had mostly fulfilled its tough mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

Indeed, more money may come into official coffers. The government still owns 19.9 percent of Nordea, a Stockholm bank that was fully nationalized and is now a highly regarded giant in Scandinavia and the Baltic Sea region.

The politics of Sweden's crisis management were similarly tough-minded, though much quieter.

Soon after the plan was announced, the Swedish government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country. A serious credit crunch was avoided. So the center-left opposition, though wary that the government might yet let the banks off the hook, made its points about penalizing shareholders privately.

"The only thing that held back an avalanche was the hope that the system was holding," said Leif Pagrotzky, a senior member of the opposition at the time. "In public we stuck together 100 percent but we fought behind the scenes."

Sweden eventually shelled out 4 percent of its gross domestic product, 65 billion krona, or $10 billion, to rescue ailing banks. That is slightly less, in terms of the national economy, than the minimum of $700 billion, or about 5 percent of GDP, that the Bush administration estimates a similar move would cost in the United States.

But enough was recouped through sales of distressed assets and bank shares that were sold later, that the cost ended up being less than 2 percent of GDP. Some officials believe it was closer to zero, depending on how certain rates of return are calculated.

Looking back, Swedish official say the tough approach toward the banks paved the way for success. It eliminated "moral hazard," the problem of relieving investors of bad decisions. And, much as it might be a shock in the United States, the demise of shareholders also underpinned the political consensus that help restore stability to financial markets even before the bailout was truly under way.

While government ownership of banks goes against the American grain, Lundgren worries that if the U.S. bailout rests on a thin reed, politically speaking, then it could fail.

The U.S. Treasury is now planning to purchase the distressed assets outright, without demanding equity. If it wants to restore the banking system's creditworthiness, it would have to err on the side of paying too much money to the banks that caused the crisis, Lundgren said.

"If the valuation is bad, from the taxpayer's point of view, you lose," he said. "And that decreases the legitimacy of the plan."

Improving Paulson's Cure

September 23, 2008

Liberal Democrats are in agony over bailing out Wall Street. Conservative Republicans are in agony over massive government intervention in what they like to call the free market. Yet neither side wants to be blamed if the financial system implodes.

It gets more complicated: An administration whose critics believe it abused the power it grabbed during a different kind of national emergency, after the Sept. 11 attacks, is asking for unprecedented authority over the financial system. Yet the man leading the charge this time, Treasury Secretary Henry Paulson, is one of the few administration officials trusted by Democrats.

All this is happening suddenly, and just six weeks before Election Day. Both presidential candidates are wary of getting on the wrong side of the public's justified populist fury or its desire for prudence in the face of potential catastrophe.

The broad outcome is already in view: Unless something very strange happens, Congress will pass a massive bailout of the financial system by week's end simply because every other option is worse.

Rep. Barney Frank, a Democrat who chairs the House Financial Services Committee, captured the prevailing mood in an interview Sunday night during a break in the negotiations. "What's the alternative?" he asked.

But the content of the bailout package matters enormously. To get what it needs, the administration will have to give taxpayers more protection and more accountability.

One core doubt about this bailout is whether taxpayers will be left holding a bag of dreadful investments that reckless financial mavens get to unload without having to part with their houses in the Hamptons. This isn't just rhetorical populism: There is a moral problem for capitalism itself if taxpayers take on a burden created by the foolishness of the privileged and get little compensation in return.

A related problem is how much new spending should be piled onto a federal budget that is already in the red.

Yes, a bailout is necessary, but several steps could limit the risks. Sen. Jack Reed (D-R.I.) has proposed granting the federal government warrants to acquire stock in financial firms that profit from the bailout. This way, taxpayers would share in the gain if the industry recovered -- which, of course, is the whole point of this exercise.

Socialism, you say? We're already into that. The administration's plan amounts to socialism for the rich only. And as Reed explained in an interview, his proposal is actually more in keeping with capitalism than a pure bailout. "If taxpayers take risks, they should be able to reap some of the rewards," he said. Frank is trying to get this provision into the final bill.

Moreover, as Reed notes, giving the government an option to have a share in companies if they succeed will protect taxpayers if the feds pay too much for a company's bad debt. If a company prospers because it receives more than what turns out to be a reasonable market price for its debt -- and the debt we're talking about will be very hard to price -- taxpayers get at least some of the money back when the company's stock goes up.

The bottom line should be: no potential upside for the taxpayers, no bailout.

Another question: Why bail out Wall Street and not help those who are losing their homes in the subprime mortgage fiasco? Frank believes that if the government comes to hold bad mortgages under the bailout plan, it will be able to halt foreclosures. Sen. Charles Schumer (D-N.Y.) wants to give bankruptcy courts the power to change mortgage provisions to keep people in their homes.

Almost everyone in both parties, including Barack Obama and John McCain, agrees that the final bailout bill should place real checks on the power of the Treasury secretary. Such accountability provisions were a key element in a proposal offered yesterday by Senate Banking Committee Chairman Chris Dodd (D-Conn.). Even if Paulson proves to be a sainted and savvy steward, what about the next secretary?

And if Congress can appropriate $700 billion for Wall Street, where is the help for everyone else hurting in this economy? Isn't it strange that an administration that could not come up with a comparatively modest sum to increase the number of children with health insurance could suddenly find all this cash for the financial industry?

Sadly, this bailout is inevitable. But it should be done right. Congress shouldn't be bullied into passing a flawed plan that will leave the next president in an even deeper hole.

A Lesson the Markets Ignored

By Richard Cohen September 23, 2008;

Of all the self-proclaimed experts I wanted to hear from about the financial crisis, the one I looked forward to the most was Nick Leeson, late of Britain's Barings Bank. In 1995, he bet hugely on Nikkei futures (whatever they are) and lost something like $1.4 billion. Leeson was 28 years old and often drunk, Barings was 233 years old and in fiduciary senility. Leeson went to prison, Barings went bust and Wall Street, without so much as a pause, went on its merry way.

Sadly, Leeson did not have much to say about the current financial crisis. Writing last week in the Guardian, he instead expressed bitterness that the former owners of Barings went on with their lives while he spent 4 1/2 years in prison. What he did not say, to the regret of us all, is how once again the kids were allowed to play with huge amounts of money without any adult supervision.

"I was astonished that nobody stopped me," he wrote in his book "Rogue Trader." "People in London should have known." Indeed.

The theme in the current financial crisis is not, as John McCain would have it, greed, since that, like lust, will be with us forever. Instead, it is transparency. Leeson, you may recall, was dealing from Singapore in exotic derivatives that his bosses in London little understood. All they knew was that Leeson was putting huge profits on the books, not that those books had anything to do with reality.

Somewhat the same thing happened on Wall Street. The complicated, exotic and downright erotic financial instruments cooked up at the investment houses were, in fact, little understood not only by the buyers but also by the sellers. You can see that from what they said and from what they did: Lehman Brothers, Bear Stearns, AIG and others all held on to financial instruments that were worth less than they once thought. This was truly a case of the blind leading the blind.

"The problem is that nobody knows what any institution owns and what the terms of the securities they own are and what they're worth," New York Mayor Michael Bloomberg said Sunday on "Meet the Press." He's saying what others on the Street having been saying for some time: Nobody knows what these things -- securitized mortgages, etc. -- are worth. And, just to darken the mystery (and maybe your mood), no one knows the value of the underlying real estate, either.

I started with Leeson for a reason. He is the personification of a generational gap in the finance industry. He was young and computer-savvy, and his bosses in London were neither. That was true on Wall Street, too. The very top guys really had little idea of what was going on below. Everything was going right. They were making lots of money, which they deserved -- in their wonderful circular reasoning -- because they were making it. This, I tell you, is the true magic of the vaunted market: It justifies both stupidity and greed.

Now the government is proposing another pig in a poke. The huge federal bailout is necessary, but Democrats are right to insist on detail and oversight. For too long, the financial markets have operated without much of either. Now the Bush administration is asking Congress for a blank check, what New Jersey Gov. Jon Corzine calls the "moral equivalent" of the congressional resolution that wound up authorizing the Iraq war. Corzine, a former Goldman Sachs chairman (not to mention U.S. senator), is a voice worth heeding nowadays. When I talked to him, he had just gotten hold of the two-page administration program. Two pages! This is another exotic financial instrument.

The wise words of William Goldman, the screenwriter, should echo in Congress's ears. He not only coined the phrase "follow the money" for "All the President's Men," but he expressed the sum total of knowledge about the making of movies with: "Nobody knows anything." The same has been true about opaque financial instruments. It's up to Congress to fix that.

The lesson of Leeson has yet to be learned. Financial markets have moved well beyond the trading of things that could be seen or measured or weighed. On Wall Street, older men employed the lingo of younger men to pretend they knew what was happening -- but they didn't. Now, Congress is being asked to do something similar. That won't do. Bear down. Ask questions. Don't be afraid to regulate. Act as if you're the government, for crying out loud. Because if you don't do this right, you soon won't be.

Countdown to a Meltdown

Congress has to act quickly but carefully to get financial rescue legislation right.

September 23, 2008

LAST THURSDAY, the top economic policymakers in the United States told congressional leaders that the financial system was only days away from a catastrophic failure -- and that the only hope was an immediate, massive government bailout. Congress agreed in principle, buoying financial markets. But five days later, the specifics of the rescue legislation remain undecided. Two of yesterday's market events -- a 372-point drop in the Dow Jones industrial average and a $16-per-barrel jump in the price of oil -- show just how rapidly the clock is ticking.

Congress and the Bush administration generally agree that the government should buy up the toxic mortgage-backed securities that are spreading losses and destroying the confidence essential for debtors and creditors to function. This taxpayer-funded bailout is not necessarily the only conceivable approach or even the most efficient one. Quite possibly, it would have been wiser instead to inject government capital directly into banks so they would be better able to work out problem assets on their own. But for better or worse, that option is off the table, and the question is how Uncle Sam can most effectively take on as much as $700 billion worth of bad debt. The basic tradeoff here is between speed and flexibility on one hand and oversight and accountability on the other.

Treasury Secretary Henry M. Paulson Jr. clearly believes that the way to get the maximum number of financial institutions to unload as much distressed paper as possible, as quickly as possible, is to keep it simple: announce that the U.S. Treasury is open for business and let the fire sale begin. That is essentially what he advocated when he asked Congress for the power to purchase troubled mortgage-backed assets from financial institutions at whatever price he and hired experts saw fit, with only minimal congressional supervision and complete immunity from lawsuits.

The problem, of course, is that this raises the risk that the government will get fleeced by the debt-sellers, raising the ultimate cost to taxpayers. It was also politically unrealistic, in that members of Congress were quite properly concerned that financial institutions accept limits on executive compensation in return for their federal lifeline. There was no provision in Mr. Paulson's proposal for taxpayers to enjoy any of the profits that financial institutions may enjoy once they have been restored to health.

A new proposal by Senate Democrats seeks to correct this by requiring would-be asset-dumpers to give the government equity if Uncle Sam winds up having to sell the paper at a loss. Of course, at the margin, the proposal could deter some firms from ridding themselves of the bad loans in the first place. And that would slow the process. Democrats are also insisting on various forms of mortgage relief for the homeowners who are about to find themselves in debt to Uncle Sam. Mortgage relief might help stabilize home prices, but since the government would now own so many mortgages, taxpayers (most of whose mortgages are not in trouble) would have to foot the bill once again.

A little delay was both inevitable and desirable. Congress cannot write a $700 billion check with no questions asked. But speed and focus are still of the essence, and leaders in both parties must not use this crisis as an opportunity to refight all the political battles of the past year. They should treat it as what it is: a chance, possibly the last chance, to keep the U.S. financial system from collapsing.

Bailout's Tricky Balancing Act: How Much Is Too Much? Architects of Government Plan Face Dilemma in Deciding How to Price .

Wall Street's Shaky Mortgage-Related Assets

Tuesday, September 23, 2008; A08

As the government weighs how to bail out the financial sector, the plan's engineers face a dilemma.

The higher the prices the government pays for troubled mortgage securities held by banks, the more the rescue will bolster those banks and sustain the lending that is vital to the broader economy. But higher prices would also mean a worse deal for taxpayers.

In other words, the more effective the plan, the more expensive it will ultimately be.

Under both the Bush administration's proposal and many of the variations finding favor among Democrats, the government would buy up to $700 billion in shaky assets now on the books of financial companies. As the government does so, it will be forced to grapple with the same question that has vexed the brightest minds on Wall Street for more than a year: What are the darn things worth?

The very reason for the financial crisis of the past 14 months is that no one knows for sure. Wall Street created securities so complex that their value can swing wildly depending on what happens to the overall housing market. For example, a particular type of mortgage-backed security might offer a giant payout if home prices drop 10 percent but be worthless if they drop another 15 percent.

The outlook for the broader economy and housing market is so uncertain that investors have been unwilling to buy these exotic securities at any price. With these impossible-to-value investments clogging their books, banks haven't been able to make loans to people and businesses, a major reason for the nation's economic distress.

If the government buys the assets at relatively high prices, this would fortify the banks and help lending return to normal. Even banks that do not sell their securities to the government could be forced under accounting rules to assign the government sale price to assets on their books, giving them some clarity about their financial outlook.

"Psychologically, it's very, very important," said Thomas A. Renyi, former chairman of Bank of New York Mellon, referring to the price the government pays. "It provides the underpinning beneath what is a very, very uncertain market. It provides a stable environment for the proper valuation of assets in the marketplace."

If the government pays relatively low prices, it would protect taxpayers more, even giving them the potential of profiting on the deal when the Treasury ultimately sells them in the future.

But if the government sets prices below those that banks have placed on their own holdings, these financial firms could be forced to take the difference as a loss. Indeed, the prices could be set by the banks most desperate to sell, artificially depressing the value of similar assets on the books of healthy banks. As a result, some of those banks may become less healthy, requiring them to raise more money to cover their expected losses.

"What it could show is the depressing news that even greater infusions of capital are needed across the banking system than previously thought," CreditSights analysts wrote in a note to clients yesterday.

The plan also could hurt banks that have set relatively high values for their holdings. Until now, there has been no way to prove those banks have inaccurately priced their assets. But the government plan could force a massive repricing. In a research note to clients yesterday, a Merrill Lynch analyst warned that regional banks were particularly vulnerable because many of them have been slower than large banks to write down the values of mortgage loans on their books.

Under the current proposal, private companies will be hired as asset managers to help figure out which assets to buy, how to buy them and ultimately when to sell them off.

The Treasury Department has provided only broad outlines of how it intends to set prices, saying in a fact sheet that it will use "market mechanisms where possible, such as reverse auctions." In a reverse auction, the government could agree to purchase a specific amount of assets and buy those that are offered at the lowest price.

But that may be harder than it sounds, economists said.

The problem is that there are thousands of kinds of mortgage-related securities. If the Treasury just opens the door for banks to sell those securities to the government, firms will offer up the very worst ones, possibly leading to huge losses for taxpayers. But if the government specifies exactly which securities it will accept, the Treasury secretary will have unusually broad authority to decide which banks get bailed out and which don't.

Imagine that the market for used cars had fallen apart and the government decided to restore order by buying up thousands of vehicles. If the winning price in a reverse auction was $3,000, owners of lower-priced Ford Pintos would trade their cars in to the government, while owners of higher-priced BMWs would hold on to theirs. When the government went to sell the Pintos, it could not recoup its investment and would lose money.

In an alternate scenario, the government could have separate auctions for Pintos and BMWs. But in choosing how many of each to buy, the government would be deciding which kinds of car owners to bail out and which to let suffer.

"Which assets do you buy and how much of each?" asked Douglas Elmendorf, a senior fellow at the Brookings Institution. "That determines who you end up helping. If it's at the discretion of investment managers, I assume we'll hire good smart ones, but that discretion when applied to $700 billion seems like a lot of discretion, and has a lot of potential for unfair outcomes and abuse."

Elmendorf suggests that a way around that problem would be for the government to make investments in financial companies, proportional to the firms' market value. That way, the companies would have extra cash and then could sell the troubled assets on private markets for a loss while continuing to make loans and operate normally.

That approach could have its own drawbacks, though, including making the government a major shareholder of large financial companies, which to some critics smacks of socialism.

The very structure of the auctions will go a long way to determining the outcome. The people who design how the auction works can set the rules such that almost any outcome is likely.

"Just because it's called a reverse auction doesn't mean it results in lower prices automatically," said Bob Emiliani, a Central Connecticut State University professor who studies reverse auctions. He said that in some cases, reverse auctions are set up so the buyer accepts the highest price submitted by any of the sellers and then pays that price across the board -- even to sellers who were willing to accept lower prices.

A Bailout or a Bonanza?

Tuesday, September 23, 2008

The uber-capitalists of Wall Street are all socialists now. Free- market ideology, it turns out, doesn't pay the mortgage. That appears to be a job for, ahem, Big Government.

Let's be clear about why we're facing a crisis that could pull down the global financial system. The irresponsibility of individuals who bought houses they couldn't quite afford pales in comparison with the irresponsibility of the financial wizards who built on those shaky mortgages a towering edifice of irrational faith. Someone in the government should have looked at all those trillions of dollars' worth of mortgage-backed securities and collateralized debt obligations and credit default swaps and demanded that Wall Street prove that all, or even most, of this purported money was real. But we're in the eighth year of the Bush administration; adult supervision left the building long ago.

Now that the whole highly leveraged structure is threatening to fall, some kind of government bailout is necessary and inevitable. But Congress shouldn't approve Treasury Secretary Henry Paulson's $700 billion rescue plan without insisting on some measure of equity and accountability.

See, neglecting such details as equity -- in both senses of the word -- and accountability is what got us here in the first place.

Congress should have learned by now what happens when this administration is given a blank check. Unlike the run-up to the Iraq war, at least this time there's a genuine emergency -- we came within a whisker of a financial meltdown last week, and we're still way deep in the woods. No one thinks that delay is an option.

Not Barack Obama, who introduced legislation in 2006 to address lax mortgage lending and in March proposed a new regulatory framework for the financial markets. Not John McCain, who has been all over the map. Within one week, McCain has gone from saying the "fundamentals of the economy are strong" to declaring that "we are in the most serious crisis since World War II."

But first we need to be convinced that Paulson's proposal -- have the government purchase the bad debt -- is the best thing to do. Not all economists believe it is, although it's true that if you put six economists in a room, they'll come up with seven sharply differing, strongly held points of view about the time of day. Assuming that Paulson's plan is deemed workable, the "details" yet to be worked out involve staggering amounts of money. Hedge funds apparently don't qualify for relief, but what about insurance companies that branched out into exotic mortgage-backed investments? What about foreign banks with big U.S. operations?

Clearly there has to be some definition of just who is covered, and there has to be some oversight. And now that the government has nationalized Fannie Mae and Freddie Mac, who's going to run those still-vital institutions? Who's going to run the giant insurance company AIG, which was effectively nationalized last week?

Maybe Congress can insert a provision that broadly insists on the principle of oversight and leaves the particulars to be worked out later. But it would be unconscionable for Congress to absolve a bunch of wealthy financiers of the consequences of their bad decisions and not do the same for homeowners who showed similarly poor judgment. Paulson has indicated his awareness that this is, indeed, an election year -- and that members of Congress are not eager to go home to their districts and explain why Wall Street's pooh-bahs get to keep their mansions and their yachts while working-class families lose their modest homes.

The more contentious issue is the idea, supported thus far mostly by Democrats on Capitol Hill, that there should be salary caps for executives of companies that take advantage of the government bailout. Paulson complains that this will provide a disincentive for companies to participate in the program -- whatever the program turns out to be -- but it seems to me to be a reasonable idea, and a winner politically.

Why shouldn't the executives who put their companies at risk by making unwise investments pay a price for their lack of prudence?

We can't just let the system collapse -- nobody wins in that event. But I thought one of the fundamental tenets of capitalism was a direct relationship between risk and reward. The Masters of the Universe who created this mess ought to share the pain of cleaning it up.

A Hedge Fund Like No Other A Key Task for Congress: Matching Managers' and Taxpayers' Interests

By Simon Johnson and James Kwak Tuesday, September 23, 2008;

Given the panic in Washington over the financial markets, it is virtually certain that Congress will soon pass some form of the bailout plan the Treasury put forward last week. This is not an ideal proposal, particularly since it does not address the underlying problem with mortgages and negative housing equity. No troubled mortgage holders would benefit directly, and key commercial banks might still end up undercapitalized.

However, no legislator wants to risk allowing the economy to collapse on his or her watch, and, according to Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, that is what's at stake.

Within these political realities, there is a key issue on which lawmakers should focus, quickly, in designing this legislation: governance.

The draft proposal authorizes the Treasury to "purchase . . . on such terms and conditions as determined by the secretary, mortgage-related assets from any financial institution having its headquarters in the United States." In effect, this would invest $700 billion (for starters) of taxpayer money in a hedge fund controlled by a single person, the Treasury secretary. Given the urgency of the effort and the complex nature of the securities involved, this de facto fund would be government-run but overseen largely by Wall Street veterans; any actual management would probably be outsourced to existing fund management companies.

Ordinarily, the interests of hedge fund managers and investors are at least somewhat aligned by the fee structure of hedge funds, in which managers are paid 2 percent of assets under management plus a share of the returns over a certain threshold (commonly 20 percent). In addition, competition in the

industry dictates that fund managers with below-market returns are less likely to be able to raise new funds. But neither of these incentives exists in this case.

Management fees cannot be tied to fund returns in the usual manner because the fund is highly likely -- some would say designed -- to lose money. To restore our nation's banks to health, the fund must pay above-market prices for mortgage-backed securities; if it paid market prices (about 22 cents on the dollar, based on the largest known recent transaction), that would simply trigger the massive write-downs that everyone fears. Because there is no competition for this fund, and no one involved is planning to raise another, the second incentive doesn't apply. Worse, the Treasury-appointed fund managers negotiating with banks to buy their mortgage-backed securities not only come from those banks but will almost certainly be looking for jobs at those banks once the need for the fund has passed, creating enormous potential conflicts of interest.

While the usual mechanisms for aligning incentives are unavailable, the stakes are unprecedented. Every dollar that the fund loses is a dollar handed from taxpayers to the banks and their shareholders. While previous bailouts, including that of AIG, have been designed to give the government at least some of the potential upside, the only upside here is that these securities may turn out to be worth more in the long term than the market thinks they are worth today. Despite this possibility, paying more for something than anyone else is willing to pay is, simply put, a sucker's bet. It is most likely that "governance" over the fund will be provided by periodic hearings of the relevant Senate and House committees during which the Treasury secretary and the fund managers will be asked why they overpaid for banks' securities and will answer that there was no choice if the financial system was to be saved.

While there is still time, Congress should consider alternative means of aligning incentives. For example, lawmakers could set a target for what return the fund is expected to get, and managers' compensation could be tied to their actual return relative to that target. Would-be fund managers should bid in an open process what target return they are willing to base their compensation on -- the management company that is willing to accept the highest (or least negative) target for a set of assets would get the contract for those assets.

In any case, the fund should provide full disclosure of the securities it buys, its valuation of them and the price paid, which would help ensure that the fund is managed in the country's best interests. Its leaders should be open about overpaying relative to market price, and on that basis, the fund should receive preferred stock in any participating bank. This would, among other things, give taxpayers some much deserved and long overdue potential upside.

Are short-sellers really to blame? September 23, 2008

The world may soon find out if short-sellers really are the scoundrels they have been made out to be.

In the past few days, regulators in the United States, Britain, Canada and Germany have imposed unprecedented temporary bans on the short-selling of financial shares as they seek to head off what is threatening to be the worst financial turmoil since the Great Depression.

The regulators blamed short-sellers for the rapid decline last week in the share prices of major banks like Morgan Stanley. For financial markets already reeling from the collapse of Bear Stearns and Lehman Brothers, the declines led to questions about whether more big banks would falter and worsen a credit markets freeze that threatens the broader economy.

At first, the short-selling crackdown helped stocks.

But after rising more than a combined 700 points on Thursday and Friday, the Dow Jones industrial average fell 372.75 points, or 3.3 percent, on Monday. Banking stocks, supposedly protected from short-selling, were hit hard, with Bank of America down almost 9 percent and JPMorgan Chase losing more than 13 percent.

Although far from conclusive, the drop illustrates that there can be very bearish days without short-selling being allowed across a big part of the market.

The ban "will result in exactly the opposite in what they want to achieve," said Doug Kass, a short-seller who is founder and president of Seabreeze Partners Management, a hedge fund. "It will scare the longs into selling, exacerbating stock price declines."

Short-sellers have been blamed for nearly every financial meltdown since the 1929 crash, but it has often been debated whether this is because they were either smart or lucky enough to profit while others struggled, or because they spread malicious rumors and provoked bear raids on quality companies.

Now, the short-sellers are being singled out again. The emergency order in the United States that halted short-selling in nearly 800 financial stocks was issued early Friday and effective immediately. The order runs through Oct. 2 and may be extended by the agency if needed. The order can last a total of 30 calendar days.

And since the SEC issued the order, nearly 100 companies, including General Electric, have been added to the ban. But there are concerns that regulators do not fully understand the forces they have unleashed with the ban.

Critics say they are interfering with the basic functioning of the markets, including taking away liquidity provided by the short-sellers, at a time when things are already enormously shaky.

"My concern is that a total ban really does not comport with free market principles," said Harvey Pitt, who was the chairman of the SEC when U.S. markets fell after the Sept. 11, 2001, terrorist attacks.

In addition, the ban may cause "dislocations in our markets that don't need to have been created this way," Pitt said. "There are a lot of people who are engaging in entirely appropriate short-selling activities."

The potential harm, short-selling experts say, comes from discouraging any short-selling. Because short-sellers borrow shares and have to buy them back later, they represent forced buying in the market, purchasing shares when no one else will.

"We are very concerned that these emergency orders will not enhance long-term market integrity, nor will they address the fundamental economic issues that have been afflicting our financial sector," said James Chanos, a prominent short-seller and president of the hedge fund Kynikos Associates. "Simply put, short-selling is a vital investment strategy that responds to market fundamentals and contributes to the integrity of stock prices."

Chanos was one of the first to point out concerns about the accounting at Enron, the energy-trading company that collapsed in 2001.

In sophisticated markets like the United States, there rarely have been restrictions on short-sellers like the ones made last week.

Christopher Cox, chairman of the SEC, justified its drastic action by saying the ban would restore equilibrium to markets.

The commission said: "Under normal market conditions, short-selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short-selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation."

Bailout is financial equivalent of the Patriot Act

September 23, 2008

The passage is stunning:

"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency," the original draft of the proposed bill says.

And with those words, the Treasury secretary - whoever that may be in a few months - would be vested with perhaps the most incredible powers ever bestowed on one person over the economic and financial life of the United States. It is the financial equivalent of the Patriot Act, after 9/11.

Treasury Secretary Henry Paulson Jr.'s $700 billion proposal to bail out Wall Street is both the biggest rescue and the most amazing power grab in the history of the American economy.

In many ways, it is classic Wall Street: a big, bold roll of the dice that one trade can save the day. But at the same time, the hypocrisy is thick. The lack of transparency and oversight that got our financial system in trouble in the first place seems written directly into the proposed bill, known as TARP, or the Troubled Asset Relief Program.

Just take a look at the original draft: "The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this act," the proposed bill read when it was first presented to Congress, "without regard to any other provision of law regarding public contracts."

It goes on to say, "Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure."

Slowly but surely, as new versions of the bill are making the rounds in Washington, some legislators are pressing to include new language to give them at least a modicum of oversight. Democrats have complained that the bill gives the Treasury Department "a blank check" - and they're right.

But given the rush to push the bill through, even if Congress cobbles together some oversight language, it will almost surely be inadequate.

Joshua Rosner, a managing director at Graham Fisher, says TARP should stand for "Total Abdication of Responsibility to the Public." He calls it "a clear abdication of all congressional oversight and fiscal authorities to a secretary of Treasury that has bungled this crisis from the beginning."

He argues that the bill grants "greater powers to the secretary of the Treasury than even the president enjoys."

The bigger issue is that the bill effectively creates protections not just for the Treasury, but for the executives on Wall Street who created this near Armageddon. Rosner says the draft bill "prevents judicial review that could allow the protection of decisions that create false marks, hide prior marks, or could be used to prevent civil or criminal prosecution in situations where a management knowingly provided false marks that aided the growth of this crisis of confidence."

False marks - using mark-to-market accounting to hide the true value of security, rather than disclose it honestly - has a lot to do with why Jeffrey Skilling, the former Enron chief executive, is in jail.

It is absolutely true, of course, that Paulson needed to do something. By Thursday afternoon, less than 48 hours after the bailout of American International Group, the financial system was near meltdown. The mere rumor that Paulson and the Federal Reserve chairman, Ben Bernanke, were devising a big bailout fund cause the stock market to soar.

In truth, I'm not sure I agree with Rosner's assessment of Paulson's job performance. I think he is one of the most competent Treasury secretaries we've ever had, and it is hard to imagine anyone else handling this crisis any better. His predecessors, who lacked his grounding in the world of high finance, would most likely have been like deer in headlights.

And when Paulson says, as he did on all the television talk shows Sunday, "I hate the fact that we have to do it, but it's better than the alternative," I believe him. (It would have looked better, of course, if he had come up with this plan before it looked as if his former firm, Goldman Sachs, was in jeopardy.)

But the question on the table now is whether the government's latest response to this crisis - the way it has been constructed, and frankly, the way it is being crammed down everyone's throat at the eleventh hour - is the right approach. Already the market has its doubts; just look at its performance Monday.

Let put aside the bill's most offensive aspect - the raw power it gives the Treasury Department, and the lack of oversight it provides - and take a closer look at the practicalities. First off, there is nothing in the bill that will prevent these problems from happening again.

The bill doesn't address adding greater transparency in investments in subprime loans and securities and credit derivatives, which led directly to the debacles at Lehman and AIG. The bill does nothing to rein in the credit-default swap market, which has turned out to be the weapon of financial mass destruction that Warren Buffett always said it was.

Nor are the Democrats going to help matters with their own changes.

It is all well and good that they hope to use the bill to restrain executive compensation, and add stipulations to help people in danger of losing their homes. But nothing the Democrats have suggested so far tackles the core issues of oversight, transparency or regulation.

Of course, the sickest part is that Wall Street is lining up at the trough for a piece of the action, lobbying to run some of the $700 billion fund - and take huge fees - for their own mess.

However the bailout is structured, no matter what safeguards are put in place, it is likely to be a conflicted mess. How can we possibly trust that the price the government agrees to buy the securities will be fair?

And then there is the jockeying among the banks so they can sell their absolute worst stuff to the government - even loans that have nothing to do with mortgages - and change the rules in the process.

The Financial Services Roundtable, which represents big financial services companies, wrote an e-mail message to members Sunday suggesting, laughably, that "the government bid for the assets should not count as a mark-to-market value for accounting purposes."

In other words, if the government drives a hard bargain - as it should - the banks don't have to take write-downs based on the price the feds pay to take junk off their balance sheets.

Watching Wall Street double-dip makes even some in the industry's top tier cringe.

"Maybe I should move to Russia," one titan of finance said to me. "It's obscene, the whole thing. I'm embarrassed for myself."

Actually, I've got a better suggestion: Venezuela.

On Friday last week, Hugo Chávez, the Socialist president of Venezuela, gave a speech in Caracas where, according to Reuters, he said, "The United States has spent $900 billion, four times what Venezuela produces in a year, to try to boost the troubled finance system and housing market."

Gloating, he added: "They have criticized me, especially in the United States, for nationalizing a great company, Cantv, that didn't even cost $1.5 billion."

U.S. rescue for mortgage industry, but not for homeowners September 23, 2008

Even if the U.S. Treasury Department reaches agreement with Democratic leaders in Congress on its $700 billion proposal to rescue the mortgage industry, housing experts warned Monday that the plan might do little to help troubled borrowers stay in their homes.

As lawmakers in the House of Representatives and Senate struggled to reach a deal with the administration of President George W. Bush, one of the most vexing battles was how much the plan should balance a rescue of financial institutions with a rescue of homeowners facing foreclosure.

Henry Paulson Jr., the Treasury secretary, has placed top priority on bailing out financial institutions by buying soured mortgages and mortgage-backed securities, so banks and other lenders can clean up their balance sheets and get back to normal lending.

But Democrats insist that the Treasury also help restructure many of those loans, by lowering the interest rate or the loan amount, to make the mortgages affordable and reduce the number of people who lose their homes through foreclosure. The Bush administration has been lukewarm to that idea, but many housing and mortgage experts say the government would have a difficult time modifying mortgages even if it were eager to do so.

The vast majority of subprime mortgages - 90 percent or more, by some estimates - are inside giant pools, or trusts, which have in turn sold bonds with different levels of seniority to institutional investors around the world.

Even if the government acquired hundreds of billions of dollars worth of mortgage-backed securities, finance experts said, the Treasury would be unlikely to acquire all the bonds tied to a particular mortgage pool. And if the government did not own all those bonds, it might not have the power to demand changes in the underlying mortgages.

"We are literally spending hundreds of billions of dollars on subsidies for financial institutions," said Christopher Mayer, a professor of real estate finance and vice dean at the Columbia Business School. "This won't do anything to help the housing market. This plan is about buying mortgage-backed securities, not mortgages, and there is a big difference."

Amanda Darwin, a partner at the law firm of Nixon Peabody who specializes in both bankruptcy and securities law, said that the Treasury was likely to become bogged down in legal problems if it tried any relief more radical than the cautious framework adopted earlier this year by the American Securitization Forum, an industry group.

"In order to modify loans beyond that framework, you have to have the consent of 100 percent of the holders of the affected securities," Darwin said. And some of those investors, especially those holding senior securities that are shielded from many of the losses, may not want to sell out or make concessions.

Because of that problem, congressional Democrats are also demanding that the final bill change the bankruptcy law to give troubled homeowners more bargaining power with their lenders.

Proposals put forward by Representative Barney Frank, the Democrat who is chairman of the House Financial Services Committee, and Senator Christopher Dodd, the Democrat who is chairman of the Senate Banking Committee, would allow bankruptcy judges to reduce a person's loan amount or interest rate in much the way that bankruptcy judges decide how much money most other creditors receive.

Bankruptcy courts have long been prohibited from modifying the terms of mortgages on a person's primary residence. Community advocates and consumer groups have argued for months that changing the law would cut through the tangle of legal conflicts involving most mortgages and give borrowers a big increase in their bargaining power with lenders.

"That is by orders of magnitude the best thing that can be done to keep people in their homes," said Eric Stein, senior vice president of the Center for Responsible Lending, a nonprofit group based in North Carolina.

On Monday, 30 community and consumer groups from around the country sent an open letter to lawmakers to press their case.

"It is an illusion to assume that bailing out financial institutions is the same thing as providing relief to foreclosure-plagued American homeowners," said the groups, which included the Consumers Union, the National Council of La Raza and the Leadership Conference on Civil Rights.

But Paulson and the Bush administration remain firmly opposed to the proposal, known informally as a cram-down, saying it would frighten even more investors away from the mortgage market.

The banking and securities industries, meanwhile, are fighting the change with all their might, as they did when it came up with the housing bill that was adopted in July.

"Authorizing write-downs of mortgages by bankruptcy judges will increase the risks of mortgage lending at a time when the market is already struggling, and this will harm consumers," Floyd Stoner, a top lobbyist for the American Banking Association, wrote in a statement on Monday.

Economists see need for a penalty in bailout package September 23, 2008

As economists puzzle over the proposed details of what may be the biggest financial bailout in U.S. history, the initial skepticism that greeted its unveiling has only deepened.

Some are horrified at the prospect of putting $700 billion in public money on the line. Others are outraged that Wall Street, home of the eight-figure salary, may get rescued from the consequences of its real estate bender, even as working families give up their houses to foreclosure.

Most economists accept that the U.S. financial crisis — the worst since the Great Depression — has reached such perilous proportions that an expensive intervention is required. But considerable disagreement centers on how to go about it. The Treasury's proposal for a bailout, now being negotiated with Congress, is being challenged as fundamentally deficient.

"At first it was, 'thank goodness the cavalry is coming,' but what exactly is the cavalry going to do?" asked Douglas Elmendorf, a former Treasury and Federal Reserve Board economist, and now a fellow at the Brookings Institution in Washington. "What I worry about is that the Treasury has acted very quickly, without having the time to solicit enough opinions."

The common denominator to many reactions is a visceral discomfort with giving Treasury Secretary Henry Paulson Jr. — himself a product of Wall Street — carte blanche to relieve major financial institutions of bad loans choking their balance sheets, all on the taxpayer's bill.

There are substantive reasons for this discomfort, not least concerns that Paulson will pay too much, thus subsidizing giant financial institutions. Many economists argue that taxpayers ought to get more than avoidance of the apocalypse for their dollars: they ought to get an ownership stake in the companies on the receiving end.

But an underlying source of doubt about the bailout stems from who is asking for it. The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress.

"This administration is asking for a $700 billion blank check to be put in the hands of Henry Paulson, a guy who totally missed this, and has been wrong about almost everything," said Dean Baker, co-director of the liberal Center for Economic and Policy Research in Washington. "It's almost amazing they can do this with a straight face. There is clearly skepticism and anger at the idea that we'd give this money to these guys, no questions asked."

Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college.

Some are suspicious of Paulson's characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress's failure to act. This time, it is financial Armageddon supposedly on the doorstep.

"This is scare tactics to try to do something that's in the private but not the public interest," said Allan Meltzer, a former economic adviser to President Ronald Reagan, and an expert on monetary

policy at the Carnegie Mellon Tepper School of Business. "It's terrible."

In part, Paulson's credibility has been dented by his pronouncements in previous weeks that the crisis was already contained. Some suggest this was a well-intentioned effort to stem panic. But the aftermath complicates his quest for the bailout.

"If you view your public statements as an instrument of policy, people don't believe you anymore," said Vincent Reinhart, a former Federal Reserve economist and now a scholar at the conservative American Enterprise Institute.

The biggest point of contention is over whether and how taxpayers would benefit if the bailout succeeded in righting the financial system, sending banking stocks upward.

In Paulson's plan, the Treasury would have the right to buy as much as $700 billion worth of troubled investments, with the taxpayer recouping the proceeds when those investments were sold over coming years. But many economists — Elmendorf among them — argue that taxpayers should get more out of the deal, securing stock in the banks that make use of the bailout. The government could then sell off that stock at a profit when conditions improve. A similar approach was used successfully in Sweden in the early 1990s when its financial system melted down.

Others argue that any bailout must pinch the people who have run the companies now needing rescue, along with their shareholders, addressing the unseemly reality that executives have amassed beach houses and fat bank accounts while taxpayers are now stuck with the bill for their reckless ways.

"It absolutely has to be punitive," Baker said. "If they sell us the junk, then we own the company. This isn't a way to make these companies and their executives rich. This should be about keeping them in business so the financial system doesn't collapse."

Other questions center on how to value what the Treasury aims to purchase — an issue that goes to the heart of the crisis itself.

The financial system got to its dangerous perch by betting extravagantly on real estate. When housing prices began plummeting and borrowers stopped making payments, financial institutions found themselves with huge inventories of bad loans. Not simple loans, but complex investments created by pooling millions of mortgages together and then slicing them into pieces. These were the investments that Wall Street bought, sold and borrowed against in cooking up the money it poured into housing.

The trouble is that these investments are so intertwined and complex that no one seems able to figure out what they are worth. So no one has been willing to buy them. This is why banks have been in lockdown mode: with mystery enshrouding both the value of their assets and their future losses, banks have held tight to their remaining dollars, depriving the economy of capital.

Now, the Treasury aims to clear the fog by buying up these investments. But their value is as mysterious as ever.

"There's a tendency for people to think these are stocks and bonds and you know what the price is," said Bruce Bartlett, a former White House economist under Reagan. "The problem is people are operating in a world in which nobody knows what the hell is going on. There are some naïve assumptions about how this would function."

If Paulson pays the market rate — whatever that is — that presumably would not be enough to persuade banks to sell. Otherwise, they would have sold already. For the plan to work, Treasury has to pay a premium.

"It's a straight subsidy to financial institutions," said Martin Baily, a former chairman of the Council of

Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings Institution. "You're essentially giving them money."

Baily favors the basics of the Paulson plan, albeit with some mechanism that would give the government a slice of any resulting profits. And yet he remains troubled by the dearth of information combined with the abundance of zeroes in the bailout request.

"I'd like a clearer statement of what we were afraid was going to happen that requires $700 billion," Baily said. "Maybe they don't want to talk about it because it would scare everybody, but it's a bit much to ask."

Congress grills Paulson and Bernanke on bailout

Sept.24th

The Treasury secretary, Henry Paulson Jr., faced a deeply skeptical audience Tuesday when he appeared before the Senate Banking Committee to defend the $700 billion plan to rescue the battered U.S. financial system.

"This is not something I ever wanted to ask for, but it is much better than the alternative," Paulson said.

Appearing alongside the chairman of the Federal Reserve, Ben Bernanke, and other senior officials, he urged lawmakers "to enact this bill quickly and cleanly, and avoid slowing it down with other provisions that are unrelated or don't have broad support."

Both men warned that without a drastic government intervention, the financial markets would be paralyzed, further hobbling the economy, costing jobs, and impeding hopes of a recovery.

"This is a precondition for a good, healthy recovery of our economy," Bernanke said. "We need to act to stabilize the situation, which is continuing to be very unpredictable and worrisome."

But one after another, senators from both parties said that, while they were prepared to move fast, they were far from ready to give the administration of President George W. Bush everything it wanted in its proposed $700 billion plan to buy and hopefully resell troubled mortgage-backed securities.

Senator Christopher Dodd, Democrat of Connecticut and chairman of the Banking Committee, called the Treasury proposal "stunning and unprecedented in its scope and lack of detail."

Asserting that the plan would allow Paulson to act with "absolute impunity," Dodd said, "After reading this proposal, I can only conclude that it is not only our economy that is at risk, Mr. Secretary, but our Constitution, as well."

Another expression of disgust came from Senator Jim Bunning, Republican of Kentucky, who said the plan would "take Wall Street's pain and spread it to the taxpayers." He added, "It's financial socialism, and it's un-American."

Investors were also taking a wait-and-see attitude to the package. After a steep slide on Monday, European markets closed down again Tuesday, while afternoon trading was moderately lower on Wall Street. Oil and gold prices also retreated. (Page 20)

In Washington, Dodd called the crisis "entirely foreseeable and preventable, not an act of God," and said that it angered him to think about "the authors of this calamity" walking away with the proverbial golden parachutes while taxpayers bore the cost.

"There is no second act on this," Dodd said, acknowledging that speed was important. But it is more important, he said, "to get it right."

Paulson said in response to questions that he shared the senators' exasperation.

"I'm not only concerned, I'm angry" over the events that led to the problem, Paulson said. He blamed an outdated regulatory system for the turmoil and, in an attempt to counter any impression that the proposed rescue plan was for the benefit of fat-cats on Wall Street, said: "This is all about the taxpayers. That is all we are about."

Paulson said that "this troubled-asset purchase program is the single most effective thing we can do to help homeowners, the American people, and stimulate our economy."

He and Bernanke said that the problems in the housing industry were the core of the crisis but that the problems would continue to spread far outside the housing sector if the problems in the mortgage markets were not addressed, and soon.

Bush, speaking in New York before the markets opened, expressed confidence that Congress would agree on a financial rescue plan and left open the possibility of accepting amendments being proposed by Democrats.

"Now there's a natural give and take when it comes to the legislative process," Bush said. "There are good ideas that need to be listened to in order to get a good bill that will address the situation."

In a statement released earlier in the day, Bush said he had reassured worried world leaders that the United States had the "right plan" to deal with the crisis.

Vice President Dick Cheney was at the Capitol on Tuesday morning, trying to round up support for the administration's package. But the senators on the banking panel were unanimous in calling for ways to protect taxpayers' investments - which, at $700 billion, would amount to $2,300 for every U.S. citizen, said Senator Mike Enzi, Republican of Wyoming.

Democrats and Republicans are eager to include legislation that would protect mortgage holders, cut the salaries of executives at Wall Street firms and prevent a breakdown of the financial system.

Senator Richard Shelby of Alabama, the ranking Republican on the banking panel, expressed disdain for regulators "who sat on the sidelines" as the crisis was building. He recalled, too, that Alan Greenspan, the former Federal Reserve chairman, once told him that the rate of borrowing in the U.S. economy and the high percentage of their incomes that many people were spending on their homes posed "a rather small risk to the mortgage market."

Shelby complained that the emerging program seemed to be "a series of ad hoc measures," rather than the kind of comprehensive approach that was needed.

The back-and-forth came as the Bush administration and congressional leaders moved closer to some kind of agreement on the bailout, including tight oversight of the program and new efforts to help homeowners at risk of foreclosure.

But Congress and the administration remained at odds over the demands of some lawmakers, including limits on the compensation of top executives, and new authority to allow bankruptcy judges to reduce mortgage payments for borrowers facing foreclosure.

Congressional leaders and Treasury officials also said they were close to an agreement over a proposal by some Democrats in which taxpayers could receive an ownership stake, in the form of warrants to buy stock, from companies seeking to sell distressed debt to the government.

Bernanke's testimony was exceptionally brief, considering the enormous stakes involved, a mere nine paragraphs, much of it devoted to a recapitulation of the growing crisis and how it took shape.

It seemed to reflect the way Paulson and the administration have presented the legislation, in bare-bones fashion, but with a clear tone of urgency.

The White House has begun intensive lobbying to persuade nervous lawmakers to support the plan. Joshua Bolten, the White House chief of staff, and Keith Hennessy, the chairman of Bush's National Economics Council, were also scheduled at the Capitol on Tuesday.

Tony Fratto, the White House deputy press secretary, told reporters there was a "great sense of urgency" to get the legislation passed this week.

Lawmakers challenge the proposed bailout plan

September 24, 2008 The White House waged a multi-front campaign Tuesday to persuade Congress to accept its vast bailout plan, with President George W. Bush telling world leaders that the United States had taken "bold steps" to stanch the financial crisis while Vice President Dick Cheney and other top officials went to Capitol Hill to try to persuade reluctant lawmakers. Treasury Secretary Henry Paulson Jr. and the chairman of the Federal Reserve Board, Ben Bernanke, faced five hours of grilling by skeptical, angry members of the Senate Banking Committee. In blunt terms, Bernanke warned the senators that if they failed to pass the $700 billion plan, they risked causing a recession, increasing joblessness and pushing more homes into foreclosure. "This will be a major drag on the U.S. economy and greatly impede the ability of the economy to recover," Bernanke said. The lawmakers objected strenuously to the broad authority Paulson was requesting, the lack of additional steps to help homeowners avoid foreclosure and the absence of any demands for ownership stakes in the banks that are helped. But with Congress and the administration negotiating intensely behind the scenes to resolve these and other major sticking points in the plan, some of the drama was intended for hometown audiences, six weeks before lawmakers face an election. Even Senator Richard Shelby of Alabama, the senior Republican on the banking committee and one of the most vocal critics of the proposal, said he expected Congress and the White House eventually to reach a deal. "I think Congress will react positively at the end of the day," he said. "But in what form, we're not sure yet."

House Speaker Nancy Pelosi; the Senate majority leader, Harry Reid of Nevada; and other Democratic leaders met Tuesday afternoon to form a strategy for bringing the bailout legislation to the floors of both chambers later this week. But there was no clear road map by the end of Tuesday. House Republicans seemed the least receptive of all. Cheney led a delegation from the White House to meet with House Republicans on Tuesday morning, including the chief of staff, Joshua Bolten, and the budget director Jim Nussle. But the visit did little to quiet a rising chorus of doubts. "My sense is that the meeting did not abate the growing discontent," said Representative Mike Pence, Republican of Indiana, who opposes the plan. Representative John Boehner of Ohio, the Republican leader, said that there seemed to be little appetite for the bailout among his conference. Still, he said that swift action was needed and he remained committed to a deal. To help win some votes, Paulson agreed to speak to House Republicans on Wednesday morning, after which he and Bernanke must give a repeat performance before the House Financial Services Committee, an audience that could prove even more hostile than the Senate banking panel. On Tuesday, Paulson rushed from the banking committee hearing to meet with Republicans at their weekly lunch. He faced tough questioning but many lawmakers emerged from the meeting expressing support. "We're anxious to act, and to act quickly, to restore confidence in the markets and in our country," Senator Mitch McConnell of Kentucky, the Republican leader, said after the meeting. Democrats, however, grew concerned that a lack of Republican support, particularly in the House, could leave them in an undesired alliance with the Bush administration. Reid, at a news conference, said Democrats were waiting for Republicans to signal that they had enough votes to support the bailout. "We have all heard what went on over in the House today," Reid said. "It was a scene of disarray. So we need the Republicans to start producing some votes for us." Before that happens, however, lawmakers were waiting to see a final version of the plan. Democrats were pushing hardest for provisions that would require the Treasury to obtain warrants that would convert into equity in the companies helped and limits on the salaries of executives whose firms participate in the bailout. Both presidential candidates, Senator Barack Obama and Senator John McCain, have called for such limits, as has Shelby, making it more likely that Treasury will have to find some form of compromise on this issue.\"The party is over for this compensation for CEO's who take golden parachutes as they drive their companies into the ground," Pelosi said. The White House is eager for a deal on the plan, recognizing that markets around the world are fluctuating daily, depending on how investors assess the United States' response to the crisis. In his speech to the United Nations, Bush said, "I can assure you that my administration and our Congress are working together to quickly pass legislation approving this strategy." He added, "And I'm confident we will act in the urgent time frame required." Along with Cheney, and Bolten, Bush dispatched Keith Hennessey, the director of Bush's National Economic Council, to Capitol Hill. Tony Fratto, Bush's deputy press secretary, told reporters that it was imperative that Congress pass a bill this week. Asked what would happen if Congress fails to act this week, he said, "You should think of that as unthinkable." Reflecting their frustration, and perhaps the narrowness of their options, the lawmakers peppered Paulson and Bernanke with questions ranging from whether the rescue would work to whether it would end up bailing out Wall Street on the backs of taxpayers. "I get some sense that we're flying by the seat of our pants," said Senator Robert Menendez, Democrat of New Jersey. "You want to come in strong and have the cavalry be there, but you're not quite sure what the cavalry does once it arrives. And that's part of my concern."

Senator Charles Schumer, Democrat of New York, proposed limiting financing to $150 billion, and budgeting more in three months, after its progress could be assessed. Several senators said they thought the best way to protect taxpayers was by requiring the Treasury Department to take warrants, which are instruments that are convertible into shares, as it did in its rescue of Fannie Mae, Freddie Mac and the American International Group. But Paulson said that could limit participation in the program, especially if companies decided to hold onto their troubled assets rather than cede some control to the Treasury Department. If that happened, Paulson said, the program would not do enough to get the market moving again. But he and Bernanke did not do much to clear up confusion about how the bailout plan would work in practice. Bernanke, an economist, gave a tutorial on valuation of assets, distinguishing between those sold at fire-sale prices — what a portfolio of mortgages would sell for if the cash were needed immediately — and those at hold-to-maturity prices, or what the same portfolio would fetch on the assumption that the underlying debt would be repaid. To unclog the market, he said, the government would have to determine the hold-to-maturity price for assets with no other buyers. "Just as you sell a painting at Sotheby's, until you sell it, nobody knows what it is worth," Bernanke said. He described a system of reverse auctions, in which the Treasury would name a price it was willing to pay, and the banks would decide whether to sell. Paulson said the government would also use other methods, depending on the assets involved, and was open to experimentation. Both officials pleaded with Congress not to tie the government's hands by writing any particular sales method into the bailout legislation. House Democrats were also reviving their push to grant bankruptcy judges the authority to modify the terms of mortgages on a primary residence, to lower payments for strapped borrowers. Several senators challenged Paulson on why the Treasury should help foreign banks with operations in the United States. He said he was "leaning on" countries to devise their own programs, but that this plan needed to be open to any banks active in the United States. "The American public, when they're dealing with the financial system, doesn't know who owns that bank," he said. None of the senators who listened to Paulson and Bernanke disputed the grim possibilities if Congress should do nothing, but it was clear they were hearing from angry constituents. On perhaps the day's most pressing question — will the plan work? — Paulson and Bernanke could offer only hope. "I do believe it is our best shot," Bernanke said. Paulson quickly added, "It's not only our best shot; we're going to make it work."

Hard landing / the real crisis may not have hit yet (from Haaretz-Jerusalem 9/24)

At the height of the subprime crisis but still before the great crash, a certain kind of derivative was still circulating in the international markets, a securitized certificate called a "CDO squared." These were collateralized debt obligations (CDOs) comprised of other CDOs whose underlying collateral included residential mortgage backed securities. Alternatively, they were bonds based on chunks of mortgage loans being sold for the third time. How on earth do you do that? You bundle together a huge package of subprime mortgage loans and divide it into 16 unequal chunks. At one end you have the chunk of loans that will almost certainly be repaid, and at the other end the shakiest loans. You sell each chunk onward through bonds whose ratings range from AAA (blue-chip) to BBB (doghouse).

But it doesn't end there. Now, you repackage all those BBB chunks together into a huge pile, divide it into 16 unequal chunks and sell it again as separate bonds. And, believe it or not, the credit rating agencies gave the most superior part of this dodgy stuff an AAA rating, while the most inferior got BBB. But even that that isn't where it ends. Now, you bundle all those inferior BBB chunks together into a huge pile, repackage and split it again and sell it again. You guessed it: the credit rating agencies gave the most superior part of this icky stuff a senior AAA rating. And that, dear reader, is a CDO squared. The most inferior stuff was sold again and again in two rounds of securitization and were rated at levels reserved for U.S. government debt. The rules of economics are that demand creates supply. The fact that there were investment banks and commercial banks that carried out the financial engineering, and sold squared garbage at an AAA rating, is structural. Banks have no sentiments. If you'll buy it, they'll sell it. The less understandable aspect of all this is, who on earth was buying this toxic stuff? Who agreed to spend hard-earned money on rubbish squared? You were, that's who. Not directly, perhaps - you didn't waltz into your back begging to buy stinking fish. Happily, Israel's capital market is an immature thing, so these financial finagles didn't cross the ocean. But the widows and orphans of America bought these hybrids through their provident and mutual fund and hedge fund holdings. Ah, you sigh, why should you care? That's their problem. But you're wrong. The mechanism by which America's fund managers bought the alchemical sludge without asking silly questions is the same mechanism that our provident and mutual funds use in Israel. It's the same mechanism driving our bankers and brokers, who by a miracle were spared the hideous wrath of the markets. The mechanism is humanity. Banks such as UBS bought billions of dollars worth of the engineered sludge because they're staffed by humans. They may be highly educated and clever humans with degrees in economics and statistics (which should have taught them about the fallacy of alchemistry), but they're just humans with that basic human craving: to make a buck. The root of the problem is basic. What motivated the finance sector employees? Was it the greater good of their customers - the investors, the shareholders? No, it wasn't. The brokers and their customers were at odds, and that was the root of all evil. Savers and shareholders want to earn money over years, at a reasonable level of risk. The finance sector employees wanted to earn as much money as possible as quickly as possible, and let long-term profit go hang. And thus the demand for the CDO squared was born. It was demand created by people driven by one thing only: achieving the highest possible returns in the shortest possible time and to hell with the risk. Interest rates around the world were very low: It was hard to make a killing through more ordinary avenues. Also, the investment banks were in a cutthroat contest over who could make the highest returns, resulting in the fattest bonuses. No wonder Wall Street shut its eyes and gorged on these mutated derivatives.

Make no mistake, much the same happened in Israel too, but luckily for us the derivatives were a lot less dangerous. Here too the contest to achieve the highest returns led to obliviousness to risk. Institutional investors gorged on corporate bonds. Provident funds today have put as much as half their managed assets into corporate debt, instead of into safer Israeli government debt, just because the companies were offering slightly higher interest rates. Institutional investors are believed to have bought NIS 11 billion worth of ungraded (read, high-risk) debt in the last few years. If it was a corporate bond and it twitched, somebody would swallow it, no matter how inferior its flavor. And we will be paying the price of this gluttony for years to come as the companies default on debt. Why did this happen? Because the competition between the investment banks focused on the wrong thing, from our perspective. All they cared about was achieving the highest profit in a given year. But all we savers care about is achieving the highest profit over time. The gap between the two is all about risk. To achieve fast gains means to take high risks and to lock in gains over the long-term is to settle for lower risk. One lesson is that the way a financial firm's results is measured must change, to factor in risk criteria. Profit must be measured not in net terms, but adjusted for risk. Also, the way the bankers and brokers running our money are remunerated must also change. They cannot be allowed to earn millions plus options plus golden parachutes if they fail us, the long-term savers. A paycheck of millions in a country with social gaps like Israel's is not merely immoral; it causes actual economic damage. Pay incentives at the banks and brokerages must be linked to long-term achievement, to link between their aspirations and ours.

Hard landing / a cry for common sense

What asset is safer for investment: illiquid bonds issued by a foreign country, or bonds backed by American subprime mortgages? That might have been a tough one once upon a time but today, every Tom, Dick and Yossi would answer without even thinking about it, bonds issued by a foreign country, even if they're illiquid (which means, you can't just up and sell them). In fact, in a world where structured financial instruments managed to destroy the entire industry of investment banking as well as the biggest insurance company in the world - blind instinct would counsel that almost anything is better than derivatives on debt. The thing is, the person who manages your pension find may not see things that way. Nor is it his fault, poor thing. The rules governing risk among Israel's institutional investors state that when it comes to liquidity risk (meaning, you may get stuck with the merchandise), illiquid government bonds are as hazardous as weird derivatives. Now, when it comes to rating the liquidity of bonds issued by foreign companies - never mind whether they're the biggest, most blue-chip companies in the world - the rule for institutionals is that they are inferior in grade to bonds issued by Israeli companies with bottom-crawling ratings of BBB. If you're hopelessly lost in the intricacies of risk rating and its ramifications, it isn't your fault, poor thing. Risk rating rules were written in a way that only experts could possibly understand. If pressed to the wall, they don't understand them either. The subprime morass exposed the bitter truth: the people who are supposed to have the greatest understanding hadn't understood anything at all.

Some even claim that the present mess was born of sheer embarrassment - the embarrassment of directors unable to admit they were baffled by the convoluted derivatives their young employees were pushing. No executive can admit that he's less clever than some junior staffer and can't understand the statistical models underlying the kid's product. Thus directors and executives allowed junior employees to get into activities they couldn't comprehend and therefore couldn't possibly supervise. So the next time you read a report by the manager of some structured note you were persuaded to buy, saying something like "As stated in the pricing statements of the respective series of notes, Lehman Bros is the guarantor under the swap accord which the issuer had entered into with Lehman Cousins Special Shoelaces. The issuer entered into the swap pact to enable it to meet its payment and other duties under such notes. Under the swap agreement the fact that Lehman Bros Holdings has filed for bankruptcy protection gives the issuer the right to decide to terminate the swap transactions which will in turn trigger early redemption of the notes" and it's Greek to you - don't be embarrassed. No: Feel angry. Feel very angry at the regulators whose ass-covering mechanism called "proper disclosure" enables companies to issue gibberish as statements to investors that nobody could possibly understand. The fact that you can't understand the announcements that companies issue to the stock exchange, and that you can't really understand the risk level at which your pension money is being managed, says nothing bad about you. It does say a lot of bad things about the supervision of the capital market. Your inability to understand the jargon being spouted enabled market players to play you. It enabled them to sell you bad assets at bad prices without you understanding. But you weren't the only victim. The incomprehension and obtuseness rose to the highest levels of Wall Street and ultimately brought down the monsters that created it: the investment banks, the commercial banks and the hedge funds. At the end of the day it was the sheer inability to understand that brought down Wall Street, and that has almost brought down the entire global economy. The pride and inability of managers to admit that they simply couldn't understand, mushroomed from a human frailty into a macroeconomic hurricane that required the intervention of global authorities. Ascertain that the people responsible for pricing assets use good judgment and don't rely solely on technical means to evaluate the assets, counsels the Institute of International Finance, which is the umbrella organization of the world's banks, discussing the roots of the present crisis. In July the IIF issued a document that relates to the human element behind the crisis. The roots of evil were opacity and poor understanding, it concluded. Everybody relied on mathematical models to price risk instead of using common sense when evaluating the assets. The result was that the global capital markets turned into a sort of pyramid scheme: Everybody passed on high-risk assets that nobody thoroughly, fundamentally understood and finally, everybody fell down together. Following that train of thought, the IIF decided that it should be the responsibility of mortgage

lenders to apply the same credit checks on borrowers, whether the lender kept the loan or sold it onward through securitization. One cause of the crisis was that this very basic rule was not followed. In the same spirit, the IIF ruled that institutional investors around the world had relied too much on the risk ratings of assets. They bought and sold assets relying solely on assessments of credit rating agencies, without checking the merits of the assets themselves. The IIF therefore recommends that institutional investors actually study assets they're thinking of buying, and develop their own risk evaluation models. Nor does the IIF spare its contempt from the capital market supervisors, who handed down rules and standards that also relied on risk ratings from credit rating agencies, which induced institutional investors to do the same - to rely on the credit rating agencies - without actually analyzing the securities themselves. The IIF recommends that supervisory regulations no longer rely solely on credit ratings. To sum up, the IIF is saying that risk models shouldn't only be based on statistical models. They should factor in actual underlying risk, the risk of the borrower, on which all these structured notes were based. And finally, the IIF acknowledges that to restore investor faith in the market, transparency has to return. The public must know what it's buying and why. To achieve that, the IIF suggests improving proper disclosure. That doesn't mean requiring more reports - too much information can be confusing, the IIF says. The whole point is for reports to be relevant and useful, it points out, providing clear qualitative and quantitative information about a company's risk. It all sounds quite trite, yet it took the umbrella organization of the world's banks and the worst capital market crash in 80 years to remind us that common sense and simple understanding are the only way to run a business properly.

Financial Fallout—Q&A

News reports about the upheaval in the world of finance have been full of esoteric terms like “mortgage-backed securities” and “credit-default swaps,” but the crisis has resonated for people who know little about Wall Street and who did not think they would ever have to know. Here are several questions and answers of concern to Main Street Americans:

Q. The bailout program being negotiated by the Bush administration and Congressional leaders calls for the government to spend up to $700 billion to buy distressed mortgages. How did the politicians come up with that number, and could it go higher?

A. The recovery package cannot go higher than $700 billion without additional legislation. As for that figure, it lies between the optimistic estimate of $500 billion and the pessimistic guess of $1 trillion about the cost of fixing the financial mess. But the $700 billion is in addition to an $85 billion agreement on a bailout of the insurance giant American International Group, plus $29 billion in support that the government pledged in the marriage of Bear Stearns and JPMorgan Chase. On top of all that, the Congressional Budget Office says the federal bailout of the mortgage finance companies Fannie Mae and Freddie Mac could cost $25 billion.

Q. Who, really, is going to come up with the $700 billion?

A. American taxpayers will come up with the money, although if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion. After the Treasury buys up those troubled mortgages, it will try to resell them to investors. The Treasury’s involvement in the crisis and the speed with which Congress is responding could generate long-range optimism and raise the value of those mortgages, although it is impossible to say by how much.

So it would not be correct to think of the federal government as simply writing a check for $700 billion. It is just committing itself to spend that much, if necessary. But the bottom line is, yes, this bailout could cost American taxpayers a lot of money.

Q. So is it fair to say that Americans who are neither rich nor reckless are being asked to rescue people who are? What is in this package for responsible homeowners of modest means who might be forced out of their homes, perhaps for reasons beyond their control?

A. Yes, you could argue that people who cannot tell soybean futures from puts, calls and options are being asked to clean up the costly mess left by Wall Street. To make the bailout palatable to the public, it is being described as far better than inaction, which administration officials and members of Congress say could imperil the retirement savings and other investments of Americans who are anything but rich.

But it is a good bet that the negotiations between the administration and Capitol Hill will include ideas about ways to help middle-class homeowners avoid foreclosure and perhaps some limits on pay for executives. And it should be noted that neither party is solely responsible for whatever neglect led the country to the brink of disaster.

Q. How is it that the administration and Congress, which have not tried to find huge amounts of money to, say, improve the nation’s health insurance system or repair bridges and tunnels, can now be ready to come up with $700 billion to rescue the financial system? And is it realistic to think that the parties can reach agreement and get legislation passed in a hurry?

A. The first question will surely come up again, involving as it does not just issues of spending policy but also more profound questions about national aspirations. As for rescuing the financial system, elected officials in both parties became convinced that, while a couple of venerable investment banks could fade into oblivion or be absorbed by mergers, the entire financial system could not be allowed to collapse.

And, yes, the parties are likely to reach an accord. Many members of Congress are eager to leave Washington to go home and campaign for the November elections, and no one wants to face the voters without having done something to protect modest savings portfolios as well as giant investors.

THE FOLLOWING 6 ARTICLES FROM BUSINESSWEEK

Strong Push for an RTC-Type Solution to the Crisis The U.S. once purged bad S&Ls for $85 billion. How much would it cost to clean up a much bigger financial crisis? No one seems to know As Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke met on the evening of Sept. 18 with congressional leaders, momentum was building for a new Resolution Trust Corp.-style entity. The vehicle would be set up to stem the slide in the markets and halt the erosion of the financial sector.

Just two days earlier, Treasury officials had said no broader entity was needed. But rather than easing market woes, the $85 billion federal bailout of insurer American International Group (AIG) sent new waves of fear through the market, as investors tried to assess what other corporations might suddenly turn up insolvent. With the markets down through midday Sept. 18, and lending among institutions all but grinding to a halt, regulators and lawmakers decided a more systematic approach was needed to keep more institutions from buckling under the strain. At the hastily called Capitol Hill meeting, Paulson and Bernanke met with House and Senate Republicans and Democrats to discuss current market conditions. Paulson and Bernanke "began a discussion with them on a comprehensive approach to address the illiquid assets on bank balance sheets that are the underlying source of the current stresses in our financial institutions and financial markets," said Treasury spokeswoman Brookly McLaughlin in a statement. "They are exploring all options, legislative and administrative, and expect to work through the weekend with congressional leaders to finalize a way forward." A CHORUS OF DEMANDS With the policy measures taken by Washington so far unable to stop the slide, there had been growing calls in recent days for a more systematic approach modeled on the RTC, which was set up in the late 1980s to restructure the underwater mortgages held by nearly 750 insolvent savings and loan institutions. "Lesson No. 1 from that era is: Move quickly. Troubled assets don't become more valuable over time; they become less valuable," said Richard Breeden, the RTC's architect and a former Securities & Exchange Commission chairman. The idea has drawn powerful supporters: ex-Treasury Secretary Lawrence Summers and former Federal Reserve chairmen Alan Greenspan and Paul Volcker have recently backed it, while lawmakers ranging from Representative Barney Frank (D-Mass.), the influential head of the House Financial Services Committee, to Senator Richard Shelby (R-Ala.), the top Republican on the Senate Banking Committee, said early in the week that a new RTC should be considered. Both Presidential contenders have also said such an approach was needed. "I am calling for the creation of the Mortgage & Financial Institutions Trust—the MFI," Senator John McCain (R-Ariz.) said Sept. 18. "The priorities of this trust will be to work with the private sector and regulators to identify institutions that are weak and take remedies to strengthen them before they become insolvent. For troubled institutions, this will provide an orderly process through which to identify bad loans and eventually sell them." Senator Barack Obama's (D-Ill.) rhetoric was similar: "I'll call for the passage of a Homeowner & Financial Support Act that would establish a more stable and permanent solution than the daily improvisations that have characterized policymaking over the last year." How would an RTC-like entity help? The original RTC sold off the restructured loans as the market improved, rather than in a quick-fire sale, thus lessening the cost of the savings and loan crisis to the economy and to taxpayers. AN UNDERCAPITALIZED SYSTEM? One key difference between the 1980s S&L affair and today's financial crisis is that the government had already taken over the insolvent banks by the time it created the RTC. In effect, Uncle Sam already owned the assets and set the agency up to facilitate a smooth liquidation. That's not the case today: The goal now would be to buy up bad mortgage-related assets from banks and other institutions to prevent a further wave of insolvencies. But the basic idea remains the same. The deepening housing crisis has forced banks and other institutions to write down repeatedly the value of the mortgage-related assets they hold, be they mortgage-backed securities or more complicated derivatives. The markdowns have eroded capital,

pushing many toward insolvency. And as those firms try to get rid of their toxic assets, the fire sales put further downward pressure on prices, weakening their capital further—and forcing more sales. With no end to that vicious spiral in sight, private buyers are scarce, as Lehman Brothers and AIG discovered. "The worry is that the system as a whole may be undercapitalized," says Brad Setser, a former Treasury official now with the Council on Foreign Relations. "There may not be enough capital to absorb the losses caused by the ferocity of the downward spiral." That's where a new entity would come in. The government fund would serve as a buyer of last resort. It could acquire the bad mortgages or related debt from the banks directly, at a heavily discounted price or in exchange for equity. That would shift some of the bad assets off the institutions' balance sheets, stop the downward price spiral, and help the banks remain solvent. Or, if troubled institutions were too far gone to save, the government might allow them to get bought up or go bust, and then step in to manage the liquidation of those assets in a more orderly fashion. BREEDEN: NEW RTC MAY BE UNNECESSARY Like the old RTC, the new entity would not face a short-term need to sell. "Rather than seeing forced sales to vulture investors for 10¢ on the dollar, the government could take its time and get, say, 40¢ on the dollar," says Lawrence J. White, an economics professor at New York University. As of the night of Sept. 18, it was unclear exactly what form the new entity might take. Breeden noted that the federal government may already have the tools it needs to buy problem assets out of the marketplace. By taking over Fannie Mae (FNM) and Freddie Mac (FRE), the government took control of their massive portfolios of mortgage securities. The Administration also won approval from Congress to buy more such securities from other holders. "That may be your RTC," Breeden said. "You don't need to go out and create something new; Treasury probably already has the structure that will work fine." Indeed, at the same time it put the government-sponsored enterprises into conservatorship, Treasury announced it would wade into the market to buy mortgage-backed securities. At the time, government officials said Treasury had no target amount it planned to purchase, but would start with a $5 billion purchase soon after the takeover. TAKE YOUR MORTGAGE TO COURT? Others would go even further. On the afternoon of Sept. 18, Senator Chuck Schumer (D-N.Y.), chairman of the Joint Economic Committee, proposed another variation: He argued that the RTC model, by taking distressed assets off the books of troubled institutions, would shift the risks and costs of the bad assets to Uncle Sam while doing little to address the underlying problems of homeowners struggling under mortgages they can no longer afford. Schumer contends that, in addition to providing capital to troubled financial institutions in exchange for equity, further measures must be included to help homeowners. He recommended allowing homeowners to renegotiate their mortgages in bankruptcy court. Such proposals have been before Congress for months, but banks and other financial institutions have fought hard against them. Schumer argues that this additional step would spur far greater efforts to modify loans, helping to avoid the defaults and foreclosures that have been at the root of the crisis. "If the federal government is going to continue to support the economy, its new formal lending program with the banks must address both the need for restoring stability and confidence in the U.S. financial system and the need to set a floor in our plummeting housing markets," Schumer said. Whatever form it takes, however, a move to shift bad mortgage assets from the balance sheets of private institutions and onto that of Uncle Sam raises plenty of questions—not least, how much such a bailout would cost. The original RTC took on some $225 billion in junky S&L assets and eventually sold them for $140 billion, so the hit to taxpayers was $85 billion. No one knows how much bad debt a new RTC would have to take on, or what the burden might ultimately be worth, but the price tag could be far higher.

Restructuring the complex mortgage-backed securities and derivatives at the heart of the crisis will also be much tougher than what the RTC faced in restructuring portfolios of mostly plain-vanilla home loans. "Doing this would be an admission we are in deep, deep trouble," says Setser. But, he adds, "if the situation doesn't stabilize, we have relatively few policy options left."

The ‘Compromises’ in the Bailout Bill The House has circulated a new draft of the troubled asset relief program, otherwise known as T.A.R.P. The bill — which was a slim three pages when Treasury Secretary Henry Paulson first pitched the idea — is now at 110 pages, and it even has a name: The “Emergency Economic Stabilization Act of 2008.” In the end, the bill is largely what Mr. Paulson wanted, with some interesting side bars. The House put in some oversight, but judicial review of the Treasury secretary’s actions is still subject to an “arbitrary and capricious” standard. Moreover, the executive compensation and the equity purchase provisions are so watered down that they are not likely to be implemented with respect to any participating company. Meanwhile, the most interesting new provision is one allowing the Securities and Exchange Commission to suspend mark-to-market accounting. As you may have heard, the mark-to-market requirements have been cited as one of the causes of the current financial-institution liquidity crisis. The working provisions in the bill are the two that define what the troubled assets are that can be bought, and from whom they can be bough. The bill provides that “troubled assets” means: (A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and (B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability. So, troubled assets are essentially any financial securities the Treasury secretary deems appropriate. Mr. Paulson originally asked only for authority to purchase mortgage-related assets. So, the House has actually expanded Paulson’s authority from what he originally requested, providing him the authority to extend this program for the entire financial system. Here, the extension is implemented by another provision, which defines the institutions who can take advantage of this program. The institutions that can so participate are defined as: any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any State So financial institution is defined as any “institution,” and the “including, but not limited to” part just provides examples. So, Mr. Paulson can buy securities from any institution in the United States. This could be the dry cleaner down the block, credit card receivables, student loans and those pesky, bailout-prone automakers. This is an incredible amount of bailout creep in only two short weeks. The bill provides for two alternatives to implement this plan. The first is Mr. Paulson’s original proposal for the Treasury to purchase these troubled assets. The second is the program demanded by House Republicans, which requires Treasury to offer insurance for these troubled assets. The first program, the purchase program, provides that: The Secretary is authorized to establish a troubled asset relief program (or “TARP”) to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with this Act and the policies and procedures developed and published by the Secretary. Again, the issue is this: What price is the government going to pay? Here, the bill states that the

Treasury will disclose policies and procedures for it to make these purchases. So we’ll know shortly after the bill is enacted. As for overpaying — the bill’s only substantive language on this states: PREVENTING UNJUST ENRICHMENT. In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset. The doctrine of unjust enrichment is defined as when a person receives money or other property through no effort of his own. But the modifier here would seem to imply that purchasing assets at above their current value would be acceptable — the government is only talking about the purchase of assets above the price paid. Given the bare level of review here, this will likely be a weak constraint on the government’s actions. Ultimately, this means that Mr. Paulson has kept the authority in his original proposal to set the manner of purchase of these assets and the price. The second program is for the Treasury secretary to provide a guarantee program for troubled assets if he sets up the first program. The bill states that “[s]uch guarantee may be on such terms and conditions as are determined by the Secretary, provided that such terms and conditions are consistent with the purposes of this Act.” However, the bill requires that the Treasury charge premiums for this guarantee and that “[t]he premiums . . . . shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected.” So, the second program is required to be offered, but since the insurance premiums required to be charged will be market rates, they are unlikely to be taken up, because the premiums will be so high that most companies cannot afford them. This is because these mortgage-related assets are decidedly risky at this point. The House Republicans ultimately win nothing but being able to say that the provision is in the bill. The bill has a provision that the Treasury Department will set compensation and corporate governance standards, but they are applicable only if the Treasury purchases troubled assets “where no bidding process or market prices are available,” and the government takes a “meaningful” equity interest. These requirements are not triggered in the event a financial institution obtains a guarantee through the second program. Moreover, the compensation standards apply only if the government makes non-market purchases. In any event, the compensation provisions do contain a claw back but any standards apply only to the top five compensated officers at the company. If the Treasury makes the purchases pursuant to an auction rather than a direct purchase, then the Treasury is only required to prohibit golden parachute payments for such officers in the “event of an involuntary termination, bankruptcy filing, insolvency, or receivership.” The bill does provide for Treasury to take warrants in publicly traded corporations participating in the program “to provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation in the case of a warrant”. It also provides for the government to make modifications on mortgage loans it controls. Ultimately, the bill gives Mr. Paulson discretion on taking equity, and executive compensation standards will only be implemented if there are direct purchases. This makes some sense, since if there is an auction or a market purchase, there is no ostensible benefit given to the corporation. However, neither a market purchase nor a reverse auction in this market is really efficient. So, perhaps this implies that Mr. Paulson will be doing this pursuant to one of these two means. Ultimately, these limitations likely mean that no corporation will be subject to these standards and the Democrats significantly retreated from their initial proposal. As for oversight, there is lots of talk about guidelines and otherwise in the bill, but ultimately these are largely phrased so broadly that the Treasury secretary has maximum latitude. There is, though, an oversight board headed by (1) the Chairman of the Board of Governors of the Federal Reserve System; (2) the Secretary of the Treasury; (3) the Director of the Federal Home Finance Agency;

(4) the Chairman of the Securities Exchange Commission; and (5) the Secretary of Housing and Urban Development. The board has only review and reporting authority. The Treasury secretary initially has authority to purchase $250 billion in troubled assets outstanding at any one time. The next $100 billion comes upon certification of the Treasury secretary, while the last $350 billion can be drawn with Congress having the right to veto if it passes a resolution. The carrying cost of these assets for purposes of these limits is still determined under the Federal Credit Protection Act, although now the government can adjust the discount rate for market risk. This will mean that the discount rate will go higher, reducing the value of the assets and meaning Treasury can buy more of these (spending much more than the $700 billion if it wants). For more on these last two points see my post “How Much Will it Really Cost?” Ultimately, this bill grants a terrific amount of authority to Mr. Paulson to implement this bailout on the terms he deems appropriate. There is a lot of talk about oversight and authority, but ultimately none of it is mandatory and the judicial review is a high standard. The standard is: Actions by the Secretary pursuant to the authority of this Act shall be subject to chapter 7 of title 5, United States Code [that’s the Administrative Procedures Act], including that such actions shall be held unlawful and set aside if found to be arbitrary, capricious, an abuse of discretion, or not in accordance with law. [But] No injunction or other form of equitable relief shall be issued against the Secretary for actions pursuant to section 101 … other than to remedy a violation of the Constitution. To quote David Zaring at the Conglomerate blog, “You tell me, dear reader, whether the Secretary’s run-of-the-mill decisions will or will not be subject to arbitrary and capricious judicial review under the statute.” If the bill is passed in this form, the Democrats will claim a victory through these executive and corporate governance provisions as well as the warrant provisions. But Mr. Paulson can decide how much of these warrants to take, and the executive compensation and corporate governance provisions are unlikely to be implemented for any companies. The bill is not much different than the original proposal — just 107 pages longer. Ultimately, the credit markets are frozen and we need this plan, but the authority provide the Treasury secretary and the potential scope of this program is troubling. Expect things to keep moving and changing today, as the Congress officially takes up this bill. Comments:

1.�September 29th,

�I know there are allot of added things that have been put in to this bill that don’t really have to do with the bailout. Why can’t the gov. officials just say it how it is (short and sweet) not 110 pages. So it’s to the point and there can’t be any vagueness. Executives should not be allowed compensation if their businesses need gov help. Their should be no lessening of bankruptcy laws, maybe they should be even stricter. The gov should not get involved with money market funds and insure them, banks will even have a harder time finding deposits and thus extend credit. Please really think this out and I would say PRAY about it, God still watches over us. �— Posted by Mark Truman�

2.�September 29th �While your analysis is usually spot-on, I don’t think you interpreted the definition

of “institution” correctly. While it is true that the “including but not limited to” merely provides examples, the phrase “established and regulated under the laws of the United States” can only be read to modify “institution.” So I don’t think Hank will be helping out the local dry cleaners. �— Posted by Reader1�

3.�September 29th, The numerous references in the articles and commentary which have been written

about the bailout bill always refer to the role of Mr. Paulson. It seems more than likely that Mr. Paulson will no longer be in office beginning in January 2009 and his

successor could be the appointee of a president of another party . This likelihood seems not to receive much consideration by the press. �— Posted by S.�

4.�September 29th, �Who could believe that amidst all of the bluster and buffoonery in Congress about

transparency, review, oversight and lax regulation over the past ten days, that that august body would even condescend to consider allowing the ‘mark to market rules’ being waived? Lots of people find it wonderfully convenient not to acknowledge that the “Emperor has no clothes”, but Regulators should not be among them. One of the intrinsic strengths and appeal of the American investment market around the world is the confidence that investors have in American accounting procedures. This rule cannot be applied on a case by case basis. If it is applied, investing in American listed shares becomes a case of blind man’s bluff. �— Posted by doubting Thomas�

5.�September 29th, I don’t think the mark to market requirement is the reason for all this financial

turmoil. The root of the problem was greed. �— Posted by paul� 6.�September 29th, �In reference to the comment from Reader 1 above, I think it could easily be

interpreted that the local dry cleaners is “established and regulated under the laws of the United States”. Agencies that come to mind that might regulate such a business (well, practically every business) include the EPA and the IRS. �— Posted by W�

7.�September 29th, �To No. 2, �The definition also includes any “State”. However, I grant you that the

term institution itself could be read to have a narrower reading than corporation. In addition, the definition states that a financial institution is �any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any State, territory, or possession of the United States . . . .�So you could argue that an institution can only be a regulated entity under the above definition, but if you slot the regulated into the part about including we are still defining any “financial institution” to be an institution. Pretty vague to me still, but you may have a point that it is more limited than I posit. �— Posted by Steven M. Davidoff�

8.�September 29th, �Mr Davidoff: Apparently the conclusion is the country will be run by Mr Paulson,

who will make the decisions, rather than the politicians. Somebody who knows something about finance, rather than someone who pretends to know something about finance. �— Posted by Garrett Skelly�

9.�September 29th, �Once again, the Bush Administration tells us the sky is falling. Once again, they

urge our Senators and Representatives to take drastic measures in order to prop it back up, quickly now, before it’s too late! (Doesn’t this sound familiar?)�What should we do? �Quick, fork over 700 billion dollars to a financial industry insider, and give him complete authority to remove those burdensome mortgage-backed securities from the ledgers of all the banks run by his old buddies. Nobody seems to know how much they’re worth, but we will encourage our insider not to overpay. Let him allow his favorite banks to subvert the rules of accounting and keep their losses off the books. What, the taxpayers want regulation? Fine, our insider will be supervised by one committee of presidential appointees, and another committee with a few appointed Democrats. That should satisfy them. This bill transfers enormous wealth from the taxpayer into the arms of a man partially responsible for the fix we’re in. Since when do we solve problems by further enriching the perpetrators of this robbery of the American people? While adding additional

oversight was a good idea in principle, the weak language of these regulations ensures that it is nothing better than — wait for it — lipstick on a pig. The Secretary of the Treasury and his banker friends will laugh all the way to the bank, giggling with anticipation for the next time they will take my hard-earned tax dollars with permission of Congress.� Is this the best we can do? I am very disappointed in this bill. �— Posted by Sarah�

10.�September 29th, �An “arbitrary and capricious” standard of review in effect is no standard of review

since courts rarely if ever find that a government official or any defendant has acted “arbitrarily” and/or “capriciously.” This is THE lowest standard of review possible which as a practical matter gives Paulsen unfettered discretion. I know this from my 40 years of being an attorney and my several decades as a law professor studying such matters. It certainly is not what the Democrats in either house or the Senate Republicans meant by judicial oversight, let alone Congressional oversight. �— Posted by Barbara Brudno, Esq.�

11.�September 29th, �As proposed, the non-judicial oversight is by a board comprised solely by

appointees of the Bush administration whose failure to regulate is a major source of the problem. This is not bipartisan oversight and thus raises serious concerns. [add to previous comment] �— Posted by Barbara Brudno, Esq.�

12.�September 29th, �The bailout bill purports to give Congress the authority to stop disbursement of

the second $350 billion by resolution, but such a legislative veto would likely be found unconstitutional as a violation of separation of powers. US v Chadha, 462 U.S. 919 (1983). �— Posted by John Adams�

13.�September 29th, �So, they EXPANDED Paulson’s authority with regard to the bad assets he could

buy with public money to include, let’s see, ANYTHING. And EXPANDED the definition of financial institution to include…wait for it…ANYBODY Paulson wants to bail out. This includes, presumably, foreign banks, private equity firms and hedge funds. Astounding.� The executive pay provision was written un such a way that it is virtually un-enforceable, and the oversight provision is toothless.� Nicely done, Rep. Frank and Sen. Dodd. Nicely done. Schmucks. �— Posted by Joe�

14.�September 29th, �Somebody has to do something, and it’s just incredibly pathetic that it has to be us.

�— Posted by mbi� 15.�September 29th, �To say that Wall Street (itself not quite a monolithic entity as it is made out to be)

is greedy is to miss the point. There is no industry in the entire world that doesn’t have its share of greedy people. At the same time, every industry also has its conservative stalwarts, those companies and individuals who shun taking larger risks. The only thing separating Wall Street from other industries is its centrality to other industries. The connection between a pizzeria in Peoria is likely minimal to a tailor in Boston, but that’s not the case with Wall Street. It is for that reason that Wall Street subjects itself to much greater regulation than your average business does (even in this time of relatively light regulatory oversight over the industry).�Politicians calling Wall Street greedy are simply using populist tactics and class warfare to get ahead in the political rat race. Bashing the rich is not only silly, but it’s counterproductive. Somehow, a belief that a person sitting at a desk, not sweating, and “not making anything” does not deserve wealth is about as antiquated a notion as a monarchy. It exists, but we’ve found superior alternatives.� But there will always be monarchists. Rather, I would ask people to consider why people who

sit in front of a computer all day at work and don’t really make anything get paid as much as they do. It is not because what they offer has no value. Such products/services go out of fashion quite quickly, but that has not been the case of the white collar worker, or even more specifically the financial type on Wall Street.� Rather, we find that white collar jobs are a growing portion of our economy and blue collar jobs are going elsewhere. We’re an economy of service providers, and someone who can provide services to thousands of people by his or her lonesome (such as a hedge fund) can rightfully ask to be compensated in such a fashion.� Yes, I understand the rules of our economy have skewed a bit towards the wealthy (let’s not forget that they still pay the bulk of the taxes in this country), but this has become a nation where people are unwilling to look into the mirror and recognize that their value has not gone up nearly as much as that of others’. What matters now is that we are competitive on a global scale. If you find yourself suddenly charging more than a Chinese laborer or an Indian call center worker, you have to wonder where you can provide more bang for your buck. You are now, for all intents and purposes, a business of one, competing in this global economy. Forget greed and blaming others. There will always be others to blame, but it’s time that we started to assess our offering (as capitalism demands) and improve upon it to keep our value higher than that for the average Chinese or Indian worker. It’s tough, but it’s this sense of continuous improvement that’s allowed our businesses to be the best in the world. It’s this sense of continuous improvement that can make our workers the best in the world. Competition, don’t forget, forces companies and individuals to push themselves beyond limits they never imagined. It’s not fun, but it is progress. That’s nothing to turn your nose up at. �— Posted by AJ�

16.�September 29th, �Essentially, Congress jumped through hoops to make it look like they were adding

important language to the bill. At the end of the day, Paulson gets exactly what he wants. When the whole thing collapses after the horrible January retail numbers come in, then it might be time for plan B. What’s plan B? Simple. Canned goods and shotgun shells. �— Posted by Juan�

17.�September 29th, �You are correct regarding the definition of “financial institution”. This is clever

drafting, which is controlled only by the interpretation of what is covered by “established and regulated under the laws of the US”. Would this extend to hedge funds? And don’t forget about Sec. 112, which extends the right of the Sec. to purchase troubled assets held by “foreign financial authorities and central bank”. So don’t be surprised to see the Sec. Treasury buying “troubled assets” from the Bank of China or the Saudi Central Bank - this is permitted under the Bill.� As to the restrictions on comp, your initial analysis is only partially correct. While there are more restrictions in the event of Direct Purchases, the tax provisions that prohibit companies from deduction executive compensation > $500K are written such that companies that participate in Direct Purchases are effectively excluded from the tax provisions. So what the bill took away, the tax provisions gaveth back - clever drafting. Frankly, the compensation provisions are basically meaningless as they are so vague as to be completely ineffective.�

Finally, Sec. 119 (a)(2) is the most disturbing. Essentially Paulson was in fact given a

judicial blank check - that is, there is no judicial relief available, “other than to remedy a violation of the Constitution” - so Paulson can cut any deal he wants with Goldman or the Bank of China or the Saudi’s and there is nothing anybody can do! No wonder the pols were congratulating themselves in front of the cameras - a very effective way of diverting attention from what really happened - they got some

reporting and $50million for an inspector general but Paulson and Bush otherwise got the blank check they asked for plus, more. The key point, that I have been waiting for the press to report, is that Paulson can expand the bailout to cover credit cards, and auto loans, and RV loans and every other form of securitized debt that has been packaged over the last decade - and so when that occurs, $700 billion is going to seem like a drop in the bucket. Better hold on tight…….. �— Posted by Frank�

18.�September 29th, �The term “mortgage related” is even too broad. It should be “mortgage backed” as

“related” is open to interpretation.� Bank of America is already taken — should this be the Paulson Federal Bank? �— Posted by ken�

19.�September 29th, �no wonder the thing did not pass.� Better luck next time. Hope the markets hold together that long.� Election is five weeks from tomorrow. . . . �— Posted by Dave

The Big Bailout: Measuring the Aftershocks While the government's plan lets Wall Street relax for the time being, huge questions about potential side effects of the strategy remain Capping possibly the wildest week in U.S. financial history, the markets breathed a sigh of relief on Friday, Sept. 19, at the U.S. government's multipronged plan to fight the financial crisis (BusinessWeek.com, 9/19/08), including a bailout fund par excellence to be created by the Treasury Dept. that will buy up bad debt and cleanse financial institutions' balance sheets of the toxic credit derivative products they have been holding. The details of the fund—how much bad stuff it will be authorized to buy and how those assets will be valued, to take two examples—are still to be worked out, and therein lies a host of questions about what negative side effects there potentially will be as a result. In addition to the bailout fund, which could cost taxpayers up to half a trillion dollars, the government's overhauled playbook includes the Federal Reserve's unprecedented $85 billion bailout of privately owned insurance giant American International Group (AIG), Treasury's $2 trillion backstop of U.S. money market funds, and the U.S. Securities & Exchange Commission's temporary ban on short-selling on nearly 800 U.S. financial stocks. To borrow the medical metaphor that's been cited all week, with priority given to restarting the patient's heart, less attention has been paid to the possible collateral damage the stress may cause his other vital functions. While survival of the financial system has been at the forefront of people's mind, there are a host of questions that remain to be answered in the weeks and months ahead, from details about how some of the government programs will work to possible unintended effects the cure may have on the way the markets function and how the economy performs over the longer term. BusinessWeek takes a look at some of the potential aftershocks. Foremost will be how actually to value the assets to be bought by the superfund, a task likely to be neither simple nor quick, given the difficulty the market has had up until now in valuing them amid widespread unwillingness to buy them, says Hank Herrmann, chief executive of Waddell & Reed (WDR) in Overland Park, Kan. "A great deal of consideration has been given to how to value [collateralized debt obligations]" to no avail, he says. "And who's going to value them? Outside professionals?" WORTH THE NEGATIVES? Herrmann also wonders what impact those valuations will have on homeowners across the country when their neighbors' foreclosed houses start being appraised differently and how fair that is to people who have kept up with their mortgage payments. "It's a lot better than the vicious cycle of

spiraling down we've been having, so I think you're going to have to put up with some of this stuff," he concludes. A related question is who exactly will U.S. taxpayers be bailing out? Should the commercial banks struggling with mortgage loans that have gone into default be treated the same way as the broker-dealers who are responsible for helping to create the crisis in the first place, asks David Joy, chief market strategist at RiverSource Investments in Minneapolis. "It's the banking system you want to help out here. You want to free up credit so lending takes place. I'm not sure that's helped by including the [large financial] institutions in this," says Joy. Another matter to be clarified: Will the government be buying bad mortgage-backed securities bought by foreign central banks and other overseas investors? Although the credit crisis has been addressed, the reality of how all these extraordinary measures taken by the government over the past two weeks will play out in the economy is still very fuzzy, says Herrmann at Waddell. A major uncertainty is what impact it will have on the creditworthiness of the U.S. government itself and whether or not that is reflected in the value of the dollar, he says. That's hard to gauge since the number of other countries with possibly more complicated problems may leave foreign investors no better alternative for where to stow their money, he adds. AN IFFY SUPPLY INCREASE With the national deficit expected to double next year to $800 billion as a result of the bailouts, a hike in inflation is very likely, say investment strategists. The extent to which the money supply expands will depend on how much money the Fed decides to create, vs. swaps and transfers says Herrmann. If the Fed decides to sell more Treasury bonds to help finance the programs, and the public gives cash to the Fed in exchange, does that really increase the money supply? he wonders. And how might the bond market react to a big expansion in Treasury debt? Treasury yields plunged this week in reaction to an enormous flight to quality into government bonds. "The Fed can attempt to sterilize some of this by selling Treasuries and taking some money out of the system, but I'm not sure they have the latitude to do that," says Joy at RiverSource. The central bank's balance sheet has gone from 80% Treasuries to 50% since the crisis began, he says. Herrmann also allows for the possibility of deflation as a result if the government moves lead to more risk-averse behavior from the banks and credit remains hard to come by. That would translate to less economic expansion and probably reduced concerns about inflation, he says. The SEC's sudden ban on short-selling on 799 financial stocks—perhaps the most controversial move—has already had an unintended disruptive impact on the options market, where market makers rely on being able to short underlying stocks in order to hedge their risk. ANOTHER CRISIS? By implementing the new rule on options expiration Friday, the busiest day of the month for the options market, without consulting the exchanges or firms that make a market in options, the SEC caused liquidity to freeze up and the bid-ask spread on options to widen on Sept. 19, says Joe Kusick, senior market analyst at OptionsXpress (OXPS) in Chicago. "Depending on what the SEC does right now, we have an extreme problem on our hands come Monday [the day the ban takes effect]. The exemption has not been made for market makers," he says. "This is adding another potential crisis. The options exchanges with the short-stop rule cannot provide the liquidity necessary to stay open." He says the SEC needs to make a definitive statement about the impact that the rule, which lasts until Oct. 2 but could be extended for up to 30 days, will have not only on retail customers but on the exchanges and how they provide that liquidity.

As for whether the government's new rule book has overturned long-standing assumptions of how free markets are supposed to operate, Alec Young, equity strategist at Standard & Poor's Equity Research, thinks it's too soon to tell. "It's dangerous to make heavy-duty judgments when you're still sort of in the eye of the storm," he says. "This has been a fairly run-of-the-mill bear market if you see the percent decline. It will reinforce the fact that equities tend to outperform other assets like Treasuries over time because you take on more risk." He doubts that many investors will turn away from stocks in the long run because of the extra volatility. Most people, he believes, own stocks for retirement purposes in tax-deferred accounts and don't rely on them for short-term gains. Joseph Biondo Sr., senior portfolio manager at Biondo Investment Advisors in Milford, Pa., says he's not worried about a challenge to the free market philosophy but warns that the regulation likely to be imposed could become too confining. Ironically, the comprehensive bailout plan could turn out to be the ultimate moral hazard, encouraging more reckless risk-taking behavior in the future. There's certainly potential that by providing a backstop for money market funds, the government might exacerbate the temptation of overly reckless behavior, unless it puts regulations in place to prevent inappropriate practices, says Herrmann. Those regulations would add an extra layer of expense on those running the money funds, however, he adds.

Wall Street Bailout: Now, the Lawsuits

Angry investors are suing the Reserve Fund for "breaking the buck," AIG for pension losses, Merrill Lynch for its Bank of America deal—but the bar is high Consider the developments of the past 10 days: collapsing share prices, huge investor losses, allegations of financial obfuscation and mismanagement. It would seem a likely setup for a new wave of litigation and a boon for the plaintiffs' bar. The reality, however, is far more muted. Legal rulings have made it significantly harder to press shareholder claims. And since the victims of the current financial carnage include some of the primary defendants themselves, investors may find themselves reaching into empty pockets for redress. Yes, lawsuits stemming directly from the turmoil of recent days have been filed. On Sept. 19, for example, an investment firm sued the Reserve Fund, a money-market fund that serves institutions, for "breaking the buck" and causing a flood of investors to cash out at less than $1 per share. A former employee sued American International Group (AIG) for losses in AIG's pension resulting from the collapse of the insurer's stock. And a Merrill Lynch (MER) shareholder sued the investment firm, claiming the terms of its proposed acquisition by Bank of America (BAC) are unfair. Reserve Fund representatives could not be reached over the weekend for comment. An AIG spokesman says the company does not discuss pending litigation, and Bank of America said it has no comment. Merrill Lynch did not immediately respond to requests for comment. TOUGH SLOG FOR PLAINTIFFS The fact is, though, many of the nation's major financial-service firms were sued months ago for losses stemming from the subprime mortgage crisis. Plaintiffs already faced tough slogging in those cases due to U.S. Supreme Court decisions in recent years that raised the bar for investor claims. To avoid having their cases dismissed, for instance, investors must now come forth with very specific allegations about what defendant companies did to knowingly deceive the market—a high hurdle. And a ruling in January of this year made it virtually impossible to try to hold corporate advisers, such as accountants and lawyers, responsible for a stock issuers' securities fraud, putting any insurance they have beyond reach. Recent events raise additional obstacles. With Lehman Brothers (LEH) in bankruptcy, all lawsuits against the firm are frozen and funds to pay out on any claims will be severely limited. Squeezing money out of institutions that have been effectively nationalized, such as AIG, Fannie Mae (FNM),

and Freddie Mac (FRE), will also be no easy task. "It's going to make it more challenging for investors to recover assets that have basically gone into thin air," says Gerald H. Silk, an attorney with Bernstein Litowitz Berger & Grossmann, the New York firm that filed suit against the Reserve Fund. As for losses incurred in recent days, defendants may assert they were due not to any misleading statements or mismanagement on their part but by the calamitous state of the markets. Courts don't award damages for market-related price drops. NEXT TARGET: RATING AGENCIES? Plaintiffs' attorneys vow to press forward, including with new cases. Rating agencies may once again come within their sites, says John P. "Sean" Coffey, another Bernstein Litowitz lawyer. They "are very complicit in this disaster," he maintains. "They were putting the Good Housekeeping seal of approval on crap." Courts have rejected past efforts to hold bond raters liable, in part based on the notion that ratings are expressions of opinion protected as free speech. Fitch Ratings said it had no comment; Moody's Investors Services (MCO) did not respond to a request for comment; Standard & Poor's, which, like BusinessWeek, is a division of The McGraw-Hill Companies (MHP), declined to comment. The phenomenon of investors losing money in supposedly highly secure money-market funds may also prompt additional litigation. Says Darren J. Robbins, an attorney at Coughlin Stoia Geller Rudman & Robbins in San Diego: "You cannot overstate the concern that our pension fund clients have concerning those investment vehicles marketed as conservative" turning out to hold "substantial amounts of high-risk, mortgage-backed products."

The Bailout: Public Anger, Private Talks

Congress is wary of angry voters, but behind the scenes a compromise is forming. Executive pay restrictions may be near

With public sentiment casting the Bush Administration's plan to resolve the financial crisis as a bailout for the firms that caused it, Senate Banking Committee members took turns grilling Treasury Secretary Henry Paulson and Federal Reserve Board Chairman Ben Bernanke at a hearing on Sept. 23. Behind the scenes, however, many expected nuts-and-bolts negotiation to yield a compromise bill, perhaps over the weekend if not by Friday's scheduled adjournment. Agreement was already coalescing to require some restrictions on executive pay at companies that sell toxic assets to the Treasury, one financial-industry official said.

The theater playing out on Capitol Hill on Tuesday reflected deeply held positions on the role of government and the economy, but with an eye toward how events would play out politically. Polls failed to give a clear picture of just how much support there is for Congress to act: Support ranged from 25% to 56% in different polls.

Lawmakers worry that failing to back the bailout could hurt them, particularly in light of the Administration's warnings of the dire consequences of inaction and the reality of a tumbling stock market (BusinessWeek.com, 9/23/08). At the same time, fears grew that a protracted debate could undermine support altogether as more questions are raised about the plan's costs and effectiveness.

SOME HOMEOWNER HELP Political analysts predicted both sides would give way at least partially on various fronts. Indeed, the Administration has already indicated it would accept at least some provisions aiding homeowners struggling to pay their mortgages, and the House was said to be cooling to a proposal, popular among many Democrats, to allow judges to modify mortgages in bankruptcy court. Congressional aides conceded the measure faced too much opposition from the financial-services industry, which has focused its most intense lobbying efforts on killing the provision.

Senator Christopher Dodd (D-Conn.), chairman of the Senate Banking Committee, said he would work with Representative Barney Frank (D-Mass.), chairman of the House Financial Services Committee, to combine draft legislation each chamber had circulated.

Many of the Democrats' demands could ultimately prove to be part of a strategy to "ask for five in the hopes of getting three," says Daniel Clifton, a political analyst for investment adviser Strategas Research. And the political calculus has many twists: Democrats, for example, could suffer if they are seen as impeding a much needed rescue, or might set themselves up for a public-relations victory if the Administration succeeds in blocking executive-pay restrictions (BusinessWeek.com, 9/22/08) or measures to help homeowners that prove popular. That would be a win-win either way: Six weeks before the election, they could tell the folks back home they won such concessions from the Administration, or they could campaign on the fact that Republicans blocked them.

However, one financial industry official said that Republicans have read the populist writing on the wall. "Senate Republicans have now endorsed putting limits on executive comp, so that will stay in the bill," said Scott E. Talbott, senior vice president of government affairs for the Financial Services Roundtable, which represents the country's largest financial services companies. "That's why Republicans endorsed the exec compensation bit—so they can go home and look their constituents in the eye and say, 'yes, it cost $700 billion in the end, but we also cut their pay.' After today's testimony, enough members heard the doom and gloom."

DIRE WARNINGS FROM THE ADMINISTRATION During Tuesday's steady-rolling, five-hour hearing, the main battle lines were clear: Bernanke, Paulson, and other Administration officials urged quick passage of a stripped-down bill to let the Treasury use up to $700 billion to buy complex mortgage-related securities from financial institutions. That would push many decisions—about oversight, disclosure, the prices the government would pay to take toxic assets off corporate balance sheets—into the future, leaving most such calls up to the Treasury, in this Presidential Administration and the next.

Bush Administration officials warned of dire consequences should Congress delay or impose too many limits on Treasury's authority. Paulson said he believed the stock market's recovery late last week stemmed from the belief that Congress would act. "I feel great urgency, and I believe it's got to be done this week or before you leave," Paulson said. Stocks opened ahead early Tuesday, but sank as the hearing progressed. The Standard & Poor's 500-stock index closed down 18.87, or 1.56%, to 1,188.22. The Dow Jones industrial average was off 161.52, or 1.47%, to 10,854.17. Including Monday's 370-point drop, the Dow was down 534 points, or 4.69%, so far for the week.

The response from lawmakers to the bailout plan was generally chilly. Most indicated that they agreed some action was necessary soon. But many took the Bush Administration to task for initially proposing to give itself nearly complete discretion, with no oversight and no judicial review. Administration officials have since indicated that they would accept some measure of oversight, though details remain unclear. Congressional proposals include an inspector-general's office, regular audits, and weekly public disclosures, among other measures.

TAKING WALL STREET TO TASK Senators of both parties demanded more oversight and transparency, questioned the Administration's decision not to give taxpayers a stake in companies benefiting from the Treasury program, and above all insisted that the final measure should clearly and in many cases directly assist homeowners struggling to pay their mortgages. Many Democrats called for restrictions on executive compensation, and several held out hope that the final measure would allow judges to modify the terms of mortgages in bankruptcy court, much as other loans can be modified.

Throughout, the senators took Wall Street and the financial sector vigorously to task. Some Senators expressed skepticism that the multibillion-dollar bailout would resolve the economic threat. "Wall Street bet that the government would rescue them if they got into trouble; it appears that bet

may be the one that pays off," said Senator Richard Shelby (R-Ala.). "I do not believe, however, that we can solve this crisis by spending a massive amount of money on bad securities."

Congressional staff and political analysts say that, while many lawmakers have been impressed by Bernanke and Paulson with the need to move swiftly, they also have constituents to satisfy. And those constituents appear to be taking a dim view of the Treasury's proposal. Some of those insiders predicted that a compromise would likely be reached by week's end, and said much of the bickering over specific provisions would fall by the wayside—with each side getting a few key concessions—as a kind of posturing aimed at placating constituents. "The phones are burning up with angry constituents," says Howard Glaser, a former Clinton housing official and mortgage-industry consultant. "Congress is looking for something to say, 'Here's help for households.'"

CALLS FOR DUE DILIGENCE Indeed, calls for "foreclosure assistance" peppered the hearing. Dodd complained at the outset that Treasury's proposal "would do nothing, in my opinion, to save a single home, at least up front."

Lawmakers have been reluctant to embrace Paulson and Bernanke's argument that helping the financial markets will help Main Street to prevent foreclosures. "The very best thing we can do is make sure the capital markets are open and that lenders are continuing to lend," Paulson said. Instead, draft legislation circulated for discussion in both the House and Senate this week have included provisions designed to help homeowners stave off foreclosure directly.

In the hearing, lawmakers also took issue with the Administration's request for access to $700 billion, and by the hearing's end, several seemed to be mulling the possibility of handing over only a portion of the $700 billion the Administration has requested and doling out more as results warrant. "None of the thousands of money managers would invest that sum without the appropriate due diligence," said Senator Charles Schumer (D-N.Y.) "This hearing today and the discussions that will follow are our due diligence."

PROFIT NOT LIKELY Paulson stressed that the loans and mortgage-related securities Treasury acquired would eventually be sold to recoup some of the outlay, and acknowledged that the agency wasn't likely to use the full amount quickly. But he said the Treasury needed access to the full amount from the beginning. "The best way to protect the taxpayer…is to do something that has the maximum chance of working," he said. "We need market confidence and we need the tools to work with."

A few lawmakers suggested that the rescue program, run judiciously, might break even or turn a small profit. Paulson and Bernanke made clear that they didn't consider a profit likely.

Paulson and Bernanke took perhaps greatest issue with suggestions that the government should receive stakes in companies that seek federal aid, and that the companies should also accept limits on executive compensation. Paulson noted that the government has acquired stakes in companies it has saved from insolvency, including a 79.9% stake in insurer American International Group (AIG). But he stressed that the plan for systematically buying up troubled securities depends on a broad spectrum of companies participating. Layering conditions on the program would dissuade them. "If we have to have companies grant equity stakes, grant options, that would render this ineffective," Paulson said. Compensation reforms, meantime, can wait for more deliberate regulation in the near future, he said.

Thomas Friedman: No laughing matter Sunday, September 21, 2008

Of all the points raised by different analysts about the economy last week, surely the best was Representative Barney Frank's reminder that Ronald Reagan's favorite laugh line was telling

audiences that: "The nine most terrifying words in the English language are: 'I'm from the government, and I'm here to help."'

Hah, hah, hah.

Are you still laughing? If it weren't for the government bailing out Fannie Mae, Freddie Mac and AIG, and rescuing people from Hurricane Ike and pumping tons of liquidity into the banking system, our economy would be a shambles. How would you like to hear the line today: "I'm from the government, and I can't do a darn thing for you."

In this age of globalization, government matters more than ever.

Smart, fiscally strong governments are the ones best able to empower their people to compete and win. I was just in Michigan to give a talk on energy. I can't tell you how many business cards I collected from innovators who had either started renewable-energy companies or were working for big firms, like the Dow Chemical Co., on clean energy solutions.

It just reminded me how much innovative prowess and entrepreneurial energy is exploding from below in this country. If it were channeled and enhanced by better leadership in Washington, no one could touch us.

If I were to draw a picture of America today, it would be of the space shuttle taking off. There is all this thrust coming from below.

But the booster rocket - Washington - is cracked and leaking energy, and the pilots in the cockpit are fighting over the flight plan. So we can't achieve escape velocity to enter the next orbit - the next great industrial revolution, which is going to be ET, energy technology.

In many ways, this election is about how we get our groove back as a country. We have been living on borrowed time and borrowed dimes.

President Bush has nothing to offer anymore. So that leaves us with Barack Obama and John McCain. Neither has wowed me with his reaction to the market turmoil. In fairness, though, neither man has any levers of power to pull. But what could they say that would give you confidence that they could lead us out of this rut? My test is simple: Which guy can tell people what they don't want to hear - especially his own base.

Think how much better off McCain would be today had he nominated Michael Bloomberg as his vice president rather than Sarah Palin.

McCain could have said, "I'm not an expert on markets, but I've got one of the best on my team." Instead of a VP to re-energize America, McCain went for a VP to re-energize the Republican base.

So what would get my attention from McCain? If he said the following: "My fellow Americans, I've decided for now not to continue the Bush tax cuts, because the most important thing for our country today is to get the government's balance sheet in order. We can't go on cutting taxes and not cutting spending. For too long my party has indulged that nonsense. Second, I intend to have most U.S. troops out of Iraq in 24 months. We have done all we can to midwife democracy there. Iraqis need to take it from here. We need every dollar now for nation-building in America. We will do everything we can to wind down our presence and facilitate the Iraqi elections, but we're not going to baby-sit

Iraqi politicians who don't have the will or the courage to reconcile their differences - unless they want to pay us for that. In America, baby sitters get paid."

What would impress me from Obama? How about this: "The Big Three automakers and the United Auto Workers union want a Washington bailout. The only way they will get a dime out of my administration is if the automakers and unions come up with a joint plan to retool their fleets to get an average of 40 miles per gallon by 2015 - instead of the 35 mpg by 2020 that they've reluctantly accepted. I am not going to bail out Detroit with taxpayer money, but I will invest in Detroit's transformation with taxpayer money, provided the management and unions agree to radical change. At the same time, while I will go along with the bailout of the banking system, it will only be on the condition that the institutions that got us into this mess accept sweeping reforms - in terms of transparency and limits on the leverage they can amass - so we don't go through something like this again. To help me figure this out, I'm going to keep Treasury Secretary Hank Paulson on the job for a while. I am impressed with his handling of this crisis."

Those are the kind of words that would get my attention. The last president who challenged his base was Bill Clinton, when he reformed welfare and created a budget surplus with a fair and equitable tax program. George W. Bush never once - not one time - challenged Americans to do anything hard, let alone great. The next president is not going to have that luxury. He will have to ask everyone to do something hard - and I want to know now who is up to that task.

Wall Street Bailout Could Cut CEO Pay Democrats want to rein in rich exit packages and reclaim millions paid to bosses who piled up toxic mortgage assets. But it won't be easy.

As Congress and the Bush Administration negotiate over the terms of a financial rescue bill, Democrats on Capitol Hill are drafting language designed to rein in executive compensation, in particular controversial severance packages at foundering companies. And for politicians concerned about the growing backlash on Main Street over what many see as a bailout of Wall Street fat cats, executive pay is a ripe target. After all, average total pay for a CEO at one of the 500 biggest companies last year was $12.8 million, double what it was a decade ago.

But compensation attorneys and experts say many of the restrictions could prove tough to enforce.

Executive pay was shaping up as one of a few remaining sticking points as Congress and the Republican Administration hurried to put a deal together amid further stock market declines on Sept. 22. In several areas the players were nearing accord, with Administration officials reportedly accepting some congressional oversight and relief for homeowners struggling to pay their mortgages -- key provisions for Democrats.

Legislative language circulating on Capitol Hill on Monday afternoon also included mechanisms that would give the government ownership stakes in companies benefiting from the bailout, to make up for losses the government might incur. Senate Democrats revived a provision that would allow judges to modify the terms of mortgages in bankruptcy proceedings, much as other debts can be adjusted. But the financial-services industry is strongly opposed to the provision and some predicted it would not garner sufficient support in the House.

Vaguely Worded Provisions

Treasury Secretary Henry Paulson was scheduled to appear before the Senate Banking Committee on Tuesday, Sept. 23, with Federal Reserve Chairman Ben Bernanke and Christopher Cox,

chairman of the Securities & Exchange Commission. Lawmakers have said they hope to craft a deal by the end of the week, when Congress is slated to adjourn.

Although executive-pay restrictions received considerable attention publicly and in negotiations on the Hill, the draft bills themselves included only short, vaguely worded sections that would require Treasury to limit pay and severance for executives at companies from which it buys troubled assets, while giving the agency wide discretion over the details. Treasury Secretary Paulson, acknowledging that "there have been excesses" in executive pay that should be addressed, has argued that the government's first priority should be stabilizing the financial markets, with compensation curbs and other reforms to come later.

A Senate discussion draft would require the government to ban incentive payments that the agency considers "inappropriate or excessive;" require executives to return incentives "based on earnings, gains, or other criteria that are later proven to be inaccurate;" and limit severance as "appropriate to the public interest" and the assistance the company receives.

Severance Pay Ban

Language in a draft House bill was similar, applying the restrictions for two years following Treasury assistance. But it also imposed additional restrictions on at least some companies, banning severance pay for top executives and requiring the companies to make it easier for substantial shareholders to nominate and elect board members and for shareholders generally to hold advisory votes on executive compensation.

Capitol Hill staffers acknowledged that the measures were worded broadly and said lawmakers want to give Treasury authority it can actually use. "The goal is something that sends a clear message of intention but is not necessarily binding" on Treasury, one senior congressional aide said.

A variety of obstacles face the Treasury if it ultimately sets out trying to enforce such provisions.

Legal Remedies May Be Required

For one thing, executive compensation is typically governed by multiyear contracts. Forcing companies to change provisions in those contracts could require them to reopen negotiations with the executives who stand to lose benefits. Getting those execs to agree without sweetening the deal in some other way could prove difficult, especially if the executives are on their way out the door or face being ousted. "If I'm being invited to modify the agreement and then being shown the door at the same time, I'm probably not going to be too agreeable," says Lewis Wiener, head of the financial-services litigation practice at Sutherland Asbill & Brennan.

Nor are many executives likely to simply agree to give up pay because of public pressure and publicity, if recent history is any guide. Most executives who have agreed to surrender compensation have done so after being sued. Former UnitedHealth Group Chief Executive William McGuire, for example, agreed earlier this month to repay $30 million and return some 3.7 million stock options to settle allegations of backdating stock-option awards. (McGuire denied wrongdoing.)

"People settle for all kinds of reasons, but usually it's because there's some kind of potentially valid legal claim," says Robert Salwen, a compensation consultant in Scarsdale, N.Y. "If that's not the case, then I wouldn't assume these people would be prepared to relinquish substantial sums of

money, period."

Constitutional Challenge Possible

"Claw-back" provisions requiring executives to give up pay or severance benefits if corporate results prove to be misstated, for example, might be even trickier. Large companies have increasingly written claw-backs into executive-pay contracts, with triggers ranging from financial restatements to fraud. But where such clauses aren't already in place, the government's insistence on adding one could leave it open to a constitutional challenge under the Fifth Amendment, which bars the government from taking private property for public use without just compensation.

That's particularly true where the severance had already been earned by the executive or paid out to him. But even where the change modified existing severance promises by the company, executives could find plenty of room to sue, says Wiener, defending "takings" litigation in which plaintiffs argued that the government had taken property in violation of the Fifth Amendment. "I think there's merit to that case," he says.

In bankruptcy proceedings, creditors in some circumstances can seek to recover compensation already paid out, particularly if executives maintained the company was still solvent when it wasn't, says Paul Hodgson, a senior research associate at the Corporate Library, a corporate-governance research firm. Still, "if the company was solvent when it paid out the compensation, there's no real legal backing for recouping any of that" in bankruptcy court, Hodgson says.

How Will Banks Fare in the Bailout?

Here are the industry winners and losers that could emerge as the grand plan takes shape

The details still have to be worked out for the $700 billion fund the U.S. government will create to take distressed mortgage-related assets off banks' hands in hopes of thawing the country's frozen credit system. The most obvious beneficiaries of the plan will be members of the "shadow banking system," including such surviving investment banks as Merrill Lynch (MER)— which has agreed to be acquired by Bank of America (BAC)— and Morgan Stanley (MS), but even more conservative commercial banks that don't have much to purge from their balance sheets are expected to gain as the effects of the program spread through the economy. A major question that will determine how helpful the bailout is: the price the government is willing to pay, which could turn out to be as low the 22 cents on the dollar that Merrill Lynch got for $30 billion in assets it sold to private equity firm Lone Star in July. The financial companies that are holding distressed assets don't even necessarily have to sell them to the U.S. Treasury in order to benefit from what many are calling the "mother of all bailouts." A financial company might decide not to sell its distressed assets in the belief that there's more value in holding onto them until the market recovers somewhat and prices for the assets increase, predicts Gerard Cassidy, senior equity analyst at RBC Capital Markets (RY) in Portland, Me. THE BUYER OF LAST RESORT As Merrill Lynch's transaction with Lone Star showed, the discount on these assets has two components: credit risk, which is based on the likelihood of defaults on the underlying mortgages, and lack of liquidity discount, which stems from a dearth of potential buyers, says Cassidy. By stepping in as the buyer of last resort, the U.S. government will be pumping liquidity into the banking system, which is expected to boost the value of these securities, he says. As a result, the

liquidity discount in the price of the assets should narrow substantially as market participants recognize there's a big buyer providing liquidity, which could help attract more buyers, Cassidy adds. One group that isn't likely to get any relief from the bailout are hedge funds that hold a large quantity of the distressed debt products, says Jack Ablin, chief investment officer at Harris Private Bank (BMO) in Chicago. "Here's a case where hedge funds, as unregulated entities, have no recourse at the table," unlike the banking lobby and mutual-fund industry group Investment Company Institute, both of which will likely have some influence over the legislation that ultimately materializes, he says. He also believes the hedge funds were directly targeted by the Securities & Exchange Commission's ban on shorting more than 800 financial stocks, which took effect on Sept. 22 and is due to last through Oct. 2. GM MAY BE A LOSER Other losers may include companies such as General Motors (GM), whose affiliated financing arm GMAC likely has exposure to toxic securities but may not qualify for the government bailout because it's not strictly a financial firm, says Ablin. "You certainly get into odd territory with GMAC," he says. "It's almost entirely owned by a private equity fund [Cerberus Capital Management]. So do you want to bail out [Cerberus chairman] John Snow?" Commercial banks, most of which have kept their balance sheets free of toxic assets, will probably benefit indirectly as the increase in market liquidity will help push their borrowing costs lower, says John Jay, senior analyst at the Aite Group, an independent financial services research firm in Boston. "If [its funding costs] go low enough, their senior managers will start to look for businesses to lend money to." In the end, their profit margins are expected to grow as the differential between their borrowing costs and lending rates widens. The shares of some financial players have had a strong run in spite of the market's attempts to paint them with the same brush as the rest of the industry, says Jocelyn Drake, an equity analyst at Schaeffer's Investment Research in Cleveland. PNC Financial Services (PNC), Wells Fargo (WFC), and Hudson City Bancorp (HCBK) all steered clear of toxic assets and their shares hit one-year highs last week before Treasury Secretary Henry Paulson announced the plan on Sept. 18. The shares posted further gains after the announcement. SKELETONS IN THE CLOSET Schaeffer's tends to base its stock picks on technical performance and the degree of pessimism directed at them. Market pessimism —which is reflected in analysts' ratings, the level of short interest and the ratio of options betting on lower prices for certain stocks vs. bets on higher prices—can give you a sense of how much investing money is sitting on the sidelines waiting for the right signals to come into the market. "There are still some skeletons that could come out of the closet [for the financial industry] and hinder the group," says Drake. But she's betting that as certain stocks continue to buck the trend and outperform their peers, sidelined investors will cave in and start to buy these stocks so as not to miss the boat. There are also a couple of homebuilder stocks that Drake expects to benefit as liquidity returns to the housing market and inventory begins to move. She likes Meritage Homes (MTH) and Toll Brothers (TOL), both of which have been in an uptrend since the beginning of this year. She takes the drop in mortgage rates after the government bailout of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) was announced two weeks ago as a positive sign, which she believes will help stoke demand for houses. A CONTRARIAN VIEW She recommends that investors hedge such bets that go contrary to market sentiment by buying shares of index exchange-traded funds that short the corresponding sectors. For financials, she

uses Financial Select Sector SPDR (XLF and UltraShort Financials ProShares (SKF) to hedge her bank picks and SPDR S&P Homebuilders (XHB) to protect against the downside in homebuilders.

A U.S. financial rescue plan, with modifications, seen as likely Wednesday, September 24, 2008

Influential U.S. lawmakers said Wednesday that the proposed $700 billion financial rescue plan was likely to win approval, but in modified form, as the Federal Reserve chairman, Ben Bernanke, warned Congress that a weakening economic outlook at home and abroad made it imperative to take quick action.

"Despite the efforts of the Federal Reserve, the Treasury and other agencies, global financial markets remain under extraordinary stress," Bernanke told the Joint Economic Committee of Congress, predicting that the U.S. economy was likely to lose ground even if the plan was approved. But without it, he warned, the situation would be far worse.

"Action by the Congress is urgently required to stabilize the situation," he said, "and avert what otherwise could be very serious consequences for our financial markets and our economy."

The committee chairman, Senator Charles Schumer, Democrat of New York, said that all but "a few outliers" among the lawmakers agreed that some version of the vast plan to rescue the U.S. financial system must be approved, and soon. But he said it would not be passed without adequate safeguards that lawmakers intend to add to protect the interests of taxpayers.

Bernanke's testimony, part of an intensive drive at the Capitol for the bailout, came the morning after Warren Buffett, the most famous American investor and one of the richest men in the world, disclosed that he would invest $5 billion in Goldman Sachs, the embattled Wall Street titan. That move, intended to bolster confidence in the financial markets, was greeted by investors with relief but did little to push up stocks trading Wednesday in Europe and the United States. Credit markets remained under stress and the cost of borrowing dollars rose on world markets, requiring central banks to add extra funds to the banking system.

Until now, Buffett, who has navigated the stock market with legendary prowess, had largely refrained from investing in the stricken financial industry, saying repeatedly that things could get worse. Thousands of people on and off Wall Street follow Buffett's moves, so his decision to invest in Goldman suggested to some that a bottom might be nearing in financial stocks.

"Buffett is saying he's confident," said Brad Hintz, an analyst at Sanford C. Bernstein.

Despite the varied efforts to relieve the financial crisis, the bailout continued to face skepticism, especially in the House of Representatives, which was holding its first day of hearings on the crisis.

As congressional leaders worked anxiously behind the scenes to build support for a vote later this week, House Republicans complained bitterly at a meeting of their caucus, telling Treasury Secretary Henry Paulson Jr. that the White House had failed to explain its proposal to the public.

The result, they said, has been a deluge of calls and e-mail messages from constituents overwhelmingly opposed to taxpayer money bailing out rich Wall Streeters.

In his testimony, Bernanke said that international trade "provided considerable support for the U.S. economy over the first half of the year," but that this stimulus could not be counted on in the long run.

"In recent months," he said, "the outlook for foreign economic activity has deteriorated amid unsettled conditions in financial markets, troubling housing sectors and softening sentiment. As a consequence, in coming quarters, the contribution of net exports to United States production is not

likely to be as sizable as it was in the first half of the year."

Bernanke's remarks added to the continuing sense of urgency, as he alluded to extraordinarily high levels of uncertainty and risk, well beyond the sagging housing market whose troubles lie at the core of the problems.

The session offered a blend of concerns over financial markets, both on Wall Street and abroad, and intensely political worries for the lawmakers as Election Day draws near.

Schumer said he and other members of Congress were listening to their constituents, who were reacting with "amazement, astonishment and intense anger" to the original outlines of the $700 billion plan, as laid out by the administration of President George W. Bush, and to the high-risk behavior that spawned the crisis.

"We were told that markets knew best, and that we were entering a new world of global growth and prosperity," Schumer said. "We now have to pay for the greed and recklessness of those who should have known better."

But Schumer suggested that Congress had little choice but to approve some sort of rescue package.

"With the exception of a few outliers on either side, there is clear recognition among members of both parties that we must act and act soon," Schumer said. Without adequate safeguards, however, "we risk the plan failing."

The White House said that Bush would make a prime-time television appearance Wednesday night to lift support for the program, whose basic premise calls for the Treasury Department to oversee the purchase of troubled mortgage-backed securities, reselling them later in a bid to recoup at least some of the taxpayers' money used to buy them.

The chief spokeswoman for Bush, Dana Perino, said Wednesday that the country could face "a financial calamity" if Congress did not act soon.

Bernanke, who reminded members of Congress on Tuesday that his background is in academe, not Wall Street, told Schumer's panel that the Fed believed in general that "private-sector arrangements" were best in straightening out problems in the financial markets.

"Government assistance should be given with the greatest of reluctance and only when the stability of the financial system and, consequently, the health of the broader economy is at risk," Bernanke said. And now is such a time, he said.

Buffett's move suggested that a few well-placed investors might also help stabilize the financial system.

Buffett's conglomerate, Berkshire Hathaway, announced the move Tuesday, two days after Goldman, long the premier investment house on Wall Street, embarked on a radical plan to transform itself into a traditional bank to ensure its survival. Goldman, which examined various options over the past week as its shares tumbled and some clients abandoned it, also said Tuesday that it would sell at least $2.5 billion of common stock to the public.

Since the credit crisis began flaring more than a year ago, Buffett had stayed his hand even as other investors, including funds controlled by governments in the Middle East and Asia, poured money into ailing U.S. financial companies like Citigroup and Merrill Lynch, only to see their investments plunge in value.

Wariness is a hallmark of Buffett's investing style, and many on Wall Street have wondered when he might jump in.

Buffett, 78, has learned from past mistakes in the financial sector. For instance, Berkshire's acquisition in 1998 of General Re, the insurance company, was marred by a portfolio of complex derivative securities and state and U.S. government investigations into reinsurance policies written by the company. Another trying experience was with Salomon Brothers, the Wall Street firm that the government pressed Buffett to take control of in the early 1990s amid a trading scandal.

But Goldman is a classic Buffett play: It is a blue-chip institution, with a premier brand and a long, successful history, that has been beaten down in the stock market, and one that he is investing in on very favorable terms. The share price of Goldman has fallen 39 percent this year and reached a peak of $250.70 less than a year ago.

Some lawmakers pointed to Buffett’s deal as an example the government should follow. Berkshire will receive perpetual preferred shares that will pay an annual dividend of 10 percent, or $500 million. Those dividends take precedence over other payments to common shareholders. Goldman has the right to buy back the shares at any time at a premium of 10 percent.

In addition, Berkshire will receive warrants to buy $5 billion in common stock at $115 a share, exercisable anytime within five years. Those warrants are already in the money: Goldman shares rose 3.5 percent Tuesday and climbed $6.62, or 5.3 percent, to $131.67 by Wednesday afternoon.

Meanwhile, doubts were raised about the ultimate cost of any government bailout. Until more details emerge about what the government will buy, and how, the director of the Congressional Budget Office said it "cannot provide a meaningful estimate of the ultimate cost" to American taxpayers.

Over time, Peter Orszag of the nonpartisan budget office told the House Budget Committee, the cost could actually be less than the $700 billion sticker price. The challenge, he said, is for the Treasury to avoid taking the riskiest assets off Wall Street's hands unless it can get them at fire-sale prices.

Ben White reported from New York

U.S. home prices tumble A record decline in U.S. home prices in August attracted more buyers in some areas and led to a sizable decline in the number of unsold homes on the market, the National Association of Realtors said Wednesday, The Associated Press reported from Washington. The median price fell 9.5 percent, to $203,100, the largest price decline in records dating to 1999. As prices fall, buyers are taking advantage of steep discounts, especially in hard-hit markets like California, Nevada and Florida. The inventory of unsold homes fell 7 percent, to 4.3 million, from the record of 4.6 million in July. That is a 10.4-month supply at the current sales pace. But the decline merits only "a small round of applause" because around 5 months of inventory is a more typical level, wrote Patrick Newport, an economist with Global Insight. Lawrence Yun, the trade group's chief economist, said he hoped the downward trend in inventories continued because "home prices will not stabilize as long as inventories remain high."

Washington Mutual may be on block Thursday, September 25, 2008

U.S. government regulators are moving quickly to broker a deal for Washington Mutual as the savings-and-loan comes under mounting financial pressure, according to people briefed on the talks.

Even as Washington moves to bail out financial institutions, the fortunes of Washington Mutual have spiraled downward. On Wednesday, Standard & Poor's, a major credit rating agency,

downgraded Washington Mutual's debt further into junk territory, citing the increased chance that the company might have to be split up to facilitate a sale.

Washington Mutual insists that it is well-capitalized and has adequate access to funding and noted "the rating actions do not affect the safety of customer deposits, which are insured up to the limits allowed" by the U.S. government.

Brad Russell, a Washington Mutual spokesman, declined to comment on speculation about a possible sale. Still, shares fell 94 cents, or 29 percent, to $2.26 a share on Wednesday, leaving them down 83 percent this year.

The government's entrance suggests the sales process may be entering a new phase after the bank struggled to find an interested buyer. Washington Mutual had vowed that it could remain independent, but it quietly hired Goldman Sachs early last week to identify potential bidders.

Among the banks that have expressed interest in buying all or part of Washington Mutual are Citigroup, JPMorgan Chase, HSBC, Banco Santander, and Wells Fargo. It is unclear what form of assistance U.S. regulators will now offer.

Analysts suggest that Washington Mutual, which plunged into the subprime mortgage and credit card business over the last few years, could rack up more losses totaling $30 billion or more.

Credit markets remain tight amid uncertainty September 25, 2008

A new bout of anxiety gripped the credit markets on Wednesday as banks hoarded cash and investors once again rushed for the safest of investments, like Treasury bills.

A crucial bank interest rate that determines the cost of money for companies and consumers around the world spiked to its highest level since January. At the same time, yields on Treasury bills fell sharply, nearly reaching the lows touched a week earlier, when many feared the nation's financial system was in jeopardy. Most financial shares declined, even as the broader stock market closed mixed.

"The credit markets are saying that things are likely to get worse before they get better," said Michael Darda, chief economist at MKM Partners, an investment and research firm in Greenwich, Connecticut

"It's harder for companies to get financing, and those conditions make economic weakness worse."

With the structure of the rescue still in doubt, and a protracted political battle brewing over its fate, worries are building in the credit markets.

Investors took little solace from the news late Tuesday that Warren Buffett, the noted investor, had agreed to invest $5 billion in the investment bank Goldman Sachs.

Several crucial barometers pointed toward renewed stress in the credit markets. The one-month London interbank offered rate, or Libor, rose nearly a fifth of a percentage point, to 3.43 percent, its highest since January.

The difference between Treasury bills and a three-month Libor jumped to nearly 3 percentage points, from 2.5 on Tuesday, signaling deep unease among investors.

In the stock market, the Standard & Poor's 500-stock index seesawed up and down most of the day and closed down 2.35 points, to 1,185.87 points. The Dow Jones industrial average fell 29 points, to 10,825.17. The Nasdaq composite index rose 2.35 points, to 2,155.68.

To some investors, the markets' skeptical reaction to the news out of Washington and from Goldman Sachs appears to be part of a pattern that was set with the near collapse of Bear Stearns. Investors cheer initially, hoping government intervention will help, but after further thought realize that the nation's economic and financial troubles will not be resolved easily.

"There are a lot of qualms about it," Martin Fridson, chief executive of Fridson Investment Advisors, said about the Treasury proposal to buy troubled assets. "The same questions still hang over us, which is what is this stuff worth?"

A report released on Wednesday showed that the housing market, where many of the financial problems originated, remains weak. Sales of previously owned homes fell 2.2 percent in August, to a 4.91 million annual rate, down from 5.02 million in July, according to the National Association of Realtors. But there were a few signs of improvement, the number of homes for sale fell 7 percent, to 4.26 million.

For financial firms it was another tough day. The cost to insure Goldman's corporate debt dropped immediately after Buffett's announcement, but climbed higher throughout the day, according to Credit Derivatives Research. By the end of the afternoon, insurance protection on Goldman Sachs debt was slightly more expensive to buy than it was on Tuesday, a sign that even the aura of Buffett was not enough to fully placate the fears of investors.

The cost of protecting against a default by Morgan Stanley, the other investment bank that this week agreed to become a bank holding company, surged toward the record highs of last week.

A big source of stress in the credit market appears to be coming from money market funds, the traditionally ultra-safe short-term investment vehicles. Over the last week, retail and institutional investors have been moving hundreds of billions of dollars from prime money market funds to government funds, because they are worried about potential losses after the net asset value of one large fund fell below $1 a share.

That has forced many money market fund managers to sell debts issued by corporations, known as commercial paper, and go into Treasury bills, creating a scramble for government-backed debt and severely reducing demand for corporate debt.

"When the money markets are attacked as they were, that is to me, and a lot of other people, a sign that there is a sense of panic out there," said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co., an investment firm in Jersey City.

At the end of last week, the Federal Reserve and Treasury announced several measures to ease the strain on money market funds and reassure investors that their money was protected. Those moves appear to have helped. The outflow of money from prime money market funds has slowed significantly in recent days, according to iMoneyNet, a research firm. But analysts said that fund managers are keeping more cash on hand in case redemptions pick up again.

The benchmark 10-year Treasury bill was down 3/32, to 101 17/32. The yield, which moves in the opposite direction from the price, was 3.81 percent, up from 3.8 percent late Tuesday.

The buck stopped then September 24, 2008

Critics of the Bush administration's Wall Street bailout condemn the waste of taxpayer dollars. But the taxpayers aren't the weightiest American financial constituency, even in this election year. The dollar is the world's currency. And it is on the world's opinion of the dollar that the U.S. Treasury's plan ultimately hangs.

It hangs by a thread, if the latest steep drop of the greenback against the euro is any indication. We Americans, constitutionally inattentive to developments in the foreign exchange markets, should be grateful for what we have. That a piece of paper of no intrinsic value should pass for good money the world over is nothing less than a secular miracle. We pay our bills with it. And our creditors not only accept it, they also obligingly invest it in American securities, including our slightly shop-soiled mortgage-backed securities. Every year but one since 1982, the United States has consumed much more than it has produced, and it has managed to discharge its debts with the money that it alone can lawfully print.

No other nation ever had it quite so good. Before the dollar, the pound sterling was the pre-eminent monetary brand. But when Britannia ruled the waves, the pound was backed by gold. You could exchange pound notes for gold coin, and vice versa, at the fixed statutory rate.

Today's dollar, in contrast, is faith-based. Since 1971, nothing has stood behind it except the world's good opinion of the United States. And now, watching the largest American financial institutions quake, and the administration fly from one emergency stopgap to the next, the world is changing its mind.

"Not since the Great Depression," news reports keep repeating, has America's banking machinery been quite so jammed up. The comparison is hardly flattering to this generation of financiers. From 1929 to 1933, the American economy shrank by 46 percent. The wonder is that any bank, any corporate borrower, any mortgagor could have remained solvent, not that so many defaulted. There is not the faintest shadow of that kind of hardship today. Even on the question of whether the nation has entered a recession, the cyclical jury is still out. Yet Wall Street shudders.

The remote cause of its troubles is the paper dollar itself - the dollar and the growth in the immense piles of debt it has facilitated. The age of paper money brought with it an increasingly uninhibited style of doing business.

The dollar emerged at the center of the monetary system that took its name from the 1944 convention in Bretton Woods, New Hampshire. The U.S. currency alone was made exchangeable into gold. The other currencies, when they got their peacetime legs back under them, were made exchangeable into the dollar.

All was well for a time - indeed, for one of the most prosperous times in modern history. Under the system of fixed exchange rates and a gold-anchored dollar, world trade boomed (albeit from a low, war-ravaged base). Employment was strong and inflation dormant. The early 1960s were a kind of macroeconomic heaven on earth.

However, by the middle of that decade it had come to the attention of America's creditors that the United States, fighting the war in Vietnam, was emitting a worryingly high volume of dollars into the world's payment channels. Foreign central banks, nervously eyeing the ratio of dollars outstanding to gold in the Treasury's vaults, began prudently exchanging greenbacks for bullion at the posted rate of $35 per ounce.

In 1965, William McChesney Martin, chairman of the Federal Reserve, sought to reassure the dollar holders. He lectured the House Banking Committee on the importance of maintaining the dollar's credibility "down to the last bar of gold, if that be necessary."

Necessary, it might have been, but expedient, it was not, and the Nixon administration, on Aug. 15, 1971, decreed that the dollar would henceforth be convertible into nothing except small change. The age of the pure paper dollar was fairly launched.

In the absence of a golden anchor, the United States produced as many dollars as the world cared to absorb. And the world's appetite was prodigious. It was the very lack of gold-standard inhibition that permitted the buildup of titanic dollar balances overseas. At the end of 2007, no less than $9.4 trillion in dollar-denominated securities were sitting in the vaults of foreign investors. Not a few of these trillions were the property of Asian central banks. So, although the United States has run heavy and persistent current account deficits - $6.7 trillion in total since 1982 - they have been "deficits without tears," to quote the French economist Jacques Rueff. The dollars American debtors sent abroad America's creditors sent right back in the shape of investments in American stocks, bonds and factories.

Under the Bretton Woods system, worried foreign creditors would long ago have cleaned out Fort Knox. But, conveniently, the dollar is uncollateralized and unconvertible. America's overseas creditors hold it for many reasons. But even the governments that scoop up dollars for no better reason than to manipulate their own currency's value presumably put some store in the integrity of American finance.

As never before, that trust is being put to the test. In the best of times, the Treasury and the Federal Reserve pretended as if the dollar were America's currency alone. Now, in some of the worst of times, Washington is treating its vital overseas dollar constituency as if it weren't even there.

Which failing financial institution will the administration pluck from the flames of crisis? Which will it let roast? Which market, or investment technique, will the regulators bless? Which - in a capricious change of the rules - will it condemn or outlaw? Just how shall the Treasury secretary spend the $700 billion he's begging for? Viewed from Wall Street, the administration's recent actions appear erratic enough. Seen from the perch of a foreign investor, they must look very much like "political risk," a phrase we Americans usually associate with so-called emerging markets, not with our own very developed one.

Where all this might end, nobody can say. But it is unlikely that either the dollar, or the post-Bretton Woods system of which it is the beating heart, will emerge whole. It behooves Barack Obama and John McCain to do a little monetary planning. In the absence of faith, what stands behind a faith-based currency?

Bailout plan's basic mystery: What's this stuff worth?

September 25, 2008 What would you pay, sight unseen, for a house that nobody wants, on a hard-luck street where no houses are selling?

That question is easy compared to the one confronting the Treasury Department as Washington works toward a vast bailout of financial institutions. Treasury Secretary Henry Paulson Jr. is proposing to spend up to $700 billion to buy troubled investments that even Wall Street is struggling to put a price on.

A big concern in Washington — and among many ordinary Americans — is that the difficulty in valuing these assets could result in the government's buying them for more than they will ever be worth, a step that would benefit financial institutions at taxpayers' expense.

Anyone who has tried to buy or sell a house when the market is falling, as it is now in the United States, knows how difficult it can be to agree on a price. But valuing the securities that the Treasury aims to buy will be far more difficult. Each one of these investments is tied to thousands of individual mortgages, and many of those loans are going bad as the housing market worsens.

"The reality is that we are not going to know what the right price is for years," said Andrew Feltus, a bond portfolio manager at Pioneer Investments, a mutual fund firm based in Boston. "It might be 20 cents on the dollar or 60 cents on the dollar, but we won't know for years."

While prices of most stocks are no mystery — they flicker across computer screens and televisions all day — the troubled investments are not traded on any exchange. The market for them is opaque: traders do business over the telephone, and days can go by without a single trade.

Not only that, many of these instruments are extremely complex. Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here's how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans — the kind often referred to as liar loans, because lenders made them without the usual documentation to verify borrowers' incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona, where home prices rose — and subsequently fell — faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for sale to investment banks, hedge funds and insurance companies.

If any of the mortgages went bad — and, it turned out, many did — the bonds at the bottom of the pecking order would suffer losses first, followed by the next lowest, and so on up the chain. By one measure, the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered losses of about 1.6 percent. Of those loans, 778 have been paid off or moved through the foreclosure process.

But by many other measures, it's a toxic portfolio. Of the 2,093 loans that remain, 23 percent are delinquent or in foreclosure, according to Bloomberg News data. Initially rated triple-A, the most senior of the securities were downgraded to near junk bond status last week. Valuing mortgage bonds, even the safest variety, requires guesstimates: How many homeowners will fall behind on their mortgages? If the bank forecloses, what will the homes sell for? Investments like the Bear Stearns securities are almost certain to lose value as long as home prices keep falling.

"Under the current circumstances it's likely that you are going to take a loss on these loans," said Chandrajit Bhattacharya, a mortgage strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the government could buy, and they are by no means the most complicated of the lot. Wall Street took bonds like those of Bear Stearns and bundled and rebundled them into even trickier investments known as collateralized debt obligations.

"No two pieces of paper are the same," said Feltus of Pioneer Investments.

On Wall Street, many of these collateralized debt obligations have been selling for pennies on the dollar, if they are selling at all. In July, Merrill Lynch, struggling to bolster its finances, sold $31

billion of tricky mortgage-linked investments for 22 cents on the dollar. Last November, Citadel, a large hedge fund in Chicago, bought $3 billion of mortgage securities and other investments for 27 cents on the dollar.

But Citigroup, the financial giant, values similar investments on its books at 61 cents on the dollar. Citigroup says its collateralized debt obligations are relatively high quality because they were created before lending standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.

"Many are tempted by a strategy of trying to do both things at once," said Lawrence Summers, a former Treasury secretary in the Clinton administration. As a hypothetical example, Summers suggested that an institution could have securities on its books at $60, but the current market price might only be $30. In that case, the government might be tempted to come in at about $55.

Many financial institutions are so weak that they must sell their troubled assets at prices near the value on their books, Carlos Mendez, a senior managing director at ICP Capital, an investment firm that specializes in credit markets. Anything less would eat into their capital.

"Depending on your perspective on the economy, foreclosure rates and home prices, the market may eventually reflect that price. But most buyers are not willing to make that bet right now," he said. "And that's why we have these low prices."

Ben Bernanke, the chairman of the Federal Reserve Board, told Congress on Tuesday that the government should avoid paying a fire-sale price, and pay what he called the "hold-to-maturity price," or the price that investors would bid if they expected to keep the bond till it was paid off.

The government would buy the troubled investments with the intention of eventually selling them back to the market when prices recover.

The Treasury has suggested it might conduct reverse auctions to determine the price for securities that are not trading in the market.

Unlike in a traditional auction in which would-be buyers submit bids to the seller, in a reverse auction the buyer solicits bids from would-be sellers. Often, the buyer agrees to pay the second-highest bid submitted to encourage sellers to compete by lowering their bids for all the assets submitted. The buyer often also sets a reserve price and refuses to pay any more than that price.

But Paulson told Congress on Tuesday that the government would use many other means in addition to auctions, suggesting that it would exercise wide discretion over the final prices to be paid.

Financial institutions will have an incentive to sell their worst assets to the government, a risk that the Treasury will have to guard against, said Robert Hansen, senior associate dean at the Tuck School of Business at Dartmouth College, New Hampshire.

"I am worried that the people who are going to offer the securities to the government will be the ones that have the absolute worst toxic waste," Hansen said. Even so, he added, the government could actually make a profit on its purchases provided the Treasury buys at the right prices. Richard

Breeden, a former chairman of the Securities and Exchange Commission, said the auctions could thaw parts of the markets that have been frozen since late last year.

"One of the problems that many institutions are having is finding any bid for some of these assets, even though they are not without value," said Breeden, who is chairman and chief executive of Breeden Capital Management, an investment firm in Greenwich, Connecticut

"What are these assets worth?" asked Breeden. "Sometimes, because of fear or extreme uncertainty in the markets, you get in a situation in which there are no bids at all, or at least no realistic bids."

A Bailout We Don't Need September 25, 2008

Now that all five big investment banks -- Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley -- have disappeared or morphed into regular banks, a question arises. Is this bailout still necessary? The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. They're called "loans." With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to take care of that. Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture -- and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can't save everyone, and those investors aren't poor. With this solution, the systemic financial threat should go away. Does that mean the economy would quickly recover? No. Sadly, it does not. Two vast economic problems will confront the next president immediately. First, the underlying housing crisis: There are too many houses out there, too many vacant or unsold, too many homeowners underwater. Credit will not start to flow, as some suggest, simply because the crisis is contained. There have to be borrowers, and there has to be collateral. There won't be enough. In Texas, recovery from the 1980s oil bust took seven years and the pull of strong national economic growth. The present slump is national, and it can't be cured that way. But it could be resolved in three years, rather than 10, by a new Home Owners Loan Corp., which would rewrite mortgages, manage rental conversions and decide when vacant, degraded properties should be demolished. Set it up like a draft board in each community, under federal guidelines, and get to work. The second great crisis is in state and local government. Just Tuesday, New York Mayor Michael Bloomberg announced $1.5 billion in public spending cuts. The scenario is playing out everywhere: Schools, fire departments, police stations, parks, libraries and water projects are getting the ax, while

essential maintenance gets deferred and important capital projects don't get built. This is pernicious when unemployment is rising and when we have all the real resources we need to preserve services and expand public investment. It's also unnecessary. What to do? Reenact Richard Nixon's great idea: federal revenue sharing. States and localities should get the funds to plug their revenue gaps and maintain real public spending, per capita, for the next three to five years. Also, enact the National Infrastructure Bank, making bond revenue available in a revolving fund for capital improvements. There is work to do. There are people to do it. Bring them together. What could be easier or more sensible? Here's another problem: the wealth loss to near-retirees and the elderly from a declining stock market as things shake out. How about taking care of this, with rough justice, through a supplement to Social Security? If you need a revenue source, impose a turnover tax on stocks. Next, let's think about what the next upswing should try to achieve and how it should be powered. If the 1960s were about raising baby boomers and the '90s about technology, what should the '10s and '20s be about? It's obvious: energy and climate change. That's where the present great unmet needs are. So, let's use the next few years to plan, mapping out a program of energy conservation, reconstruction and renewable power. Let's get the public sector and the universities working on it. And let's prepare the private sector so that when the credit crunch finally ends, we'll have the firms, the labs, the standards and the talent in place, ready to go. Some will ask if we can afford it. To see the answer, don't look at budget projections. Just look at interest rates. Last week, in the panic, the federal government could fund itself, short term, for free. It could have raised money for 30 years and paid less than 4 percent. That's far less than it cost back in 2000. No country in this situation is broke, or insolvent, or even in much trouble. For once, Wall Street's own markets speak the truth. The financially challenged customer isn't Uncle Sam. He's up on Wall Street, where deregulation, greed and fraud ran wild.

The crisis last time September 25, 2008

The Federal Reserve chairman and senior economic officials of the Bush administration solemnly filed into the large conference room of the Treasury Department. There was a sense of urgency, an understanding that drastic action - restructuring the financial landscape of corporate America - was desperately needed.

Last week? This past Wednesday night, as the president and his advisers prepared for his address to the nation? Hardly. It was Feb. 22, 2002. The officials were President Bush's original economic team, including the Securities and Exchange Commission's chairman, Harvey Pitt; Glenn Hubbard, the chairman of the Council of Economic Advisers; and the senior White House economic adviser, Lawrence Lindsey. The Federal Reserve chairman, of course, was Alan Greenspan.

The crisis of that moment was the implosion of Enron, Global Crossing and other companies. Along with conflicts of interest and criminally creative bookkeeping, the culprit was often a combination of financial complexity and insanely expensive compensation packages.

Enron is long gone, but this episode - as much a warning for our financial security as the 1993 World Trade Center bombing was to the threat of wider terrorism - carries some telling lessons as our best minds struggle now to save the economy.

The meeting, recounted to me by Paul O'Neill, Bush's first Treasury secretary, and several other participants, was something of a showdown. Everyone came armed for battle, none more than Greenspan and O'Neill, who railed that day like a pair of blue-suited Jeremiahs.

Their colloquy on economic policy and corporate practice, which began when they were senior officials in the Ford administration, had evolved over three decades.

To the surprise of many younger men in the room, the duo opened by reminiscing about a bygone era when the value of a company's stock was assessed by how strong a dividend was paid. It was a standard that demanded tough, tangible choices. Everything, of course, came out of the same pot of cash, from executive compensation and capital improvements to the dividend - which could be spent by a shareholder or reinvested in more stock as a show of support.

In contrast to dividends, Greenspan intoned, "Earnings are a very dubious measure" of corporate health. "Asset values are, after all, just based on a forecast," he said, and a chief executive can "craft" an earnings statement in misleading ways.

Speaking with a hard-edged frankness rarely heard in public - and seeing that those assembled were not sharing his outrage - Greenspan slapped the table. "There's been too much gaming of the system," he thundered. "Capitalism is not working! There's been a corrupting of the system of capitalism."

O'Neill, for his part, pushed to alter the threshold for action against chief executives from "recklessness" - where a difficult finding of willful malfeasance would be necessary for action against a corporate chief - to negligence. That is, if a company went south, the boss could face a hard-eyed appraisal from government auditors and be subject to heavy fines and other penalties. By matching upside rewards with downside consequences - a bracing idea for the corner office - O'Neill and Greenspan hoped fear would compel the titans of business to enforce financial discipline, full public disclosure and probity down the corporate ranks.

But they were in the minority. Pitt, the SEC chairman, voiced concern that creation of a new entity to assess negligence by corporate honchos might draw power away from his agency. Lawrence Lindsey said, "There's always the option of doing nothing," that the markets are "already discounting the stocks in companies that show accounting irregularities."

An article about the meeting appeared a few days later in The Wall Street Journal. The next day, O'Neill was in Florida addressing chief executives of America's top 20 financial services companies. They piled on. One told the Treasury secretary that he'd "rather resign" than be held accountable for "what's going on in my company." A phalanx of outraged financial industry chiefs, many of them large Republican contributors, called the White House. Real reform was a political dead letter.

A presidential speech that followed was toothless, mostly recommending that chief executives personally certify their companies' financial statements. Earnings per share remained the gold standard.

The Sarbanes-Oxley bill, signed into law a few months later, largely focused on the auditors, and actually increased the complexity of reporting practices. As for lawsuits? Not to worry. No significant rise.

At issue, of course, were those twins, transparency and accountability. The years since have shown that the first one is meaningless without the second. With a world financial crisis upon us, the president and his economic team are forced again to talk about accountability. Let's hope this time they mean it.

Ron Suskind is the author of "The Price of Loyalty: George W. Bush, the White House and the Education of Paul O'Neill" and "The Way of the World: A Story of Truth and Hope in an Age of Extremism."

An inadequate case for the bailout plan IHT Editorial--September 25, 2008

Under skeptical questioning in the Senate Banking Committee on Tuesday, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke gave no ground in defense of their $700 billion proposal to bail out the financial system. They also gave little reason to believe that their proposal would protect taxpayers from huge losses. Instead, they said that any eventual loss would be less than the losses that Americans would endure if lending froze up, as it did briefly last week in the panicked aftermath of the failure of Lehman Brothers and the near-death of the American International Group.

The candor is appreciated, but it is not a good enough answer for Congress or the American people. Rather than rushing to approve the $700 billion bailout, lawmakers need to examine alternatives. They should look for one that ideally would let taxpayers share in the gains from any post-bailout revival, along with the bankers and private investors who will make money if the bailout succeeds. Several ideas have been advanced that Congress should examine.

Prominent among them is a plan to make a direct investment of taxpayer dollars into financial firms, rather than buying up their bad assets. With that money, the firms could absorb the losses that they are bound to take as their investments go sour. Once the firms begin to recover, taxpayers would earn a return.

Such equity investments are risky, and careful analysis is needed to show if they would be riskier than what the administration has proposed.

Another proposal, advanced by Senator Christopher Dodd, would buy up bad assets, as proposed by the administration, but would give the government the option to acquire stock in the firms receiving help. The danger is that private investors, fearful of seeing their ownership stakes diluted if the government becomes a shareholder, might be reluctant to invest money. That would deprive the firms of investments they need to recover.

There is time to clarify that sort of uncertainty. The system is vulnerable to more severe problems, but the credit squeeze has eased a bit since the administration's bailout was proposed.

That's partly because of the expectation of a bailout, so Congress should be clear that it is working on a plan with appropriate speed.

One thing is certain. If taxpayers do not share in the potential profits from a bailout, someone else will. On Tuesday, the Federal Reserve announced that it was relaxing rules that require investors who take large stakes in banks to submit to longstanding regulations on transparency and managerial control. Private equity firms have pushed for the changes because they would like to become big investors in beaten-down banks but do not want to be regulated.

Relaxing the rules invites more of the same type of opacity and risk-taking into banking that caused many of today's financial problems. Politically, the Fed's timing could not have been worse.

Taxpayers are being asked to buy up banks' junky assets, with little expectation of return. At the same time, private equity firms are being invited to make what are likely to be highly profitable investments in the same banks. That's not a plan that lawmakers and voters can support. Congress has more work to do.

America's bail-out plan

I want your money

Sep 25th 2008 From The Economist print edition

No government bail-out of the banking system was ever going to be pretty. This one deserves support

SAVING the world is a thankless task. The only thing beyond dispute in the $700 billion plan of Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, to stem the financial crisis is that everyone can find something in it to dislike. The left accuses it of ripping off taxpayers to save Wall Street, the right damns it as socialism; economists disparage its technicalities, political scientists its sweeping powers. The administration gave ground to Congress, George Bush delivered a televised appeal and Barack Obama and John McCain suspended the presidential campaign. Even so, as The Economist went to press, the differences remained. There was a chance that Congress would say no.

Spending a sum of money that could buy you a war in Iraq should not come easily; and the notion of any bail-out is deeply troubling to any self-respecting capitalist. Against that stand two overriding arguments. First this is a plan that could work. And, second, the potential costs of producing nothing, or too little too slowly, include a financial collapse and a deep recession spilling across the world: those far outweigh any plausible estimate of the bail-out’s cost.

Mr Market goes to Congress America’s financial system has two ailments: it owns a huge amount of toxic securities linked to falling house prices. And it is burdened by losses that leave it short of capital (although the world has capital, not enough has been available to the banks). For over a year, since August 2007, central bankers, principally Mr Bernanke, have been trying to make this toxic debt liquid. But by September 17th, following the bankruptcy of Lehman Brothers and the nationalization of American International Group earlier that week, the problem started to become one of the system’s solvency too. The market lost faith in a strategy that saved finance one institution at a time. The economy is not healing itself. If credit markets stay blocked, consumers and firms will enter a vicious spiral.

Mr Paulson’s plan relies on buying vast amounts of toxic securities. The theory is that in any auction a huge buyer like the federal government would end up paying more than today’s prices, temporarily depressed by the scarcity of buyers, and still buy the loans cheaply enough to reflect the high chance of a default. That would help recapitalize some banks—which could also set less capital aside against a cleaner balance sheet. And by creating credible, transparent prices, it would at last encourage investors to come in and repair the financial system: this week Warren Buffett and Japan’s Mitsubishi-UFJ agreed to buy stakes in Goldman Sachs and Morgan Stanley. Some banks would still not have enough capital, but under Mr Paulson’s original plan, the state could put equity in them, or, if they become insolvent, take them over and run them down.

The economics behind this is sound. Government support to the banking system can break the cycle of panic and pessimism that threatens to suck the economy into deep recession. Intervention may help taxpayers, because they are also employees and consumers. Although $700 billion is a lot—about 6% of GDP—some of it will be earned back and it is small compared with the 16% of GDP that banking crises typically swallow and trivial compared with the Depression, when unemployment surged above 20% (compared with 6% now). Messrs Bernanke and Paulson also have done well by acting quickly: it took seven years for Japan’s regulators to set up a mechanism to take over large broke banks in the 1990s.

Could the plan be better structured? Some economists want the state to focus on putting equity into the banks—arguing that it is the best way to address their lack of solvency. In theory you would need to spend less, because a dollar of new equity would support $10 in assets. Yet the banks might not take part until they were on the ropes and, if house prices later fell dramatically more, the value of the banks’ shares would collapse. The threat of the government taking stakes would scare

off some private investors. And in the charged atmosphere after this bail-out meddling politicians, as part-owners, would have a tempting lever over the banks.

Mr Paulson’s plan also has its shortcomings. He will find it hard to stop sellers from rigging auctions, if only because no two lots of dodgy securities are exactly the same. Taxpayers may thus pay over the odds and banks may be rewarded for their stupidity. Yet these costs seem small against the benefit of putting a floor under the markets. And fine calculations about moral hazard are less pressing when investors are fleeing risk.

If the economics of Mr Paulson’s plan are broadly correct, the politics are fiendish. You are lavishing money on the people who got you into this mess. Sensible intervention cannot even buy long-term relief: the plan cannot stop house prices falling and the bloated financial sector shrinking. Although the economic risk is that the plan fails, the political risk is that the plan succeeds. Voters will scarcely notice a depression that never happened. But even as they lose their houses and their jobs, they will see Wall Street once again making millions.

Buckle a little, but do it briefly In retrospect, Mr Paulson made his job harder by misreading the politics. His original plan contained no help for homeowners. And he assumed sweeping powers to spend the cash quickly. He was right to want flexibility to buy a range of assets. But flexibility does not exclude accountability. As complaints mounted, Mr Paulson and Mr Bernanke buckled—agreeing, for instance, to more oversight. Now that Messrs McCain and Obama have returned to Congress to forge a deal, more buckling may be necessary. Ideally, concessions should not outlast the crisis: temporary help for people able to stay in their houses, a brief ban on dividends in financial firms, even another fiscal package. They should not be permanent or so onerous that the program fails for want of participants—which is why proposed limits on pay are a mistake.

Mr Paulson’s plan is not perfect. But it is good enough and it is the plan on offer. The prospect of its failure sent credit markets once again veering towards the abyss. Congress should pass it—and soon.

America’s bail-out plan

The doctors' bill

Sep 25th 2008 | WASHINGTON, DC From The Economist print edition

The chairman of the Federal Reserve and the treasury secretary give Congress a gloomy prognosis for the economy, and propose a drastic remedy AMERICAN congressmen are used to hyperbole, but they were left speechless by the dire scenario Ben Bernanke, the chairman of the Federal Reserve, painted for them on the night of September 18th. He “told us that our American economy’s arteries, our financial system, is clogged, and if we don’t act, the patient will surely suffer a heart attack, maybe next week, maybe in six months, but it will happen,” according to Charles Schumer, a Democratic senator from New York. Mr Schumer’s interpretation: failure to act would cause “a depression”.

Mr Bernanke and Hank Paulson, the treasury secretary, had met congressional leaders to argue that ad hoc responses to the continuing financial crisis like that week’s bail-out of American International Group (AIG), a huge insurer, were no longer sufficient. By the weekend Mr Paulson had asked for authority to own up to $700 billion in mortgage-related assets. By the time The Economist went to press, Congress and Mr Paulson appeared to have agreed on the broad outlines of what is being called the Troubled Asset Relief Program, or TARP.

However, passage was not assured as rank-and-file congressmen, in particular Republicans, balked. Uncertainty over the outcome rattled credit markets: three-month interbank rates jumped and Treasury yields fell on September 24th. In a prime-time address that evening to rally support, George Bush warned of bank failures, plummeting house values and millions of lost jobs if Congress did not act.

Both the crisis and the authorities’ response have been called the most sweeping since the Depression. Yet the differences from that era are more notable than the similarities to it. From the stockmarket crash of 1929 to the federally declared bank holiday that marked its bottom, three and a half years elapsed, and unemployment reached 25%. This crisis has been under way for a little over a year and unemployment is just over 6%, lower even than in the wake of the last, mild recession. More than 4% of mortgages are now seriously delinquent (see chart 1), but the figure topped 40% in 1934.

The scale of the American authorities’ response reflects both the violence with which this crisis has spread, and the determination of the American authorities, most importantly Mr Bernanke, to learn from the mistakes that made the Depression so deep and long.

In responding with such speed and vigor, they run several risks. One is that they overdo it, paying far too much for assets, sending the deficit into the stratosphere and triggering a run on the dollar. The risk of underdoing it may be even greater. Politicians, determined not to be seen as doing favors for Wall Street, might blunt the program’s effect in the name of protecting the taxpayer. Then there’s the logistical nightmare of fixing a market whose very complexity is central to the crisis.

Experience, at home and abroad, is a poor guide. In past episodes authorities have typically not committed public money to their financial systems until bank failures and insolvency have become widespread. The first wave of savings-and-loan failures came in the early 1980s; the Resolution Trust Corporation was not created to dispose of their assets until 1989. Japan’s banks began to fail in 1991, but a mechanism for taking over large, insolvent banks was not set up until 1998. Mr Paulson and Mr Bernanke are attempting to prevent the crisis from reaching that stage. “The firms we’re dealing with now are not necessarily failing, but they are contracting, they are deleveraging,” Mr Bernanke told Congress. They are unable to raise capital and are refusing to lend, and that, he said, is squeezing the economy.

One risk with such a pre-emptive bail-out is that to congressmen the benefits are hypothetical whereas the fiscal and political costs, five weeks before an election, are all too real. In polls voters waver between opposition and support depending on how the question is asked.

In spite of these risks, the odds seem to be in favor of both political passage and success. America has owned up to its mistakes with exceptional speed, and pulled out the stops to correct them.

After the crisis first broke in August last year, the Fed pursued a two-pronged strategy. The first element was to lower interest rates to cushion the economy. The second was to use its balance sheet to help commercial and investment banks finance their holdings of hard-to-value securities and avoid fire-sales of assets. Behind this approach lay the belief that the economy and the financial system were basically solid. Yes, too many houses had been built and prices were too high, but a return to more normal levels would be manageable if stretched over a few years. And

banks in aggregate had entered the crisis in good shape, with much more capital this June than in 1990. The Fed saw their problem essentially as illiquidity, not insolvency. The Bush administration broadly shared this diagnosis—and an aversion to using public money to help overextended borrowers.

The intensification of the crisis came not from the banks but the “shadow banking system”: the finance companies, investment banks, off-balance-sheet vehicles, government-sponsored enterprises and hedge funds that fuelled the credit boom, aided by less regulation and more leverage than commercial banks. As home prices fell and loan losses mounted, more of the shadow system became insolvent.

Insolvency cannot be cured with more loans, no matter how easy the terms. It requires more capital, which in deep crises only the government can provide. Mr Bernanke’s groundbreaking paper on the Depression, published in 1983, noted that recovery began in 1933 with large infusions of federal cash into institutions, through the Reconstruction Finance Corporation, and households, through the Home Owners’ Loan Corporation. They were, he wrote, “the only major New Deal program which successfully promoted economic recovery.”

A month ago Mr Bernanke and his closest aides began to think something similar might now be needed. The Fed and the Treasury had already drawn up contingency plans, thinking it would be months before a need arose. Then the financial hurricane blew up over the weekend of September 13th and 14th. That is when Mr Paulson, Mr Bernanke and Tim Geithner, president of the Federal Reserve Bank of New York, decided not to commit any public money to a bail-out of Lehman Brothers. They reasoned, wrongly, that the financial system was adequately prepared. The company’s failure, coupled with the near-bankruptcy of AIG, threw the safety of all financial institutions into doubt, causing their stocks to plunge and borrowing costs to soar.

Several money-market funds that held Lehman debt reported negative returns, sparking a flight of cash to the safety of Treasury bills that briefly pushed their yields close to zero. On September 18th companies could no longer issue commercial paper. Banks, anticipating huge demands from companies seeking funds, began hoarding cash, sending the federal funds rate as high as 6%. That week, no investment-grade bonds were issued, for the first time (holidays aside) since 1981.

Conceivably, the Fed could have contained the damage by supplying lots of cash. But that would have meant ever greater and more creative use of its balance sheet. By September 17th it had grown to $1 trillion, up by 10% in a fortnight, with most of it tied up in loans to banks, investment banks, foreign central banks, AIG and Bear Stearns (see chart 2). It was becoming the lender of first resort, not last.

Such steps were also courting political risk. After the rescue of AIG, Nancy Pelosi, speaker of the House of Representatives, demanded, “Why does one person have the right to grant $85 billion in a bail- out [to AIG] without the scrutiny and transparency the American people deserve?” Mr Bernanke later acknowledged that the Fed wanted to get out of crisis management, for which it lacked authority and broad support. “We prefer to get back to monetary policy, which is our function, our key mission,” he told Congress this week.

The Fed chairman told Mr Paulson on September 17th that the time had come to call for a big injection of public money. By the next day Mr Paulson was in agreement and the two men, after getting Mr Bush’s approval, approached Capitol Hill.

Mr Paulson’s first proposal left Democrats cold: it would give the Treasury virtually unchecked

authority for two years to spend up to $700 billion on mortgage assets or anything else necessary to stabilize the system. It looked like a power-grab. Democrats countered with several conditions: troubled mortgages would be modified where possible to keep homeowners in their homes; an oversight board would watch over the program; taxpayers would share any gains for participating companies via shares or warrants; and executives’ compensation would be capped. By September 24th, Mr Paulson seemed to be bending to all these conditions. For its part, the finance industry is ready to yield to all of these conditions in order to get something done. “It was a gargantuan abyss that we faced last week,” says Steve Bartlett, chairman of the Financial Services Roundtable, which represents about 100 big financial firms.

Assuming it comes into existence, there are still numerous risks surrounding the TARP. The first is that it does too much. At $700 billion, the amount allocated to it easily exceeds the Federal Deposit Insurance Corporation’s (FDIC) estimate of roughly $500 billion of residential mortgages seriously delinquent in June, out of a total of $10.6 trillion, though that figure will rise. The Treasury has sought broad authority to buy not just mortgage securities but anything related to them, such as credit derivatives, and if necessary equity in companies weakened by their bad loans.

The arithmetic of crisis When the loans to AIG and Bear Stearns assets are added in, the gross public backing so far approaches 6% of GDP, well above the 3.7% of the savings-and-loan bail-out in the late 1980s and early 1990s (see chart 3). That would still be much less than the average cost of resolving banking crises around the world in the past three decades, which a study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%. One reason why bail-outs, especially in emerging markets, have been so costly is inadequate safeguards against abuse, says Gerard Caprio, an economist at Williams College. “There was a lot of outright looting going on.”

The Congressional Budget Office had pegged next year’s federal budget deficit at more than $400 billion, or 3% of GDP. Private estimates top $600 billion. Tack on $700 billion and various other crisis-related outlays and the total could reach 10% of GDP, notes JPMorgan Chase, a level last seen in the Second World War. On September 22nd the euro made its largest-ever advance against the dollar on worries that America might one day inflate its way out of those debts. Such fears are compounded by the expansion of the Fed’s balance sheet. Some even think that the burden of repairing a broken financial system could place the dollar’s status as the world’s leading reserve currency in jeopardy.

The consequences will probably not be so far-reaching. The true cost to taxpayers is unlikely to be anywhere near $700 billion, because many of the acquired mortgages will be repaid. The expansion of the Fed’s balance sheet reflects a fear-induced demand for cash, which drove the federal funds rate above the 2% target.

It is more likely that the program will not go far enough. Conscious of the public’s deep antipathy to anything that smacks of favors for Wall Street, politicians from both parties have insisted that the protection of the taxpayer be paramount. Yet the point of bail-outs is to socialize losses that are clogging the financial system. If taxpayers are completely insulated from losses, the bail-out will probably be ineffective. “The ultimate taxpayer protection will be the market stability provided,” Mr Paulson argues.

This is especially critical in deciding how the government will set the price for the assets it purchases. An impaired mortgage security might yield 65 cents on the dollar if held to maturity. But because the market is so illiquid and suspicion about mortgage values so high, it might fetch just 35 cents in the market today. Recapitalizing banks would mean paying as close to 65 cents as possible. Those that valued them at less on their books could mark them up, boosting their capital. On the other hand, minimizing taxpayer losses would dictate that the government seek to pay only 35 cents. But this would provide little benefit to the selling banks, and those that carried them at higher values on their books could see their capital further impaired.

To some, that would be fine. “If they choose to fail rather than sell their debt at its real market value and record the loss on the books, they should be free to take that option,” said Michael Enzi, a Republican senator from Wyoming. The failure of smaller regional banks may be tolerable. The FDIC offers a proven system for coping with failed entities (although it too may need a loan from the taxpayer) and other banks are keen to snap up their deposits. But the final result of big-bank failures would be a deeper crisis and a bigger cost in lost economic output.

Similarly, requiring participating banks to give the government warrants or cap their executives’ salaries might make them less willing to take part. Veterans of the emerging-markets crises of the 1990s say their effectiveness would have been crippled had their ability instantly to deploy cash as they saw fit been compromised. “There is far more risk that the authorities will have too little flexibility…than there is risk that they will have too much authority,” says Lawrence Summers, a former treasury secretary.

A more serious criticism is that buying assets is an inefficient way to recapitalize the banking system. Better, many argue, to inject cash directly into weakened banks. A dollar of new equity could support $10 in assets, reducing the pressure to deleverage. Moreover, since the price of banks’ shares are less arbitrary and more homogeneous than those of illiquid mortgage securities, the process would be far more transparent, says Doug Elmendorf of the Brookings Institution. But banks might not volunteer to sell equity to the government before they reach death’s door; and the prospect of share dilution could discourage private investors. In any event, the Treasury plan could be flexible enough to permit such capital injections.

But will it work?

Reuters

Time to mend the market

There have been several false dawns since the crisis began in August of last year. This could be another. The TARP may address the root cause, namely house prices and mortgage defaults, but the crisis has long since mutated. “The same underlying phenomenon that we saw in housing we’re seeing in auto loans, in credit-card loans and student loans,” says Eric Mindich, head of Eton Park Capital Management, a hedge fund. The crisis could claim another institution before the TARP’s effect is felt.

The TARP could conceivably slow the resolution of the crisis by stopping property prices and home ownership falling to sustainable levels. Some homeowners who are up-to-date with payments but whose home is worth less than their mortgage may stop paying, betting the federal government will be a more forgiving creditor. The Treasury is considering using the TARP to write down mortgages to levels that squeezed homeowners can afford. But in the meantime, buyers might be reluctant to step in while a big inventory of government-owned property hangs over the market. That’s one reason Japan’s many efforts to bail out its banks failed to revitalize its economy: the institutions that took over the loans were hesitant to dispose of them for fear of pushing insolvent borrowers into bankruptcy, says Takeo Hoshi of the University of California at San Diego.

All the same, the TARP is likely to mark a turning-point. “It promises to break the vicious circle of deleveraging in the mortgage market,” predicts Jan Hatzius, an economist at Goldman Sachs. This

does not mean the economy will soon rebound, but it does suggest the worst scenarios will be averted. If the TARP helps banks and investors establish reliable prices for mortgage securities, it could restart lending and help bring the housing crisis to an end.

This will not come without a price. The unprecedented intrusion of the federal government into the capital markets seems certain to be accompanied by a heavier regulatory hand, something on which both Barack Obama and John McCain now agree.

Even without new rules, more of the system will be regulated because so much of it has been absorbed by banks, which are closely overseen. Sheila Bair, chairman of the FDIC, thinks this is a good thing. Banks were relative pillars of stability because of their insured deposits and the regulation that accompanied it. Although some banks have failed, she notes that other banks, not taxpayers, will pay the clean-up costs. Now that institutions like money-market funds are caught by the federal safety net even though that was never intended, they can expect to pay for it.

Yet predictions of a sea change towards more invasive government are premature. The Depression witnessed a pervasive expansion of the federal government into numerous walks of life, from trucking and railways to farming, out of a broadly shared belief that capitalism had failed utterly. If Mr Paulson and Mr Bernanke have prevented a Depression-like collapse in economic output with their actions these past two weeks, then they may also have prevented a Depression-like backlash against the free market.

And then there were none….

What the death of the investment bank means for Wall Street

THE radical overhaul of the City of London in 1986 was dubbed the Big Bang. The brutal reshaping of Wall Street might be better described as the Big Implosion. The “bulge-bracket” brokerage model—the envy of moneymen everywhere before the crunch—has collapsed in on itself. Even more humiliating for the Green Berets of the markets, the new force in finance is the government.

The last remaining investment banks, Goldman Sachs and Morgan Stanley, sought safety by becoming bank holding companies after last week’s run on the industry, which sent Wall Street scrambling for loans from the central bank (see chart). After Lehman Brothers collapsed, the markets could no longer stomach their mix of illiquid assets and unstable wholesale liabilities. Both will now start gathering deposits, a more stable form of funding. Signing up strong partners should also help. Mitsubishi UFJ Financial Group (MUFG), a giant Japanese bank, will buy up to 20% of Morgan. Goldman has gone one better, coaxing $5 billion from Warren Buffett.

Mr Buffett, no idle flatterer, describes Goldman as “exceptional”. But some doubt that it will be able to adapt and thrive. As a bank, it faces more supervision from the Federal Reserve, tougher capital requirements and restrictions on investing. Universal banks, such as Citigroup and Bank of America, long dismissed as stodgy, argue that their vast balance sheets and wide range of businesses, from credit cards to capital markets, give them an edge in trying times. The head of one bank suggests that the golden years of risk-taking enjoyed by investment banks in 2003-06 were an “aberration”, fuelled by the global liquidity glut.

Private-equity firms and hedge funds spy opportunity, too. Blackstone’s Stephen Schwarzman is keen to take advantage of Wall Street’s disarray. Kohlberg Kravis Roberts, a rival, has ambitions to create a financial “ecosystem”. The buy-out barons got good news this week, when the Fed relaxed its rules on their ownership of banks. One of them, Christopher Flowers, bought a small lender in Missouri, which he may use to hoover up other troubled financial firms. Citadel, a hedge-fund group that is already an options marketmaker, is reportedly mulling a move into the advisory business. Hedge funds have stepped up their financing of mid-tier firms that cannot get loans from Wall

Street.

These investors are also going after the “talent” in investment banks. Morale there is not high. One executive admits that becoming a bank “does little for our cachet”. Hedge funds will be particularly keen to get their hands on cutting-edge risk-takers, particularly the Goldman crowd who used to thrive on leverage.

Power may shift in two other directions: abroad and, to a lesser extent, to boutique investment banks. MUFG will be joined by others. After a brief wrangle in the bankruptcy courts, Britain’s Barclays has taken over Lehman’s American operations and quickly put its logo on the fallen firm’s headquarters. “Global financial power is becoming more diffuse,” says Andrew Schwedel of Bain & Company, a consultancy. Merger boutiques, such as Lazard and Greenhill, will emphasize their stability to pick up business. Their shares have done relatively well this year.

But all is not lost for the former investment banks. For one thing, they may not have to cut leverage by as much as feared. Though their overall leverage ratios are high, their risk-adjusted capital ratios under the Basel 2 rules are stronger than those of most commercial banks. They acknowledge, however, that they may have to raise these even higher for a while to assuage market concerns about hard-to-sell assets.

Brad Hintz of Sanford Bernstein, an asset manager and research firm, reckons regulatory shackles will cut Goldman’s return on equity by four percentage points over the cycle. The bank disputes this. Either way, even if it is forced to tone down its in-house proprietary trading it can make up for this by, for instance, launching more hedge funds. And it faces no immediate pressure to sell its large private-equity or commodities holdings. It will continue to co-invest in projects alongside clients, a key Goldman strategy.

Moreover, there are some advantages to becoming a bank. Goldman and Morgan should be able to amass deposits cheaply and easily, because dozens of regional lenders are expected to fail. Almost one-fifth have less capital than regulators consider a safe minimum. However, the new banks will be under scrutiny to ensure they do not put those deposits at great risk.

As sharp distressed-debt investors, they will also be looking to buy assets from the government’s giant loan-buying entity when it gets going. This is likely to be more helpful to them than to commercial banks, which have marked down their mortgage assets less and will not benefit as much when clearing prices are set.

Given the acute stress that remains in money markets, however, the accent for the time being is still on survival. Morgan Stanley’s debt with a maturity of four months was trading to yield as much as 37.5%. Maybe it should consider using credit cards instead.

Financial firms fear further fallout from the recent, potentially catastrophic run on money-market funds, after several of the supposedly ultra-safe vehicles saw their net asset values slip below the sacrosanct $1 level at which investors break even. Only when the government stepped in to guarantee that no more funds would “break the buck” did a semblance of calm return. But “prime” money funds, which are big buyers of corporate debt, are still pulling away from anything deemed risky. This is a big problem for banks, since some $1.3 trillion of their short-term debt is held by such funds, and they may have to turn to longer-term (and dearer) sources.

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Once markets stabilize, Wall Street will start to wonder if it is better or worse off without its stand-alone investment banks. Some think they were no more worth saving than Detroit, another once-iconic industry caught up in its own battle for a public rescue. Perhaps even less so: the securities Wall Street packaged were the financial equivalent of slick-looking cars with no brakes. But they may leave a hole. As broker-dealers, regulated more lightly by the Securities and Exchange

Commission, they were free to put large dollops of capital to work, providing liquidity, making markets and assuming risk. As banks, they may find the Fed takes a more restrictive view.

It seems implausible that the investment bank will make a comeback, given the speed with which it has unraveled. Yet, 75 years after the legal separation of commercial and investment banking, America has made a full return to the one-stop-shop model practiced by John Pierpont Morgan. Another black swan in 2083, and who knows?

WaMu is largest U.S. bank failure September 25, 2008

Washington Mutual Inc was closed by the U.S. government in by far the largest failure of a U.S. bank, and its banking assets were sold to JPMorgan Chase & Co for $1.9 billion.

Thursday's seizure and sale is the latest historic step in U.S. government attempts to clean up a banking industry littered with toxic mortgage debt. Negotiations over a $700 billion bailout of the entire financial system stalled in Washington on Thursday.

Washington Mutual, the largest U.S. savings and loan, has been one of the lenders hardest hit by the nation's housing bust and credit crisis, and had already suffered from soaring mortgage losses.

Washington Mutual was shut by the federal Office of Thrift Supervision, and the Federal Deposit Insurance Corp was named receiver. This followed $16.7 billion of deposit outflows at the Seattle-based thrift since Sept 15, the OTS said.

"With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to transact business," the OTS said.

Customers should expect business as usual on Friday, and all depositors are fully protected, the FDIC said.

FDIC Chairman Sheila Bair said the bailout happened on Thursday night because of media leaks, and to calm customers. Usually, the FDIC takes control of failed institutions on Friday nights, giving it the weekend to go through the books and enable them to reopen smoothly the following Monday.

Washington Mutual has about $307 billion of assets and $188 billion of deposits, regulators said. The largest previous U.S. banking failure was Continental Illinois National Bank & Trust, which had $40 billion of assets when it collapsed in 1984.

JPMorgan said the transaction means it will now have 5,410 branches in 23 U.S. states from coast to coast, as well as the largest U.S. credit card business.

It vaults JPMorgan past Bank of America Corp to become the nation's second-largest bank, with $2.04 trillion of assets, just behind Citigroup Inc. Bank of America will go to No. 1 once it completes its planned purchase of Merrill Lynch & Co.

The bailout also fulfills JPMorgan Chief Executive Jamie Dimon's long-held goal of becoming a retail bank force in the western United States. It comes four months after JPMorgan acquired the failing investment bank Bear Stearns Cos at a fire-sale price through a government-financed transaction.

On a conference call, Dimon said the "risk here obviously is the asset values."

He added: "That's what created this opportunity."

JPMorgan expects to incur $1.5 billion of pre-tax costs, but realize an equal amount of annual

savings, mostly by the end of 2010. It expects the transaction to add to earnings immediately, and increase earnings 70 cents per share by 2011.

It also plans to sell $8 billion of stock, and take a $31 billion write-down for the loans it bought, representing estimated future credit losses.

The FDIC said the acquisition does not cover claims of Washington Mutual equity, senior debt and subordinated debt holders. It also said the transaction will not affect its roughly $45.2 billion deposit insurance fund.

"Jamie Dimon is clearly feeling that he has an opportunity to grab market share, and get it at fire-sale prices," said Matt McCormick, a portfolio manager at Bahl & Gaynor Investment Counsel in Cincinnati. "He's becoming an acquisition machine."

BAILOUT UNCERTAINTY

The transaction came as Washington wrangles over the fate of a $700 billion bailout of the financial services industry, which has been battered by mortgage defaults and tight credit conditions, and evaporating investor confidence.

"It removes an uncertainty from the market," said Shane Oliver, head of investment strategy at AMP Capital in Sydney. "The problem is that markets are in a jittery stage. Washington Mutual provides another reminder how tenuous things are."

Washington Mutual's collapse is the latest of a series of takeovers and outright failures that have transformed the American financial landscape and wiped out hundreds of billions of dollars of shareholder wealth.

These include the disappearance of Bear, government takeovers of mortgage companies Fannie Mae and Freddie Mac and the insurer American International Group Inc, the bankruptcy of Lehman Brothers Holdings Inc, and Bank of America's purchase of Merrill.

JPMorgan, based in New York, ended June with $1.78 trillion of assets, $722.9 billion of deposits and 3,157 branches. Washington Mutual then had 2,239 branches and 43,198 employees. It is unclear how many people will lose their jobs.

Shares of Washington Mutual plunged $1.24 to 45 cents in after-hours trading after news of a JPMorgan transaction surfaced. JPMorgan shares rose $1.04 to $44.50 after hours, but before the stock offering was announced.

119-YEAR HISTORY

The transaction ends exactly 119 years of independence for Washington Mutual, whose predecessor was incorporated on September 25, 1889, "to offer its stockholders a safe and profitable vehicle for investing and lending," according to the thrift's website. This helped Seattle residents rebuild after a fire torched the city's downtown.

It also follows more than a week of sale talks in which Washington Mutual attracted interest from several suitors.

These included Banco Santander SA, Citigroup Inc, HSBC Holdings Plc, Toronto-Dominion Bank and Wells Fargo & Co, as well as private equity firms Blackstone Group LP and Carlyle Group, people familiar with the situation said.

Less than three weeks ago, Washington Mutual ousted Chief Executive Kerry Killinger, who drove

the thrift's growth as well as its expansion in subprime and other risky mortgages. It replaced him with Alan Fishman, the former chief executive of Brooklyn, New York's Independence Community Bank Corp.

WaMu's board was surprised at the seizure, and had been working on alternatives, people familiar with the matter said.

More than half of Washington Mutual's roughly $227 billion book of real estate loans was in home equity loans, and in adjustable-rate mortgages and subprime mortgages that are now considered risky.

The transaction wipes out a $1.35 billion investment by David Bonderman's private equity firm TPG Inc, the lead investor in a $7 billion capital raising by the thrift in April.

A TPG spokesman said the firm is "dissatisfied with the loss," but that the investment "represented a very small portion of our assets."

DIMON POUNCES

The deal is the latest ambitious move by Dimon.

Once a golden child at Citigroup before his mentor Sanford "Sandy" Weill engineered his ouster in 1998, Dimon has carved for himself something of a role as a Wall Street savior.

Dimon joined JPMorgan in 2004 after selling his Bank One Corp to the bank for $56.9 billion, and became chief executive at the end of 2005.

Some historians see parallels between him and the legendary financier John Pierpont Morgan, who ran J.P. Morgan & Co and was credited with intervening to end a banking panic in 1907.

JPMorgan has suffered less than many rivals from the credit crisis, but has been hurt. It said on Thursday it has already taken $3 billion to $3.5 billion of write-downs this quarter on mortgages and leveraged loans.

Washington Mutual has a major presence in California and Florida, two of the states hardest hit by the housing crisis. It also has a big presence in the New York City area. The thrift lost $6.3 billion in the nine months ended June 30.

"It is surprising that it has hung on for as long as it has," said Nancy Bush, an analyst at NAB Research LLC.

Amid GOP revolt, bailout deal breaks down September 25,2008

A Republican rebellion stalled government efforts Thursday to avoid economic meltdown, a chaotic turnaround that disrupted the choreography of an extraordinary White House meeting meant to show joint resolve from the president, the political parties and the presidential candidates. Instead, the summit broke up so bitterly that Treasury Secretary Henry Paulson got on one knee before Democratic leaders in a theatrical attempt to salvage talks. After six days of bare-knuckled negotiations on the $700 billion financial industry bailout proposed by the Bush administration, with Wall Street tottering and presidential politics intruding six weeks before the election, there was far more confusion than clarity.

An apparent breakthrough was announced with fanfare at midday by key members of Congress from both parties — but not top leaders. Wall Street cautiously showed its pleasure, with the Dow Jones industrials closing 196 points higher.

But the good news and the market close were followed by a rash of less-positive developments.

Washington Mutual Inc. was seized by the Federal Deposit Insurance Corp. in the largest failure ever of a U.S. bank, after which JPMorgan Chase & Co. Inc. came to its rescue by buying the thrift's banking assets.

And the late-afternoon White House gathering of President Bush, presidential contenders John McCain and Barack Obama, and top congressional leaders turned into what one person in the room described as "a full-throated discussion" and McCain's campaign called "a contentious shouting match."

Conservatives were in revolt over the astonishing price tag of the proposal and the hand of government that it would place on private markets.

Sen. Richard Shelby of Alabama, the top Republican on the Senate Banking Committee, emerged from the White House meeting to say the announced agreement "is, obviously, no agreement." McCain's campaign issued a statement saying, "the plan that has been put forth by the administration does not enjoy the confidence of the American people as it will not protect the taxpayers and will sacrifice Main Street in favor of Wall Street." The White House, too, acknowledged there was no deal, only progress.

Meanwhile a group of House GOP lawmakers circulated an alternative that would put much less focus on a government takeover of failing institutions' sour assets. This proposal would have the government provide insurance to companies that agree to hold frozen assets, rather than have the U.S. purchase the assets.

Inside the White House session, House Republican leader John Boehner announced his concerns about the emerging plan and asked that the conservatives' alternative be considered, said people from both parties who were briefed on the exchange.

Financial Services Chairman Barney Frank, the feisty Democrat who has been leading negotiations with Paulson, reacted angrily, saying Republicans had waited until the last moment to present their proposal.

McCain, who dramatically announced Wednesday that he was suspending his campaign to deal with the economic crisis, stayed silent for most of the session and spoke only briefly to voice general principles for a rescue plan.

After the session, Paulson, hoping to prevent any chance for agreement from being torpedoed, pleaded with Democratic leaders not to publicly disclose how poorly the session had gone, said three people familiar with the episode. Frank and House Speaker Nancy Pelosi responded angrily, and Paulson, in an attempt to lighten the mood, got down on one knee, said the sources who spoke on condition of anonymity, like the others, because the conversations were private.

Weary congressional negotiators then resumed working with Paulson into the night in an effort to revive or rework the proposal that Bush said must be quickly approved by Congress to stave off "a long and painful recession." They gave up after 10 p.m. EDT, more than an hour after the lone House Republican involved, Rep. Spencer Bachus of Alabama, left the room.

Talks were to resume Friday morning on the effort to bail out failing financial institutions and restart the flow of credit that has begun to starve the national economy.

The Bush administration plan's centerpiece remained for the government to buy the toxic, mortgage-based assets of shaky financial institutions in a bid to keep them from going under and setting off a cascade of ruinous events, including wiped-out retirement savings, rising home foreclosures, closed businesses and lost jobs.

The earlier bipartisan accord establishing principles and important details would have given the Bush administration just a fraction of the money it wanted up front, subjecting half the $700 billion total to a congressional veto. The treasury secretary would get $250 billion immediately and could have an additional $100 billion if he certified it was needed, an approach designed to give lawmakers a stronger hand in controlling the unprecedented rescue.

The Bush administration had already agreed to several concessions based on demands from the right and left, including that the government take equity in companies helped by the bailout and put rules in place to limit excessive compensation of their executives, according to a draft of the outline obtained by The Associated Press.

Democrat Obama and Republican McCain, who have both sought to distance themselves from the unpopular Bush, sat down with the president at the White House for the hour-long afternoon session that was striking in this brutally partisan season. By also including Congress' Democratic and Republican leaders, the meeting gathered nearly all Washington's political power structure at one long table in a small West Wing room.

"All of us around the table ... know we've got to get something done as quickly as possible," Bush declared optimistically at the start of the meeting. Obama and McCain were at distant ends of the oval table, not even in each other's sight lines. Bush, playing host in the middle, was flanked by Congress' two Democratic leaders, Pelosi and Senate Majority Leader Harry Reid.

But neither Bush, McCain nor Obama have been deeply involved so far in this week's scramble to hammer out a package. The meeting was intended more to provide bipartisan political cover for lawmakers to support a plan in the face of an angry public and their own re-election bids in six weeks.

At day's end, Frank said he told Paulson "this whole thing is at risk if the president can't get members of his own party to participate."

Layered over the White House meeting was a complicated web of potential political benefits and consequences for both presidential candidates.

McCain hoped voters would believe that he rose above politics to wade into nitty-gritty and ultimately successful deal making at a time of urgent crisis, but he risked being seen instead as either overly impulsive or politically craven, or both. Obama saw a chance to appear presidential and fit for duty but was also caught off guard strategically by McCain's surprising campaign gamble.

U.S. bailout plan stalls after day of talks September 26, 2008

The day began with an agreement that U.S. government hoped would end the financial crisis that has gripped the United States. It dissolved into a verbal brawl in the Cabinet Room of the White House, warnings from an angry president and pleas from a Treasury secretary who knelt before the House speaker and appealed for her support.

"If money isn't loosened up, this sucker could go down," President George W. Bush declared Thursday as he watched the $700 billion bailout package fall apart before his eyes, according to one person in the room.

It was an implosion that spilled out from behind closed doors into public view in a way rarely seen in

Washington. Left uncertain was the fate of the bailout, which the White House says is urgently needed to fix broken financial and credit markets, as well as whether the first presidential debate would go forward as planned Friday night in Mississippi.

When congressional leaders and Senators John McCain and Barack Obama, the two major party presidential candidates, trooped to the White House on Thursday, all signs pointed toward a bipartisan agreement on a grand compromise that could be accepted by all sides and signed into law by the weekend. It was to have pumped billions of dollars into the financial system and transformed the way Wall Street is regulated.

"We're in a serious economic crisis," Bush told reporters as the meeting began shortly before 4 p.m. in the Cabinet Room, adding, "My hope is we can reach an agreement very shortly."

But once the doors closed, the House Republican leader, John Boehner of Ohio, surprised many in the room by declaring that his caucus could not support the plan to allow the government to buy distressed mortgage assets from ailing financial companies.

Boehner pressed an alternative that involved a smaller role for the government, and McCain, whose support of the deal is critical if fellow Republicans are to sign on, declined to take a stand.

The talks broke up in angry recriminations, according to accounts provided by a participant and others who were briefed on the session, and were followed by dueling news conferences and interviews rife with partisan finger pointing.

In the Roosevelt Room of the White House after the session, Treasury Secretary Henry Paulson Jr. literally bent down on one knee as he pleaded with Nancy Pelosi, the House speaker, not to withdraw her party's support for the package over what Pelosi derided as a Republican betrayal.

It was the very outcome the White House had said it intended to avoid, with presidential politics appearing to trample what had been exceedingly delicate congressional negotiations.

Senator Christopher Dodd, Democrat of Connecticut and chairman of the Senate banking committee, denounced the session as "a rescue plan for John McCain" in an interview on CNN, and proclaimed it a waste of precious hours that could have been spent negotiating.

But a top aide to Boehner said it was Democrats who had done the political posturing. The aide, Kevin Smith, said Republicans revolted, in part, because they were chafing at what they saw as an attempt by Democrats to jam through an agreement on the bailout early Thursday and deny McCain an opportunity to participate in the agreement.

The day seemed to hold promise as it began. On Wednesday night, Bush had delivered a prime-time televised address to the nation, warning that "our country could experience a long and painful recession" if lawmakers did not act quickly to pass a massive Wall Street bailout plan.

After spending Thursday morning behind closed doors, senior lawmakers from both parties emerged at noon in the ornate painted corridors on the first floor of the Capitol to herald their agreement on the broad outlines of a deal.

They said the legislation, which would authorize unprecedented government intervention to buy distressed debt from private firms, would include limits on pay packages for executives of some firms that seek assistance and a mechanism for the government to take an equity stake in some of the firms, so taxpayers have a chance to profit if the bailout plan works.

"I now expect we will indeed have a plan that can pass the House, pass the Senate, be signed by the president, and bring a sense of certainty to this crisis that is still roiling in the markets," said Senator Robert Bennett, Republican of Utah, a senior member of the banking committee. "That is our primary responsibility and I think we are now prepared to meet it."

Bennett made a point of describing that meeting as free of political maneuvering. "We focused on solving the problem, rather than posturing politically, and it was one of the most productive sessions in that regard that I have participated in since I have been in the Senate," Bennett said.

But a few blocks away, a senior House Republican lawmaker was at a luncheon with reporters, saying his caucus would never go along with the deal. This Republican said Representative Eric Cantor of Virginia, the chief deputy whip, was circulating an alternative proposal that would rely on government-backed insurance, rather than taxpayer-financed purchase of mortgage assets.

He said the recalcitrant Republicans were calculating that Pelosi, Democrat of California, would not want to leave her caucus politically exposed in an election season by passing a bailout bill without rank-and-file Republican support.

"You can have all the meetings you want," this Republican said, referring to the White House session with Bush, the presidential candidates and congressional leaders, still hours away. "It comes to the floor and the votes aren't there. It won't pass."

House Republicans have spent days expressing their deep unease about such a huge government intervention, which they regard as a step down the path to socialism.

Smith, the aide to Boehner, said the leader had directed a group of Republicans a few days ago to see if they could come up with alternatives that relied less on tax funds in providing the rescue package; that led to Cantor's mortgage-insurance approach.

Smith said Boehner was supportive of Cantor's idea, and believed the concepts should be considered as part of the solution.

But the new initiative shocked Democrats; the Senate majority leader, Harry Reid of Nevada, said later that he was under the impression that Boehner had been a strong advocate for moving forward with the Paulson plan.

Representative Barney Frank, the Massachusetts Democrat, who attended the White House meeting, was shocked as well. "We were ready to make a deal," Frank said later.

At 4 p.m., Bush convened his meeting at the White House; McCain had already met with House Republicans to hear their concerns. He later said on ABC that he had known going into the White House that "there never was a deal," but he kept that sentiment to himself.

The meeting opened with Paulson, the chief architect of the bailout plan, "giving a status report on the condition of the market," Tony Fratto, Bush's deputy press secretary, said. Fratto said Paulson warned in particular of the tightening of credit markets overnight, adding, "that is something very much on his mind."

McCain was at one end of the long conference table, Obama at the other, with the president and senior congressional leaders between them. Participants said Obama peppered Paulson with questions, while McCain said little. Outside the West Wing, a huge crowd of reporters gathered in the driveway, anxiously awaiting an appearance by either presidential candidate, with expectations running high.

Instead, the first politician to emerge was Senator Richard Shelby of Alabama, the senior Republican on the banking committee, waving a sheet of paper that he said detailed his own concerns. "The agreement," Shelby declared, "is obviously no agreement."

At 8 p.m., an exasperated Frank, the lead Democratic negotiator, walked back to the ornate Rules Committee room on the second floor of the Senate side of the Capitol, with a pack of reporters on his heels.

He was headed for another late-night meeting with Paulson and many other lawmakers to see if

they could restart the negotiations — and ward off a Monday morning bloodbath in the markets.

Bailout talks in disarray

High stakes talks over $700 billion rescue end in chaos, one day after President Bush warns 'entire economy at risk.'

One day after President Bush said the nation's economy is at grave risk, the high-stakes negotiations over the proposed $700 billion bailout of the financial system ended in chaos on Thursday.

Lawmakers bickered over competing counterproposals and hours of meetings between key lawmakers broke down without any progress late into the evening.

A meeting at the White House between President Bush, congressional leaders and the presidential candidates was meant to speed approval of an agreement. Instead, the session revealed deep divisions between Democrats and House Republicans.

As a result, House and Senate leaders and Treasury Secretary Henry Paulson rushed to Capitol Hill at 8 p.m. to try to hash out a deal.

But shortly after 10 p.m., Rep. Barney Frank, D-Mass., the lead House Democrat on the issue who had been in close talks with Paulson for days, accused Republicans of refusing to negotiate.

"At this point, we have absolutely no participation or cooperation from House Republicans," Frank said.

The next step was not clear late Thursday night. One thing seems certain: Lawmakers won't recess for the year on Friday, as originally planned. Instead, if they can't reach a deal in the next 24 hours, they're likely to work through the weekend.

The page many thought they were on Leading Democrats said they were presented for the first time with the House Republican principles at the White House meeting.

Senate Banking Committee Chairman Christopher Dodd, D-Conn., said the White House meeting was thrown off course when participants were blindsided by a new "core agreement" that emerged in the meeting that not many had seen before.

Earlier in the day, congressional negotiators said they had agreed to a set of principles on revisions to the rescue plan, which calls for the Treasury Department to buy up bad mortgage securities from banks in an effort to get them to lend again.

The proposal, as amended by leaders in both chambers, will help homeowners, curb executive pay packages at participating firms and provide oversight of Treasury's actions, Dodd said in a lunchtime address.

"We've reached a fundamental agreement on a set of principles, one, for taxpayers, which is tremendously important," he said. "We're very confident we can act expeditiously."

Details on the plans The principles the Democrats said had been agreed upon call for Congress to make $250 billion available immediately with $100 billion available, if needed, without requiring additional congressional approval, said two senior Democratic aides familiar with the negotiations. The second half of $350 billion would then become available by a special approval of Congress.

On executive compensation, the draft would require limits on compensation for executives of any company participating in the bailout. These caps would apply for as long as the company is in the program. This would include some language to limit excess "golden parachutes."

Treasury will also get an equity stake in the companies being helped by the bailout, though what type remains to be worked out.

Still to be worked out is whether to allow bankruptcy judges to modify mortgage terms, a provision backed by many Democrats and community activists but opposed by Republicans and the banking industry.

What House Republicans want: The bankruptcy provision is not the only sticking point, however. House Republicans are not on board, according to Minority Leader Rep. John Boehner, R-Ohio.

"House Republicans have not agreed to any plan at this point," Boehner said.

Instead, they issued a statement of economic rescue principles that calls for Wall Street to fund the recovery by injecting private capital - not taxpayer dollars - into the financial markets. Easing tax laws would prompt investors to put in their own dollars, they said.

The plan also calls for: participating firms to disclose the value of the mortgage assets on their books, ending Fannie Mae and Freddie Mac's securitization of "unsound mortgages," reviewing the performance of the credit rating agencies and having the Securities and Exchange Commission audit failed companies to ensure their financial standing was accurately portrayed.

House Republicans also want to create a panel to make recommendations for reforming the financial industry by year's end.

Meanwhile, the ranking Republican on the Senate Banking Committee has another idea. Sen. Richard Shelby, R-Ala., said he doesn't support the Treasury plan until there is serious consideration of alternatives. He proposed Thursday adding funds to the Federal Reserve and Treasury to allow them to lend more to financial institutions.

Bush still hopeful Before the afternoon meeting, Bush said he expects a deal "very shortly."

After, a counselor to the president said "we're getting closer. There's some more that has to be done. It's going to be a consensus plan at the end of the day."

"Both sides are going to have to work hard to get to an agreement," presidential counselor Ed Gillespie said on CNN.

Administration officials have spent countless hours this week behind closed doors with and in public hearings before Congress. Lawmakers were hoping to have a deal agreeable to both parties hammered out before Thursday's meeting at the White House.

On Wednesday night, Bush took the nation's airwaves in a prime-time address in which he laid out a looming economic disaster.

"The government's top economic experts warn that, without immediate action by Congress, America could slip into a financial panic and a distressing scenario would unfold," Bush said. "More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically."

Buffett's deal versus Paulson's September 25, 2008

Maybe the American taxpayers should be asking Warren Buffett to be negotiating on their behalf.

Treasury Secretary Henry Paulson Jr. spent a good part of two days on Capitol Hill arguing that the federal government should not demand a stake in any Wall Street concerns it bails out. Demanding such a stake, Paulson said, could scare away many of those companies from participating in the bailout, leaving the credit markets as hobbled as they are now.

And then Buffett swooped in and announced that his company, Berkshire Hathaway, was investing $5 billion in Goldman Sachs, which made far fewer bad investments than most of Wall Street. Buffett's money will help Goldman shore up its balance sheet. What will he receive in exchange? Something like a 7 percent stake.

Paulson, of course, has a different objective than Buffett. The Treasury secretary is trying to resuscitate the U.S. financial system and keep the economy from falling into a deep recession. If he drives too hard a bargain, he won't solve the problem. Buffet is merely trying to make money.

But to the many critics of the Paulson plan, the juxtaposition of the Goldman deal crystallizes the problems. The critics are worried that the government is taking on too much risk with too little upside. And they can't help but notice that other governments that faced similar crises in recent decades - in Japan and Sweden - struck deals that looked more like Buffett's than Paulson's.

On Wednesday, several members of Congress wistfully mentioned the Goldman deal. "When Warren Buffett invests $5 billion, he gets preferred stock in Goldman Sachs," Senator Jeff Bingaman, Democrat of New Mexico, said to Ben Bernanke, the Federal Reserve chairman. "We're being asked to endorse a bailout where we basically take the assets that these companies - these firms - can't otherwise dispose of at a reasonable price and take them off their hands."

Buffett appears to have gotten a very good deal, one that may not have been available to anybody whose name carries less prestige - which is to say, just about anybody else. (He will receive dividends that will effectively pay him a 10 percent annual return on his investment, as well as the right to buy a sizable stake in Goldman at a price below the current market price.) Goldman partners surely figured that his investment would allow them to turn around and raise yet more capital from other investors. Sure enough, they announced Wednesday that they were doing so.

A company that accepted money from the Treasury Department would get none of this halo effect. If anything, investors might view a company desperate enough to approach the Treasury as an endangered species unworthy of further investment.

But as imperfect as the Buffett analogy may be, it still raises a real question: Is the government getting a raw deal? The inability of Paulson and Bernanke - as well as President George W. Bush - to make people comfortable with the answer is the main reason that the bailout has encountered so much hostility.

Economists overwhelmingly agree that the economy faces risk that is serious enough to need quick, bold action. Yet they're deeply skeptical that Paulson's plan is the right one. Buffett's deal nicely highlights their two main worries.

The first is that the Paulson plan may not have the best chance of success. Buffett's deal with Goldman injects $5 billion in cash into the company, and those dollars strengthens Goldman's balance sheet. Goldman will then presumably become more willing to lend money, and the credit crisis will be one small step closer to lifting.

The Japanese government, after years of missteps, followed a strategy much like that one in 1998, putting capital directly into its banks. The move helped end a long downturn.

Paulson, on the other hand, has asked for a $700 billion credit line to buy distressed assets from financial concerns. It is the equivalent of trying to cut a tumor out of the financial system. But there is a potential downside.

The Treasury would not be giving money to the companies. It would be buying an asset of some value (albeit much less value than a year ago). As a result, the transaction might not do enough to bolster the companies' balance sheets.

The second worry is that even if the Paulson plan works, it may end up being needlessly expensive. There is huge uncertainty about the true value of those distressed assets. If the government ends up overpaying for them, it won't have any way to recoup the money.

Without an ownership stake - like the one Buffett got or the one the Swedish government got when it bailed out its banks in the 1990s - taxpayers wouldn't really be able to share in the bounty of a Wall Street recovery.

What would Buffett have said if Goldman asked for his money and wouldn't let him share in the upside? "He would have said 'no deal!"' Daniel Alpert of Westwood Capital, an investment firm, said. "And that is what Congress must say as well in defense of the American people."

On Capitol Hill, Bernanke and Paulson answered their critics by returning to the same point they have made before. If companies must hand over an ownership stake, only the sickest may come forward. Others may wait out the crisis, confident they can survive. But the credit markets would meanwhile remain paralyzed, as a Treasury official argued to me, and the economy could deteriorate.

But the Goldman deal, in which a company that didn't seem near extinction agreed to give up a fat equity stake in exchange for cash, puts the onus on Bernanke and Paulson to make a better case than they have so far.

Bernanke pointed out Wednesday that Buffett had urged Congress to pass the current bailout plan. I'd point out that Buffett drove a harder bargain when his own money was on the line.

Big bailout is unlikely to work

September 25, 2008 The U.S. "hold-to-maturity" bailout plan is really just the new "mark-to-myth," and even its heroic proportions are not likely to paper over solvency problems in the banking system.

Ben Bernanke, the chairman of the U.S. Federal Reserve, told lawmakers that the plan to spend $700 billion to buy up bad assets would allow banks to avoid unloading loans at fire-sale prices.

"Auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets," he said, trying to persuade a skeptical Congress that the plan he and Treasury Secretary Henry Paulson Jr. have been pushing will give value for taxpayers' money.

Banks are forced to mark their assets to market, a process that has become increasingly painful and is likely to lead to bank failures as a shortage of investors and the swiftly declining performance of the underlying collateral have driven prices lower. Since many securities are so complex that they seldom trade, banks sometimes must mark the assets according to modeled prices, a process sometimes referred to as "marking to myth" by doubters.

What "is a 'held-to-maturity' price, and how in the world can an auction or 'other mechanism' be devised that gives the market a good idea of 'hold-to-maturity' prices - since there is no such thing?" the economist Thomas Lawler, a former Fannie Mae manager now with Lawler Economic & Housing Consulting, wrote in a note to clients. "Of course, everyone knew what he meant: 'held-to-

maturity' means 'above market."'

The hope, presumably, is that the subsidy given by buying debt for more than it will fetch on the open market will be enough to prop up banks and attract new investors.

If it is a subsidy, why not call it one?

And though $700 billion is a lot, it is not enough to wipe the slate clean and leave banks with workable balance sheets; the plan will only work if that $700 billion, which amounts to far less in terms of capital relief, is leveraged by new money from outsiders now sitting on the sidelines.

But I find it hard to believe that the sovereign wealth funds of the world, already burned by banking investments, will be attracted by a price arrived at through what promises to be an opaque process.

One possibility being discussed is a reverse auction, where banks will compete to sell bonds to the government. Given that private label securities are often unique, that may be difficult to carry out in a competitive and transparent way.

And since part of the purpose of the exercise is to establish a mark for banks to use on their portfolios, there is scope for collusion.

If banks do compete and bid down the prices of debt instruments, the authorities may be faced with another round of failures, as ailing banks are forced to use new marks and find their capital deficient in the new light.

Alternatively, the government, which has bottomless pockets and no liquidity risk, may simply arrive at a price based on what it, or its advisers - and one wonders who they could be and if they saw this disaster coming - think is a fair bet on what repayment flows will be.

There is also the issue of protecting the taxpayers, who may justifiably argue that they should share in the benefit of any subsidy offered to the industry in return for footing the bill. But taking equity stakes in banks in exchange for below-market funding or asset sales probably would choke off any hope of new equity infusions from actual investors seeking profits.

It's easy to understand why the United States is considering an apparently indiscriminate reward for those who took too much risk. The stakes are very high, and a disorderly deleveraging would be worse than an orderly one, even if the orderly one isn't perfect.

The debate about whether or not the United States will need a huge intervention of public capital into its banking system and wider economy is over. The crisis requires a huge outlay of public funds, both to clean up after the many banks that will fail and to soften the blow to homeowners and consumers.

Banking is a confidence game, even if done soberly and responsibly. But this plan, because it fails to meet the issue of insolvent and failing institutions head on, is not likely to work.

What About the Rest of Us?

September 26, 2008 Lawmakers were still wrangling Thursday night about the Bush administration’s $700 billion bailout of the financial system. Political theater was mainly responsible for the delay, but it will be worth the wait if lawmakers take the time to make sure that the plan includes real relief for homeowners and not only for Wall Street. The problems in the financial system have their roots in the housing bust, as do the problems of America’s homeowners. Millions face foreclosure, and millions more are watching their equity being wiped out as foreclosures provoke price declines.

The problems became even more evident Thursday night with the federal seizure and sale of Washington Mutual to JPMorgan Chase. It’s unacceptable that lawmakers have yet to come out squarely in favor of bold homeowner relief in the bailout bill. Treasury Secretary Henry Paulson, the biggest advocate of bailing out Wall Street, is also a big roadblock to helping hard-pressed borrowers. He wants to keep relying on the mortgage industry to voluntarily rework troubled loans, even though that approach has failed to stem the foreclosure tide — and does a disservice to the taxpayers whose money he would put at risk in the bailout. Many of the assets that Mr. Paulson wants to buy with the $700 billion have gone sour because they are tied to mortgages that have defaulted or are at risk of default. Unless homeowners get some help — and its a pittance compared to what Mr. Paulson wants to give to bankers — the downward spiral of defaults, foreclosures and tumbling home prices will continue, which could push down the value of those assets even further. We could make a strong moral argument that the government has a greater responsibility to help homeowners than it does to bail out Wall Street. But we don’t have to. Basic economics argues for a robust plan to stanch foreclosures and thereby protect the taxpayers’ $700 billion investment. Mr. Paulson has long opposed what is probably the best way to help Americans stay in their homes: allowing a bankruptcy court to reduce the size of bankrupt borrowers’ mortgages. Unfortunately, but predictably, drafts of the bailout plan circulated late Thursday do not mention that relief. It is simply outrageous that every type of secured debt — except the mortgage on a primary home — can be reworked in bankruptcy court. The law was designed to protect lenders, who have obviously and disastrously abused that protection. There would be no favors dispensed in bankruptcy proceedings. Lenders would have to accept less of a payback and borrowers would have to submit to the oversight of the bankruptcy court for years. But the bankruptcy process would mean many fewer foreclosures. And that would halt the downward slide in home prices, reduce the number of vacant homes — and the blight that comes with them — and help preserve equity for all homeowners. It would cost the taxpayer nothing. Arguments against bankruptcy relief for mortgages have all been raised and refuted in Congressional hearings and debates over the past year. There should be no more balking. Any bailout bill must allow struggling homeowners to modify their mortgages in bankruptcy court. Mr. Paulson should drop his opposition now. If he won’t, Congress should insist on the bailout for homeowners. Americans’ $700 billion investment needs to be protected.

Timeline: Crisis on Wall Street Sept. 27, 2008

The credit crisis shaking the global economy is forcing a dramatic reconfiguration of Wall Street. Here is a day-by-day look at the impact of the crisis on the markets and Wall Street and the steps legislators and government officials are taking to avert a meltdown in the global financial markets.

Sept. 26 The Dow opens down triple digits, but recovers most of its losses during morning trading. President Bush delivers a brief address on national television saying that key negotiators would pass a bailout bill. John McCain says he will join Barack Obama for their debate in Mississippi. Democrats say they are 'back on track' after hitting yesterday's roadblock, but no agreement on the $700 billion plan has been reached.

Dow Jones Industrial Average: +121.07 Sept. 25 Negotiators from the Republican and Democratic parties say they have reached agreement on basic principles governing the massive financial bailout, but later in the day top Republicans deny reports of an agreement. Federal regulators seize troubled mortgage lender Washington Mutual in the largest bank failure in U.S. history, then immediately sell much of the company to J.P. Morgan Chase for $1.9 billion in a deal that will create the largest bank in the country. Despite weak economic data, stocks soar as hopeful investors are buoyed by news reports that the financial rescue plan was making its way through Congress. James B. Lockhart III, the chairman of the Federal Housing Finance Agency tells the House Financial Services Committee that the new chiefs of Fannie Mae and Freddie Mac will receive salaries of $900,000. Dow Jones Industrial Average: +196.89 Sept. 24 President Bush delivers a nationally televised address, asking the nation to support the financial bailout plan. Sen. John McCain suspends his presidential campaign to focus on crafting the bailout package and asks Sen. Barack Obama to delay a debate scheduled for Friday, Sept. 26. Obama says it is more important than ever to have the debate. During his second day of testimony on Capitol Hill, Federal Reserve chairman Ben Bernanke tells lawmakers the U.S. economy is faltering. Peter R. Orszag, the director of the Congressional Budget Office tells the House Budget Committee that the proposed Wall Street bailout could actually worsen the current financial crisis. The Dow takes a breather, moving little amid light trading. Standard & Poors cuts the credit rating of troubled bank Washington Mutual from BB- to CCC. Dow Jones Industrial Average: -28.28 | Graphic Analysis Sept. 23 Lawmakers from both parties question policymakers in the first day of Capitol Hill hearings. Federal Housing Finance Agency official, James B. Lockhart III, says Fannie Mae and Freddie Mac could not continue to cover mortgage losses without government support. The FBI launches an investigation into whether fraud played a role in the collapse of finance giants Fannie Mae, Freddie Mac, Lehman Brothers and AIG, bringing to 26 the number of bureau investigations tied to the crisis. Major Japanese banks continue to snap up Wall Street holdings. Despite pressure from Vice President Dick Cheney and Chief of Staff Joshua Bolten, House Republicans are reluctant to approve massive rescue plan.

The Dow falls in late trading. Billionaire investor Warren Buffet's company Berkshire Hathaway invests $5 billion in Goldman Sachs. Dow Jones Industrial Average: -161.52 Sept. 22 Democrats call for the bailout plan to include caps on executive compensation and aid for struggling homeowners. Those engineering the bailout plan struggle with how to value the troubled securities that would be purchased and with how to auction them. Goldman Sachs and Morgan Stanley are converted into bank holding companies, offering them broader government protection in exchange for tighter regulation. Asian banks invest in Morgan Stanley and gobble up the remains of Lehman Brothers. The SEC expands its temporary ban on short selling of financial stocks to 100 additional companies. Fearing massive transfers from bank accounts to money market funds, the Treasury Dept. says it will only guarantee existing investments in money market funds. Inflation fears spark the steepest one-day drop in the dollar in years. Gold prices soar. Oil prices spike more than $16 a barrel, the biggest one-day price jump ever. Dow Jones Industrial Average: -372.75 | Graphic Analysis Sept. 19 President Bush announces plan to buy troubled assets from financial firms. Treasury Dept. offers to protect investments in money market funds. Fannie Mae and Freddie Mac will increase their purchases of mortgage-backed securities, Treasury Dept. says. SEC temporarily bans short selling in shares of nearly 800 financial institutions and expands its investigations into credit default swaps. Stock markets soar as details of the multi-billion dollar financial rescue plan emerge. Dow Jones Industrial Average: +360.93 | Graphic Analysis Sept. 18 Global Lenders The Fed and central banks in Europe, Japan and Canada team up to inject as much as $180 billion into global markets to ease the cash crunch, while investors withdraw $80 billion from money market funds. The Bush administration urgently prepares a massive rescue plan to revive the U.S. financial system by buying up bad debts

choking the books of financial institutions. Stocks whipsaw, ending on a high note as word spreads of a possible U.S. plan to address the crisis. Putnam Investments closes a $12.3 billion money-market fund to limit losses to its investors. Dow Jones Industrial Average: +410.68 Sept. 17 London interbank offered rate (LIBOR) As banks abruptly stop lending to each other, cash becomes scarce, driving up the cost of capital. Washington Mutual puts itself up for sale. Morgan Stanley and Goldman Sachs shares drop 24 and 14 percent respectively. Morgan Stanley and Wachovia enter merger talks. The price of gold soars more than 8 percent. Markets sustain heavy losses as AIG takeover unnerves investors. The SEC adopts new rules prohibiting abusive "naked short-selling." Dow Jones Industrial Average: -446.92 Sept. 16 AIG stock price, daily close The Fed lends insurance giant American International Group (AIG) $85 billion in exchange for nearly 80 percent of its stock. Lawmakers clamor for government action and contemplate other dramatic interventions. Lehman Brothers heads to bankruptcy court and seeks to sell parts of its business to ease the bankruptcy process. Oil prices drop almost $4.56 a barrel, continuing a two-month decline from all-time highs. The Dow Jones industrial average rebounds on the news that the Fed has agreed to help AIG. Dow Jones Industrial Average: +153.40 Sept. 15 Lehman Brothers files for bankruptcy protection. Bank of America agrees to buy Merrill Lynch. The Federal Reserve elects not to raise interest rates, despite pleas from Wall Street. Global stocks plunge on Wall Street worries. Oil drops below $100 a barrel. New York state allows insurance giant AIG to use $20 billion

from its own insurance subsidiaries to ease a financial crunch. Dow Jones Industrial Average: -498.86 | OPINIONS | SPORTS | ARTS & LIVING | Discussions | Photos & Video | City Guide | CLASSIFIEDS | JOBS | CARS | REAL ESTATE

Lawmakers Get Down to Details of Drafting Bill September 27, 2008

Talks over the Bush administration's plan to stabilize the U.S. financial system lurched forward yesterday, as rebellious Republicans returned to the negotiating table and congressional aides began the tortuous work of drafting a bill to execute one of the biggest interventions into the private market in modern history.

One day after they nearly derailed the plan, House Republicans agreed to send their second-ranking leader to negotiate with Democrats and Senate Republicans.

Lawmakers canceled plans to adjourn yesterday for the November election and instead prepared to work through the weekend on the proposal, which would authorize the Treasury Department to spend up to $700 billion to take bad assets off the books of faltering financial institutions. Democrats said they hoped to announce an agreement late Sunday before Asian financial markets open, with a House vote on the measure possible by Monday. A Senate vote would follow later in the week.

"Great progress is being made. We will not leave until legislation is passed that will be signed by the president," said House Speaker Nancy Pelosi (D-Calif.).

Added Rep. Barney Frank (D-Mass.), an architect of the legislation: "I am convinced that by Sunday we will have an agreement people will understand."

With global markets hanging on every twist of the debate in Washington, White House officials swarmed Capitol Hill in an attempt to salvage a deal, while President Bush issued another call for action during a brief appearance outside the Oval Office.

"There are disagreements over aspects of the rescue plan, but there is no disagreement that something substantial must be done," Bush said yesterday morning. "The legislative process is sometimes not very pretty, but we are going to get a package passed. We will rise to the occasion."

Bush followed his remarks with calls to House Republican leaders, who have balked at approving a massive bailout for Wall Street dealmakers and are pushing an alternative plan to create a government insurance program for home mortgages. Republicans say that plan would blunt the impact of record foreclosures, which have paralyzed institutions that hold mortgage-related assets. But critics say it would do nothing to inject needed cash into banks and other institutions.

Treasury Secretary Henry M. Paulson Jr. presented lawmakers with a three-page plan for salvaging the country's financial system one week ago. By yesterday, following discussions with Democratic leaders, the draft proposal had grown to more than 100 pages, with hours of negotiation to come.

Under a tentative agreement among lawmakers and administration officials, the measure would grant the Treasury sweeping power to buy up bad mortgage-related assets through Dec. 31, 2009, but it also would create an independent inspector general to oversee that program. As the new owner of billions of dollars worth of mortgage-backed assets, Treasury would be required to reduce the number of foreclosures by modifying the terms of the loans that underlie those assets.

Frank said Treasury also has agreed to accept other changes to its original plan, though aides were

still haggling over details. Among the changes:

· A proposal to dole out the money in segments, with Paulson getting $250 billion immediately, another $100 billion later and the final $350 billion after giving Congress 30 days to object.

· A plan to help taxpayers recover their investment by granting them equity in companies that participate in the bailout and return to profitability.

· A provision that would require the Treasury to ban "excessive and inappropriate" compensation for top executives at participating firms. Democrats are also seeking to eliminate a tax deduction companies take for executive compensation if a senior manager is paid more than $400,000 a year.

Republican negotiators, meanwhile, appeared to be most concerned yesterday about a Democratic proposal to dedicate a portion of any profits from the eventual sale of the assets to an affordable housing fund. Republicans argue that the fund would benefit social service organizations with strong ties to the Democratic party.

Lawmakers from both parties reached an agreement in principle on the bailout plan around lunchtime Thursday. But that deal was imperiled hours later, after a White House summit that included Bush and both presidential candidates turned into a shouting match. House Minority Leader John A. Boehner (R-Ohio) angered Democrats by floating the insurance idea, then refusing to participate in a late-night negotiating session with Paulson.

Yesterday got off to a much better start, as House Minority Whip Roy Blunt (R-Mo.) announced that he would join the negotiations. A member of GOP leadership for six years, Blunt enjoys a comfortable relationship with some Democrats and played the lead role in several recent bipartisan negotiations, including a compromise on foreign intelligence surveillance legislation.

Meanwhile, Rep. Eric Cantor (R-Va.), a key figure in a band of Republicans that had adamantly opposed the bailout plan, softened his opposition. Cantor acknowledged that, in dealing with the most troubled mortgage securities, the insurance model preferred by many Republicans would not be sufficient because the securities already had minimal value. "So you've got to go with Paulson's model," Cantor said.

Including an option for mortgage insurance might persuade more Republicans to support the bailout plan, Cantor said. Boehner concurred, saying the entire deal could collapse unless the idea were given serious consideration.

Without it, "a large majority of Republicans cannot -- and will not -- support Secretary Paulson's plan," Boehner wrote in a letter to Pelosi yesterday.

Democrats said they don't think insuring mortgages would solve the credit crisis, because the Republican plan proposes to charge premiums to the very banks that are struggling to stay afloat. They sad the idea also would make the government the insurer of last resort, exposing it to losses that could exceed the price of the Bush proposal.

But Frank said he was willing to add an insurance option if it secured Republican votes. With less than six weeks until the November election, Pelosi, Frank and other Democrats have demanded that a large number of Republicans join them in approving the controversial legislation.

"It's no problem to add something that's not going to do much," Frank said.

Democrats have accused the GOP presidential candidate, Sen. John McCain (R-Ariz.), of engineering Thursday's breakdown in hopes of garnering attention for his campaign. Republicans yesterday defended McCain but acknowledged that his intervention had created a stir that threatened the bailout.

With McCain and his Democratic opponent, Sen. Barack Obama (D-Ill.), both back on the campaign trail, the talks are "back on track," said Sen. Lamar Alexander (R-Tenn.). Alexander said he expects more than 40 Republicans in the Senate to support the final legislation if it is endorsed by their lead negotiator, Sen. Judd Gregg (R-N.H.).

"He'll have overwhelming support for it," Alexander said.

In Full Stride as Others Fall During Crisis, Dimon Bolsters J.P. Morgan Chase's Position

September 27, 2008\

Jamie Dimon steered his bank away from the bad mortgage bets and risky financing methods that have damaged much of his competition. But the J.P. Morgan Chase chief executive finds himself playing a major role in the credit crisis anyway.

From a dashing rescue of Bear Stearns in March to this week's winning bid in an emergency auction of savings and loan Washington Mutual, Dimon has helped federal officials avoid potential messes stemming from the turmoil in the financial markets.

"It's very fortunate that he's in the position to appear as a white knight, but make no mistake: J.P. Morgan and Jamie Dimon are in this thing to make money for their shareholders," said Tom Kersting, a banking analyst at Edward Jones.

J.P. Morgan shares jumped 11 percent to $48.24 on Friday as investors applauded Dimon's $1.9 billion acquisition of Washington Mutual's banking operations.

Dimon has been instrumental in turning J.P. Morgan into a banking giant. He came to the firm from Bank One, itself the product of mergers, after J.P. Morgan bought it in 2004. With the latest acquisition, he now heads a U.S. banking empire of 5,400 locations in 23 states whose only peer is Bank of America.

The son and grandson of stockbrokers who for many years worked alongside former Citigroup chairman Sanford Weill, Dimon has never shared the appetite for risk and disdain for plain-vanilla lending that have defined much of Wall Street in recent years.

"Jamie has always been focused on deposits and on creating what he calls a 'fortress balance sheet,' which among other things means carrying a stable supply of cash that doesn't run out the door at the first sign of crisis," said former J.P. Morgan investment banker David Stowell, now a professor at Northwestern University's Kellogg School of Management.

That fortress mentality has raised Dimon's already considerable profile as competitors, investors and federal officials scramble to unfreeze credit markets and restore faith in the American banking system.

Dimon, 52, said that he and his top lieutenants don't consider themselves "go-to guys" for the federal government.

Although he conceded to showing some degree of flexibility when he was asked by top regulators to buy Bear Stearns and stave off the fallout from a failure of a major securities firm, he suggested that anyone in his position would have responded similarly.

"We went out of our way to accommodate what we thought could have been a devastating situation," Dimon told reporters Friday on a conference call. "Personally, I think that should be the attitude of everybody."

Earlier this month, J.P. Morgan joined Goldman Sachs in trying to arrange a $75 billion loan for ailing insurance giant American International Group, also at the government's behest. But the firms could not raise the financing in the two-day time frame that AIG needed to meet its obligations, and the government stepped in with a loan.

Dimon appeared on the scene again Thursday, picking up Washington Mutual's banking operations for far less than what he was rumored to be interested in paying earlier this year when he was mulling a takeover of the company. But this time, Dimon's bid was not solicited by the government.

"This was an arm's length transaction," he said. "There may have been other people willing to do it," he said, but not at the price J.P. Morgan had offered.

Unlike the Bear Stearns transaction, the Washington Mutual acquisition comes with no guarantees from the Federal Reserve, which put up $29 billion to help J.P. Morgan absorb potential losses from Bear Stearns's assets.

The Washington Mutual purchase, executed late Thursday evening, should generate profit quickly, adding an estimated 50 cents to per-share earnings for 2009, the company said. And crucially, J.P. Morgan sold $10 billion of common stock Friday to ensure that it could absorb any potential losses on Washington Mutual's mortgage-laden books.

Costs related to the merger are expected to total $1.5 billion, the company said.

The acquisition quickly expands J.P. Morgan Chase's retail banking business in California, Florida and Washington State, and strengthens its presence in key markets including New York and Texas.

Michael Moskow, president of the Chicago Fed, described the New York native as a "personable, but no-nonsense" executive who "speaks about a thousand words a minute," is widely known for his attention to detail.

"He's willing to go into the weeds," similar to his mentor, said Stowell, of Northwestern. "Sandy Weill was another extreme detail guy who understood the plumbing of an organization. That was, I'm sure, a very big influence on him. But above and beyond that, he's just a very tenacious guy. And he sees things that a lot of people don't see."

J.P. Morgan hasn't been completely shielded from the mortgage crisis that has infiltrated Wall Street. But its write-downs have been relatively small, and investors have maintained confidence in Dimon's ability to keep the bank healthy.

"He's been preparing for this moment for years," said Jason Polun, a banking analyst at T. Rowe Price. "It's not luck. He's very, very smart. And his discipline, while others were jumping into growth opportunities with great risk, kept the balance sheet in great position to take advantage of the situation at Bear Stearns and at Washington Mutual."

That doesn't mean J.P. Morgan won't have to worry about the backdrop to the ongoing credit crisis: a slowing economy and a more cautious consumer. But Dimon doesn't expect economic tides to throw his growing company too far off course.

"We've never said we're immune to that," Dimon said in the conference call with reporters. "We're just prepared for it."

What $700B won't buy: a quick fix for the economy Sat Sep 27, 2:45 PM ET

Not even $700 billion will be enough to spare the United States from more economic anguish if the government's proposed banking bailout pans out like similar desperation moves during the past two

decades.

It usually takes years to recover from a financial crisis severe enough for politicians to ride to the rescue with truckloads of taxpayer money.

Take, for example, the U.S. government's August 1989 bailout of the savings-and-loan industry. The stock market fell by 12 percent within the first 14 months of the rescue plan while the economy slipped into an eight-month recession that began in July 1990. Housing prices that had just begun to erode continued to fall for another three years.

There's little reason to believe it will be dramatically different this time around, particularly since this bailout involves harder-to-value assets and comes with the U.S. economy already on the edge of a recession, if one hasn't begun already.

"This is going to take years to work out and it will be incredibly complicated," predicted banking consultant Bert Ely, who has extensively studied the U.S. government's 1989 bailout.

Although lawmakers are still sparring over the precise details, the proposed bailout would authorize the government to borrow up to $700 billion to buy the toxic assets poisoning banks. Most of these holdings are tied to mortgages made to borrowers who either can't afford to make their monthly payments or have simply chosen to default because they owe far more than their homes are worth. No one seems quite certain how much these assets are worth, but the government is betting that — with time — it can get a handle on it and eventually profit.

Even as the government tries to clean up the mess left by reckless home lenders, borrowers and investors, more problems are likely to stack up.

The trouble could include longer unemployment lines as struggling companies faced with declining sales and limited access to credit trim their payrolls. That could lead to even more bank failures, as cash-strapped borrowers don't repay loans. And most experts think there's still a good chance the downturn in the housing and stock markets will deepen to further spook already frightened consumers.

The government is hoping its intervention will unclog the lending pipeline, but that isn't a certainty either, said Sung Won Sohn, an economics professor at California State University, Channel Islands.

"If I am a medium-sized bank on Main Street, simply because the government is bringing a bailout package to Wall Street doesn't mean I am suddenly going to change my mind and start lending money again," Sohn said.

That suggests the economic statistics won't even capture some of the collateral damage — all the lost lending opportunities that occur as banks try to bolster their rickety balance sheets. Many banks have curtailed their lending because they are already swimming in losses and don't want to risk drowning by taking chances on more borrowers.

"The real tragedy is we will never know how many businesses would have been started or how many businesses might have expanded if all this hadn't happened," said Jonathan Macey, deputy dean of Yale Law School, who wrote a book about a government bailout in Sweden during the early 1990s.

In a best case scenario, Macey said the United States will bounce back within two years, like Sweden did after the government spent billions of dollars to salvage the country's troubled banks and prop up a slumping housing market.

Before the medicine took effect, Sweden suffered through a 20-month recession that saw nearly 60,000 companies go bankrupt, housing prices fall by 19 percent and the country's bellwether stock market index plunge 45 percent from its peak. Once the hangover ended, the good times resumed; Sweden's economic growth has averaged 3.2 percent since 1994.

Sweden spent 65 billion kronor (about $10 billion at the time), but made most of the money back because it bought a stake in some of the troubled banks. The government still owns nearly 20 percent in one bank — a stake that is now up for sale. U.S. lawmakers also have been debating whether it makes sense to acquire stock in some of the banks that the government intends to help out.

In a more sobering situation, the payoff from the U.S. bailout might take much longer. That's what happened in Japan after its government finally intervened in a real estate and banking crisis that began in the early 1990s.

By the time the government acted in 1997, the economic hole was so deep that it took another seven or eight years to climb out. The net public outlay to clean up mess was 18 trillion yen ($168 billion), according to the Financial Services Agency.

The abysmal times in Japan during the 1990s are now known as the "lost decade." Even though the economy is better now, the Japan's stock market still hasn't returned to its peak before the bubble burst. And Japan still has about $9 billion worth of property held as collateral that needs to be sold.

It seems unlikely that the United States will have to wait as long for a recovery because the government is wading into the financial muck much more quickly than Japan did.

In contrast, the United States is promising to bail out its banks 18 months after mortgage lender New Century Financial Corp. filed for bankruptcy — a move that set off alarms about the rot ruining home loan portfolios.

"Some resolution measures are more effective than others in restoring the banking system to health and containing the fallout on the real economy," the International Monetary Fund concluded in a study of 124 financial crises since 1970. "Above all, speed appears to be of the essence."

Even if the U.S. government is moving in time to make a difference, success is likely to hinge on the ability to figure out the right price to pay for an exotic mix of mortgage-backed investments and other serpentine securities that aren't easily appraised. And then the government must hope the housing market eventually rebounds to lift the value of the acquired assets.

If those pieces fall into place, the United States could profit or at least minimize its losses. On the flip side, the losses could be huge if the government misjudges the value of the problem assets or the housing market remains in a funk. "The best we can hope for is that this (bailout) buys us time," said Edward Yardeni, who runs his own economic research firm.

The United States moved a little quicker to address the mortgage crisis than it did in the savings-and-loan debacle of the 1980s. Although warning signs of an industry breakdown started to flash in the mid-1980s, the government waited until August 1989 to create the Resolution Trust Corp. to dispose of the repossessed homes, offices, cars, planes and even artwork held by failed S&Ls.

During the next six years, the RTC sold nearly $400 billion in assets on the books of more than 700 failed thrifts. Taxpayers ended up sustaining a loss of $125 billion to $150 billion on the fire sale — about 2 percent of the country's gross domestic product by the time the bailout was completed in 1995. Entering the S&L bailout, the government had projected a taxpayer loss of $40 billion to $50 billion.

If the ratio of losses to assets inherited in the latest $700 billion bailout is similar to what occurred in the S&L crisis, the taxpayers will be saddled with a bill of more than $250 billion, which also translates into about 2 percent of the nation's current GDP.

Data from the IMF's study suggest the losses could run even higher. The monetary fund calculated governments typically recover about 18 cents on every dollar spent in bailouts — a rate that would translate into a loss of more than $500 billion. The United States seems unlikely to sustain a loss that large since it presumably will be buying the banking assets at a sharp discount — leaving plenty of room for an upside.

Although the S&L bailout was the biggest in U.S. history before this one, the challenges facing the government are radically different.

In 1989-95, the government and an army of contractors disposed of assets that were dumped into their laps as S&Ls collapsed. And it wasn't too difficult to figure what those assets were worth because their value could be easily measured against similar property. That's not the case this time. Part of the reason so many banks are imperiled is that no one is sure what their investments are worth.

Most economists agree absorbing the bailout's costs are preferable to running the risk of the entire U.S. financial system unraveling — a calamity that would probably trigger a global depression. But knowing things could be even worse probably won't make it easier to stomach the turmoil still to come.

"Unwinding asset and credit bubbles is a long and arduous task even with aggressive government involvement," Merrill Lynch economist David Rosenberg wrote in a report titled "Capitalism takes a sabbatical."

$700B rescue plan finalized; House to vote Monday

September 28,2008

Congressional leaders and the White House agreed Sunday to a $700 billion rescue of the ailing financial industry after lawmakers insisted on sharing spending controls with the Bush administration. The biggest U.S. bailout in history won the tentative support of both presidential candidates and goes to the House for a vote Monday.

The plan, bollixed up for days by election-year politics, would give the administration broad power to use taxpayers' money to purchase billions upon billions of home mortgage-related assets held by cash-starved financial firms.

President Bush called the vote a difficult one for lawmakers but said he is confident Congress will pass it. "Without this rescue plan, the costs to the American economy could be disastrous," Bush said in a written statement released by the White House.

Flexing its political muscle, Congress insisted on a stronger hand in controlling the money than the White House had wanted. Lawmakers had to navigate between angry voters with little regard for Wall Street and administration officials who warned that inaction would cause the economy to seize up and spiral into recession.

A deal in hand, Capitol Hill leaders scrambled to sell it to colleagues in both parties and acknowledged they were not certain it would pass. "Now we have to get the votes," said Sen. Harry Reid, D-Nev., the majority leader.

The final legislation was released Sunday evening. House Republicans and Democrats met

privately to review it and decide how they would vote. "This isn't about a bailout of Wall Street, it's a buy-in, so that we can turn our economy around," said House Speaker Nancy Pelosi, D-Calif.

The largest government intervention in financial markets since the Great Depression casts Washington's long shadow over Wall Street. The government would take over huge amounts of devalued assets from beleaguered financial companies in hopes of unlocking frozen credit.

"I don't know of anyone here who wants the center of the economic universe to be Washington," said a top negotiator, Sen. Chris Dodd, chairman of the Senate Banking, Housing and Urban Affairs Committee. But, he added, "The center of gravity is here temporarily. ... God forbid it's here any longer than it takes to get credit moving again."

The plan would let Congress block half the money and force the president to jump through some hoops before using it all. The government could get at $250 billion immediately, $100 billion more if the president certified it was necessary, and the last $350 billion with a separate certification — and subject to a congressional resolution of disapproval.

Still, the president, meaning it would take extra-large congressional majorities to stop it, could veto the resolution.

Lawmakers who struck a post-midnight deal on the plan with Treasury Secretary Henry Paulson predicted final congressional action might not come until Wednesday.

The proposal is designed to end a vicious downward spiral that has battered all levels of the economy. Hundreds of billions of dollars in investments based on mortgages have soured and cramped banks' willingness to lend.

"This is the bottom line: If we do not do this, the trauma, the chaos and the disruption to everyday Americans' lives will be overwhelming, and that's a price we can't afford to risk paying," Sen. Judd Gregg, the chief Senate Republican in the talks, told The Associated Press. "I do think we'll be able to pass it, and it will be a bipartisan vote."

A breakthrough came when Democrats agreed to incorporate a GOP demand — letting the government insure some bad home loans rather than buy them. That would limit the amount of federal money used in the rescue.

Another important bargain, vital to attracting support from centrist Democrats, would require that the government, after five years, submit a plan to Congress on how to recoup any losses from the companies that got help.

"This is something that all of us will swallow hard and go forward with," said Republican presidential nominee John McCain. "The option of doing nothing is simply not an acceptable option."

His Democratic rival Barack Obama sought credit for taxpayer safeguards added to the initial proposal from the Bush administration. "I was pushing very hard and involved in shaping those provisions," he said.

Later, at a rally in Detroit, Obama said, "it looks like we will pass that plan very soon."

House Republicans said they were reviewing the plan.

As late as Sunday afternoon, Republicans regarded the deal as "a proposal that is promising in principle, but that is still not final," said Antonia Ferrier, a spokeswoman for Missouri Rep. Roy Blunt, the top House GOP negotiator.

Executives whose companies benefit from the rescue could not get "golden parachutes" and would see their pay packages limited. Firms that got the most help through the program — $300 million or more — would face steep taxes on any compensation for their top people over $500,000.

The government would receive stock warrants in return for the bailout relief, giving taxpayers a chance to share in financial companies' future profits.

To help struggling homeowners, the plan would require the government to try renegotiating the bad mortgages it acquires with the aim of lowering borrowers' monthly payments so they can keep their homes.

But Democrats surrendered other cherished goals: letting judges rewrite bankrupt homeowners' mortgages and steering any profits gained toward an affordable housing fund.

It was Obama who first signaled Democrats were willing to give up some of their favorite proposals. He told reporters Wednesday that the bankruptcy measure was a priority, but that it "probably something that we shouldn't try to do in this piece of legislation."

"It's not a bill that any one of us would have written. It's a much better bill than we got. It's not as good as it should be," said Democratic Rep. Barney Frank of Massachusetts, the House Financial Services Committee chairman. He predicted it would pass, though not by a large majority.

Frank negotiated much of the compromise in a marathon series of up-and-down meetings and phone calls with Paulson, Dodd, D-Conn., and key Republicans including Gregg and Blunt.

Pelosi shepherded the discussions at key points, and cut a central deal Saturday night — on companies paying back taxpayers for any losses — that gave momentum to the final accord.

An extraordinary week of talks unfolded after Paulson and Ben Bernanke, the Federal Reserve chairman, went to Congress 10 days ago with ominous warnings about a full-blown economic meltdown if lawmakers did not act quickly to infuse huge amounts of government money into a financial sector buckling under the weight of toxic debt.

The negotiations were shaped by the political pressures of an intense campaign season in which voters' economic concerns figure prominently. They brought McCain and Obama to Washington for a White House meeting that yielded more discord and behind-the-scenes theatrics than progress, but increased the pressure on both sides to strike a bargain.

Lawmakers in both parties who are facing re-election are loath to embrace a costly plan proposed by a deeply unpopular president that would benefit perhaps the most publicly detested of all: companies that got rich off bad bets that have caused economic pain for ordinary people.

But many of them say the plan is vital to ensure their constituents don't pay for Wall Street's mistakes, in the form of unaffordable credit and major hits to investments they count on, like their pensions.

Some proponents even said taxpayers could come out as financial winners.

Gregg, R-N.H., said: "I don't think we're going to lose money, myself. We may — it's possible — but I doubt it in the long run."

Who wins, who loses under proposed bailout plan? Sun Sep 28, 4:16 PM ET

The proposal to bail out U.S. financial markets to the tune of up to $700 billion creates a lot of

potential short-term winners, as well as some losers.

Wall Street and the banking industry are perhaps the biggest winners. Scores of banks and other financial institutions faced with going under stand to gain a lifeline that should allow them to start making loans again.

Under the plan that congressional aide sought to put into final form Sunday, the Treasury Department can start buying up troubled mortgage-related securities now held by these institutions.

These securities are clogging balance sheets, leaving banks without the required capital to make new loans and putting the banks dangerously close to insolvency.

Banks not only have slowed lending to individuals and businesses, they have stopped making loans to each other. The rescue plan should help restore confidence to financial markets.

There are other winners, too, if the bailout works as intended: anyone soon trying to borrow money — for cars, student loans, even to open new credit card accounts.

Top executives at troubled financial institutions, on the other hand, are in the losing column because the proposal would limit their compensation and rules out "golden parachutes."

Of course, these executives may take solace in knowing their jobs still exist.

Investors, including the millions of people who hold stock in their 401(k) and pension plans, should benefit. Failure to reach a deal over the weekend could have sent stock markets around the world tumbling on Monday.

Homeowners faced with foreclosure or those who have lost their homes get little help from the agreement. Nor will it help people whose houses are worth less than what they owe get refinancing or take out equity loans.

It would do little to halt the slide in home values that are one of the root causes of the current economic slowdown.

"It doesn't deal with the fundamental problems that gave rise to the problem — or alleviate the credit crisis," said Peter Morici, an economist and business professor at the University of Maryland

Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are potential winners. In just a few months, they have remade Wall Street. If the plan helps to get the economy moving again, they may be remembered for having kept the financial crisis from spreading throughout the economy.

"When I see Hank Paulson and Ben Bernanke on TV, I see fear in their eyes. Like on a battlefield when people are shooting at you. I think they are afraid to say how serious the problem is for fear of making it worse," said Bruce Bartlett, an economist who was a Treasury official under the first President Bush.

Bartlett said the plan is flawed, yet the alternative of doing nothing could be catastrophic.

After the heavy dose of new regulation in the agreement, New York will have a hard time claiming it is the center of the financial universe. That title may have shifted to Washington.

If the plan stays together, Congress — with approval ratings even lower than those of President Bush — may be seen as having acted decisively at a time of national emergency.

Congressional leaders added new protections to the administration's original proposal. That was only three pages long and bestowed on the treasury secretary almost unfettered powers.

Instead, the agreement would divide the $700 billion up into as many as three installments, creates an oversight board to monitor the treasury secretary's actions and set up several major protections for taxpayers, including a provision putting taxpayers first in line to recover assets if a participating company fails.

The president, on the other hand, probably would get little credit for the deal. He allowed Paulson and Bernanke to do the heavy lifting. The only time he called all the players to the White House — late Thursday afternoon — the wheels almost came off the process entirely.

It's hard to tell which presidential candidate benefits the most from an agreement they tentatively endorsed Sunday, a little more than five weeks before the Nov. 4 election. Democrat Barack Obama and Republican John McCain each sought to claim some credit for the deal, even though they played active roles only over the past few days.

Hard economic times traditionally work against the party that holds the White House, and in recent polls Obama has inched ahead of McCain. Furthermore, there is widespread consumer resentment over being asked to bail out Wall Street and lawmakers have learned the proposal has not been popular with their constituents.

That may help Democrats in general. The strongest opposition to the original bailout plan came from House Republicans.

Lawmakers and presidential candidates alike are "trying to orchestrate everybody jumping off the cliff together," said Robert Shapiro, a consultant who was an economic adviser to President Clinton. "I think we'd have a different plan if we weren't five weeks out from the election."

And ordinary taxpayers?

Nothing that potentially adds $700 billion to the national debt — already surging toward the $10 trillion mark — can be considered a winner for those who foot the bills. But lawmakers did put in taxpayer protections, including one to require that taxpayers be repaid in full for loans that go bad.

The package could even end up making money for taxpayers, supporters claimed. But only if the loans and interest on them are repaid in full. Few expect that provision to be a winning proposition, however.

Investors give $700B rescue plan ho-hum reception Sun Sep 28, 7:52 PM ET

Financial markets were subdued in early trading Sunday night after congressional leaders said they are poised to pass a $700 billion rescue plan for banks, brokerages, credit unions, thrifts and insurance companies.

Failure to reach an agreement would have led to severe market disruptions, analysts said. But even if investors did dodge a bullet and credit markets start to stabilize, the realities of a weak economy are likely to weigh on markets, they said.

"When you start thinking of the broader issues, a lot of this is very troubling," said Joseph Battipaglia, chief investment officer at Ryan Beck & Co. "We have in front of us a recession in the general economy, the consumer is dramatically retrenching their habits by cutting spending, and our financial system has sputtered. This isn't necessarily a confidence builder because now everybody knows how precarious the financial system really is."

In electronic trading Sunday night, futures on the Dow Jones industrial average, Standard & Poor's

500 index and the Nasdaq 100 all rose about 0.1 percent. The dollar recovered moderately against currencies such as the pound, euro and yen. The yield on three-month Treasuries fell slightly to 0.81 percent in Sunday night trading, an indication that flight-to-quality fears remain high.

The plan would allow the government to buy toxic mortgage-backed assets from embattled financial institutions, giving them fresh cash to bolster lending. It would permit the Treasury to immediately spend $250 billion to buy banks' risky assets, provide another $100 billion at the discretion of the president, and a final $350 billion unless Congress has a change of heart and the president decides not to veto the decision.

Even if the bailout is passed — the House votes on Monday, and the Senate later this week — the economy remains balanced on the edge of a recession. Unemployment has been rising; it's now at a five-year high of 6.1 percent and is expected to rise as high as 7.5 percent by late 2009.

With worries running high about recessions around the world, global stock market volatility should remain elevated. And while anxiety about the financial institutions could keep boosting demand for Treasury bills, pushing short-term rates down for U.S. government debt, a glut of new issues with longer maturities that must be sold to finance the rescue plan could weaken the dollar over time.

In early trading Sunday night, the euro fell to $1.4545, the pound fell to $1.8336, while the dollar rose to 106.28 yen.

There are also plenty of banks still in trouble, and it may take time before the plan helps them.

Banks and brokerages wrote down about $400 billion worth of toxic mortgage investments since last year. Analysts believe write-downs could reach $1 trillion as rising home foreclosures further erode the values of mortgage-backed securities.

In the second quarter, the Federal Deposit Insurance Corp. estimated there were 117 banks and thrifts in trouble, the highest level since 2003. This past week Washington Mutual Inc. became the largest bank to fail in U.S. history, and investors are concerned there might be more failures to come.

In Europe, the beleaguered Dutch-Belgian banking and insurance giant Fortis NV is being partially nationalized due to the market dislocation. Troubled British mortgage lender Bradford & Bingley will also be nationalized and sold off in parts, British media reported Sunday.

The threat of more banks failing in the U.S. and abroad forced the government to act swiftly.

"Without this rescue plan, the costs to the American economy could be disastrous," President Bush said in a statement late Sunday after the legislation was finalized.

Stocks have been volatile and the credit markets have been tight for over a year. The turbulence escalated to unprecedented levels a few weeks ago.

T-bill yields fell to zero for the first time since 1940 as investors pulled their money out of money-market funds and turned to the safest assets out there even if they offered no returns. The difference between those T-bill yields and bank-to-bank lending rates — a key measure of banks' willingness to lend — rose to the highest levels since 1982. And the Dow Jones industrial average swung violently, dropping to its lowest point since November 2005.

The proposed $700 billion bailout is aimed at reviving a market for mortgage-backed securities that has all but disappeared as credit has tightened.

"This gives us a much stronger background to work in compared to the past three weeks," said Ned

Riley, chief investment officer of Boston-based Riley Asset Management. He added, however, that "we're still not out of the woods relative to all the other problems facing the economy, and there will be doomsayers who predict this package won't work."

The plan gave no details about how the government will buy banks' troubled assets, leaving it up to the U.S. Treasury Department to come up with the fine points. The government could price the assets very conservatively, which will mean further losses for institutions with souring debt on their books. Pricing the assets too high might leave taxpayers on the hook.

While those details have yet to be worked out, the market's biggest worry is that the rescue package may trigger inflation, said Quincy Krosby, chief investment strategist for The Hartford. She said "the government might have to print money to pay for the bailout" by issuing large amounts of Treasury debt.

"If the market believes this is going to be inflationary, you'll see mortgage rates go up and money go into commodities," Krosby said.

That would deliver another blow to already struggling consumers. Banks have tightened up their lending practices, making it more difficult to get everything from home loans to credit cards. And surging energy prices and an uncertain job market have caused Americans to pare spending.

After the events of the past few weeks, analysts believe Americans are even angrier and more distrustful of the U.S. financial system. Many have watched their stock portfolios and nest eggs plummet in the past few weeks, and are going to be more unwilling to take risks.

"Who is going to want to borrow to buy a new home in this environment?" Battipaglia said.

Broad Authority, Lots of Money And Uncertainty

September 29, 2008

Congress is on the verge of granting Treasury Secretary Henry M. Paulson Jr. sweeping powers to stabilize the nation's financial system. He would stand largely unfettered by traditional rules, largely unrestricted in his ability to spend $700 billion of federal money.

The Treasury Department would decide what kind of assets to buy, and which financial firms could sell them. It would decide how much to pay. And it would hire firms to manage its acquisitions, without having to obey the normal rules for hiring contractors. These decisions would take several weeks, Paulson said.

The results will determine whether $700 billion is enough to end the financial crisis.

"This is really an unusual situation, a highly unusual situation. And we need flexibility, we need a variety of tools, we need to figure out how to get out there in weeks," Paulson said in an interview last night.

It is not clear how patiently investors and depositors in troubled institutions will wait. Nor is it clear whether, in the meantime, the banking system itself will begin to recover from the uncertainty that is freezing the flow of loans to major corporations, small businesses and individuals.

Two European banks moved toward failure over the weekend: Bradford & Bingley, a British mortgage lender, and Fortis, a giant banking and insurance company based in Belgium. Several American institutions continue to teeter.

The legislation, which the House is expected to vote on today, is the latest in a series of government efforts to stem the wave of financial failures, which started with large numbers of

Americans losing their homes to foreclosure. The bill allows the Treasury Department to buy mortgage-related securities devalued by those foreclosures in hopes of leaving troubled financial institutions with fewer problems and more cash.

With the political process nearly complete, the work of helping the financial markets has only just begun. The most critical decision facing the Treasury is how to go about buying troubled assets. Officials say the department may well use different approaches for different kinds of assets, rather than pursuing a uniform strategy.

The goal is not to vacuum all the industry's troubled assets into a federal holding tank. Rather, the government wants to determine credible prices for the assets held by banks, through the mechanism of buying some of those assets. If the plan succeeds, the prices paid by the government will become a new market standard, bridging the current gap between the higher prices sought by banks and the lower prices offered by investors.

"We need confidence, and this is about confidence," Paulson said.

In a practical sense, the government is trying to revive the markets because buying up all the troubled assets would require far more than $700 billion.

Twenty of the nation's largest financial institutions owned a combined total of $2.3 trillion in mortgages as of June 30. They owned another $1.2 trillion of mortgage-backed securities. And they reported selling another $1.2 trillion in mortgage-related investments on which they retained hundreds of billions of dollars in potential liability, according to filings the firms made with regulatory agencies. The numbers do not include investments derived from mortgages in more complicated ways, such as collateralized debt obligations.

Experts say the Treasury plan could do more harm than good.

If the Treasury pushes to buy troubled assets at bargain-basement prices, many banks that hold similar assets would be forced to mark down their holdings. Such losses could push some institutions over the edge.

If the Treasury overpays, taxpayers could lose massive sums.

"There are more questions of doing this and the consequence of doing it poorly than anything else," said Richard H. Baker, a former Congressman and the chief executive of the Managed Funds Association, which lobbies for hedge funds.

Baker recalled during the savings and loan crisis of the late 1980s and early 1990s, the government set up the Resolution Trust Corp. to buy real estate and other assets of banks that went into bankruptcy. The RTC eventually sold some of these properties at such severe discounts in Baker's home state of Louisiana that real estate values around the region became depressed.

The Treasury faces few boundaries on how it can proceed, and many of those can be waived at the department's discretion.

The program is focused on mortgages and related securities -- unless the Treasury deems it important to buy other kinds of assets, such as car or student loans. The Treasury plans to focus on mortgage-backed securities in the first round of purchases.

It is focused on buying from banks, insurance companies and other financial firms with substantial U.S. operations -- unless the Treasury decides it's important to buy from any foreign institution that holds mortgage assets.

The Treasury plans to hire private companies to manage what it buys, and the bill gives the

department the power to waive the rules that govern the use of contractors.

"The Secretary of the Treasury still has huge latitude," said Douglas Elmendorf, a senior fellow at the Brookings Institution. "Now we have to wait to see how he chooses to proceed."

Treasury officials said the broad discretion is important to the success of the program and the health of the financial system. Including foreign firms, for example, is intended to encourage those institutions to continue lending to domestic banks, which often offer mortgage securities as collateral.

The bill also requires the Treasury to establish an insurance program in which private firms would pay premiums to the government for a guarantee of their assets. But the department can shape how this program would be implemented. The difference between the premiums that the firms pay and the value of the assets would count against the $700 billion cap on the total federal effort.

And Treasury has the authority to decide what restrictions should be imposed on companies that seek government help, including limits on executive compensation, and what kind of stake the government should take in companies, so that taxpayers benefit if the companies return to profitability.

In practice, that is likely to mean companies will pay different costs for participation. Representatives of financial companies say the details of the plan will determine whether and how much they participate.

Treasury officials said that flexibility was important to ensure that companies are willing to participate. There is concern that some companies might refrain, either as a demonstration of financial strength or to avoid restrictions.

When the Federal Reserve made loans available to investment banks earlier this year, for example, some companies stayed away, fearful that borrowing would be interpreted by investors as a sign of weakness.

Scott Talbott, a lobbyist for the Financial Services Roundtable, said he thought the program would attract wide participation, but that some of the strongest financial institutions might well refrain.

"If you're in a position of strength, you don't need the program," he said. "And if you're in a position of weakness, you'll do it regardless of the restrictions."

In structuring the program, the Treasury will rely on outside experts. The government already has tapped Edward Forst, Harvard University's executive vice president, to work on the legislation and oversee the launch of the program. But Forst is planning to return within two months to Harvard, where he started as an executive vice president on Sept. 1.

Paulson said he will find longer-term help. "We'll have an organization in place and hire a really strong person to run this," he said. "We're going to get someone who understands markets and we'll find someone who's a real professional to come to Treasury and run it."

The bill also forces a re-evaluation of "mark to market" accounting rules, under which banks and other financial institutions must adjust the value of their assets to reflect current market prices, even if they intend to hold the assets for the long term. Bank executives have blamed these rules in part for their troubles, saying that distressed sellers have pushed market prices below actual values, forcing unreasonable write-downs.

The Securities and Exchange Commission already has the power to overrule the board that sets those accounting rules, the Financial Accounting Standards Board, but the bill restates that the SEC had authority to change mark-to-market rules. It also orders a study be conducted on the role mark-

to-market rules played in the current crisis.

Lynn E. Turner, a former chief accountant at the SEC, criticized the provision, which he said was designed to help bend the commission to the banks' will.

"What they've done here is say let's study whether banks should be allowed to lie," he said. "Regardless of whether you had mark-to-market accounting, you would have this problem, which is banks running out of cash. And they're running out of cash because they made loans to people who aren't paying them back."

Sweeping Bailout Bill Unveiled House Set to Vote Today, Senate to Follow

September 29, 2008

After a week of political tumult and deepening economic anxiety, congressional leaders yesterday rallied support for an historic proposal that would grant the government vast new powers over Wall Street and offer fresh help to homeowners at risk of foreclosure.

The proposed legislation, which is scheduled for a vote today in the House, would authorize Treasury Secretary Henry M. Paulson Jr. to initiate what is likely to become the biggest government bailout in U.S. history, allowing him to spend up to $700 billion to relieve faltering banks and other firms of bad assets backed by home mortgages, which are falling into foreclosure at record rates.

The plan would give Paulson broad latitude to purchase any assets from any firms at any price and to assemble a team of individuals and institutions to manage them. In wielding those powers, Paulson and others hope to contain a crisis that already has caused the failure or forced the rescue of a half-dozen major Wall Street firms and unnerved markets around the world.

The measure was forged during a marathon negotiating session between lawmakers from both parties and Paulson -- who at one point appeared to negotiators to be on the verge of collapse. Restive Republican lawmakers originally criticized the package as putting taxpayers at risk and violating free-market principles, but many of them appeared yesterday to be dropping their opposition.

House Minority Leader John A. Boehner (R-Ohio) emerged last night from a meeting of House Republicans to say he is "encouraging every member whose conscience will allow them to support this." Boehner said he and other GOP leaders made the case that negotiators had improved the bill by gaining a key concession on a plan to limit taxpayer exposure.

A vote in the Senate could take place as soon as Wednesday.

President Bush last night released a statement praising the measure. Although it has been panned as a massive bailout for Wall Street financiers, Bush argued the bill would have broad benefits for ordinary families and business owners who need "access to credit" to "make purchases, ship goods and meet their payrolls."

"This plan sends a strong signal to markets around the world that the United States is serious about restoring confidence and stability to our financial system," Bush said. "Without this rescue plan, the costs to the American economy could be disastrous."

Bush has stressed that the ultimate cost of the bailout would be much less than $700 billion because the government would eventually sell the assets it purchases and recover most, if not all, of its investment.

Still, he acknowledged yesterday that the measure presents lawmakers with "a difficult vote" barely a month before the November elections. Polls show the bailout is hugely unpopular, and lawmakers

have been inundated with calls and e-mails from angry constituents. With investors hanging on every twist of the debate in Washington, leaders in both chambers predicted that the bill would pass.

"If we do this and it works right, it's most likely that people will never appreciate how close we came to the brink. So there's not much political upside to this," said Sen. Judd Gregg (R-N.H.), the lead negotiator for Senate Republicans. But lawmakers are ready to support the bill, Gregg said, because they know "we are facing a crisis of proportions that are almost incomprehensible."

The scope of the crisis was laid out 11 days ago during a late-night meeting in the Capitol where Paulson and Federal Reserve Chairman Ben S. Bernanke warned lawmakers that an imminent meltdown in financial markets threatened to destroy the wealth and jobs of millions of Americans. Two days later, Paulson presented lawmakers with a three-page economic rescue plan that would have granted the Treasury nearly unfettered power to shore up the nation's financial system, unchecked by federal or judicial review.

By yesterday, the measure had grown to 110 pages; many of them devoted to the creation of myriad oversight agencies, including an independent inspector general. Still, the measure would give Paulson broad authority to create an Office of Financial Stability within the Treasury, to hire its staff and to direct their activities. The head of the office would be subject to Senate confirmation and would be required to quickly publish guidelines for identifying, pricing and purchasing troubled assets.

Money for the program would be released in segments, with the Treasury secretary receiving $250 billion immediately. Paulson has said he expects to spend about $50 billion a month on the program.

The Treasury secretary's power to purchase assets would end on Dec. 31, 2009, although the next administration could seek a one-year extension. The assets could be held indefinitely and sold when the housing market recovers, theoretically for a profit.

To protect taxpayers, participating firms would be required to give the government warrants to buy stock so taxpayers could benefit if they return to profitability. If the government does not regain all of its money after five years, the president would be required to submit a plan for recovering the money "from entities benefiting from the program." Given those provisions, some firms might be discouraged from participating, but few have so far indicated their intentions either way.

The measure also would require federal officials to rein in excessive compensation for corporate executives who participate in the bailout program, a first step toward addressing a longtime Democratic priority. According to a recent report by the Institute for Policy Studies, the chief executives of large U.S. companies made an average of $10.5 million last year, 344 times the pay of the average worker.

The bill also requires Paulson to establish a new federal insurance program, funded by the banks, that would protect firms against loss from troubled assets. Although Paulson and Bernanke had concluded that such a program would not be an effective way to pump needed cash into struggling firms, House Republicans demanded the provision, saying it would offer an alternative method for shoring up companies at no cost to taxpayers.

After days of at-times grueling negotiations, House Speaker Nancy Pelosi (D-Calif.) said lawmakers will now be asked to approve the bill without further changes. "The bill is frozen. It's on the Internet," she told reporters. "The public is looking at it."

While the bill is likely to have strong support in the Senate, its chances are less clear in the House, where leaders in both parties said they were still unsure how many votes it would receive. Democrats and Republicans were summoned into separate private meetings late yesterday where

leaders shared the final details of the bill and urged a vote for its passage.

After stalling negotiations late last week, key Republicans spoke in support of the measure. Rep. Eric Cantor (R-Va.) who helped draft the insurance provision assured lawmakers that the bill now contains important safeguards for taxpayers. Rep. Chris Shays (R-Conn.), a moderate who represents many financial services industry executives, said the meeting took on a solemn tone as several retiring lawmakers spoke with passion about the historic nature of what will likely be their last vote.

Meanwhile, Democrats meeting nearby in the basement of the Capitol also heard a rallying cry from their leaders, who won support from some surprising corners. Rep. Jim Marshall (D-Ga.), who represents a conservative-leaning district and is a frequent GOP target, told his colleagues that passing the legislation is more important than winning re-election.

"I am willing to give up my seat over this," Marshall said, according to one attendee.

In both meetings, lawmakers continued to worry aloud about how to protect taxpayers from bearing the cost of the bailout, an issue that was also one of the most fiercely contested matters in talks with Paulson early yesterday.

The negotiators gathered just after 3 p.m. Saturday under an ornate painting of Abraham Lincoln in a large conference room in Pelosi's suite of offices on the second floor of the Capitol. The first few hours were intense and contentious, participants said, marked by shouting over executive pay and a last-minute Democratic request for a fee on the financial services industry to cover the cost of the bailout program.

When details about the fee quickly leaked to reporters in a hallway outside Pelosi's offices, a senior aide walked around the negotiating table confiscating BlackBerrys, labeled them by name with Post-It notes and dumped them into a recycling bin.

As negotiations dragged into the night, Paulson -- already drained by weeks of crisis management -- appeared at one point to be weary and teary-eyed, according to Rep. Rahm Emanuel (D-Ill.), prompting lawmakers to fear for his health. "Are you okay?" asked Gregg, who suggested calling the Capitol physician. Paulson waved them off, saying he was just very tired.

Just before midnight, Pelosi called the White House chief of staff, Joshua Bolten, to report an impasse over executive compensation and the industry fee. With Emanuel on the call, Pelosi threatened to let lawmakers vote on the two issues, which she thought would pass overwhelmingly.

"You gotta understand, this is politics at this point," Emanuel told Bolten, a friendly rival. The White House and Paulson soon reached to a compromise.

The meeting finally broke up around 12:30 a.m. Sunday, when Paulson and lawmakers briefly addressed journalists. After the historic declarations beneath a statue of Will Rogers, Paulson locked arms with Sen. Charles E. Schumer (D-N.Y.) and leaned heavily on the senator for support as they walked away.

Dr. Paulson's Tough Medicine, In a Pill the Public Can Swallow September 29, 2008

After a week of political brinksmanship and 100 pages of concessions to political reality, Treasury Secretary Hank Paulson seems to have finally won the power and money he asked for to mount an unprecedented rescue of the financial system.

If approved by a reluctant Congress and signed into law by the president, the Economic Stabilization Act of 2008 will authorize Paulson to continue in a bigger and systematic way what the

Treasury and Federal Reserve have been doing since March when they committed $29 billion to facilitate the sale of Bear Stearns to its stronger rival, J.P. Morgan Chase. And although the initial focus will be on home mortgages and mortgage-backed securities, there remains enough flexibility in the legislation for Paulson to address similar problems with auto loans, credit card debt and loans for commercial real estate.

Global investors no doubt will cheer the weekend's political breakthrough, focusing less on the details than on the perceived commitment by the United States to do whatever is necessary to prevent a meltdown in global financial markets.

But nobody should view even this effort as sufficient to keep the U.S. economy out of recession, stabilize housing markets or prevent the failure of additional banks, investment houses, insurers and hedge funds. Although more than $600 billion in private-sector credit losses have already been posted, a number of private and public-sector analysts now estimate that won't be even half the final tab from the bursting of the greatest credit bubble the world has seen.

The normally sure-footed Paulson stumbled badly last weekend when he rushed to the Capitol with a vague and poorly explained proposal that all but invited politicians and the news media to label it as a "$700 billion bailout for Wall Street" -- a moniker from which it nearly never recovered.

In fact, even in its original form, the Paulson plan would not have cost taxpayers anywhere near $700 billion, nor was Wall Street ever to be the primary beneficiary. The aim all along was to restore the flow of credit to Main Street's homeowners and businesses through banking and credit channels that have become dangerously constricted in recent months, threatening to choke off capital to the entire economy.

By acting as a buyer of last resort and allowing financial institutions to compete to sell some of their depressed mortgage-backed securities, Paulson hoped to jump-start credit markets to the point that prices for the securities would rise to close to their real economic value, private investors would feel confident enough to re-enter the market and banks would have the capital to begin lending again.

Paulson also intended to use some of the money to inject fresh capital into banks and financial institutions whose failure would jeopardize the stability of the financial system, in exchange for government ownership and control, much as the Treasury and Fed had done with Fannie Mae, Freddie Mac and insurance giant AIG.

And all along he had made informal promises to congressional leaders that, as the government gained effective control of millions of troubled mortgages, it would use its newfound position to prevent unnecessary foreclosures by renegotiating the loans on more favorable terms.

All three elements -- the auctions, the negotiated recapitalizations and the foreclosure mitigation -- survived the week's negotiations and remain the core of the 106-page bill, along with the mandate to implement the program quickly, to structure it as he sees fit and to alter it as market conditions require.

What was added over the past week was a panoply of procedural safeguards, taxpayer protection and structural reforms to provide an acceptable political context for the use of so much public money and the grant of such extraordinary discretion and power.

Although the Treasury secretary will have a free hand in hiring staff and outside contractors, buying assets and negotiating the terms of government investment in struggling banks, he will have to answer to a board consisting of five other top government officials, be required to post the details of everything he does on the Internet and be subject to constant oversight by two congressional committees, a battalion of government auditors and a special inspector general.

For the first time, the federal government will limit the compensation of some top corporate

executives to $500,000 annually -- directly in the case of big banks that participate heavily in the new program and through limits on tax deductions for everyone else. There will be tough restrictions on golden parachutes and clawback provisions for bonuses based on profits that later disappear.

And the legislation takes not-too-subtle swipes at nearly all federal regulators of the financial system, directing the Securities and Exchange Commission to review the wisdom of "mark-to-market" accounting, chiding the Treasury for unilaterally extending deposit insurance to money-market funds and requiring the Fed to make a monthly accounting for its bailouts of Bear Stearns and AIG. A five-member blue ribbon panel of outside experts is to recommend a new regulatory blueprint for the financial services industry -- including supervision of hedge funds and derivative trading -- by Inauguration Day in January.

Finally, the legislation contains several mechanisms for the government to recoup all of its money, and perhaps even turn a profit, by collecting insurance premiums, demanding stock from participating banks and, should all else fail, slapping a new tax on the financial services industry beginning in 2014.

Normally, the mere discussion of such measures would have brought on a furious lobbying effort to kill them. But it is a measure of the industry's newfound impotence in Washington that it was forced to sit silently on the sidelines over the weekend as Republicans and Democrats, leaders and backbenchers joined hands in demanding that Wall Street foot the bill for the mess it has created.

Citigroup to buy Wachovia banking operations

Sept. 29th In the latest byproduct of the widening global financial crisis, Citigroup Inc. will acquire the banking operations of Wachovia Corp. in a deal facilitated by the Federal Deposit Insurance Corp.

Citigroup will absorb up to $42 billion of losses from Wachovia's $312 billion loan portfolio, with the FDIC covering any remaining losses, the government agency said Monday. Citigroup also will issue $12 billion in preferred stock and warrants to the FDIC.

The deal greatly expands Citigroup's retail outlets and secures its place among the U.S. banking industry's Big Three, along with Bank of America Corp. and J.P. Morgan Chase & Co. But it comes at a cost — Citigroup said Monday it will seek to sell $10 billion in common stock and slashed its quarterly dividend in half to 16 cents to shore up its capital position.

The agreement comes after a fevered weekend courtship in which Citigroup and Wells Fargo & Co. both were reportedly studying the books of Wachovia, which suffers from mounting losses linked to its ill-timed 2006 acquisition of mortgage lender Golden West Financial Corp.

Wachovia, like Washington Mutual Inc., which was seized by the federal government last week, was a big originator of option adjustable-rate mortgages, which offer very low introductory payments and let borrowers defer some interest payments until later years. Delinquencies and defaults on these types of mortgages have skyrocketed in recent months, causing big losses for the banks.

The FDIC asserted Monday that Wachovia did not fail, and that all depositors are protected and there will be no cost to the Deposit Insurance Fund. Federal Reserve Chairman Ben Bernanke, in a statement Monday, said he supports the "timely actions" taken by the FDIC "which demonstrate our government's unwavering commitment to financial and economic stability."

Treasury Secretary Henry Paulson also welcomed the sale of Wachovia to Citigroup, saying it would "mitigate potential market disruptions." Paulson said he agreed with the FDIC and the Fed

that a "failure of Wachovia would have posed a systemic risk" to the nation's financial system. "As I have said before, in this period of market stress, we are committed to taking all actions necessary to protect our financial system and our economy," Paulson said.

As details of its takeover unfolded, Wachovia shares plunged 91 percent to 94 cents. The stock had closed Friday at $10, down 74 percent for the year.

Now that a deal for Wachovia is complete, the most troubled of the nation's largest financial institutions have been dealt with. However, the FDIC estimated there were 117 banks and thrifts in trouble during the second quarter, the highest level since 2003. And that number is likely to have increased during the third quarter.

With the acquisition of Wachovia, Citigroup has reclaimed its title as the biggest U.S. bank by total assets. Including Wachovia, the bank now has assets of $2.91 trillion, as of June 30. That could change, however, as Citigroup shrinks its balance sheet, a decision Chief Executive Vikram Pandit made in May to rid the bank's books of risky debt.

In terms of current market capitalization, Bank of America Corp. remains the largest U.S. bank, followed by JPMorgan Chase & Co. in second and Citigroup in third place.

Just a short time ago, Citigroup was under the scrutiny of investors who worried about the possibility of its collapse given its massive exposure to mortgage-backed securities. The New York-based bank has not turned a profit for three straight quarters, and lost a total of $17.4 billion during that period after writing down its assets by about $46 billion. That's the most write-downs of any U.S. bank.

But the government's proposed $700 billion bailout plan could prove to be the deal's silver lining. While the plan broadly aims to prevent banks from profiting on the sale of troubled assets to the government, there is an exception made for assets acquired in a merger or buyout, or from companies that have filed for bankruptcy. This detail could allow Citigroup to sell toxic mortgages and other assets it gained from Wachovia for a higher price than the bank actually paid for them.

The Wachovia deal caps a wave of unprecedented upheaval in the financial sector in the past six months that has redefined the banking industry, starting with the government-led forced sale of Bear Stearns Cos. to JPMorgan in March.

The failure of IndyMac Bancorp in July reignited investors' fears about the stability of the financial sector, which led to the eventual takeover of struggling mortgage lenders Fannie Mae and Freddie Mac.

Earlier this month, officials seized both Fannie and Freddie, temporarily putting them in a government conservatorship, replacing their chief executives and taking a financial stake in the mortgage finance companies.

After U.S. regulators made it clear that they would not bail out struggling investment bank Lehman Brothers Holdings Inc., rival Merrill Lynch & Co. arranged a hasty deal to be bought by Bank of America Corp. for $50 billion in stock.

Lehman Brothers was subsequently forced to declare bankruptcy, the largest ever in the United States. Investor concerns quickly turned to American International Group Inc., the nation's largest insurer. Staving off a failure that could have sent shock waves throughout the global markets, the federal government injected an $85 billion emergency loan into the insurer.

Just days later, the government seized Seattle-based Washington Mutual, marking the largest bank failure in U.S. history. WaMu's deposits and assets were acquired by JPMorgan for $1.9 billion.

These events have now culminated in extraordinary moves by the federal government to try to fix the financial crisis that began more than a year ago. Lawmakers are to vote Monday on an unpopular $700 billion plan to rescue troubled financial companies.

Wachovia's problems stem largely from its acquisition of mortgage lender Golden West Financial Corp. in 2006 for roughly $25 billion at the height of the nation's housing boom. With that purchase, Wachovia inherited a deteriorating $122 billion portfolio of Pick-A-Payment loans, Golden West's specialty, which let borrowers skip some payments.

This summer, Wachovia reported a $9.11 billion loss for the second quarter, announced plans to cut 11,350 jobs — mostly in its mortgage business — and slashed its dividend. Wachovia also boosted its provision for loan losses to $5.57 billion during the second quarter, up from $179 million in the year-ago period.

A Bailout Is Just a Start By Lawrence Summers�

September 29, 2008

Congressional negotiators have completed action on a $700 billion authorization for the bailout of the financial sector. This step was as necessary as the need for it was regrettable. In the coming weeks, the authorities will need to consider hugely important tactical issues regarding the deployment of these funds if the chance of containing the damage is to be maximized.

Right now, what must be considered are the conditions necessitating the bailout and its impact on federal budget policy. The idea seems to have taken hold that the nation will have to scale back its aspirations in areas such as health care, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis suggests that dismal conclusions are unwarranted and recent events suggest that in the near term, government should do more, not less.

First, note that there is a major difference between a $700 billion program to support the financial sector and $700 billion in new outlays. No one is contemplating that $700 billion will simply be given away. All of its proposed uses involve purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700 billion depends on how it is deployed and how the economy performs.

The American experience with financial support programs is somewhat encouraging. The Chrysler bailout, President Bill Clinton's emergency loans to Mexico and the Depression-era support programs for the housing and financial sectors all ultimately made profits for taxpayers. While the savings and loan bailout through the Resolution Trust Corp. was costly, this reflected enormous losses exceeding the capacity of federal deposit insurance. The head of the FDIC has offered assurances that nothing similar will be necessary this time.

It is impossible to predict the ultimate cost to the Treasury of the bailout and the other commitments that financial authorities have made -- this will depend primarily on the economy as well as the quality of execution and oversight. But it is very unlikely to approach $700 billion and will be spread over a number of years.

Second, the usual concern about budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognized that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. After using

the economic expansion of the 1990s to bring down government indebtedness, the United States made a serious error in allowing deficits to rise over the past eight years. But it would compound this error to override what economists call "automatic stabilizers" by seeking to reduce deficits in the near term.

Indeed, in the current circumstances the case for fiscal stimulus -- policy actions that increase short-term deficits -- is stronger than ever before in my professional lifetime. Unemployment is almost certain to increase -- probably to the highest levels in a generation. Monetary policy has little scope to stimulate the economy given how low interest rates already are and the problems in the financial system. Global experience with economic downturns caused by financial distress suggests that while they are of uncertain depth, they are almost always of long duration.

The economic point here can be made straightforwardly: The more people who are unemployed, the more desirable it is that government takes steps to put them back to work by investing in infrastructure or energy or simply by providing tax cuts that allow families to avoid cutting back on their spending.

Fourth, it must be emphasized that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the United States is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.

From this perspective the worst possible actions would be steps that have relatively modest budget impacts in the short run but that cut taxes or increase spending by growing amounts over time. Examples would include new entitlement programs or exploding tax measures. The best measures would be short-run investments that will pay back to the government over time or those that are packaged with longer-term actions to improve the budget, such as investments in health-care restructuring or steps to enable states and localities to accelerate, or at least not slow, their investments.

A time when confidence is lagging in the consumer, financial and business sectors is not a time for government to step back.

Well-designed policies are essential to support the economy and, given the seriousness of health-care, energy, education and inequality issues, can make a longer-term contribution as well.

The writer served as Treasury secretary from 1999 to 2001, is a managing director of D.E. Shaw & Co. He writes a monthly column for the Financial Times, where this article also appears today.

In Times of Crisis, Trust Capitalism By Joseph Calhoun September 29, 2008

The US government is executing a coup d’etat of capitalism and I fear that we will pay the price for many years to come. Hank Paulson, Ben Bernanke and a host of others tell us the credit market is not working and the only way to get it working again is for the government to intervene. They claim this intervention is urgently needed and if we don’t act, the consequences are dire. Dire, as in New Depression dire. Have these supposed experts on capitalism forgotten how it really works? Last week Goldman Sachs raised $10 billion in new capital in one day. They sold $5 billion in preferred stock and warrants to Berkshire Hathaway and also completed a secondary offering of common stock that raised another $5 billion. Friday, JP Morgan raised $10 billion in a secondary offering to help pay for the Washington Mutual takeunder. Both of these offerings were oversubscribed, meaning that the companies could have raised more capital if they wanted. There is not a shortage of capital for well run financial companies. There is, however, a shortage of capital for companies that have acted irresponsibly with investor capital in the recent past. For some reason, our political leaders believe this is a failure of the

market, but isn’t this what should be expected from rational investors? Given a choice, why would a rational investor allocate limited capital to the losers rather than the winners? If capital is really as scarce as it seems, isn’t it better for our economy if we make sure that it is allocated wisely?

The biggest bank failure in the history of the United States happened last Thursday night and by Friday morning, it was business as usual. The only difference was the name on the door and the losses suffered by those unfortunate enough to invest in Washington Mutual bonds or stock. The taxpayers didn’t lose anything and depositors didn’t lose anything, only investors. That is how capitalism works in case everyone has forgotten.

The “crisis” we face today is not a creation of the market. Government intervention over many years (but especially the last year) is what brought us to the point where we’ve placed our hopes for economic recovery on the good intentions of a Congress facing re-election in a few weeks. There has been much commentary recently about the role of Fannie Mae and Freddie Mac in the creation and expansion of the sub-prime mortgage market which many believe to be the cause of this mess. That criticism is certainly warranted, but little attention has been paid to the real culprit - the Federal Reserve. Furthermore, what attention there has been is concentrated on the role of Alan Greenspan rather than Ben Bernanke. While Alan Greenspan deserves his share of the blame, Bernanke’s contribution to this mess should not be minimized or excused.

Bernanke obviously does not trust the market to sort the winners from the losers. When this erupted last year, the Fed lowered interest rates, including the discount rate, which is the rate charged by the Fed to lend directly to banks. There has always been a stigma attached to borrowing directly from the Fed and for good reason. If a bank can’t get other banks to lend it money, that tells the market something about the condition of the bank in question. Last August, Bernanke convinced three large banks to borrow at the discount window in an effort to remove that stigma. When that didn’t work, he concocted a scheme to allow banks to borrow from the Fed in anonymity via a mechanism he called the Term Auction Facility. When Bear Stearns blew up, he added the Term Securities Lending Facility for investment banks. By removing the stigma of borrowing from the Fed and hiding the identity of the borrowers, Bernanke removed important information from the market.

Now we face a situation where banks are not willing to lend to each other and have therefore become dependent on the Fed for daily liquidity. This is a direct result of the Fed’s actions. Banks will not lend to each other because they don’t know which ones are really in trouble. The rise in inter-bank lending rates is a rational market response to a lack of information. Furthermore, why pay those inter-bank rates when the Fed or ECB is offering easier terms?

These opaque lending facilities are just part of the problem created by the Fed and Treasury. The Bear Stearns intervention started the process by raising expectations that the government would step in and broker deals that would normally be left to the private sector. By providing favorable terms to JP Morgan in the deal, private actors came to see an advantage in waiting to see if the Fed would provide similar terms again. The worry at the time was that a Bear Stearns failure would cause a collapse of the system, but after watching Lehman Brothers file bankruptcy one has to wonder if that worry was based on fear or facts. Lehman filed bankruptcy on a Sunday night and the market opened the next day and functioned as it should. Would a Bear bankruptcy have been different? We will never know, but I have my doubts.

Now markets are waiting on pins and needles as the politicians haggle over the details of the latest bailout attempt by the Fed and Treasury. This has introduced another roadblock to the re-capitalization and reorganization of the financial industry. Companies that are in need of capital are waiting to see if the plan will bail them out of their difficulties. If Hank Paulson is willing to pay an above market price for their bad loans, why should they dilute their equity now? Why not wait until they can offload the bad paper on the taxpayer and raise capital at a better price? Why take Tony Soprano terms when Uncle Sam is willing to let the taxpayer take the hit for you?

If this bailout goes ahead in its current form and the Treasury pays a high enough price to recapitalize the troubled banks, what has been accomplished? The plan may be enough to induce the banking sector to start lending again, although frankly, I don’t know why we would want institutions that have shown such poor judgment in the past to stay in that business. This plan short-circuits the capitalist model which would allow the stronger, well-run institutions to gain market share and/or expand profit margins. The long-term effect will be to lower the overall return on capital in the financial services industry. The government apparently believes that the key to economic recovery is to allocate limited resources in an inefficient manner. Does that make sense?

Paulson and Bernanke have testified to Congress that the market for the mortgage paper rotting on the balance sheets of bad banks is not working. They have not offered an explanation of why that market is not functioning except to blame the complicated nature of some of the securities. That explanation begs the question of how exactly the Treasury believes it will be any better at deciphering the mortgage market. A more logical explanation is not a lack of willing buyers, but a lack of willing sellers. The Fed has allowed institutions to use collateral of ever falling quality to secure loans from the Fed. If a bank can finance its activities through the Fed and keep the bad loans on the balance sheet, what incentive does it have to sell? Selling will reveal the true condition of the company and will also force other institutions to do the same under mark- to-market accounting. The Fed is the one keeping the market from functioning. The Treasury does not need to enter the market for it to start functioning; the Fed needs to leave the market.

Paulson has said that the cause of the current problems is the housing deflation, but that ignores the elephant in the living room. The housing bubble, which was concentrated in a relatively small number of states, was caused by the reckless actions of the Greenspan Fed. The consequences of that bubble have been exacerbated by the Bernanke Fed. The market is functioning as it should. It is the Fed that is not functioning correctly. There is no reason we had to go through either the bubble or the aftermath. We got into this mess because we tried to avoid the consequences of the Internet bubble. We will only make things worse by trying to avoid the consequences of the housing bubble.

We are not on the verge of a new depression. The housing bubble collapse in California, Florida and a few other states is not enough to bring down the entire banking system. Investors who made mistakes in these markets should be held responsible and those who navigated the Fed-distorted market should be rewarded for their wisdom and prudence. Enacting the Paulson plan will not allow that to happen and our economy will suffer for it in the long run. The Japanese tried to prop up failed banks in the aftermath of the bursting of their twin bubbles and the result was 15 years of stagnation. Why are we emulating a strategy that is a demonstrable failure? A better alternative would be to allow capitalism to work as it should and stop the interventions of the Fed in the money market. Trust capitalism. It works.

House defeats $700B financial markets bailout

September 29th—2pm EDT

The House on Monday defeated a $700 billion emergency rescue package, ignoring urgent pleas from President Bush and bipartisan congressional leaders to quickly bail out the staggering financial industry. Stocks plummeted on Wall Street even before the 228-205 vote to reject the bill was announced on the House floor.

When the critical vote was tallied, too few members of the House were willing to support the unpopular measure with elections just five weeks away. Ample no votes came from both the Democratic and Republican sides of the aisle.

Bush and a host of leading congressional figures had implored the lawmakers to pass the legislation despite howls of protest from their constituents back home.

The overriding question for congressional leaders was what to do next. Congress has been trying to adjourn so that its members can go out and campaign. And with only five weeks left until Election Day, there was no clear indication of whether the leadership would keep them in Washington. Leaders were huddling after the vote to figure out their next steps.

A White House spokesman said that President Bush was "very disappointed."

"There's no question that the country is facing a difficult crisis that needs to be addressed," Tony Fratto told reporters. He said the president will be meeting with members of his team later in the day "to determine next steps."

Monday's mind-numbing vote had been preceded by unusually aggressive White House lobbying, and spokesman Tony Fratto said that Bush had used a "call list" of people he wanted to persuade to vote yes as late as just a short time before the vote.

Lawmakers shouted news of the plummeting Dow Jones average as lawmakers crowded on the House floor during the drawn-out and tense call of the roll, which dragged on for roughly 40 minutes as leaders on both sides scrambled to corral enough of their rank-and-file members to support the deeply unpopular measure.

They found only two.

Bush and his economic advisers, as well as congressional leaders in both parties had argued the plan was vital to insulating ordinary Americans from the effects of Wall Street's bad bets. The version that was up for vote Monday was the product of marathon closed-door negotiations on Capitol Hill over the weekend.

"We're all worried about losing our jobs," Rep. Paul Ryan, R-Wis., declared in an impassioned speech in support of the bill before the vote. "Most of us say, 'I want this thing to pass, but I want you to vote for it — not me.' "

With their dire warnings of impending economic doom and their sweeping request for unprecedented sums of money and authority to bail out cash-starved financial firms, Bush and his economic chiefs have focused the attention of world markets on Congress, Ryan added.

"We're in this moment, and if we fail to do the right thing, Heaven help us," he said.

The legislation the administration promoted would have allowed the government to buy bad mortgages and other rotten assets held by troubled banks and financial institutions. Getting those debts off their books should bolster those companies' balance sheets, making them more inclined to lend and easing one of the biggest choke points in the credit crisis. If the plan worked, the thinking went, it would help lift a major weight off the national economy that is already sputtering.

The fear in the financial markets sent the Dow Jones industrials cascading down by as over 700 points at one juncture. As the vote was shown on TV, stocks plunged and investors fled to the safety of the credit markets, worrying that the financial system would keep sinking under the weight of failed mortgage debt.

A White House spokesman said that President Bush was "very disappointed."

"There's no question that the country is facing a difficult crisis that needs to be addressed," Tony Fratto told reporters. He said the president will be meeting with members of his team later in the day "to determine next steps."

House defeats $700B financial industry bailout

Sept. 29,2008 The House on Monday defeated a $700 billion emergency rescue for the nation's financial system, ignoring urgent warnings from President Bush and congressional leaders of both parties that the economy could nosedive into recession without it. Stocks plummeted on Wall Street even before the 228-205 vote to reject the bill was announced on the House floor.

Bush and a host of leading congressional figures had implored the lawmakers to pass the legislation despite howls of protest from their constituents back home. Despite pressure from supporters, not enough members were willing to take the political risk just five weeks before an election.

Ample no votes came from both the Democratic and Republican sides of the aisle. More than two-thirds of Republicans and 40 percent of Democrats opposed the bill.

The overriding question for congressional leaders was what to do next. Congress has been trying to adjourn so that its members can go out and campaign. And with only five weeks left until Election Day, there was no clear indication of whether the leadership would keep them in Washington. Leaders were huddling after the vote to figure out their next steps.

A White House spokesman said that President Bush was "very disappointed."

"There's no question that the country is facing a difficult crisis that needs to be addressed," Tony Fratto told reporters. He said the president will be meeting with members of his team later in the day "to determine next steps."

"Obviously we are very disappointed in this outcome," Fratto said. "There's no question that the country is facing a difficult crisis that needs to be addressed. The president will be meeting with his team this afternoon to determine the next steps and will also be in touch with congressional leaders."

Monday's mind-numbing vote had been preceded by unusually aggressive White House lobbying, and Fratto said that Bush had used a "call list" of people he wanted to persuade to vote yes as late as a short time before the vote.

Lawmakers shouted news of the plummeting Dow Jones average as lawmakers crowded on the House floor during the drawn-out and tense call of the roll, which dragged on for roughly 40 minutes as leaders on both sides scrambled to corral enough of their rank-and-file members to support the deeply unpopular measure.

They found only two.

Bush and his economic advisers, as well as congressional leaders in both parties had argued the plan was vital to insulating ordinary Americans from the effects of Wall Street's bad bets. The version that was up for vote Monday was the product of marathon closed-door negotiations on Capitol Hill over the weekend.

"We're all worried about losing our jobs," Rep. Paul Ryan, R-Wis., declared in an impassioned speech in support of the bill before the vote. "Most of us say, 'I want this thing to pass, but I want you to vote for it — not me.' "

With their dire warnings of impending economic doom and their sweeping request for unprecedented sums of money and authority to bail out cash-starved financial firms, Bush and his economic chiefs have focused the attention of world markets on Congress, Ryan added.

"We're in this moment, and if we fail to do the right thing, Heaven help us," he said.

The legislation the administration promoted would have allowed the government to buy bad mortgages and other rotten assets held by troubled banks and financial institutions. Getting those debts off their books should bolster those companies' balance sheets, making them more inclined to lend and easing one of the biggest choke points in the credit crisis. If the plan worked, the thinking went, it would help lift a major weight off the national economy that is already sputtering.

The fear in the financial markets sent the Dow Jones industrials cascading down by over 700 points at one juncture. As the vote was shown on TV, stocks plunged and investors fled to the safety of the credit markets, worrying that the financial system would keep sinking under the weight of failed mortgage debt.

"As I said on the floor, this is a bipartisan responsibility and we think (Democrats) met our responsibility," said House Majority Leader Steny Hoyer, D-Md.

Asked whether majority Democrats would try to reverse the stunning defeat, Hoyer said, "We're certainly not going to abandon our responsibility. We'll continue to focus on this and see what actions we can take."

Several Republican aides said House Speaker Nancy Pelosi, D-Calif., had torpedoed any spirit of bipartisanship that surrounded the bill with her scathing speech near the close of the debate that blamed Bush's policies for the economic turmoil.

Without mentioning her by name, Rep. Adam Putnam, R-Fla., No. 3 Republican, said: "The partisan tone at the end of the debate today I think did impact the votes on our side."

Putnam said lawmakers were working "to garner the necessary votes to avoid a financial collapse."

But the defeat was already causing a brutal round of finger-pointing.

"We could have gotten there today had it not been for the partisan speech that the speaker gave on the floor of the House," House Minority Leader John Boehner said. Pelosi's words, the Ohio Republican said, "poisoned our conference, caused a number of members that we thought we could get, to go south."

Rep. Roy Blunt, R-Mo., the whip, estimated that Pelosi's speech changed the minds of a dozen Republicans who might otherwise have supported the plan.

Rep. Barney Frank, D-Mass., scoffed at the explanation.

"Well if that stopped people from voting, then shame on them," he said. "If people's feelings were hurt because of a speech and that led them to vote differently than what they thought the national interest (requires), then they really don't belong here. They're not tough enough."

More than a repudiation of Democrats, Frank said, Republicans' refusal to vote for the bailout was a rejection of their own president. "The Republicans don't trust the administration," he said. "It's a Republican revolt against George Bush and John McCain."

In her speech, Pelosi had assailed Bush and his administration for reckless economic policies.

"They claim to be free market advocates when it's really an anything-goes mentality: No regulation, no supervision, no discipline. And if you fail, you will have a golden parachute and the taxpayer will bail you out. Those days are over. The party is over," Pelosi said.

"Democrats believe in a free market," she said. "But in this case, in its unbridled form, as encouraged, supported, by the Republicans — some in the Republican Party, not all — it has

created not jobs, not capital. It has created chaos."

Bailout, Take II: What the Feds Do Next Sept. 30, 2008

OK, so that didn't work. After a bunch of all-nighters in Washington and some premature back-slapping, we're right back where we were a couple of weeks ago, after Lehman Brothers declared bankruptcy and the government lent AIG $85 billion. There's no one-size-fits-all bailout plan, after all. That $700 billion in taxpayer money remains under lock and key. Glum investors are now the ones bailing out, fleeing stocks and bonds and seeking safer ground. But there are still some levers the government can pull. Working through the mess just won't be as orderly or predictable as it would if there were a single plan and a big pot of money. Here's what's likely to happen next: Another try at a big bailout plan. A lot of those constituents who have been calling Congress to complain about rescuing fat cats are going to rethink their indignation as they watch the stock markets--and their own portfolios--sink. Lawmakers who voted against the bailout plan are going to have to explain why they're letting the markets collapse. The more uncomfortable voters get, the more likely Congress will be to pass some kind of sweeping relief plan. This is far from over.

More piecemeal bailouts. Before the big $700 billion bailout plan even existed, the Fed and the Treasury Department were already patching leaks in the financial system--one trouble spot at a time. The idea behind an umbrella bailout plan was to overhaul the whole system, establishing public standards and treating every ailing company more or less the same, before a bunch of leaks became a gusher. That would have eliminated the guesswork over whether a struggling company meets the criteria for a rescue--like AIG--or falls short, like Lehman Brothers.

Now we're back to guessing. The feds still have the wherewithal to lend money, buy bad assets, or take other measures to keep ailing companies afloat. What they don't have is a single plan that applies to all companies and the authority to soak up vast amounts of bad assets. So those weekend meetings at the New York Fed, with supplicant CEOs pleading for help, are likely to continue.

More failed companies. Duke University finance Prof. Campbell Harvey predicts there could be 750 to 1,000 bank failures over the next six months because of billions in bad assets stemming from the housing meltdown. Scarce credit also threatens other types of companies that are already struggling and desperately need capital, such as the Detroit automakers and some of the airlines. The government will be able to deal with some of those companies one at a time, but without a comprehensive plan, others will fall through the cracks.

Manic markets. Investors were hoping that a big bailout plan would offer some predictability about how the government will deal with struggling companies. Their crystal ball is once again very dark. That means wild swings in stock prices as big investors try to get out of the market ahead of bad news, and get back in if it looks like the feds will ride to the rescue. One of the most volatile sectors is likely to be regional bank stocks as investors worry that banks like Sovereign Bancorp and National City might be the next to fail.

Patchwork regulation. There's already a system in place for dealing with failed banks--led by the FDIC--but that may not be enough to handle the damage that's unfolding. Even without a big bailout bill, Congress may have to set up a new agency to deal with dozens or hundreds of bank failures, one similar

to the Resolution Trust Corp. formed in the late 1980s. We could see a whole slew of lesser regulations, too, like restrictions on certain lending practices and higher federal coverage limits on bank deposits.

Continued government intervention. The Federal Reserve continues to pump huge sums of money into the global banking system in a desperate effort to prompt banks to loosen their grip on loans to companies, consumers, and one another. For now, that seems to be having little effect as banks absorb the startling news from Washington and hunker down. That may lead the Fed to pump out even more money and take other important steps, like cutting interest rates. Sooner or later, that will probably help loosen things up. Until then, however, it's apparently up to the markets to fix themselves. Plan accordingly.

Recent Blogs by Paul Krugman

Tuesday, September 30, 2008OK, we are a banana republic House votes no. Rex Nutting has the best line: House to Wall Street: Drop Dead. He also correctly places the blame and/or credit with House Republicans. For reasons I’ve already explained, I don’t think the Dem leadership was in a position to craft a bill that would have achieved overwhelming Democratic support, so make or break was whether enough GOPers would sign on. They didn’t.

I assume Pelosi calls a new vote; but if it fails, then what? I guess write a bill that is actually, you know, a good plan, and try to pass it — though politically it might not make sense to try until after the election.

For now, I’m just going to quote myself:

So what we now have is non-functional government in the face of a major crisis, because Congress includes a quorum of crazies and nobody trusts the White House an inch. As a friend said last night, we’ve become a banana republic with nukes.

September 29, 2008

Bailout questions answered I’m being asked two big questions about this thing: (1) Was it really necessary? (2) Shouldn’t Dems have tossed the whole Paulson approach out the window and done something completely different?

On (1), the answer is yes. It’s true that some parts of the real economy are doing OK even in the face of financial disruption; big companies can still sell bonds (and have lots of cash on hand), qualifying home buyers can still get Fannie-Freddie mortgages, and so on. But commercial paper, which is important to a lot of businesses, is in trouble, and I’m hearing anecdotes about reduced credit lines causing smaller businesses to pull back. Plus there’s a serious chance of a run on the hedge funds, which could make things a lot worse. With the economy already looking like it’s headed into a serious recession by any definition, the risks of doing nothing look too high.

It’s true that we might be able to stagger through with more case-by-case rescues — I think of this as the “two, three, many AIGs” strategy; in fact, we might not be at this point if Paulson hadn’t decided to make an example of Lehman. But right now it’s not even clear who to rescue, and the credit markets are freezing up as you read this (1-month t-bill at 0.04 %, TED spread at 3.5)

On (2), the call is tougher. But putting myself in Barney Frank or Nancy Pelosi’s shoes, I’d look at it this

way: the Democrats could start over, with a bailout plan that is, say, centered on purchases of preferred stock and takeovers of failing firms — basically, a plan clearly focused on recapitalizing the financial sector, with nationalization where necessary. What the plan should have looked like:

The good, the bad, and the ugly Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; he’s right. I haven’t been clear enough about this, it seems, but it’s where my basic diagnosis leads: the problem is insufficient capital, you want to inject capital, but you don’t want it to be a windfall to existing stockholders — hence, take over and recapitalize the failing firms. By the way, that’s what we did with AIG 10 years days ago.

So that’s the good solution. The Paulson plan, which is some combination of sheer giveaway and mystic faith that a slap in the market’s face will make everything OK, is a bad solution (and probably no solution at all.)

But nationalization doesn’t seem like a politically realistic answer now. This leaves the rough question of whether to hold out for a good solution, which won’t be possible until Jan. 21st, or accept the ugly compromise that the WH and the Congressional Dems, once again, say they’ve reached. It’s a tough call, but as I’ve written, I’ll probably hold my nose and say OK — as long as it has broad Republican support.

If not, go back to the good plan.

Maybe such a plan would have passed Congress; and maybe, just maybe Bush would have signed on; Paulson is certainly desperate for a deal.

But such a plan would have had next to no Republican votes — and the Republicans would have demagogued against it full tilt. And the Democratic leadership cannot, cannot, be seen to have sole ownership of this stuff.

So that, I think, is why it had to be done this way. I don’t like it, and I don’t like the plan, but I see the constraints under which Dodd, Frank, Pelosi, and Reid were operating.

Comments (83) September 29, 2008, 8:41 am 21st century prewar crises In Manhattan, at 85th Street and West End Ave., there’s an apartment building going up; the sign advertises “21st century prewar living!” which only makes sense if you spend a lot of time in New York. But I found myself thinking about that sign when reading this terrific WSJ article about how the fall of Lehman triggered global panic.

One lesson of the article is that Paulson messed up very badly by letting Lehman fail; it’s not clear where Bernanke stood, but it seems clear that Tim Geithner of the NY Fed was on the other side.

What the article really adds, though, is the details of the chain reaction that did the damage.(More for the mixed metaphor bin: we already knew that the financial markets have melted down into a freezing crunchy squeeze, but now we know that it was a chain reaction that did it.) There’s a great graphic in the print

edition, which doesn’t seem to be online: Lehman’s fall led to (1) a run on money market funds, causing commercial paper rates to soar (2) soaring rates on credit default swaps, driving AIG over the edge and sending LIBOR sky-high.

All in all, it’s the story of a massive run on the shadow banking system, the modern analogue of 1931 — a 21st-century prewar crisis.

PS: Commenter Mark asks what “21st century prewar living” means. In Manhattan, prewar apartments have high ceilings and thick walls. So the builders of this thing are promising all that, plus modern convenience. They’re also, if I remember rightly, offering places starting at $3.7 million; lotsa luck on that, given the Wall Street implosion.

Comments (20) E-mail this Share September 29, 2008, 8:27 am Not so good morning As of now, markets are not reassured. Three-month LIBOR at 3.88 percent, 3-month Treasuries at 0.75 percent (and one-month at only 0.16), hence TED spread at 3.1, the equivalent of a 105-degree fever.

All this shows that the flight to safety continues unabated.

We may be back to the drawing board very soon …

Update: Went out for my morning constitutional, and on return things look even grimmer. 1-month T-bill at .05, 3-month at .36. Panic on the Street.

The world according to TARP I don’t, in the end, have much more to say about the plan. It passes my test of no equity, no deal; that, plus the danger of financial panic if it doesn’t go through, makes it worth passing, though celebration is not in order.

I am surprised that they stayed with Troubled Asset Relief Program; isn’t everything these days supposed to be MPAPRA (the motherhood, patriotism, and apple pie reconciliation act) or something like that? Anyway, you know what comes next: an avalanche of TARP jokes. Say, throwing money into a TARP-pit.

Overall, Dodd and Frank succeeded in pushing Paulson a fairly long way back; probably as good a deal as they could have gotten. But someday we’ll have an administration that actually proposes good policies to start with.

TARP draft So there’s a draft version of the bailout out there. Pretty much as expected. Section 113, MINIMIZATION OF LONG-TERM COSTS AND MAXIMIZATION OF BENEFITS FOR TAXPAYERS, is where the rubber meets the road — it’s where the plan says something about how the deals will be done.

As I read it, Treasury can�(1) conduct reverse auctions and suchlike�(2) buy directly — but only if it gets

equity warrants or, in companies that don’t issue stock, senior debt

My view is that (1) will be ineffective but also not a bad deal for taxpayers — firms that can afford to will dump their toxic waste at low prices, the way some already have on the private market, and taxpayers may end up making money in the end. Firms in big trouble will probably stay away from the auctions. The plan’s real traction, if any, is in (2), which is a backdoor way to provide troubled firms with equity — and the bill seems to say that taxpayers have to own this equity, although I wish it was clearer how much equity will be judged sufficient.

Not a good plan. But sufficiently not-awful, I think, to be above the line; and hopefully the whole thing can be fixed next year.

Add: House staff tells me that there are significant changes from this draft. More info when I get it.

The good, the bad, and the ugly Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; he’s right. I haven’t been clear enough about this, it seems, but it’s where my basic diagnosis leads: the problem is insufficient capital, you want to inject capital, but you don’t want it to be a windfall to existing stockholders — hence, take over and recapitalize the failing firms. By the way, that’s what we did with AIG 10 years days ago.

So that’s the good solution. The Paulson plan, which is some combination of sheer giveaway and mystic faith that a slap in the market’s face will make everything OK, is a bad solution (and probably no solution at all.)

But nationalization doesn’t seem like a politically realistic answer now. This leaves the rough question of whether to hold out for a good solution, which won’t be possible until Jan. 21st, or accept the ugly compromise that the WH and the Congressional Dems, once again, say they’ve reached. It’s a tough call, but as I’ve written, I’ll probably hold my nose and say OK — as long as it has broad Republican support.

If not, go back to the good plan.

Tricky bailout politics Nouriel Roubini has a characteristically scathing takedown of the Paulson plan, and here’s the thing: language aside, his economic analysis is similar to mine. The fundamental problem in the financial system is too little capital; bizarrely, the Treasury chose not to address that problem directly, by (say) purchasing preferred shares in financial institutions. Instead, the plan is premised on the belief that toxic mortgage-related waste is underpriced, and that the Treasury can recapitalize banks on the cheap by fixing the markets’ error.

The Dodd-Frank changes make the plan less awful, mainly by creating an equity stake. Essentially, this makes it possible for the plan to do the right thing through the back door: use toxic-waste purchases to acquire equity, and hence inject capital after all. Also, the oversight means that Treasury can be prevented

from making the plan a pure gift to financial evildoers. But it’s still not a good plan.

On the other hand, there’s no prospect of enacting an actually good plan any time soon. Bush is still sitting in the White House; and anyway, selling voters on large-scale stock purchases would be tough, especially given the cynical attacks sure to come from the right. And the financial crisis is all too real.

So is it better to have no plan than a deeply flawed plan? If it was the original Paulson plan, no plan is better. Dodd-Frank-Paulson may just cross the line — let’s see what details we have if and when agreement is reached. If the plan looks not-awful enough, I’ll be pro. But I won’t be cheering — I’ll be holding my nose.

Demolition accomplished A few more thoughts about the incredible scene described in today’s Times (great reporting, by the way):

In the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulson Jr., literally bent down on one knee as he pleaded with Nancy Pelosi, the House Speaker, not to “blow it up” by withdrawing her party’s support for the package over what Ms. Pelosi derided as a Republican betrayal.

“I didn’t know you were Catholic,” Ms. Pelosi said, a wry reference to Mr. Paulson’s kneeling, according to someone who observed the exchange. She went on: “It’s not me blowing this up, it’s the Republicans.”

Mr. Paulson sighed. “I know. I know.”

How did we get to this point? It’s the culmination of many past betrayals.

First of all, we have the Republican Study Committee blowing things up with a complete nonsense proposal — solving the crisis with a holiday on capital gains taxes. How is that possible? Well, if a party runs on economic nonsense for 25 years, eventually many of its foot soldiers will be people who actually believe the nonsense.

More specifically, though, the failure to get a deal reflects the betrayals of the Bush years. Democrats weren’t going to trust Henry Paulson, because behind him they see the ghost of Colin Powell (and Paulson’s “all your bailout are belong to me” proposal, aside from being bad economics, showed an incredible tone-deafness.)

And after the way the Bushies and their allies double-crossed the Democrats again and again in the aftermath of 9/11 — demand national unity, then accuse you of being soft on terrorists anyway — there’s no way Pelosi and Reed will do the responsible but unpopular thing unless the Republicans agree to share ownership.

So what we now have is non-functional government in the face of a major crisis, because Congress includes a quorum of crazies and nobody trusts the White House an inch.

As a friend said last night, we’ve become a banana republic with nukes.

Paulson’s pratfall

You know that Paulson produced a lemon when Glenn Hubbard and Greg Mankiw have basically the same objections to the plan that I do. The plan doesn’t directly address the key issue of undercapitalized financial institutions; instead, it relies on the assumption that mortgage-related toxic waste is under priced, and that the Treasury can wave its $700 billion magic wand and make everything fine again.

Let me say, however, that this already seems like old news. Paulson plan 1.0 is dead; the question now is whether Dodd-Frank, or something like it, will happen.

Madness on Pennsylvania Avenue I hate nights like this — the news kept changing as I tried to finish the column. But this White House meeting was obviously one for the ages:

House Financial Services Committee Chairman Barney Frank (D-Mass.) angrily accused House Republicans — with the tacit support of Republican presidential candidate John McCain — of crafting an alternative to undercut Treasury Secretary Henry Paulson.

Both McCain and his Democrat rival, Sen. Barack Obama, left without any joint endorsement. A beleaguered President Bush had to struggle to maintain order and reassert himself. And when Democrats left after the meeting to caucus in the Roosevelt Room, Paulson pursued them, begging that they not “blow up” the legislation.

The former Goldman Sachs CEO even went down on one knee as if genuflecting, to which Speaker Nancy Pelosi (D-Cal.) is said to have joked, “I didn’t know you were Catholic.”

I don’t even want to think about what tomorrow’s TED spread will look like.

A sneaking suspicion So now the whole rationale for the plan is “price discovery”: we’re going to throw lots of taxpayer funds into the pot because that will let us find the true values of troubled assets, which are higher than the fire sale prices out there, and so balance sheet will improve, confidence will return, etc, etc..

So I just did a Nexis search trying to find out when Paulson and Bernanke started talking about price discovery, which we’re now told are at the core of the plan’s logic. And the answer is …

Yesterday.

I can’t find any use of the term, or even a hint of the argument, until yesterday’s Senate hearings. One possible explanation. It wasn’t until yesterday that they realized that it would actually be necessary to explain themselves.

But there’s another possible explanation, which I find terrifyingly plausible: the plan came first, and all this stuff about price discovery is an after-the-fact rationalization, invented when people started asking questions.

It has seemed very strange to me that such a supposedly crucial economic program would be based on such an exotic argument. My sneaking suspicion is that they started with a determination to throw money

at the financial A $700 billion slap in the face The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we should believe the proposed intervention would work. So many of us turned to our own analyses, and concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry.

Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve the crisis so far.

Credit Default Swaps

Credit default swaps, which were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default -- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised.

In essence, it is a form of insurance. Its purpose is to make it easier for banks to issue complex debt securities by reducing the risk to purchasers, just like the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture.

Here is a more detailed, but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:

"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss.

"The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.

"As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."

The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated.

When the mortgage-backed securities that many swaps were supporting began to lose value in 2007, investors began to fear that the swaps, originally meant as a hedge against risk, could suddenly become huge liabilities.

The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety. Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge in late 2007.

Credit default swaps also played an integral role in the federal government's decision to bail out the American International Group, one of the world's largest insurers, in September 2008. The Federal Reserve concluded that if A.I.G. failed and defaulted on its swaps, throwing the liability for the insured securities onto the swaps' counterparties, the result could be a daisy chain of failures across the

international financial system.

Don't blame the New Deal for today's financial crisis September 29, 2008

This year's serial bailouts are proof of a colossal regulatory failure. But it is not "the system" that failed, as President Bush, Treasury Secretary Henry Paulson and others who are complicit in the calamity would like Americans to believe. People failed.

For decades now, anti-regulation disciples of the Reagan Revolution have eliminated vital laws, blocked the enactment of much-needed new regulations, or simply refused to exercise their legal authority.

The regulatory system for banks, securities, commodities and insurance is unwieldy and in need of modernization. The system has gaps, like the absence of regulation for "innovations" such as credit default swaps, the insurance-like contracts now valued at $62 trillion whose destructive potential prompted the bailouts of Bear Stearns and the American International Group.

But the failures that have landed us in the mess we are in today are not mainly structural. To assert that they are masks deeper failings and sets false terms for the coming debate on regulatory reform.

Under a law passed in 1994, for example, the Federal Reserve was obligated to regulate banks and nonbank lenders to curb unfair, deceptive and predatory lending. Alan Greenspan, the former Federal Reserve chairman, ignored his responsibility, even as junk mortgage lending proliferated in plain sight.

Greenspan later said the law defined "unfair" and "deceptive" too vaguely. If so, he should have asked Congress for clarification. Instead, he did nothing - and the Republican-led Congress did not question him. When Ben Bernanke took over as Fed chairman in early 2006, the negligence continued. It was not until mid-2007, after the housing bubble had begun to burst, that federal regulators offered guidelines for subprime lending.

The systematic dismantling of laws that called for regulation also contributed to the current crisis. In 1995, Congress passed a law that restricted the ability of investors to sue companies, securities firms and accounting firms for misstatements and pie-in-the-sky projections. That helped inflate the dot-com bubble and contributed to the Enron debacle. It also engendered a sense of impunity that helped to foster the excessive risk-taking so prevalent in the mortgage mess. Then, in 1999, Congress dismantled the Glass-Steagall Act, a pillar of the New Deal, which separated commercial and investment banking.

That enormous change was undertaken with no effort to regulate the world that it would help to create. Now we know that an entire "shadow banking system" has grown up, without rules or transparency, but with the ability to topple the financial system itself.

It was in the Bush years that anti-regulation and deregulation found full expression, fueled by an ideology that markets know best, government hampers markets, and problems will fix themselves. America is now painfully relearning that the opposite is true.

Christopher Cox, chairman of the Securities and Exchange Commission, admitted on Friday that his agency's "voluntary regulation" of investment banks was a failure that contributed to the current crisis. That is a good starting point for a debate about how to get back on the road to sensible, responsible government regulation.

Krugman: Where are the grown-ups?

By Paul Krugman Many Americans on both the right and the left are outraged at the idea of using taxpayer money to bail out the U.S. financial system. They're right to be outraged, but doing nothing isn't a serious option. Right now, players throughout the system are refusing to lend and hoarding cash - and this collapse of credit reminds many economists of the run on the banks that brought on the Great

Depression.

It's true that we don't know for sure that the parallel is a fair one. Maybe we can let Wall Street implode and Main Street would escape largely unscathed. But that's not a chance we want to take.

So the grown-up thing is to do something to rescue the financial system. The big question is, are there any grown-ups around - and will they be able to take charge?

Earlier this week, Henry Paulson, the Treasury secretary, tried to convince Congress that he was the grown-up in the room, come to protect Americans from danger. And he demanded total authority over the rescue: $700 billion to be used at his discretion, with immunity for future review.

Congress balked. No government official should be entrusted with that kind of monarchical privilege, least of all an official belonging to the administration that misled America into war. Furthermore, Paulson's track record is anything but reassuring: He was way behind the curve in appreciating the depth of the nation's financial woes, and it's partly his fault that America has reached the current moment of meltdown.

Besides, Paulson never offered a convincing explanation of how his plan was supposed to work - and the judgment of many economists was, in fact, that it wouldn't work unless it amounted to a huge welfare program for the financial industry.

But if Paulson isn't the grown-up America needs, are congressional leaders ready and able to fill the role?

Well, the bipartisan "agreement on principles" released on Thursday looks a lot better than the original Paulson plan. In fact, it puts Paulson himself under much-needed adult supervision, calling for an oversight board "with cease and desist authority." It also limits Paulson's allowance: He only (only!) gets to use $250 billion right away.

Meanwhile, the agreement calls for limits on executive pay at firms that get federal money. Most important, it "requires that any transaction include equity sharing."

Why is that so important? The fundamental problem with the U.S. financial system is that the fallout from the housing bust has left financial institutions with too little capital. When he finally deigned to offer an explanation of his plan, Paulson argued that he could solve this problem through "price discovery" - that once taxpayer funds had created a market for mortgage-related toxic waste, everyone would realize that the toxic waste is actually worth much more than it currently sells for, solving the capital problem. Never say never, I guess - but you don't want to bet $700 billion on wishful thinking.

The odds are, instead, that the U.S. government will end up having to do what governments always do in financial crises: Use taxpayers' money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably have done this by buying toxic waste for much more than it was worth - and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that's what the equity sharing is about.

The congressional plan, then, looks a lot better - a lot more adult - than the Paulson plan did. That said, it's very short on detail, and the details are crucial. What prices will taxpayers pay to take over some of that toxic waste? How much equity will they get in return? Those numbers will make all the difference.

And in any case, lawmakers are still negotiating a deal.

This has to be a bipartisan plan, and not just at the leadership level. Democrats won't pass the plan

without votes from rank-and-file Republicans - and as of Thursday night, those rank-and-file Republicans were balking.

Furthermore, one non-rank-and-file Republican, Senator John McCain, is apparently playing spoiler. Earlier this week, while refusing to say whether he supported the Paulson plan, he claimed not to have had a chance to read it; the plan is all of three pages long. And during Thursday's meeting at the White House, reported Marc Ambinder of the Atlantic, McCain brought up proposals that had already been rejected by congressional leaders of both parties and declared unworkable by Paulson.

The bottom line, then, is that there do seem to be some adults in Congress, ready to do something to help get the United States through this crisis. But the adults are not yet in charge.

U.S. House rejects plan for bailout September 29, 2008

Defying President George W. Bush and the leaders of both parties, rank-and-file lawmakers in the House on Monday rejected a $700 billion economic rescue plan in a revolt that rocked the Capitol, sent markets plunging and left top lawmakers groping for a resolution.

The stunning defeat of the proposal on a 228-205 vote after marathon talks by senior congressional and Bush administration officials lowered a fog of uncertainty over economies around the globe. Its authors had described the measure as essential to preventing widespread economic calamity.

The markets began to plummet even before the 15-minute voting period expired on the House floor. For 25 minutes, uncertainty gripped the nation as television showed party leaders trying, and failing, to muster more support. Finally, Representative Ellen Tauscher, Democrat of California, pounded the gavel and it was done.

In the end, only 65 Republicans — just one-third of those voting — backed the plan despite personal pleas from President George W. Bush and encouragement from their presidential nominee, Senator John McCain. By contrast, 140 Democrats, or 60 percent, voted in favor, many after voicing grave misgivings. Their nominee, Senator Barack Obama, also backed the bill.

By the end of day, the Dow had fallen almost 778 points, or nearly 7 percent, to 10,365. Credit markets also remained distressed, with bank lending rates rising and investors fleeing to the safety of Treasury bills.

Among opponents of the rescue plan, some Republicans cited ideological objections to government intervention, and liberal Democrats said they were of no mind to race to aid Wall Street tycoons. Other critics complained about haste and secrecy in assembling the plan.

But lawmakers on both sides pointed to an outpouring of opposition from deeply hostile constituents just five weeks before every seat in the House was up for election as a fundamental reason that the measure was defeated. House members in potentially tough races and those seeking Senate seats fled from the plan in droves.

"People's re-elections played into this to a much greater degree than I would have imagined," said Representative Deborah Pryce of Ohio, a former member of the Republican leadership who is retiring this year and voted for the plan.

Congressional leaders in both parties said they did not know how they would proceed but were examining options, including having the Senate, where there was more support for the bailout, advance a bill after the Jewish New Year on Tuesday. Congressional leaders said any doubt about the need for action should have been removed by the market fall.

"We're not leaving town till we get it fixed," said Senator Mitch McConnell of Kentucky, the Republican leader.

At the White House, Bush met with his economic advisers as well as the Federal Reserve chairman, Ben Bernanke, to discuss next steps. "I was disappointed in the vote," Bush said, appearing in the Oval Office with President Viktor Yushchenko of Ukraine. "Our strategy is to continue to address this economic situation head on."

The Treasury secretary, Henry Paulson Jr., who was the main architect of the financial rescue plan, said he would continue to work with congressional leaders "to find a way forward to pass a comprehensive plan to stabilize our financial system and protect the American people." He added, "This is much too important to simply let fail."

McCain and Obama renewed their calls for swift action, though each campaign sought to partly blame the other for the defeat.

At the Capitol, Democrats accused Republicans of failing to deliver enough number of votes. "Sixty-seven percent of the Republican Conference decided to put political ideology ahead of the best interest of our great nation," the Democratic whip, Representative James Clyburn of South Carolina, said after the vote.

Representative Roy Blunt of Missouri, the Republican whip, said that before the vote he had tallied 75 votes in his conference in favor of the plan. By the time the votes were cast, the Republicans could deliver only 65 of them.

Other top Republicans pointed at what they saw as a partisan speech by Speaker Nancy Pelosi in advance of the vote as a factor — a charge Democrats derided.

Republicans said they had alerted Democrats they might not have the numbers required. But they never recommended the legislation be put off and in the end they were unable to win any last-second converts to change the votes that would have been necessary to turn defeat into victory.

Representative John Boehner of Ohio, the House Republican leader, said he tried repeatedly and unsuccessfully to sway a handful of holdouts, but eventually gave up.

"You can't break their arms, you can't put your whole relationship on the line with them and ask them to do something they do not want to do and have that member regret that vote for the rest of their life," said Boehner, who said he could not remember a time when the muscle of both parties and the White House failed to produce a victory.

The outcome after a slightly more than 40-minute vote on the House floor left lawmakers almost speechless. Even the strongest opponents of the measure did not expect to prevail, and the leadership of both parties, while increasingly nervous, figured they would squeak out a victory despite a parade of Republicans and Democrats to microphones to assail the measure. At the White House, the deputy press secretary, Tony Fratto, said just before the vote: "We're confident that it will pass."

Under the proposal, the Treasury Department could tap up to $700 billion in taxpayer money in installments to buy troubled debt from financial firms, in the hopes of freeing up credit to fuel normal economic activity.

In the final stages of negotiations, new provisions intended to recoup taxpayer losses were added. They helped the measure win support from Boehner and some other House Republican leaders, who had strongly opposed an earlier version of the bill. But they did not put the package over the top.

In impassioned speeches on the House floor, Democrats and Republicans alike vented their frustration over the nation's perilous economic condition and the uncomfortable position they were in, facing pressure to approve an unpopular bailout package during an election year, with no guarantee that it would work.

"This is a huge cow patty with a piece of marshmallow stuck in the middle of it and I am not going to eat that cow patty," said Representative Paul Broun, Republican of Georgia.

"Nobody wants to do this," said Representative Edward Markey, Democrat of Massachusetts, who nonetheless voted for it. "Nobody wants to clean up the mess created by Wall Street recklessness."

In the speech that Republicans said infuriated them, Pelosi accused Bush of squandering the budget surpluses of the Clinton years. "They claim to be free-market advocates, when it's really an anything-goes mentality," she said. "No supervision. No discipline. And if you fail, you will have a golden parachute and the taxpayer will bail you out."

Democrats later said that if her speech truly cost votes, then Republicans, in the words of Representative Barney Frank, Democrat of Massachusetts, were guilty of punishing the country because Pelosi had hurt their feelings.

As the voting time expired on the floor, party leaders realized they were coming up far short. At 1:49 p.m., it was 205 for and 228 against. At 1:54 p.m., they inched closer: 207 to 226, as some representatives changed their votes. What followed was a remarkable stalemate on the House floor, with top lieutenants in both parties clutching lists of votes, as they clustered in the well and made unusual forays into what is normally enemy territory across the aisle.

"I was asking where the hell their votes were," said Representative Rahm Emanuel of Illinois, the No. 4 Democrat.

Blunt said he told Democrats he thought he could flip five votes, if Democrats could do the same. Democrats had warned that the Republicans that they would need to produce 80 to 100 votes to adopt an unpopular plan championed by the Republican White House. Ultimately, the Democrats decided the votes were not there and they allowed the gavel to come down. Opponents of the measure said they expected the administration and congressional leaders to try again on a rescue proposal and were not worried about being held responsible for the stock decline or other economic uncertainty.

"I think we will be back in a couple of days with a proposal more palatable to more members," said Representative John Yarmuth, a Kentucky Democrat who voted against the plan. "You don't make the biggest financial decision in the history of this country in a few days' time without hearings."

But Representative Tom Davis, a Virginia Republican who is retiring from Congress and who backed the proposal, said those who opposed to the measure might be hearing a different message from their voters if economic conditions worsen. "The members who voted no will have some culpability," he said.

The House leadership said Monday night that the House would reconvene at noon Thursday, though it was not known if another economic plan would be on the table.

"Stay tuned," said Pelosi, who seemed physically drained. But she added: "What happened today cannot stand. We must move forward, and I hope that the markets will take that message."

Representative Greg Walden, an Oregon Republican who supported the bailout, said lawmakers may quickly discover "whether this is as dire a situation as we were told."

"This is playing with fire," Walden said. "It's very, very dangerous."

HIGH & LOW FINANCE

After the Deal, the Focus Will Shift to Regulation By FLOYD NORRIS September 29, 2008

Even before Congress passes a $700 billion bank bailout that nearly all legislators believe to be both necessary and unpopular, the jostling has begun over legislation that may prove to be the first test for the next president: How to reshape the financial system and its regulation. It is clear that the old system failed — it wouldn’t need the bailout otherwise — but the diagnosis of why that happened may be crucial in deciding what changes are needed. Already, liberals are blaming the deregulation that began under Ronald Reagan for letting a financial system get out of control, and conservatives are pointing to market interventions by liberals — notably efforts to assure mortgage loans for the poor and minorities — as being the root cause of the mess. Conservatives are also pointing to accounting rules, which forced banks to write down the value of their loans, and to excesses by Fannie Mae and Freddie Mac, the government-sponsored mortgage enterprises that have since been nationalized, whose troubles they have tried to tie to Democrats. Both sides roundly denounce Wall Street greed, but there is no clear legislative solution to that, so such rhetoric is more likely to shape the campaign than the post election legislative battle. When the liberals talk about deregulation, they most often point to the Gramm-Leach-Bliley Act of 1999, which tore down the last remaining walls between commercial banks and investment banks. But there is little evidence to tie much of the problem to that law. Most of the walls, erected during the Depression, had already been breached over many years, with the approval of regulators. Besides, the first major failures of this crisis, Bear Stearns and Lehman Brothers, were investment banks that did not go into commercial banking in a big way. Instead, it might be more appropriate to describe the problem as “unregulation.” That regulation was scaled back was less of a factor than Wall Street’s finding ways around regulation by establishing new products that could work between the cracks. Those new products grew to dominate the financial system, and they turned out to be prone to collapse. Both parties bear responsibility for that, because there was little controversy over it when it was happening. Alan Greenspan, then the chairman of the Federal Reserve, believed that the new products could distribute risk to investors, who were better able to bear it than was the banking system he was charged with regulating, and few legislators were willing to challenge Mr. Greenspan on what appeared to be an arcane issue. But the family that can take the most credit for that is the Gramms, Phil and Wendy. It was Wendy Gramm, as chairwoman of the Commodity Futures Trading Commission in the early 1990s, who championed keeping her agency out of derivative trading. It was Phil Gramm, as the chairman of the Senate Banking Committee, who pushed through legislation in 2000 to assure that no future C.F.T.C., let alone any other regulator, would have jurisdiction over such products. At the same time that the credit-default swap market was growing, so were hedge funds, which became behemoths that were largely exempt from any regulation. The logic behind both of those decisions was that regulation was about protecting individual investors. Because small investors could not invest in hedge funds or mortgage-backed securities or credit-default swaps, the government had no reason to interfere with private enterprise. It turns out that those products could threaten the entire financial system, and their abuse could produce a credit crisis affecting virtually everyone. One obvious answer is that the new regulation system should not have so many loopholes. It is possible that the old markets and old products do have too much regulation, and that deregulation in some areas would be appropriate. But the guiding principle should be that similar products and similar institutions deserve similar regulation. If large institutional investors are required to disclose their positions every quarter, why should large hedge funds be treated differently?

That principle will need to be applied internationally as well, which will require diplomacy and a willingness to consider views of governments that are much less sympathetic to financial innovation. The growth of the new financial system also tends to undermine the conservative argument that much of the problem can be traced to the Community Reinvestment Act, which was passed by Congress in 1977. It has been cited by some bankers as a reason they made what turned out to be bad loans, but most of the worst loans appear to have been made outside of the banking system, by mortgage brokers not subject to its rules. Similarly, Fannie Mae and Freddie Mac undoubtedly bought many loans that should not have been made. But the worst loans were privately syndicated and snapped up by investors. The accounting rule requiring banks to mark their assets to their market value has been widely blamed for producing losses that alarmed investors. Newt Gingrich, the former House speaker, said Sunday on the ABC program “This Week” that “between half to 70 percent of the problem” was caused by the rule, and some Republican legislators pushed to have the bailout bill suspend the rule. But if one wants to look at accounting rules as a cause, it would be more productive to examine the rules that permitted the crisis to grow without being noticed, not at the rule that finally brought the truth to public attention. When the Financial Accounting Standards Board met after the Enron scandal to tighten the rules over off-balance-sheet entities, it permitted banks to continue keeping many assets off their balance sheets, under rules that now — belatedly — are being changed. Out of sight should not have meant out of mind, as many of the off-balance-sheet items have produced major losses. Similarly, the rules permitted banks to turn groups of mortgages into securities and report profits even though they retained some of the risk that the mortgages would go bad. By underestimating that risk, the banks reported higher profits than they should have, and the executives qualified for larger bonuses. Many of the recent losses are just reversing profits that, in reality, were never earned. In any case, it is too late to abandon mark-to-market accounting. Just how reassuring to investors would it be for the government to issue a rule saying it is O.K. for banks to value assets for far more than anyone would pay for them? Perhaps the most important cause of this disaster is one that probably does not need legislation: belief in so-called rocket scientists and their computer models, which used the past to forecast the future, and did so with complete, and completely unjustified, assurance. It was that faith that led rating agencies to give top-grade classification to securities that were in fact very risky and led investors to buy them. It was that faith that led regulators to defer to the banks’ own risk models in determining how much capital they needed. It was that faith that led senior managements of Wall Street firms — many of whom had only a general understanding of what their traders were doing — to assume that risk was under control when it was not. That faith is gone now. It will not come back soon. The legislation next year will shape the efforts of the American financial system to right itself, and to provide credit to families and businesses without taking undue risks that can again threaten to destroy the system. The details of those decisions will be far more important than the details of the bailout that is about to be approved.

The 3 A.M. Call By PAUL KRUGMAN

September 29, 2008 It’s 3 a.m., a few months into 2009, and the phone in the White House rings. Several big hedge funds are about to fail, says the voice on the line, and there’s likely to be chaos when the market opens. Whom do you trust to take that call?

I’m not being melodramatic. The bailout plan released yesterday is a lot better than the proposal Henry Paulson first put out — sufficiently so to be worth passing. But it’s not what you’d actually call a good plan, and it won’t end the crisis. The odds are that the next president will have to deal with some major financial emergencies. So what do we know about the readiness of the two men most likely to end up taking that call? Well, Barack Obama seems well informed and sensible about matters economic and financial. John McCain, on the other hand, scares me. About Mr. Obama: it’s a shame that he didn’t show more leadership in the debate over the bailout bill, choosing instead to leave the issue in the hands of Congressional Democrats, especially Chris Dodd and Barney Frank. But both Mr. Obama and the Congressional Democrats are surrounded by very knowledgeable, clear-headed advisers, with experienced crisis managers like Paul Volcker and Robert Rubin always close at hand. Then there’s the frightening Mr. McCain — more frightening now than he was a few weeks ago. We’ve known for a long time, of course, that Mr. McCain doesn’t know much about economics — he’s said so himself, although he’s also denied having said it. That wouldn’t matter too much if he had good taste in advisers — but he doesn’t. Remember, his chief mentor on economics is Phil Gramm, the arch-deregulator, who took special care in his Senate days to prevent oversight of financial derivatives — the very instruments that sank Lehman and A.I.G., and brought the credit markets to the edge of collapse. Mr. Gramm hasn’t had an official role in the McCain campaign since he pronounced America a “nation of whiners,” but he’s still considered a likely choice as Treasury secretary. And last year, when the McCain campaign announced that the candidate had assembled “an impressive collection of economists, professors, and prominent conservative policy leaders” to advise him on economic policy, who was prominently featured? Kevin Hassett, the co-author of “Dow 36,000.” Enough said. Now, to a large extent the poor quality of Mr. McCain’s advisers reflects the tattered intellectual state of his party. Has there ever been a more pathetic economic proposal than the suggestion of House Republicans that we try to solve the financial crisis by eliminating capital gains taxes? (Troubled financial institutions, by definition, don’t have capital gains to tax.) But even President Bush has, in the twilight of his administration, turned to relatively sensible people to make economic decisions: I’m not a fan of Mr. Paulson, but he’s a vast improvement over his predecessor. At this point, one has the suspicion that a McCain Administration would have us longing for Bush-era competence. The real revelation of the last few weeks, however, has been just how erratic Mr. McCain’s views on economics are. At any given moment, he seems to have very strong opinions — but a few days later, he goes off in a completely different direction. Thus on Sept. 15 he declared — for at least the 18th time this year —that “the fundamentals of our economy are strong.” This was the day after Lehman failed and Merrill Lynch was taken over, and the financial crisis entered a new, even more dangerous stage. But three days later he declared that America’s financial markets have become a “casino,” and said that he’d fire the head of the Securities and Exchange Commission — which, by the way, isn’t in the president’s power. And then he found a new set of villains — Fannie Mae and Freddie Mac, the government-sponsored lenders. (Despite some real scandals at Fannie and Freddie, they played little role in causing the crisis: most of the really bad lending came from private loan originators.) And he moralistically accused other politicians, including Mr. Obama, of being under Fannie’s and Freddie’s financial influence; it turns out that a firm owned by his own campaign manager was being paid by

Freddie until just last month. Then Mr. Paulson released his plan, and Mr. McCain weighed vehemently into the debate. But he admitted, several days after the Paulson plan was released, that he hadn’t actually read the plan, which was only three pages long. O.K., I think you get the picture. The modern economy, it turns out, is a dangerous place — and it’s not the kind of danger you can deal with by talking tough and denouncing evildoers. Does Mr. McCain have the judgment and temperament to deal with that part of the job he seeks?

US 'casino' mentality blamed for planet's meltdown September 30th

Astounded by the U.S. government's failure to resolve the financial crisis threatening the foundations of the global free market, fingers of blame are pointing at America from around the planet. Latin American leaders say the U.S. must quickly fix the financial crisis it created before the rest of the world's hard-won economic gains are lost.

"The managers of big business took huge risks out of greed," said President Oscar Arias of Costa Rica, whose economy is highly dependent on U.S. trade. "What happens in the United States will affect the entire world and, above all, small countries like ours."

In Europe, where some blame a phenomenon of "casino capitalism" that has become deeply engrained from New York to London to Moscow, there is more of a sense of shared responsibility. But Europeans also blame the U.S. government for letting things get out of hand.

Amid harsh criticism is a growing consensus that stricter financial regulation is needed to prevent unfettered capitalism from destroying economies around the globe.

And leaders of developing nations that kept spending tight and opened their economies in response to American demands are warning of other consequences — a loss of U.S. influence globally and the likelihood that the world's poor will suffer the most from greed by the biggest players in global finance.

"They spent the last three decades saying we needed to do our chores. They didn't," a grim-faced Brazilian President Luiz Inacio Lula da Silva said Tuesday.

Even staunch U.S. allies like Colombian President Alvaro Uribe blasted the world's most powerful country for egging on uncontrolled financial speculation that he compared to a wild horse with no reins.

"The whole world has financed the United States, and I believe that they have a reciprocal debt with the planet," he said.

It's harder for European leaders to point the finger directly at the United States since many of their financiers participated in the recklessness. London was home to the division of failed insurer AIG that racked up huge losses on credit-default swaps, and many reputable European banks disregarded risk to load up on higher yielding subprime assets.

But the House's rejection Monday of the U.S. bank bailout proposed by Treasury Secretary Henry

Paulson provoked a sharper tone and warnings that America must act. Though global markets on Tuesday recovered some of the ground they lost in a worldwide slide the day before, politicians from Europe to South America insisted the risk of a further plunge remains high.

German Chancellor Angela Merkel called on U.S. lawmakers to pass a package this week, saying it was the "precondition for creating new confidence on the markets — and that is of incredibly great significance."

In an unusually blunt statement from the 27-country European Union, EU Commission spokesman Johannes Laitenberger said: "The United States must take its responsibility in this situation, must show statesmanship for the sake of their own country, and for the sake of the world."

The crisis also has strengthened voices in France and Germany calling for EU regulations to eliminate highly deregulated financial markets, despite objections from Britain, which along with the U.S. is considered by some to practice a freer form of "Anglo-Saxon" capitalism.

"This crisis underlines the excesses and uncertainties of a casino capitalism that has only one logic — lining your pockets," said German lawmaker Martin Schulz, chairman of the Socialists in the EU assembly. "It also shows the bankruptcy of 'law of the jungle' capitalism that no longer invests in companies and job creation, but instead makes money out of money in a totally uncontrolled way."

The U.S. government's failure to apply rules that might have prevented the crisis is seen as a betrayal in many developing countries that faced intense U.S. pressures to liberalize their economies. In some developing nations, state enterprises were privatized, currencies were allowed to float against the U.S. dollar and painful measures were taken to bring down debts.

These advances are at risk now that credit is drying up. Countries with commodities-based economies are particularly vulnerable since more industrialized nations could reduce their demand for everything from soy to iron ore.

"It doesn't seem fair to me that those of us who endured so much hunger in the 20th century, who began to improve in the 21st century, should have to suffer due to the international financial system," Silva said. "There are going to be a lot of people going hungry in the world."

Just before meeting with Silva on Tuesday, Venezuelan leader Hugo Chavez said he believes a new economic order is in store for the planet.

"What's to blame? Imperialism, the United States, the irresponsibility of the United States government," said the self-avowed socialist and frequent U.S. critic. "From this crisis, a new world has to emerge, and it's a multi-polar world."

China's influence in the outcome of all this could be profound because it is a huge investor in U.S. debt. It is already calling for strict new international regulatory systems to apply to globalized financial markets.

Liu Mingkang, chairman of the Chinese Banking Regulatory Commission, said Saturday before a weeklong bank holiday in China that debt in the United States and elsewhere has risen to dangerous and indefensible levels.

The rest of the world is taking notice. Many newspapers made references Tuesday to China's increasing importance in global finance. In Algeria, a large cartoon on the front page of the

newspaper El-Watan showed Uncle Sam at prayer: "Save us!" he says, kneeling before a portrait of China's Mao Zedong.

In London, Jane Ayerson, a 20-year-old Irish exchange student, said Europeans share the blame. The problem started with America, but banks here have been greedy, too," she said.

Treasury Announces Temporary Guarantee Program for Money Market Funds September 29, 2008�

The U.S. Treasury Department today opened its Temporary Guarantee Program for Money Market Funds. The U.S. Treasury will guarantee the share price of any publicly offered eligible money market mutual fund – both retail and institutional – that applies for and pays a fee to participate in the program.

All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, maintain a stable share price of $1, and are publicly offered and registered with the Securities and Exchange Commission will be eligible to participate in the program. Treasury first announced this program on Friday, September 19.

The temporary guarantee program provides coverage to shareholders for amounts that they held in participating money market funds as of the close of business on September 19, 2008. The guarantee will be triggered if a participating fund's net asset value falls below $0.995, commonly referred to as breaking the buck.

The program is designed to address temporary dislocations in credit markets. The program will exist for an initial three month term, after which the Secretary of the Treasury will review the need and terms for extending the program. Following the initial three-month term, the Secretary has the option to renew the program up to the close of business on September 18, 2009. The program will not automatically extend for the full year without the Secretary's approval, and funds would have to renew their participation at the extension point to maintain coverage. If the Secretary chooses not to renew the program at the end of the initial three-month period, the program will terminate.

To participate in the program, the Treasury Department will require money market funds with a net asset value per share greater than or equal to $0.9975 as of the close of business on September 19, 2008, to pay an upfront fee of 0.01 percent, 1 basis point, based on the number of shares outstanding on that date. Funds with net asset value per share of greater than or equal to $0.995 and below $0.9975 as of the close of business on September 19, 2008, will be required to pay an upfront fee of 0.015 percent, 1.5 basis points, based on the number of shares outstanding on that date. These fees will only cover the first three months of participation in the program.

Funds with a net asset value below $0.995 as of the close of business on September 19, 2008, may not participate in the program.

While the program protects the accounts of investors, each money market fund makes the decision to sign-up for the program. Investors cannot sign-up for the program individually. Funds should apply by October 8, 2008 for the program using the forms on the program webpage: http://www.treas.gov/offices/domestic-finance/key-initiatives/money-market-fund.shtml.

Eligible funds include both taxable and tax-exempt money market funds. The Treasury and the IRS issued guidance that confirmed that participation in the temporary guarantee program will not be treated as a federal guarantee that jeopardizes the tax-exempt treatment of payments by tax-exempt money market funds.

President George W. Bush approved the use of existing authorities by Secretary Henry M. Paulson, Jr. to make available as necessary the assets of the Exchange Stabilization Fund to guarantee the payment

The Exchange Stabilization Fund was established by the Gold Reserve Act of 1934, as amended, and has approximately $50 billion in assets. This Act authorizes the Secretary of the Treasury, with the approval of the President, "to deal in gold, foreign exchange, and other instruments of credit and securities" consistent with the obligations of the U.S. government in the International Monetary Fund to promote international financial stability. More information on the Exchange Stabilization Fund can be found at

Frequently Asked Questions: Treasury’s Temporary Guarantee Program for Money Market Funds

September 29, 2008�

How does an investor sign up to participate in the Treasury's Temporary Guarantee Program for Money Market Funds?

While the program protects the shares of all money market fund investors as of September 19, 2008, each money market fund makes the decision to sign up for the program. Investors cannot sign up for the program individually.

How will investors know if their money market fund participates in the program?

Investors should contact their money market fund directly to determine if it is participating in the program.

What type of funds does the program cover?

All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, are publicly offered, are registered with the Securities and Exchange Commission and maintain a stable share price of $1 will be eligible to participate in the program. This includes both taxable and non-taxable funds.

Is an investor in a fund that is managed like a money market fund but that is not registered with the SEC covered?

No, the program only covers money market funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, are publicly offered, are registered with the Securities and Exchange Commission and maintain a stable share price of $1 will be eligible to participate in the program. This includes both taxable and non-taxable funds.

When will my fund be covered by the program?

Each fund must decide to participate in the program. If your fund participates in the program, your investment as of September 19, 2008 will be covered.

How much of an investor's money market fund is insured? What happens if the number of shares held in an investor's account increase above the level at the close of business on September 19, 2008? What happens if the number of shares held in an investor's account decreases below the level at the close of business on September 19, 2008?

The program provides a guarantee based on the number of shares held at the close of business on September 19, 2008. Any increase in the number of shares held in an account after the close of business on September 19, 2008 will not be guaranteed. If the number of shares held in an account fluctuates over the period, investors will be covered for either the number of shares held as of the close of business on September 19, 2008 or the current amount, whichever is less.

Examples include:

If an investor owned 100 shares in a money market fund as of close of business September 19, 2008, but owns 50 shares on the day the guarantee payment is made, after the fund breaks the buck, then that

investor will be guaranteed for 50 shares. � If an investor owned 100 shares in a money market fund as of close of business September 19, 2008, but

owns 150 shares on the day the guarantee payment is made, after the fund breaks the buck, then that investor will be guaranteed for 100 shares. The fund, upon liquidation, will distribute proceeds to the shareholder for the additional 50 shares, at net asset value. �

If an investor owned 100 shares in a fund as of close of business September 19, 2008, subsequently sold 50 shares and later bought 25 shares, the investor owns 75 shares on the day the guarantee payment is made and will be guaranteed for 75 shares. �

If an investor owned no shares in a fund as of close of business September 19, 2008, but owns 100 shares on the day the guarantee payment is made, none of the investor's shares are guaranteed by the program and the investor will receive the net asset value directly from the fund.

What if another fund in an investor's fund family breaks the buck before this program starts? Is the investor covered?

The program provides a guarantee on a fund-by-fund basis up to the amount of shares held as of the close of business on September 19, 2008. The performance of a different fund, even one in the same fund family of the investor's fund, doesn't affect the investor's fund's eligibility. Investors should contact their fund to determine if their fund participates in the program.

When does the program terminate?

The program is designed to address temporary dislocations in credit markets. The program will be in effect for an initial three month term, after which the Secretary of the Treasury will review the need and terms for the program and the costs to provide the coverage. The Secretary has the option to extend the program up to the close of business on September 18, 2009. In order to maintain coverage, funds would have to renew their participation in the program after each extension. If the Secretary chooses not to extend the program at the end of the initial three month period, the program will terminate.

Who provides this guarantee? Are investors able to get all of their money back whenever they want?

The U.S. Treasury Department, through the Exchange Stabilization Fund, is providing this guarantee. In the event that a participating fund breaks the buck and liquidates, a guarantee payment should be made to investors through their fund within approximately 30 days, subject to possible extensions at the discretion of the Treasury.

Is shareholder in a fund that broke the buck before September 19, 2008 covered?

No. This does not meet the program's eligibility criteria noted above.

What should shareholders in a participating fund that breaks the buck do? Who should they call?

If your fund enrolled in the program you will be covered and do not need to take any action. Shareholders should contact their fund directly.

Who should a fund contact if it has further questions about this program?

U.S. Senate passes bailout plan; House to vote Friday October 2, 2008

The Senate strongly endorsed the $700 billion economic bailout plan Wednesday, leaving backers optimistic that the easy approval, coupled with an array of popular additions, would lead to House acceptance by Friday and end the legislative uncertainty that has rocked the markets.

In stark contrast to the House rejection of the plan on Monday, a bipartisan coalition of senators —

including both presidential candidates — showed no hesitation in backing a proposal that had drawn public scorn, though the outpouring eased somewhat after a market plunge following the House defeat. The Senate margin was 74 to 25 in favor of the White House initiative to buy troubled securities to ease a growing credit crunch.

The presence in the Senate of both presidential candidates in the final weeks of the campaign gave weight to the moment. The political tension was clear as Senator Barack Obama walked to the Republican side of the aisle to greet John McCain, who offered a chilly look and a brief return handshake.

McCain did not make remarks on the legislation. Obama, in his speech, said the bailout plan was regrettable but necessary and he referred to the stock market drop after the House vote. "While that decline was devastating, the consequences of the credit crisis that caused it will be even worse if we do not act now," he said.

In the House, officials of both parties said they were increasingly confident that politically enticing provisions bootstrapped to the original bill — including $150 billion in tax breaks for individuals and businesses — would win over at least the dozen or so votes needed to reverse Monday's outcome and send the measure to President George W. Bush.

The stock market reflected nervous jitters over a vote that was to occur after it closed, but that could affect the future of many Wall Street workers. The Dow Jones industrial average was off almost 220 points during the day, but recovered to close down just 19.6 points, or 0.2 percent, at 10,831.07.

Stock markets in Asia rose early Wednesday morning in anticipation of Senate passage of the legislation, only to fall soon after the Senate had finished voting in what market analysts described as a classic case of investors buying on the expectation of good news and then selling on confirmation of the news.

Many investors in Asia are uncertain about whether the final details of the legislation will be enough to help American financial institutions with their heavy losses or to prevent the United States economy from slowing significantly, said Thomas Lam, the senior treasury economist at the United Overseas Bank in Singapore. "The situation in the U.S. is still pretty hairy," he said.

By mid-morning on Wednesday, the Hang Seng Index was down 2 percent in Hong Kong, the Nikkei 225 had fallen 1.1 percent in Tokyo, the Kospi had dropped 0.7 percent in Seoul and the Standard and Poor's/Australian Stock Exchange 200 Index had dipped 0.5 percent in Sydney and the Straits Times Index had declined 0.4 percent in Singapore.

Besides the tax breaks, senators also made a change that had drawn widespread support in recent days — an increase in the amount of bank deposits covered by the Federal Deposit Insurance Corp., to $250,000 from $100,000. And the entire package was attached to legislation requiring insurers to treat mental health conditions more like general health problems — a long-sought goal of Domenici and other lawmakers who demanded such parity.

As the shape of the new bill became clearer Wednesday, some House Republicans and Democrats indicated that the changes were enough to get them to take another look at the measure and perhaps change their minds — even though the new items being added would substantially increase the burden on taxpayers.

Representative John Yarmuth, a Kentucky Democrat who on Monday voted no, said he found the new proposal more acceptable, as did Representative Jim Ramstad, a retiring Republican from Minnesota who voted in opposition as well.

"The inclusion of parity, tax extenders and the FDIC increases has caused me to reconsider my position," Ramstad said. "All three additions have greatly improved the bill."

Leaders of both parties in the House, who spent much of Wednesday on the phone taking the temperature of lawmakers not scheduled to return until Thursday, said they were identifying other potential converts as well, and were finding a more receptive audience for the revised measure because of the tax package and other changes.

Some conservative House Republicans and liberal Democrats remained adamantly opposed. "The bailout legislation that the Senate is sending back to the House is a fraternal twin to the one I voted against on Monday — meet the new bill, same as the old bill," said Representative Joe Barton, Republican of Texas.

While popular, the tax breaks, which had been the center of a bitter dispute between House and Senate Democrats, caused problems as well.

A coalition of centrist Democrats led by Representative Steny H. Hoyer of Maryland, the majority leader, had refused to back the tax benefits unless they were deficit neutral — offset by tax increases or spending cuts elsewhere. The bill now includes the Senate version of the tax plan, which adds most of the cost to the deficit over the next decade.

But the Senate leaders decided to present the House with a take-it-or-leave-it choice, and it is possible some Democrats could desert the bill over the tactic.

Hoyer said he was disappointed in the Senate's decision and worried it could cost Democratic votes. "Certainly there are people who are upset we are making the deficit worse as we are trying to stabilize the economy," Hoyer told reporters. But in a telephone conference call among the Democratic leadership Wednesday morning, he told his colleagues he would back the measure because the economic rescue needed to take priority, according to participants.

In the end, Senate leaders decided to overcome some of the ideological and political resistance that doomed the measure in the House with the tried-and-true congressional approach of stuffing the bill with provisions that would make it hard for many lawmakers to resist.

"All I'm trying to do is get this thing passed," said Senator Harry Reid, Democrat of Nevada and the majority leader, denying he was trying to jam the House by giving members no choice but to accept the tax proposal he favored or again reject the bailout.

The multiple tax breaks, called extenders in the Capitol because they renew or extend expiring tax benefits, appeal to many lawmakers and could provide a political argument for backing a bill that has otherwise been very unpopular.

Instead of siding with a $700 billion bailout, lawmakers could now say they voted for increased protection for deposits at the neighborhood bank, income tax relief for middle class taxpayers and aid for schools in rural areas where the U.S. government owns much of the land.

"This bill has been packaged with a lot of very popular things to give it even more momentum," said Senator Jeff Sessions, a Republican from Alabama, who is an opponent.

The approximately $150 billion in new tax breaks, which offer incentives for the use of renewable energy and relieve 24 million households from an estimated $65 billion alternative-minimum tax scheduled to take effect this year, would be offset by only about $40 billion in spending cuts or tax increases elsewhere.

Moreover, the increase in federal deposit insurance will not be funded over the short-term, as the insurance program now is, by assessing premiums on banks that benefit. Instead, banks will get an open-ended line of credit directly to the Treasury Department. But the congressional Budget Office noted Wednesday that U.S. law requires the banks to eventually make up any shortfall and any loans to be repaid, though not until at least 2010.

The changes in the bill were measurable by volume. The initial proposal from the Treasury Department ran just three pages; the latest version exceeds 450.

After receiving the proposal from Treasury Secretary Henry Paulson Jr. almost two weeks ago, Congress instituted a series of changes, including additional oversight, steps to limit home foreclosures and restrictions on the compensation of executives of institutions that take part in the Treasury program.

Under pressure to tighten the plan even more, congressional and administration negotiators decided to parcel out the $700 billion in installments, starting with a first tranche of $350 billion. And during a weekend of negotiations, they added as a final backstop a requirement that in five years the president must present Congress with a plan to make up any losses of tax funds by assessing the financial community. The Congressional Budget Office pointed out, however, that the provision does not require Congress to enact it.

Beyond what they described as the fragile economy, lawmakers and aides said they saw another factor in the new drive to dispose of the bill and recess Congress for the elections. Polls suggest the economic fight is taking a toll on Republicans and their presidential candidate, McCain, and they want to put it behind them.

"We have to get out of here and get our guys back home campaigning," said a senior Senate Republican aide who did not want to be quoted expressing

Foreign exchange--The buck swaps here Oct 2nd 2008

Central banks ease the market’s pain A BIG problem for the banks has been a shortage of dollars in the money markets; particularly in the European morning before the New York market opens. That is one reason why dollar interest rates have been so high relative to those for euros.

Normally, investors and banks would arrange foreign exchange swaps among themselves, agreeing to switch euros into dollars for a set period. But banks are nervous about the risk that their counterparty will go bust while the swap is being put in place and so are shying away from such agreements.

Hence the facility set up by the Federal Reserve on September 29th to supply $620 billion to its counterparts, so that they can lend them on to banks. At first glance, this may seem to be a back door bail-out on a similar scale to the plan proposed by Hank Paulson, the American treasury secretary.

There are some similarities in that the central banks involved in the swaps make loans secured on assets that commercial banks pledge as collateral. If that collateral falls in value, the central banks could lose money. But the collateral is generally of much higher quality than the troubled assets that were the subject of the bail-out plan, and the central banks generally apply a discount when assessing the collateral’s value. Furthermore, the Fed (and thus the American taxpayer) is lending its currency directly to other central banks, and thus has no real credit risk.

Global banks--On life support Oct 2nd 2008

Governments in America and Europe scramble to rescue a collapsing system

AFTER lurching robotically into their worst crisis in more than three-quarters of a century, the fundamental weakness of banks in America and Europe has now become horribly clear. With funding markets frozen and American plans to remove toxic assets from banks’ balance-sheets in limbo for much of this week, confidence in a raft of institutions evaporated. Between September 28th and 30th,

governments on both sides of the Atlantic shored up or split up six banks threatened by failure. Other institutions remain on high alert.

Observers scratch their heads to think of any other industry that has been reshaped so quickly or so dramatically. In America, where the authorities have helped to shovel failing banks into the hands of bigger ones, the retail-banking landscape now has three towering figures. On September 25th JPMorgan Chase overtook Bank of America as the country’s largest deposit-taking institution by snapping up the assets and deposits, but not the other liabilities, of Washington Mutual (WaMu), a Seattle-based savings-and-loan bank that had been suffocated by bad mortgage loans.

Four days later Citigroup, its risks capped by a loss-protection agreement with the Federal Deposit Insurance Corporation (FDIC), strengthened its domestic deposit base by acquiring the banking operations of Wachovia. Further consolidation is likely. Jim Eckenrode, an analyst at Tower Group, a consultancy, reckons that a top tier of five banks (Wells Fargo and US Bancorp are two other contenders) may end up holding as much as half of America’s deposits.

In Europe the pace of consolidation has not been quite as rapid but the scale of government intervention is just as breathtaking. The continent has turned into a laboratory of bank bail-outs. One approach has been to inject equity into institutions and try to keep the show on the road. Fortis, a Belgo-Dutch bank overstretched by its role in acquiring ABN AMRO, is now part-owned by the Benelux governments. The Icelandic government has taken a 75% stake in Glitnir, a bank with outrageous reliance on gummed-up wholesale funding markets. The French, Belgian and Luxembourgeois authorities stumped up €6.4 billion ($9.3 billion) to bolster the capital base of Dexia, a public-sector lender that dabbled fatally in bond insurance.

Another approach has been to borrow from the American model, parceling out the good bits of failing banks to solvent rivals and keeping the rest. The deposits and branches of Bradford & Bingley, a British mortgage lender that made Northern Rock look well managed, are now in the hands of Santander, a respected Spanish bank. Its mortgage book now rests with the luckless taxpayer. Germany’s Hypo Real Estate, a commercial-property lender which found that the tenor of its funding was becoming shorter as investors shied away from long-term lending, got help of a different sort—a €35 billion secured-credit facility from a consortium of unnamed German banks and the government.

The most sweeping intervention of all came from Ireland’s government, where concerns about spiking credit-default swap (CDS) spreads, falling share prices and jittery depositors led the finance minister to announce, on September 30th, a blanket guarantee on the deposits and almost all the debts of the country’s six biggest banks until September 2010. “The Irish move confirms that this is a systemic crisis in certain countries,” says Simon Adamson of CreditSights, a research firm. Investors and creditors of Irish banks liked the move, which recalled one of the actions taken by Sweden during its feted 1990s bail-out. The European Commission and other banks, worried about deposit flight to Ireland, are bound to be less enthused.

Safe as houses All this activity had one immediate prize: not a single bank needed rescuing on October 1st. But for those with longer-term horizons, the future remains bleak, and in some ways, worse than before. There are two sources of pressure on the banks. To date government intervention has tended to focus on one or the other, but not both.

The first source of pressure is concern about solvency, and the ability of banks to withstand further losses. The unexpected rejection of the American bail-out plan on September 29th cast doubt on one obvious mechanism to remove the worst-performing assets from banks’ balance-sheets. But even if it is revived, as most expect, the cycle of losses will continue as the drumbeat of bad economic news intensifies. WaMu and Wachovia were undone not by mark-to-market losses, after all, but by the appalling quality of their loan books. It is the same story in many parts of Europe.

The second source of pressure is liquidity. Even the most solid-looking banks are having trouble raising long-term debt. As their debt matures, they are having to refinance with shorter-term debt, ratcheting up their costs and their vulnerability to a sudden withdrawal of credit. If banks have enough funding through deposits, problems in the wholesale markets should be navigable. But others are much weaker. Witness the continuing pressures on Morgan Stanley and Goldman Sachs, despite their conversion into bank holding companies. Mitsubishi UFJ, a Japanese bank, lost more than $500m on its $9 billion investment in Morgan Stanley on September 29th, the day the deal was inked.

The problem is that attempts to shore up liquidity do not necessarily address the capital shortfalls, and vice versa. Even Ireland’s lavish guarantee does not quell concerns about rising impairments on the Irish banks’ property portfolios. Glitnir’s capital ratio looks robust after the government’s investment, for example, but its CDS spreads still surged, indicating rising fears of a national crisis (see chart).

Worse still, the effect of most government interventions, necessary as they are, is to make it even harder for private investors to heal the system on their own. Shareholders are losing both money and reputations as bank failures multiply. TPG, a vaunted private-equity firm, was wiped out by the collapse of WaMu. Shareholders in Wachovia, Fortis and Bradford & Bingley had all recently dipped into their pockets to raise fruitless capital. The risk of sudden dilution by governments, or worse, hangs darkly over prospects for industry recapitalization. Creditors have also become far more risk-averse in recent days, thanks to the bankruptcy of Lehman Brothers and the brutal treatment of WaMu’s senior creditors. Hypo Real’s new credit line will presumably have shunted unsecured creditors down the queue too.

So far only the Irish solution has avoided this adverse effect, by indemnifying most creditors and allowing shareholders to reap the subsequent gains. Moral hazard, it seems, can go hang. So too can other governments, which are under pressure to match the Irish guarantee but may not be able to, either because their sovereign-debt rating is less strong or because the liabilities of their banks are too big.

There are other dangers in the rapid consolidation of the sector. A world of fewer, bigger banks promises even greater havoc if one was ever to fail. The universal banks have remained largely above the fray in recent days, but on October 1st, UniCredit, a big Italian bank, announced plans to raise its capital ratio by spinning off property assets. If banks of this size and geographical scope were to get sucked into the mire, the consequences would be devastating. In the meantime, they have little choice but to present a steely exterior and carry on as if nothing were wrong.

Rethinking Lehman Brothers The price of failure

The government must privately rue its hard line towards Lehman

Oct 2nd 2008 CONFRONTED by blaze after blaze in recent weeks, America’s financial firemen have rushed to douse the flames—with one exception. Unable to persuade any rival to take on a battered Lehman Brothers, the government was left with a hard choice: spray the investment bank with public money or let it burn. In choosing destruction, the government has provided a painful lesson in the dangers of doing the right thing at the wrong time.

In a sense, Lehman’s misfortune was not to have hit trouble earlier. After broking the sale of Bear Stearns, another Wall Street firm, and nationalizing the country’s mortgage agencies, officials felt an example needed to be made so as to combat “moral hazard”, or the risk that banks will act recklessly if they know they will be bailed out when their bets sour. Hank Paulson, the treasury secretary, believed Lehman’s problems were sufficiently well advertised to have given derivatives markets time to prepare for the worst.

He was partly right: the credit-default swaps market has buckled but not broken. But Lehman’s bankruptcy shredded the last remnants of confidence in American International Group, an insurer, and crystallized fears over the stability of the remaining free-standing investment banks, Goldman

Sachs and Morgan Stanley. Alarm over “counterparty” risk—the risk of a borrower or trading partner failing to cough up—turned into outright terror, paralyzing money markets. “It was the mistake of a lifetime,” says one senior bank executive, echoing the view across Wall Street.

Lehman went bust with $613 billion of debt, of which $160 billion was unsecured bonds held by an array of investors around the world, including European pension funds and individuals in Asia who had taken comfort in Lehman’s high credit rating. The price of this paper quickly collapsed to 15 cents on the dollar or less, destroying overnight twice as much value as Lehman’s shareholders had seen evaporate over several months.

These losses set off a spiral in money markets. Investors yanked $400 billion from money-market funds, a supposedly super-safe source of funding, when one fund that had loaded up on Lehman debt suffered losses. The run was halted by a government pledge to guarantee money funds’ par value, but it stripped money funds of all appetite for risk. Their flight into safe government and mortgage-agency paper has left banks and companies struggling to raise working capital.

Had officials foreseen this debacle, Lehman would surely have been propped up. One theory doing the rounds is that they seriously underestimated the money funds’ holdings of its debt. As they fretted over Lehman’s vast notional exposures in swaps, they may have taken their eye off the potential impact of its failure on more prosaic cash markets.

Taken aback, policymakers now seem unsure how much protection to offer creditors of other basket-cases. When Washington Mutual (WaMu), America’s largest savings-and-loan institution, was hurriedly sold to JPMorgan Chase on September 25th, its bondholders lost everything. This infuriated senior debt holders, who felt the seizure deprived them of the chance to recover some of their money through a public liquidation. Wachovia’s creditors were spared that fate in the bank’s equally rushed sale to Citigroup a few days later. There was some justification for this different treatment: Wachovia has much more short-term debt than WaMu, so wiping out its creditors would have caused a bigger shock. Still, to some, America’s bail-out policy looks haphazard.

The full costs of Lehman’s failure have yet to be determined, both in terms of the damage to credit markets and the losses inflicted on its creditors and trading partners. Its swap exposures are still being unwound. Recovery values on its bonds could be anything from pennies to more than 30 cents on the dollar. Dozens of hedge funds that used Lehman as a prime broker are fighting for the return of assets. The task is complicated by the fact that the firm used some of these as collateral for its own loans. Its bankruptcy is by far the messiest in American corporate history.

Throughout this crisis, Mr Paulson’s Treasury has stressed the importance for the long-term health of the financial system of letting sick financial institutions fail. In highly stressed markets, however, there are short-term costs. In Lehman’s case they are proving almost unbearably onerous.

Thanks to the Wing Nuts October 3, 2008

We all owe a debt of thanks to the wing nuts and the populists, the soldiers of the far left and (gulp) the far right, the know-nothings and the know-it-alls, the income redistributionists and the free-market fundamentalists -- all the skeptics who refused to be steamrollered by the Bush administration's $700 billion financial bailout plan until we had at least some understanding of what we were doing and why.

Since the risk of a Wall Street meltdown is still very real, and since nobody has come up with a better idea, the bailout should go forward. It will probably save the homes and livelihoods of millions of Americans. But it will do so by absolving some of our wealthiest citizens of the consequences of their shortsightedness, dishonesty and greed.

Everyone knew we were in a housing bubble. Across the country, real estate prices were rising so

fast that anyone thinking about buying a home had one logical course of action: Do it now. Anyone who already owned a home, especially in one of the red-hot markets, was building equity -- or what looked like equity -- so rapidly that there seemed no harm in pulling money out, even to pay for luxuries, since the property was going to keep appreciating. The nation was awash in cheap money, and everyone who owned a house was going to be rich.

As long as housing prices continued to rise, all was well. Any individual homeowner who ran into trouble with an adjustable-rate or interest-only mortgage could be refinanced back to financial health.

But bubbles inevitably burst, and here's where the mendacity and greed come in.

Wall Street, in its collective wisdom, knew that housing prices couldn't rise indefinitely at such an unprecedented rate. Yet Wall Street created a gargantuan market in securities and insurance, worth many trillions of dollars, based on the premise that the impossible -- a housing bubble that expands forever and lasts forever -- had become inevitable.

The traders who invented, sold and resold these mortgage-backed instruments, making profits and commissions with every transaction, knew what legendary swindler Charles Ponzi knew: that those who got into and out of the market while housing prices were still rising would make a lot of money, and that when prices fell someone would be left holding the bag.

To find out who that someone is, dear reader, look in the mirror.

Unfortunately, telling Wall Street to clean up its own mess isn't an option. Already, the nation's largest insurer, the nation's largest savings and loan, many of Wall Street's major investment banks, and the mortgage giants Fannie Mae and Freddie Mac have either gone belly-up, been sold or been nationalized. Commercial banks are gasping for air. Somebody has to do something to get credit flowing through the economy again, and the only entity big enough for the job is the federal government.

There may be more effective remedies than the one outlined by Treasury Secretary Henry Paulson. But I'm persuaded that it would be unwise to spend a lot more time looking for a better solution -- and also that any solution is likely to be similarly expensive.

It's a good thing, though, that we've had a couple of weeks to take stock. Congress can call this a "rescue plan" and festoon it with all kinds of bells and whistles, but it's still a bailout that lets Wall Street off the hook. And in the end, despite some limits on executive compensation and stirring words about oversight, it promises nothing but a temporary setback for the "greed is good" Wall Street mentality that created this awful situation. Gordon Gekko will just lie low while the heat's on, then come back with a vengeance. The environment's getting hot, in more ways than one; maybe the next phantom market will be in pumped-up securities somehow based on "clean" technology.

Do we as a nation really care about those struggling homeowners who bought more house than they could afford because that was the only way for them to keep from slipping out of the middle class? Do we care that medical expenses, for the 46 million uninsured, are a chief cause of bankruptcy? Do we care that income distribution is worsening and we're rapidly becoming a nation not of haves and have-nots, but of haves and never-gonna-gets?

"Reform" has suddenly become a popular word in Washington. If it's to have any meaning at all, Congress and the new president will have a lot more work to do.

SEC move may relax asset rule By Floyd Norris-October 1, 2008

Under pressure from banks and legislators, the Securities and Exchange Commission issued an interpretation of an accounting standard that could make it easier for banks to report smaller losses,

or perhaps even profits, when they announce results for the third quarter, which ended Tuesday.

The move on Tuesday drew praise from the American Bankers Association, which had complained to the SEC that auditors were forcing banks to value assets at unrealistically low "fire sale" prices, rather than at the higher values the banks believe the assets should be worth in an orderly market.

Some congressmen had pressed to order a suspension of the fair-value rule, known as SFAS 157, as part of the bailout bill that the House defeated on Monday but that may be revived later in the week. That bill stopped short of that, but did require a study of the rule and authorized the SEC to suspend it.

The SEC said it was interpreting, not changing, the mark-to-market rule. Nonetheless, the immediate praise from the bankers could reduce the pressure to drop the rule and make it easier for some legislators to change their votes.

The commission’s chief accountant and the staff of the Financial Accounting Standards Board issued the statement jointly. While the rule has been criticized by many banks, others have argued that the problem was caused by the banks' purchase of risky assets.

In a report earlier this year, Dane Mott and Sarah Deans, analysts for JPMorgan, argued that "blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick."

On Tuesday, they said there was "nothing new" in the SEC statement, but some other analysts thought it could make a difference.

Companies have long been required to mark many financial assets to their fair value, but rule 157 clarified how that was to be measured, saying that market values should be used if they are available.

Many mortgage securities have plunged in value, forcing large write-offs by financial institutions that own them. Bankers have argued that the current market prices are far below what the securities should be worth, and say that they should not be forced to take write-downs that are sure to be reversed later.

The rule had exceptions, saying that "distress sales" need not be used as the basis for reporting, but it was unclear how broadly that could be interpreted. Some auditors argued that more than one or two sales at a level provided a real market price, and thus should be used for valuing that security and similar ones.

"More and more of our members in recent weeks have raised concerns that a number of accounting firms were mistakenly interpreting SFAS 157 in a way that required marking assets to fire-sale values," Edward Yingling, the president of the American Bankers Association, said as he praised the SEC for the interpretation. "This guidance will help auditors more accurately price assets that are difficult to value under current market conditions."

Yingling said the bankers had held "a productive meeting" on Thursday with staff members from both the SEC and the accounting board, as well as representatives of the major accounting firms.

Under rule 157, there is a hierarchy of valuation techniques. The first is when there is an active market for a security, which must always be used. If there is no such market, level two is based on prices of similar securities. Only if those are not available is level three to be used, which depends on the company's model of value in the absence of a usable market price.

"They're saying that in some cases, using level three might be more appropriate than using level two," said Patrick Finnegan, the director of the financial reporting policy group of the CFA Institute,

a group of securities analysts.

The statement did that by providing more definition of what was an inactive market, whose prices sometimes can be ignored, and of what constituted a disorderly market.

"The results of disorderly transactions are not determinative when measuring fair value," the statement said. "The concept of a fair-value measurement assumes an orderly transaction between market participants. An orderly transaction is one that involves market participants that are willing to transact and allows for adequate exposure to the market. Distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered when weighing the available evidence. Determining whether a particular transaction is forced or disorderly requires judgment."

Banks could use the phrase "adequate exposure to the market" to justify not using privately negotiated sales of mortgage securities to value similar securities held by others. Finnegan pointed to the sale this year by Merrill Lynch of mortgage-related securities at 22 cents on the dollar. The sale was made to a private equity firm, and details of which securities were included was not disclosed.

"This is probably giving you some leeway," he said. "With this guidance, you could say I can ignore that transaction and use a level three approach. While it is not disorderly, it does not meet the definition of orderly."

Finnegan said that while investors might not agree with those decisions, the interpretation would be acceptable so long as it was accompanied by adequate disclosures.

"Investors can be well served if they understand that, from quarter two to quarter three, management has developed a different interpretation of fair value, and they provide a reconciliation of the changes," he said.

Companies now must report on assets moved between levels, but it is not clear if they would have to disclose that the move came about because of a different interpretation of the rule, rather than a change in the availability of market information.

Congress OKs historic bailout bill; Bush signs it Oct. 3, 2008

With the economy on the brink and elections looming, Congress approved an unprecedented $700 billion government bailout of the battered financial industry on Friday and sent it to President Bush who quickly signed it.

"We have acted boldly to help prevent the crisis on Wall Street from becoming a crisis in communities across our country," Bush said shortly after the vote, although he conceded, "our economy continues to face serious challenges."

Underscoring that somber warning, the Dow Jones industrials, up more than 200 points at the time of the House vote, ended the day down 157.

The final vote, 263-171 in the House, capped two weeks of tumult in Congress and on Wall Street, punctuated by daily warnings that the country confronted the gravest economic crisis since the Great Depression if lawmakers failed to act. There were 58 more votes for the measure than an earlier version that failed on Monday.

"We all know that we are in the midst of a financial crisis," House Republican leader John Boehner of Ohio said shortly before casting his vote for a massive government intervention in private capital

markets that was unthinkable only a month ago. "And we know that if we do nothing, this crisis is likely to worsen and to put us into an economic slump like most of us have never seen," he said.

House Speaker Nancy Pelosi, D-Calif., said the bill was needed to "begin to shape the financial stability of our country and the economic security of our people." Treasury Secretary Henry Paulson pledged to begin using his new authority quickly, and Federal Reserve Chairman Ben Bernanke said the central bank would work closely with the administration.

Wall Street welcomed the action, but investors also were buffeted by a bad report on the job market. The Labor Department said employers slashed 159,000 jobs in September, the largest cut in five years and further evidence of a sinking economy.

At its core, the bill gives the Treasury Department $700 billion to purchase bad mortgage-related securities that are weighing down the balance sheets of institutions that hold them. The flow of credit in the U.S. economy has slowed, in some cases drying up, threatening the ability of businesses to conduct routine operations or expand, and adversely affecting consumers seeking financing for mortgages, cars and student loans. Some state governments have also experienced difficulty borrowing money.

The House vote marked a sharp change from Monday, when an earlier measure was sent down to defeat, largely at the hands of angry conservative Republicans.

On Friday, 91 Republicans joined 172 Democrats to support the bill, while 108 Republicans and 68 Democrats opposed it. Twenty-five Republicans and 33 Democrats switched their votes from "no" to "yes." One Democrat who supported Monday's version, Rep. Jim McDermott of Washington, opposed the bill Friday. One Republican, who didn't vote Monday, Rep. Jerry Weller of Illinois, voted "yes" on Friday.

Several of the Democrats who switched were members of the Congressional Black Caucus who said presidential candidate Barack Obama had pledged to support legislation easing the burden on consumers if he wins the White House. Republican presidential candidate John McCain also lobbied for the measure, according to aides who declined to release a list of lawmakers he called.

Following Monday's vote, Senate leaders quickly took custody of the measure, adding on $110 billion in tax and spending provisions designed to attract additional support, then grafting on legislation mandating broader mental health coverage in the insurance industry. The revised measure won Senate approval Wednesday night, 74-25, setting up a furious round of lobbying in the House as the administration, congressional leaders, the major party presidential candidates and outside groups joined forces behind the measure.

In addition, the measure was changed to broaden the federal government's deposit insurance program, and the Securities and Exchange Commission loosened a regulation to ease the impact of the distressed assets on the balance sheet of financial institutions.

Despite occasionally strong criticism of the added spending and tax measures, the maneuvers worked — augmented by a sudden switch in public opinion that occurred after the stock market took its largest-ever one-day dive on Monday. "No matter what we do or what we pass, there are still tough times out there. People are mad — I'm mad," said Republican Rep. J. Gresham Barrett of South Carolina, who opposed the measure the first time it came to a vote. Now, he said, "We have to act. We have to act now."

Rep. John Lewis, D-Ga., another convert, said, "I have decided that the cost of doing nothing is greater than the cost of doing something."

Critics were unrelenting.

"How can we have capitalism on the way up and socialism on the way down," said Rep. Jeb Hensarling of Texas, a leader among conservative Republicans who oppose the central thrust of the legislation — an unprecedented federal intervention into the private capital markets.

It was little more than two weeks ago that Paulson and Bernanke concluded that the economy was in such danger that a massive government intervention in the private markets was essential.

White the main thrust of their initial proposal was unchanged, lawmakers insisting on greater congressional supervision over the $700 billion, measures to protect taxpayers and steps to crack down on so-called "golden parachutes" that go to corporate executives whose companies fail.

Earlier in the week, the legislation was altered to expand the federal insurance program for individual bank deposits, and the Securities and Exchange Commission took steps to ease the impact of the questionable mortgage-backed securities on financial institutions.

In the moments before the vote, Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, pledged "serious surgery" next year to address the underlying causes of the crisis.

If anything, the economic news added to the sense of urgency.

The Labor Department said initial claims for jobless benefits had increased last week to the highest level since the gloomy days after the 2001 terror attacks. The news of the payroll cuts came on top of Thursday's Commerce Department report that factory orders in August plunged by 4 percent.

Typifying arguments the problem no longer is just a Wall Street issue but also one for Main Street, lawmakers from California and Florida said their state governments were beginning to experience trouble borrowing funds for their own operations.

Pelosi said, "We must win it for Mr. and Mrs. Jones on Main Street."

One month before Election Day, the drama unfolded in an intensely political atmosphere. Members of the Congressional Black Caucus credited Obama with changing their minds.

Reps. Elijah Cummings and Donna Edwards, both Maryland Democrats, were among them. They said Obama had pledged if he wins the White House that he would help homeowners facing foreclosure on their mortgages. He also pledged to support changes in the bankruptcy law to make it less burdensome on consumers.

Obama's rival, Republican Sen. McCain, announced a brief suspension in his campaign more than a week ago to try and help solve the financial crisis.

Republican Rep. Sue Myrick of North Carolina, who switched her vote to favor the measure, said, "I may lose this race over this vote, but that's OK with me. This is the right vote for the country."

Myrick said she hadn't heard from McCain as she made up her mind about how to vote. "They told

me he was going to call me. He didn't," she said.

The vote on Monday had staggered the congressional leadership and contributed to the largest one-day stock market drop in history, 778 points as measured by the Dow Jones Industrials.

36 hours of alarm and action as crisis spiraled

October 2, 2008

It was early on Wednesday, Sept. 17, when executives at Pershing Square, Bill Ackman's hedge fund, began getting nervous calls and e-mail messages from investors. Ackman, 42, has been a top Wall Street player for 15 years, making his clients - and himself - billions of dollars.

But now, Ackman and his colleagues were taken aback by what they were hearing. His big investors were worried about all of the Pershing assets held by Goldman Sachs, the blue-chip investment bank, whose stock had come under siege.

Never mind that Goldman kept Pershing's assets in a segregated account, and that the money was safe. And never mind that Ackman believed Goldman was the world's best-run investment bank and would come through the credit crisis unscathed. Pershing investors still feared their money might be exposed.

Ackman advised Goldman executives to do something to restore confidence - like getting an infusion of capital from Warren Buffett, the billionaire investor. And while Ackman kept his assets at Goldman, he hurriedly set up accounts at three other institutions - just in case things got much worse.

Pershing had more faith than most. Up and down Wall Street, hedge funds with billions of dollars at Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out and looking for safer havens.

Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors in the United States and other financial centers around the world - not small investors - were panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a global credit crisis looks like. It is not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people cannot see. It is banks refusing to lend to other banks - even though that is one of the most essential functions of the banking system. It is a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman - both of which reported profits, even as the pressure was mounting. It is panicked hedge funds pulling out cash.

It is frightened big investors protecting themselves by buying credit default swaps - a financial insurance policy against potential bankruptcy - at prices 30 times what they normally would pay. It was this 36-hour period two weeks ago - from the morning of Sept. 17 in New York and Washington, to the afternoon of Sept. 18 - that spooked policy makers by opening fissures in the worldwide financial system.

In their rush to do something, and do it fast, the Federal Reserve chairman, Ben Bernanke, and the Treasury secretary, Henry Paulson Jr., concluded that the time had come to use the "break-the-glass" rescue plan they had been developing.

But in their urgency, they bypassed a crucial step in Washington. They fashioned their $700 billion bailout without doing political spadework, which led to a resounding rejection Monday in the House of Representatives.

On that Thursday evening, however, time was of the essence. In a hastily convened meeting in the conference room of the House speaker, Nancy Pelosi, the two men presented, in the starkest terms imaginable, the outline of the $700 billion plan to congressional leaders. "If we don't do this," Bernanke said, according to several participants, "we may not have an economy on Monday."

Setting the stage Wall Street executives and federal officials had known since the previous weekend that it was likely to be a difficult week. With the government refusing to offer the same financial guarantees that had helped save Bear Stearns, Fannie Mae and Freddie Mac, efforts Saturday to find a buyer for Lehman Brothers had failed. Sunday was spent preparing to deal with Lehman's bankruptcy, which was announced Monday morning, thrusting global markets into a new phrase of the 14-month-old financial crisis because of the intricate web of connections between Lehman and just about every international bank. Merrill Lynch, fearing it would be next, had agreed to be bought by Bank of America. American International Group was near collapse. (It would be rescued with an $85 billion loan from the Federal Reserve on Tuesday evening.) With government policy makers appearing to career from crisis to crisis, the Dow Jones industrial average plunged 504 points on Monday, Sept. 15. Panic was in the air. At those weekend meetings, Wall Street executives and federal officials talked about the possibility of contagion - that the Lehman bankruptcy might set off so much fear among global investors that the market "would pivot to the next weakest firm in the herd," as one federal official put it. That firm, everyone knew, was likely to be Morgan Stanley, whose stock had been dropping since the previous Monday, Sept. 8. In the space of three hours Tuesday, Sept. 16, Morgan Stanley shares fell an additional 28 percent, and the rising cost of its credit default swaps suggested investors were predicting bankruptcy. To allay the panic, the firm decided to report its earnings a day early - after the market closed Tuesday afternoon instead of Wednesday morning. The firm's profits were terrific - $1.425 billion, a decline of just 3 percent from 2007 - and the thinking was that would give investors the night to absorb the good news. "I am hoping that this will generally help calm the market," Morgan Stanley's chief financial officer, Colm Kelleher, said in an interview late that afternoon. The spreading contagion But contagion was already spreading. The problem posed by the Lehman bankruptcy was not the losses suffered by hedge funds and other investors who traded stocks or bonds with the firms. As federal officials had predicted, that turned out to be manageable. (That was one reason the government had not stepped in to save the firm.) The real problem was that a handful of hedge funds that used the firm's London office to handle their trades had billions of dollars in balances frozen in the bankruptcy. Diamondback Capital Management, for instance, a $3 billion hedge fund, told its investors that 14.9 percent of its assets were locked up in the Lehman bankruptcy - money it could not extract. A number of other hedge funds were in the same predicament. (When called for comment, Diamondback officials did not answer the phone.) As this news spread, every other hedge fund manager had to worry about whether the balances they had at other Wall Street firms might suffer similarly. And Morgan Stanley and Goldman Sachs were the two biggest firms left that served this back-office role. That is why Ackman's investors were calling him. And that is what caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs,

hedge their exposure by buying credit default swaps that would cover losses if either firm could not pay money they owed - or do both. It was fear, not greed that was driving everyone's actions. Breaking the buck There was another piece of bad news spooking investors - and government officials. On Tuesday, the Reserve Primary Fund, a $64 billion institutional money market fund, and two smaller, related funds, disclosed that they had "broken the buck" and would pay investors no more than 97 cents on the dollar. Money market funds serve a critical role in greasing the wheels of commerce. They use investors' money to make short-term loans, known as commercial paper, to big corporations like General Motors, IBM and Microsoft. Commercial paper is attractive to money market funds because it pays them a higher interest rate than, say, U.S. Treasury bills, but is still considered relatively safe. A run on money funds could force fund managers to shy away from commercial paper, fearing they were no longer safe. One reason given by the Reserve Primary Fund for breaking the buck was that it had bought Lehman commercial paper with a face value of $785 million that was now worth little because of Lehman's bankruptcy. If money market funds became afraid of buying commercial paper that would make it far more difficult for companies to raise the cash needed to pay employees, for instance. At that point, it would not just be the credit markets that were frozen, but commerce itself. Just as important, in the eyes of federal officials, was that money market funds had long been viewed by investors as akin to bank accounts - a safe place to store cash and earn interest on that money. Even though they lacked federal deposit insurance, these funds held $3.4 trillion in assets. Since that Monday, big institutional investors like pension funds and college endowments had been pulling money out of money funds. On Tuesday, individual investors joined the stampede. "We were saying to Treasury and the Fed, at a very high level: Pay attention to this issue. This will have an impact," recalled Greg Ahern, the chief communication officer for the Investment Company Institute, the trade group for the mutual fund industry. But government officials monitoring the crisis did not need the warning. They were already watching money fund outflows with alarm. Surprisingly, stock investors - feeling better because of the government's AIG rescue plan - either did not comprehend or ignored the growing chaos in credit markets; the Dow actually rose 141.51 points on Tuesday. A dark day The respite was brief. Wednesday, Sept. 17, was one of those dark, ugly market days that offers not even a glimmer of hope. Fearing the worst, Alex Ehrlich, the global head of prime services at the Swiss bank UBS, arrived at work in New York at 5 a.m. and immediately started putting out fires. Because he ran the firm's prime brokerage unit, clients were calling to see whether their money was safe. "We were being flooded with client requests to move positions, and the funding markets, which are critically important to prime brokers, were extremely volatile," he said. Within seconds of the market opening, the Dow was down 160 points. Among the big losers was Morgan Stanley. Despite its having disclosed strong earnings late Tuesday, its stock continued to plummet. The Dow rallied in the afternoon, but went into free fall in the last 45 minutes, closing down 449 points. And that was just what investors could see. Behind the scenes, the credit markets had almost completely frozen up. Banks in the United States and Europe were refusing to lend to other banks, and spreads on credit default swaps on financial stocks - the price of insuring against bankruptcy -

veered into uncharted waters. The drain on money funds continued. By the end of business Wednesday, institutional investors had withdrawn more than $290 billion from U.S. money market funds. In what experts call a "flight to safety," investors were taking money out of stocks and bonds and even money market funds and were buying the safest investments in the world: Treasury bills. As a result, yields on short-term Treasury bills dropped close to zero. That was almost unheard of. A chief executive's anger A week before, Morgan Stanley stock had been trading in the mid-40s. On Wednesday, it fell from $28.70 a share to $21.75 - down about 50 percent over a week. "There is no rational basis for the movements in our stock or credit default spreads," Morgan Stanley's chief executive, John Mack, wrote in a company-wide memo Wednesday. Mack lashed out at the people he felt were responsible for Morgan Stanley's troubles: the short-sellers, who profit by betting that a stock will fall. Like most Wall Street firms, Morgan Stanley over the years had handled transactions for short-sellers, despite complaints by other companies that short-sellers unfairly ganged up on their stock. Nevertheless, Mack called Senator Charles Schumer, a Democrat of New York, and Christopher Cox, the chairman of the Securities and Exchange Commission, pressing them to ban short-selling. He raged about what he viewed as a concerted effort to drive down the firm's stock. "He got emotional," says one person who knows him well. Meeting with staff members on Thursday morning as the stock plunged further - hitting a low of $11.70 at midday - Mack said: "Listen. I know everybody is anxious about the stock price. I'm not selling any shares, and neither is my team. But I understand if you're nervous and want to sell some shares." Some did. At the same time, Mack began talks to merge with Wachovia and called other banks about possible combinations. He also called Buffett for advice, while aides in Tokyo made contact with Mitsubishi UFJ, the biggest lender in Japan, hoping to raise additional capital. A run on a fund Even as stocks tanked, turmoil was worsening in money markets. On Wednesday evening, Paul Schott Stevens, the head of the Investment Company Institute, learned about a problem with another money fund. "This time it was Putnam," recalled Stevens, referring to the Boston-based mutual fund company Putnam Investments. Out of the blue, it seemed, there was a run on the $12.3 billion Putnam Prime Money Market Fund. That meant the money fund contagion was spreading. Because of huge withdrawals, Putnam decided it had to shut the fund, and distribute the cash to shareholders. Executives of the Investment Company Institute and fund officials scrambled to find a solution that would keep Putnam from having to take that step, but they failed. On Thursday, Putnam shuttered the fund, then sold it to another company. The Fed takes action Ben Bernanke had spent his career studying financial crises. His first important work as an economist had been a study of the events that led to the Great Depression. Along with several economists, he came up with a phrase, "the financial accelerator," which described how deteriorating market conditions could gather speed until they became unmanageable. To an alarming degree, the credit crisis had played out precisely as his academic work predicted. But his research had also led Bernanke to the view that "situations where crises have really spiraled out of control are where the central bank has been on the sideline," according to Mark Gertler, a New York University economist who has collaborated with Bernanke on some papers. Bernanke had no intention of keeping the Fed on the sidelines. As the crisis deepened, it took more aggressive steps.

Among the steps, it agreed to absorb as much as $29 billion in Bear Stearns losses and made an $85 billion loan to keep AIG afloat. Representative Barney Frank, a Democrat of Massachusetts who leads the House Financial Services Committee, asked Bernanke if the Fed had $85 billion to spare. "We have $800 billion," Bernanke replied, according to Frank. Since the Bear Stearns bailout, Treasury and Fed officials had been discussing what a broad government intervention might look like. Paulson and Bernanke had both assembled teams to map out drastic rescue plans - the "break-the-glass" plans. Almost from the start, they concluded the best systemic solution was to buy hard-to-sell mortgage-backed securities. On Wednesday morning, during a conference call with other top officials, including Jean-Claude Trichet, the president of the European Central Bank, Bernanke sounded them out on a big government bailout. The other officials sounded relieved; their main questions were about whether Congress could act quickly. That evening, Bernanke told Paulson during a conference call: "You have to go to Congress. This is pervasive." Paulson agreed. Asian markets fall By Thursday morning, the need for dramatic action had grown even more urgent. In Asia, where the markets had already closed, stocks in Hong Kong had dropped 4.7 percent, and 2.2 percent in Tokyo. To quell fears before the opening of European markets, the Fed and other central banks announced, at 9 a.m. in Europe, that they would make $180 billion available, in an effort to get banks to start lending to each other again. The Fed had agreed to open its discount window to make loans available to money market funds to prevent further runs. For a time in Europe the central bank actions succeeded in breaking the panic in credit markets and encouraging a brief rally in the stock markets. But at 8:30 Thursday morning in Washington, when Paulson and Bernanke reviewed the state of affairs, they remained convinced that the crisis was not easing up. One bank's solution Lloyd Blankfein, Goldman Sachs's chief executive, had arrived at the firm's office in Manhattan just before 7 a.m. Thursday, anticipating another bad day. The investment bank's stock had already been pummeled. From a peak of nearly $250 a share last October, it had fallen to $114.50 on Wednesday - after hitting a low of $97.78 during the day. One idea Blankfein had been exploring was to transform Goldman into a bank holding company. Mack, meantime, was also considering such a move for Morgan Stanley, and both were in separate discussions with the Fed. There was safety in that notion - they would become depository institutions regulated by the Fed and others - even though it also meant they would not be able to pile on as much debt as they had as investment banks. That would hurt profits. But now profits were less pressing than survival. Blankfein accelerated the planning. By 1 p.m., the Dow had fallen another 150 points - meaning that in a day and a half it was down nearly 600 points. Goldman's stock dropped to $85.88, its lowest in nearly six years. Just then, a prankster piped the national anthem "The 'Star Spangled Banner" over the firm's loudspeaker system on the 50th floor. Fixed-income traders stopped and stood at attention, some with hands on their hearts. Oddly, it was at precisely that moment that the U.S. market - and Goldman's shares - started to rise. The traders began to cheer. Curbing short-selling What happened? At 1 p.m. New York time, Britain's Financial Services Authority, which regulates its

financial institutions, announced a ban on short-selling of 29 financial stocks that would last at least 30 days. Realizing that the Securities and Exchange Commission was likely to follow suit, U.S. hedge funds began "covering their shorts" - that is, buying the stocks they had borrowed to short, even if it meant taking a loss. That caused all kinds of stocks to begin rising. Sure enough, the SEC followed suit the next day - placing a temporary short-selling ban on 799 financial stocks. A few hours later came the second event. At 3:01 CNBC reported that the Treasury and the Fed were planning a giant fund to buy toxic mortgage-backed assets from financial institutions. Though there had been hints of this earlier in the afternoon, and stocks had started rising around 2:30, the wide dissemination set off a huge rally. In a 45-minute burst, the Dow gained another 300 points, closing the day up 410 points. Meeting on Capitol Hill Two hours later, Paulson and Bernanke trooped up to Capitol Hill for a somber session with congressional leaders. "That meeting was one of the most astounding experiences I've had in my 34 years in politics," recalled Schumer. As the congressmen and their aides listened, the two laid out their plan. They would begin offering federal insurance to money market funds immediately, in order to stop the run on money funds. In addition, the SEC would institute a ban on short-selling of financial stocks. Although Treasury officials concede the move was mostly symbolic - investors can still buy put options that have the same effect as shorting stocks - they did it mainly "to scare the hell out of everybody," as one official put it. After Bernanke made his remark about the possibility that there might not be an economy on Monday without this plan, you could hear a pin drop. Congressional leaders were near unanimous in saying that it needed to be done for the good of the country. Representative John Boehner of Ohio - the Republican House leader - said it was time to put politics aside and move quickly, according to several participants. (An aide to Boehner denied that he voiced support for the plan, only that he made a plea for cooperation.) Hearing that Bernanke and Paulson wanted legislation passed in a matter of days, Senator Harry Reid, the majority leader, expressed astonishment. "This is the United States Senate," he said. "We can't do it in that time frame." His Republican counterpart, Senator Mitch McConnell, replied, "This time we can." He was wrong. After a week of wrangling, political in-fighting and compromise, the House on Monday voted down the legislation. The Dow plunged nearly 778 points, and credit markets had worsened, with interest rates rising and loans becoming harder to obtain. On Wednesday, the Senate approved the bailout. And two weeks after Paulson and Bernanke made their appeal, the House plans to try again.

Timeline Graphic from IHT

How U.S. regulators laid the groundwork for disaster October 3, 2008

"We have a good deal of comfort about the capital cushions at these firms at the moment." — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets — more than enough to weather the storm.

Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase backed by a $29 billion taxpayer dowry.

Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom Merrill Lynch sold itself to Bank of America, Lehman Brothers filed for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial banks.

How could Cox have been so wrong?

Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency's failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary. A lone dissenter a software consultant and expert on risk management weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.

One commissioner, Harvey Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told those with assets greater than $5 billion.

"We've said these are the big guys," Goldschmid said, provoking nervous laughter, "but that means if anything goes wrong, it's going to be an awfully big mess."

Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul Sarbanes when he rewrote the nation's corporate laws after a wave of accounting scandals. "Do we feel secure if there are these drops in capital we really will have investor protection?" Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks' balance sheets.

Annette Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.

"I'm very happy to support it," said Commissioner Roel Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: "And I keep my fingers crossed for the future."

The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.

After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the then-chairman, William Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms' own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio a measurement of how much the firm was borrowing compared to

its total assets rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.

The 2004 decision for the first time gave the SEC a window on the banks' increasingly risky investments in mortgage-related securities. But the agency never took true advantage of that part of the bargain. The supervisory program under Cox, who arrived at the agency a year later, was a low priority.

The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Cox more than a year and a half ago.

The few problems the examiners preliminarily uncovered about the riskiness of the firms' investments and their increased reliance on debt clear signs of trouble were all but ignored.

The commission's division of trading and markets "became aware of numerous potential red flags prior to Bear Stearns's collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain" capital standards, said an inspector general's report issued last Friday. But the division "did not take actions to limit these risk factors."

Drive to Deregulate

The commission's decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President George W. Bush.

A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies.

"It's a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs," said Roderick Hills, a Republican who was chairman of the SEC under President Gerald Ford. "The problem with such voluntary programs is that, as we've seen throughout history, they often don't work."

As was the case with other agencies, the commission's decision was motivated by industry complaints of excessive regulation at a time of growing competition from overseas. The 2004 decision was aimed at easing regulatory burdens that the European Union was about to impose on the foreign operations of United States investment banks.

The Europeans said they would agree not to regulate the foreign subsidiaries of the investment banks on one condition that the commission regulate the parent companies, along with the brokerage units that the SEC already oversaw.

A 1999 law, however, had left a gap that did not give the commission explicit oversight of the parent companies. To get around that problem, and in exchange for the relaxed capital rules, the banks volunteered to let the commission examine the books of their parent companies and subsidiaries.

The 2004 decision also reflected a faith that Wall Street's financial interests coincided with Washington's regulatory interests.

"We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing," said Professor James Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).

"Letting the firms police themselves made sense to me because I didn't think the SEC had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We've all learned a terrible lesson," he added.

In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities. A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Indiana, who said the computer models run by the firms which the regulators would be relying on could not anticipate moments of severe market turbulence.

"With the stroke of a pen, capital requirements are removed!" the consultant, Leonard Bole, wrote to the commission on Jan. 22, 2004. "Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?"

He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.

Bole, who earned a master's degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements. He said in a recent interview that he was never called by anyone from the commission. "I'm a little guy in the land of giants," he said. "I thought that the reduction in capital was rather dramatic."

Policing Wall Street

A once-proud agency with a rich history at the intersection of Washington and Wall Street, the Securities and Exchange Commission was created during the Great Depression as part of the broader effort to restore confidence to battered investors. It was led in its formative years by heavyweight New Dealers, including James Landis and William O. Douglas. When President Franklin D. Roosevelt was asked in 1934 why he appointed Joseph Kennedy, a spectacularly successful stock speculator, as the agency's first chairman, Roosevelt replied: "Set a thief to catch a thief."

The commission's most public role in policing Wall Street is its enforcement efforts. But critics say that in recent years it has failed to deter market problems. "It seems to me the enforcement effort in recent years has fallen short of what one Supreme Court justice once called the fear of the shotgun behind the door," said Arthur Levitt Jr., who was SEC chairman in the Clinton administration. "With this commission, the shotgun too rarely came out from behind the door."

Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.

Under Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.

Cox dismantled a risk management office created by Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Paulson, the Treasury secretary, that proposed to reduce their stature and that of the SEC Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency.

In the process, Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors.

'Stakes in the Ground'

Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks. "The last six months have made it abundantly clear that voluntary regulation does not work," Cox said. The decision to shutter the program came after Cox was blamed by Senator John McCain, the Republican presidential candidate, for the crisis. McCain has demanded Cox's resignation.

Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general's report have suggested that a major reason for its failure was Cox's use of it.

"In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the SEC didn't oversee well enough," Goldschmid said in an interview. He and Donaldson left the commission in 2005.

Cox declined requests for an interview. In response to written questions, including whether he or the commission had made any mistakes over the last three years that contributed to the current crisis, he said, "There will be no shortage of retrospective analyses about what happened and what should have happened." He said that by last March he had concluded that the monitoring program's "metrics were inadequate."

He said that because the commission did not have the authority to curtail the heavy borrowing at Bear Stearns and the other firms, he and the commission were powerless to stop it.

"Implementing a purely voluntary program was very difficult because the commission's regulations shouldn't be suggestions," he said. "The fact these companies could withdraw from voluntary supervision at their discretion diminished the mandate of the program and weakened its effectiveness. Experience has shown that the SEC could not bootstrap itself into authority it didn't have."

But critics say that the commission could have done more, and that the agency's effectiveness comes from the tone set at the top by the chairman, or what Levitt, the longest-serving SEC chairman in history, calls "stakes in the ground."

"If you go back to the chairmen in recent years, you will see that each spoke about a variety of issues that were important to them," Levitt said. "This commission placed very few stakes in the ground."

Paul Krugman: A leadership vacuum

October 3, 2008 As recently as three weeks ago it was still possible to argue that the state of the U.S. economy, while clearly not good, wasn't disastrous - that the financial system, while under stress, wasn't in full meltdown and that Wall Street's troubles weren't having that much impact on Main Street.

But that was then.

The financial and economic news since the middle of last month has been really, really bad. And what's truly scary is that we Americans are entering a period of severe crisis with weak, confused leadership.

The wave of bad news began on Sept. 14. Henry Paulson, the Treasury secretary, thought he could

get away with letting Lehman Brothers, the investment bank, fail; he was wrong. The plight of investors trapped by Lehman's collapse - as an article in The New York Times put it, Lehman became "the Roach Motel of Wall Street: They checked in, but they can't check out" - created panic in the financial markets, which has only grown worse as the days go by. Indicators of financial stress have soared to the equivalent of a 107-degree fever, and large parts of the financial system have simply shut down.

There's growing evidence that the financial crunch is spreading to Main Street, with small businesses having trouble raising money and seeing their credit lines cut. And leading indicators for both employment and industrial production have turned sharply worse, suggesting that even before Lehman's fall, the economy, which has been sagging since last year, was falling off a cliff.

How bad is it? Normally sober people are sounding apocalyptic. On Thursday, the bond trader and blogger John Jansen declared that current conditions are "the financial equivalent of the Reign of Terror during the French Revolution," while Joel Prakken of Macroeconomic Advisers says that the economy seems to be on "the edge of the abyss."

And the people who should be steering us away from that abyss are out to lunch.

The House will probably vote Friday on the latest version of the $700 billion bailout plan - originally the Paulson plan, then the Paulson-Dodd-Frank plan, and now, I guess, the Paulson-Dodd-Frank-Pork plan (it's been larded up since the House rejected it on Monday). I hope that it passes, simply because we're in the middle of a financial panic, and another no vote would make the panic even worse. But that's just another way of saying that the economy is now hostage to the Treasury Department's blunders.

For the fact is that the plan on offer is a stinker - and inexcusably so. The financial system has been under severe stress for more than a year, and there should have been carefully thought-out contingency plans ready to roll out in case the markets melted down. Obviously, there weren't: the Paulson plan was clearly drawn up in haste and confusion. And Treasury officials have yet to offer any clear explanation of how the plan is supposed to work, probably because they themselves have no idea what they're doing.

Despite this, as I said, I hope the plan passes, because otherwise we'll probably see even worse panic in the markets. But at best, the plan will buy some time to seek a real solution to the crisis. And that raises the question: Do we have that time?

A solution to America's economic woes will have to start with a much better-conceived rescue of the financial system - one that will almost surely involve the U.S. government taking partial, temporary ownership of that system, the way Sweden's government did in the early 1990s. Yet it's hard to imagine the Bush administration taking that step.

We also desperately need an economic stimulus plan to push back against the slump in spending and employment. And this time it had better be a serious plan that doesn't rely on the magic of tax cuts, but instead spends money where it's needed. (Aid to cash-strapped state and local governments, which are slashing spending at precisely the worst moment, is also a priority.) Yet it's hard to imagine the Bush administration, in its final months, overseeing the creation of a new Works Progress Administration.

So we probably have to wait for the next administration, which should be much more inclined to do the right thing - although even that's by no means a sure thing, given the uncertainty of the election outcome. (I'm not a fan of Paulson's, but I'd rather have him at the Treasury than, say, Phil "nation of whiners" Gramm.)

And while the election is only 32 days away, it will be almost four months until the next administration takes office. A lot can - and probably will - go wrong in those four months.

One thing's for sure: The next administration's economic team had better be ready to hit the ground running, because from day one it will find itself dealing with the worst financial and economic crisis since the Great Depression.

For bailout to work, housing market needs to mend Oct. 3rd

Washington's financial bailout plan is now law. So the credit spigot will start flowing again, banks will resume lending, and an economic recovery can begin, right?

Wrong--Experts say the most important thing that needs to happen before the $700 billion bailout even has a chance of working: Home prices must stop falling. That would send a signal to banks that the worst has passed and it's safe to start doling out money again.

The problem is the lending freeze has made getting a mortgage loan tough for everyone except those with sterling credit. That means it will take several months or longer to pare down the glut of houses built when times were good — and those that have come on the market because of soaring foreclosures — before home prices start appreciating.

Housing is a critical component to the U.S. economy and by extension the availability of credit. Roughly one in eight U.S. jobs depends on housing directly or indirectly — from construction workers to bank loan officers to big brokers on Wall Street. A turnaround in housing prices would boost confidence in the wider economy and, experts hope, goad banks into lending again.

"Housing traditionally does lead the economy through a recovery. I think it's going to be critical for a sustained recovery in this cycle, too," said Gary Thayer, senior economist at Wachovia Securities.

The dilemma boils down to a matter of trust.

"Credit, by definition, means trust and faith, and for many reasons trust and faith have been damaged," said Sung Won Sohn, an economics professor at California State University, Channel Islands. Sohn said the near certainty of a recession makes it too risky for the thousands of small and medium-sized banks across the country to lend to people like Elliot.

"Banks know the economy is getting worse, so ... they will keep being cautious," said Sohn, a former banking executive.

Still, the government hopes that by scooping up billions of dollars in bad mortgage debt and other toxic assets, banks eventually can clean up their shaky balance sheets, crack open the vaults and send money washing through the system again.

The rescue plan also raises the federally insured deposit limit from $100,000 to $250,000, a move that could boost banks' reserves and further grease the lending wheels.

Rep. Barney Frank, D-Mass., the Financial Services Committee chairman and a key negotiator over the past weeks, said the measure was just the beginning of a much larger task Congress will tackle next year: overhauling housing policy and financial regulation in a legislative effort comparable to the New Deal.

In the meantime, the Treasury Department is moving swiftly to get the plan started. Treasury Secretary Henry Paulson said Friday he did not wait for final approval of the measure to begin preparation. He has been lining up outside advisers as his staff works out details on a multitude of

complex issues.

But several hurdles could trip up the plan. For starters, even when the Treasury starts buying bad assets, some banks may hoard the cash they receive in return until they see how the plan pans out. That has the potential to make the lending logjam worse, said Vincent R. Reinhart, former director of the Federal Reserve's monetary affairs division.

"They may sit on the sidelines and wait to see (the bailout) get some traction. The problem is if everybody sits on the sidelines, nobody gets in the game. It's a risk," he said.

It also creates a vicious cycle: No trust means no lending; tight credit means it's harder to buy a home; the more difficult it is to buy or sell a home, the further home prices will fall; and the further prices drop, the more foreclosures there will be.

U.S. home prices — down 20 percent from their peak in July 2006 — still have further to fall, and must hit bottom before demand picks up. The long-awaited bottom in prices could be a year or more away.

But Jim Gillespie, chief executive of Coldwell Banker Real Estate, said he hopes that lower prices, combined with the government's actions will jump-start stagnant demand. The federal bailout plan, he said, "will give people reassurance that mortgage money is available."

Jobs are another big concern. The stranglehold on credit has choked companies big and small that depend on regular inflows of borrowed money to pay employees and stay afloat.

The Labor Department said Friday that employers cut 159,000 jobs in September, the fastest pace of losses in more than five years. Experts say that number will grow as the effects of the credit gridlock course through the economy in coming days and weeks.

The nation's unemployment rate is now 6.1 percent, up from 4.7 percent a year ago. Over the last year, the number of unemployed people has risen by 2.2 million to 9.5 million. The unemployment rate could rise to as high as 7.5 percent by late 2009, economists predict. If that happens, it would mark the highest since after the 1990-91 recession.

Boosting employment is critical to kick-starting lending because "if jobs are growing, then incomes are a growing, and if incomes are growing then people are consuming," Reinhart said.

Consumers and businesses have retrenched so much that some analysts fear the economy stalled or shrank in the third quarter that ended last week. The Labor Department report Friday showed wage growth for workers is slowing, meaning they'll be more hard-pressed to spend, especially for something as expensive as a home.

Many economists predict the economy will contract in the final quarter of 2008 and the first quarter of next year. That would meet the classic definition of a recession — two consecutive quarters of a shrinking economy.

One bright spot: optimism hasn't been totally squashed yet.

Morgan Cavanaugh, proprietor of Moriarty's Pub in downtown Cleveland, has been trying to sell another bar he owns to ease his workload, but the prospective buyer hasn't been able to raise the money. Now that the bailout legislation has the green light, he's hopeful he'll get a deal done.

"It passed. Let's work something out," Cavanaugh told the man over a cell phone Friday just after the House approved the plan. He flipped the phone shut and smiled from behind the weathered mahogany bar of his 75-year-old Irish pub. "He's going to put the loan request in again. It's looking up," Cavanaugh said.

A Snarl of Regulation

October 5, 2008 Who's to blame for the implosion of financial markets? The finger-pointing has gone in every direction, and it's easy to see why: the regulatory structure points in every direction. The apparatus that oversees the nation's financial system is an ad hoc creation: every time there is a fiscal panic, new agencies are formed and existing ones receive new responsibilities. This is the first crisis since the 1987 market crash, and financial institutions and products have changed rapidly in the last 20 or so years, exposing regulatory redundancies and enormous gaps, like a lack of oversight for some derivatives and credit default swaps. In March, Treasury Secretary Henry M. Paulson Jr. issued a plan to revamp regulation and modernize the system, but at the time, most lawmakers and lobbyists considered it far down the list of priorities and unlikely to be adopted. "Few, if any, will defend our current Balkanized system as optimal," Mr. Paulson shot back to critics in a speech that month at the Treasury Department. One change in the Treasury's plan would have expanded the role of the President's Working Group on Financial Markets, which is headed by the Treasury secretary and consists of the top officials from the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission. Other proposed changes would have broadened the authority of the Federal Reserve. The plan offered both regulatory and deregulatory elements and seemed to satisfy no one. With a growing chorus of officials saying the present system is in shambles, however, a regulatory overhaul by the next Congress seems likely. Howell E. Jackson, a Harvard Law professor and author of a book on the regulation of financial institutions, says it is likely that lawmakers will give the Federal Reserve more regulatory power and they may forge new oversight agencies. "If history is a guide," he said, "you'd have to bet that the most likely result is for us to come out of the crisis with more regulatory agencies than we had going in."

Europeans scramble to save failing banks Germany joined Ireland and Greece on Sunday in guaranteeing all private savings accounts, putting Europe's biggest economy at odds with calls for a unified European response to the global financial meltdown.

The decision came as governments across Europe scrambled to save failing banks, working largely on their own a day after leaders of the continent's four biggest economies called for tighter regulation and a coordinated response.

Chancellor Angela Merkel said that no citizen should fear for the safety of their investments, speaking to reporters as her government held crisis talks on the collapse of a ballyhooed euro35

billion (US$48.4 billion) bailout of Hypo Real Estate AG, the country's second- biggest property lender.

In Iceland — particularly hard-hit by the credit crunch — government officials and banking chiefs were discussing a possible rescue plan for the country's overstretched commercial banks.

Belgian Prime Minister Yves Leterme said he aims to find a new owner for troubled bank Fortis NV to restore confidence in the company before the opening of markets on Monday.

Leterme told two media outlets that government officials were going over a takeover bid for Fortis' Belgian operations. The bank's Dutch operations were nationalized amid fears they could go insolvent.

British treasury chief Alistair Darling said that he was ready to take "pretty big steps that we wouldn't take in ordinary times" to help the country in weather the credit crunch.

In the past year the government has acted to nationalize struggling mortgage lenders Northern Rock and Bradford & Bingley.

"The European banking industry is feeling the wind of default blowing from the other side of the Atlantic," said Axel Pierron, senior vice president at Celent, a Boston, Massachusetts-based financial research and consulting firm.

The erosion has also been seen in overall confidence and concern among investors, politicians and the European public, too.

The leaders of Germany, France, Britain and Italy met Saturday to discuss the growing meltdown which has leapfrogged across the Atlantic from the U.S. to Europe, but shied away from the massive US$700 billion (euro506 billion) bailout passed by the U.S. Congress a day earlier that President Bush signed into law.

Their failure to agree an EU-wide plan showcased the divisions in Europe on how to deal with the crisis.

France had suggested a multibillion-euro (multibillion-dollar) EU-wide government bailout plan, but backed off after Germany said banks must find their own way out.

Hypo Real Estate said Saturday that the rescue plan had fallen apart after private lenders withdrew support, a key element to the proposal that had already been approved by the EU earlier this week.

Icelandic banks expanded rapidly after deregulation of the domestic financial market in the 1990s and now have combined foreign liabilities in excess of euro100 billion (US$138.34 billion) — dwarfing the tiny country's gross domestic product of euro14 billion (US$19.37 billion.

The government last week took over Iceland's third-largest bank, Glitnir, a decision that prompted major credit ratings agencies to downgrade both Iceland's four major banks and its government credit rating.

Looming large was a growing sense that the Federal Reserve and Europe's major central banks — which have been flooding euros and dollars to banks that have become increasingly stingy about lending money even to themselves — were ready to institute emergency cuts to their benchmark

interest rates this week.

None of the banks, including the European Central Bank and Bank of England, have commented on potential rate hikes or cuts. But analysts believe the Bank of England, which meets this Thursday, will likely lower its rate from 5 percent. The ECB left its rate unchanged at 4.25 percent on Thursday, but opened the door to a rate cut.

Robert Brusca, chief economist at the New York-based Fact and Opinion Economics, said that the ECB does issue such a cut it would a be a sign "that they're really, really scared."

The bailout bill passes, but the meltdown continues

October 5, 2008

After the U.S. Senate approved the $700 billion bank bailout, the majority leader, Harry Reid, tried to persuade his colleagues to address another economic calamity before they left town for the long election recess. He urged them to extend unemployment benefits for 800,000 jobless Americans.

In the face of Republican opposition, the measure failed. Benefits start expiring this week. So much for Main Street.

If it works as promised, the bailout will thaw the credit freeze and keep more banks from going under. But it is unlikely to save even more Americans from losing their jobs and homes.

The Labor Department reported Friday that 159,000 jobs were lost in September. That is the biggest monthly drop in five years and the ninth straight month of job contraction. It brings total job losses for this year to 760,000.

Of the 9.5 million Americans now out of work, two million have been jobless for more than six months. Nearly 6.1 million people are working part time because they cannot find full-time work or because slack business conditions have led to fewer hours - and less pay.

Cutbacks in hours and pay are especially pernicious because for most of the Bush years, wage growth has lagged behind worker productivity and prices. As Americans have worked harder they have fallen further behind. The only good news - if you can call it that - was that credit was easy.

As a result, many Americans today have no savings and are deep in debt. That means they are even less prepared to take care of themselves and their families when they lose their jobs.

Conditions are only getting worse. Personal spending stagnated in August, the latest month with government data. Auto sales plunged in September. Factory orders are off. New home sales fell to a 17-year low in August, according to the Census Bureau. And home prices continued to fall sharply in July, for a decline of 16.3 percent over 12 months, according to the Standard & Poor's/Case-Shiller index of prices in 20 major cities. There is no sign that prices have hit their bottom.

Exports, the one bright spot, are also set to fall, because many other nations took part in America's financial follies and are now faltering as well.

All that weakness means that more Americans will lose their jobs in the months to come. Extending unemployment benefits is the least that Congress can do to help. The House overwhelmingly passed

a bill to do that before it left Washington last week. The Senate must take the bill up as soon as it returns for its lame duck session.

There is a lot more work to do to fill in the gaps of the bailout bill. It does virtually nothing to prevent foreclosures and keep Americans in their homes. Congress must finally change the code to allow a bankruptcy court to reduce the size of bankrupt borrowers' mortgages.

A new stimulus bill must also be crafted. It must include bolstered food stamps and aid to states and cities, so that they can continue to provide health care and keep paying for construction and other projects that provide desperately needed jobs.

The meltdown on Wall Street is only part of a larger meltdown, and the bailout bill is only one attempt at a fix.

Financial crises spread in Europe By Floyd Norris

October 6, 2008 European nations scrambled on Sunday night to prevent a growing credit crisis from bringing down major banks and alarming savers as troubles in financial markets spread around the world, accelerating economic downturns on three continents.

The German government moved to guarantee all private savings accounts in the country on Sunday, hoping to reassure depositors who had grown nervous as efforts to bail out a large German lender and a major European financial company failed.

Late Sunday, it was disclosed that new bailouts had been arranged for both of those companies, Hypo Real Estate, the German lender, and Fortis, a large banking and insurance company based in Belgium but active across much of the Continent.

The spreading worries came days after the United States Congress approved a $700 billion bailout package that officials had hoped would calm financial markets globally.

The moves came as a merger fight in the United States continued to be played out. Court hearings were under way in New York on Sunday over competing efforts by Citigroup and Wells Fargo to acquire Wachovia, a large bank that nearly failed a week ago.

In Europe, meanwhile, the crisis appears to be the most serious one to face the Continent since a common currency, the euro, was created in 1999. Jean Pisani-Ferry, director of the Bruegel research group in Brussels, said Europe confronted "our first real financial crisis and it's not just any crisis. It's a big one."

The European Central Bank has aggressively lent money to banks as the crisis has grown. It had resisted lowering interest rates, but signaled on Thursday that it might cut rates soon. The extra money, aimed at ensuring that banks would have adequate access to cash, has not reassured savers or investors, and European stock markets have performed even worse than the American markets.

In Berlin, Chancellor Angela Merkel and her finance minister, Peer Steinbrück, appeared before television cameras to promise that all bank deposits would be protected, although it was not clear whether legislation would be needed to make that promise good.

Mindful of the rising public anger at the use of public money to buttress the business of high-earning bankers, Merkel promised a day of reckoning for them as well. "We are also saying that those who

engaged in irresponsible behavior will be held responsible," she said. "The government will ensure that. We owe it to taxpayers."

Stock markets fell sharply in early trading on Monday in Asia on growing fears about the health of European banks and the resilience of the global economy.

The Nikkei 225 index dropped 3 percent in Tokyo on Monday, while Kospi index in Seoul and the Standard and Poor's/Australian Stock Exchange 200 index in Sydney both declined 3.3 percent. The events in Berlin and Brussels underscored the failure of Europe's case-by-case approach to restoring confidence in the Continent's increasingly jittery banking sector. A European summit meeting Saturday night did little to calm worries.

President Nicolas Sarkozy of France and his counterparts from Germany, Britain and Italy vowed to prevent a Lehman Brothers-like bankruptcy in Europe but they did not offer an American-style bailout package.

The crisis has underlined the difficulty of taking concerted action in Europe because its economies are far more integrated than its governing structures.

"We are not a political federation," Jean-Claude Trichet, the president of the European Central Bank, said. "We do not have a federal budget."

Last week, Ireland moved to guarantee both deposits and other liabilities at six major banks. There was grumbling in London and Berlin about the move giving those banks an unfair advantage. But Germany proposed its deposit guarantee Sunday after Britain raised its guarantee to £50,000, or almost $90,000, from £35,000.

Unlike in the United States, where deposits are fully guaranteed up to a limit of $250,000 — a figure that was raised from $100,000 last week — deposits in most European countries have been only partially guaranteed, sometimes by groups of banks rather than governments. In Germany, the first 90 percent of deposits up to 20,000 euros, or about $27,000, was guaranteed.

The Paris meeting produced a promise that European leaders would work together to halt the financial crisis and reassure nervous investors, but even before the meeting began it was becoming clear that two bailouts announced the week before had not succeeded and that a major Italian bank might be in trouble. That bank, UniCredit, announced plans on Sunday to raise as much as 6.6 billion euros, or $9 billion, in capital.

Fortis, which only a week ago received 11.2 billion euros from the governments of the Netherlands, Belgium and Luxembourg, was unable to continue its operations. On Friday, the Dutch government seized its operations in that country, and Sunday night the Belgian government helped to arrange for BNP-Paribas, the French bank, to take over what was left of the company.

In Berlin, the government arranged a week ago for major banks to lend 35 billion euros to Hypo, but that fell apart when the banks concluded that more money would be needed. Late Sunday, the government said a 50 billion euro package had been arranged, with the government and other banks participating.

The credit crisis began in the United States, a fact that has led European politicians to claim superiority for their country's financial systems, in contrast to what Silvio Berlusconi, Italy's prime minister, called the "speculative capitalism" of the United States. On Saturday, Gordon Brown, the British prime minister, said the crisis "has come from America," and Berlusconi bemoaned the lack of business ethics that had been exposed by the crisis.

Many of the European banks' problems have stemmed from bad loans in Europe, and Fortis got into trouble in part by borrowing money to make a major acquisition. But activities in the United States have played a role. Bankers said Sunday that the additional need for funds at Hypo came from newly discovered guarantees it had issued to back American municipal bonds that it had sold to investors.

The credit market worries came on top of heightening concerns about economic growth in Europe and the United States. Many economists think there are recessions in both areas, and one also appears to have started in Japan, where the Nikkei newspaper reported Monday that a poll of corporate executives found that 94 percent thought the country's economy was deteriorating.

"Unless there is a material easing of credit conditions," said Bob Elliott of Bridgewater Associates, an American money management firm, after the retail sales figures were announced, "it is unlikely that demand will turn around soon."

Almost unnoticed as the United States Congress approved a $700 billion bailout for banks last week, it also agreed to guarantee $25 billion in loans for America's troubled automakers. European automakers said Sunday they would seek similar aid from the European Commission.

Henry Paulson Jr., the United States Treasury secretary, hoped that approval of the American bailout, which will involve buying securities from banks at more than their current market value, would free up credit by making cash available for banks to lend and by reassuring participants in the credit markets.

But that did not happen last week. Instead, credit grew more expensive and harder to get as investors became more skittish about buying commercial paper, essentially short-term loans to companies. Rates on such loans rose so fast that some feared the market could essentially close, leaving it to already-stressed banks to provide short-term corporate loans.

Altria, the parent company of the cigarette maker Philip Morris, said lenders wanted it to delay its planned $10.3 billion acquisition of UST, another tobacco maker, until 2009, but promised it would complete the deal.

Europe's need to scramble is in part the legacy of a decision to establish the euro, which 15 countries now use, but not follow up with a parallel system of cross-border regulation and oversight of private banks.

"First we had economic integration, then we had monetary integration," said Sylvester Eijffinger, a member of the monetary expert panel advising the European parliament. "But we never developed the parallel political and regulatory integration that would allow us to face a crisis like the one we are facing today," he added.

In Brussels, Daniel Gros, director of the Center for European Policy Studies, agreed. "Maybe they will be shocked into thinking more strategically instead of running behind events," he said. "The later you come, the higher the bill."

While the European Central Bank has power over interest rates and broader monetary policy, it was never granted parallel oversight of private banks, leaving that task to dozens of regulators across the Continent.

This patchwork system includes national central banks in each of the euro-zone's 15 members and they still retain broad powers within their own borders, further complicating any regional approach to problem-solving.

The European economic landscape today bears little resemblance to the 1990s, when the groundwork for the euro was laid. Back then, Pisani-Ferry recalled, few banks in Europe had cross-border operations on a significant scale.

It was a wave of mergers over the last decade that created giants like HSBC and Deutsche Bank, which straddle countries and continents and have major American exposure.

"The European banking landscape was transformed fairly recently," Pisani-Ferry said. "When the euro was first introduced, the question of cross-border regulation didn't really arise."

Optimists say one potential long-term benefit from the current turmoil is that it often takes a crisis to propel European integration forward.

"Progress in Europe is usually the result of a crisis," Eijffinger said. "This could be one of those rare moments in EU history."

How an embrace of risk tripped up Fannie Mae October 5, 2008

"Almost no one expected what was coming. It's not fair to blame us for not predicting the unthinkable." - Daniel Mudd, former chief executive of Fannie Mae.

When the mortgage giant Fannie Mae recruited Daniel Mudd, he told a friend he wanted to work for an altruistic business. Already a decorated U.S. Marine and a successful executive, he wanted to be a role model to his four children - just as his father, the television journalist Roger Mudd, had been to him.

Fannie, a government-sponsored company, had long helped Americans get more affordable home loans by serving as a powerful middleman, buying mortgages from lenders and banks and then holding or reselling them to Wall Street investors. This allowed banks to make even more loans - expanding the pool of homeowners and permitting Fannie to ring up handsome profits along the way.

But by the time Mudd became Fannie's chief executive in 2004, his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.

So Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.

For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the U.S. housing market and the economy.

Dozens of interviews, most with people who requested anonymity to avoid legal repercussions, offered an inside account of the critical juncture when Fannie Mae's new chief executive took additional risks that pushed his company, and, in turn, a large part of the country's financial health, to the brink.

From 2005 to 2008, Fannie purchased or guaranteed at least $230 billion in loans to risky borrowers - more than three times as much as in all its earlier years combined, according to company filings and industry data.

"We didn't really know what we were buying," said Marc Gott, a former director in Fannie's loan servicing department. "This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears."

Last month, the White House had to orchestrate a $200 billion rescue of Fannie and its corporate cousin, Freddie Mac. On Sept. 26, the companies disclosed that U.S. government prosecutors and the Securities and Exchange Commission were investigating potential accounting and governance problems.

Mudd said during an interview that he responded as best he could given the company's challenges, and worked to balance risks prudently.

"Fannie Mae faced the danger that the market would pass us by," he said. "We were afraid that lenders would be selling products we weren't buying, and Congress would feel like we weren't fulfilling our mission. The market was changing, and it's our job to buy loans, so we had to change as well."

When Mudd arrived at Fannie eight years ago, it was the beginning a rapid expansion that, at its peak, had it buying 40 percent of all U.S. mortgages.

Just two decades earlier, Fannie had been on the brink of bankruptcy. But chief executives like Franklin Raines and the chief financial officer J.Timothy Howard built it into a financial juggernaut by aiming to tap new markets.

Fannie never actually made loans. It was essentially a mortgage insurance company, buying mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan if the borrower defaulted. The only real danger was that the company might guarantee questionable mortgages and lose out when large numbers of borrowers walked away from their obligations.

So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie's stock price and rewarded top executives with tens of millions of dollars. Raines received about $90 million from 1998 to 2004, while Howard was paid about $30.8 million, according to regulators. Mudd collected more than $10 million in his first four years at Fannie.

Whenever competitors asked Congress to rein in the company, lawmakers were besieged with letters and phone calls from angry constituents, some orchestrated by Fannie itself. One automated phone call warned voters: "Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership."

The ripple effect of Fannie's plunge into riskier lending was profound. Fannie's stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks.

From 2001 to 2004, the overall subprime mortgage market - loans to the riskiest borrowers - grew to $540 billion from $160 billion, according to Inside Mortgage Finance, a trade publication. Communities were inundated with billboards and fliers from subprime-loan providers offering to help almost anyone buy a home.

Within a few years of Mudd's arrival, Fannie was the most powerful mortgage company on earth.

Then it began to crumble.

Regulators, incited by the revelation of a wide-ranging accounting fraud at Freddie Mac, began scrutinizing Fannie Mae's books. In 2004 they accused Fannie of fraudulently concealing expenses to make its profits look bigger.

Howard and Raines resigned. Mudd was quickly promoted to the top spot.

But the company he inherited was becoming a shadow of its former self.

Washington bore down on Mudd as well. The same year he took the top position, regulators sharply increased Fannie's affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority home buyers.

"When homes are doubling in price in every six years and incomes are increasing by a mere 1 percent per year, Fannie's mission is of paramount importance," Senator Jack Reed, Democrat of Rhode Island, lectured Mudd at a congressional hearing in 2006. "In fact, Fannie and Freddie can do more, a lot more."

But Fannie Mae's computer systems were not able to fully analyze many of the risky loans that customers, investors and lawmakers wanted Mudd to buy. Many of them - like balloon-rate mortgages or mortgages that did not require paperwork - were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans. In one meeting, according to two people present, Mudd told employees to "get aggressive on risk-taking, or get out of the company." During the interview, Mudd said he did not recall that conversation and that he always emphasized taking only prudent risks.

Employees, however, say they got a different message. "Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little," said a former senior executive at Fannie. "But our mandate was to stay relevant and to serve low-income borrowers. So that's what we did."

From 2005 to 2007, the company's acquisitions of mortgages with down payments of less than 10 percent almost tripled. As the market for risky loans soared to $1 trillion, Fannie expanded in white-hot real estate areas like California and Florida.

For two years, Mudd operated without a permanent chief risk officer to guard against unhealthy hazards. When Enrico Dallavecchia was hired for that position in 2006, he told Mudd that the company should be charging more to handle risky loans. In the following months, Dallavecchia warned that some markets were becoming overheated and argued that a housing bubble had formed, according to a person with knowledge of the conversations. But many of the warnings were rebuffed.

Mudd told Dallavecchia that the market, shareholders and Congress all thought the companies should be taking more risks, not fewer, according to a person who observed the conversation. "Whom am I supposed to fight with first?" Mudd asked.

During the interview, Mudd said he never made those comments. Dallavecchia was among those whom Mudd pushed out of the company during reorganization in August. Mudd added that it was almost impossible during most of his tenure to see trouble on the horizon, because Fannie interacted with lenders rather than borrowers, which created a delay in recognizing market conditions.

He said Fannie sought to balance market demands prudently against internal standards that executives always sought to avoid unwise risks and that Fannie bought far fewer troublesome loans than many other financial institutions. Mudd said he heeded many warnings from his executives and that Fannie refused to buy many risky loans, regardless of outside pressures.

"You're dealing with massive amounts of information that flow in over months," he said. "You almost never have an 'Oh my God' moment. Even now, most of the loans we bought are doing fine."

But, of course, that moment of truth did arrive. In the middle of last year it became clear that millions of borrowers would stop paying their mortgages. For Fannie, this raised the terrifying prospect of paying billions of dollars to honor its guarantees.

Europe governments strive to avoid bank meltdown October 6th

European governments struggled to find a coordinated response to the crisis sweeping financial markets Monday, as countries one after the other announced sweeping deposit guarantees on their own to try and shore up their banks. Stock markets plunged.

Iceland and Denmark became the latest countries to declare a deposit guarantee Monday after a startling announcement by German Chancellor Angela Merkel on Sunday that her government would guarantee all private bank savings and CDs held in the euro zone's largest economy. "We want to tell people that their savings are safe," she said.

Faltering confidence in the financial system, undermined by a series of bank bailouts, was precipitating the measures, analysts said, since a failure to match guarantees by Ireland, France, Greece and Sweden could risk a massive fund outflow. Yet the guarantees themselves raised questions about their potential impact on government finances, and showed European governments were unable to find a unified approach despite a weekend summit where they agreed to do just that.

"Governments have no choice but to give the guarantees on deposits, otherwise we will see runs on banks and a complete loss of business and consumer confidence," said Neil Mackinnon, chief economist at ECU Group.

"The stakes have never been higher," he added.

Markets responded to the disarray by sinking rapidly, following sell offs in Asia. Russia shut down both its stock markets after they fell more than 15 percent. Germany's DAX was down 428.04, or 7.4 percent, at 5,368.99, while France's CAC-40 was 350.74 points, or 8.9 percent, lower at 3,730.01. The CAC's fall in afternoon trading exceeded the record one-day decline of 7.39 percent from Sept. 11, 2001.

The FTSE 100 index of leading British shares was down 269.30 points, or 5.5 percent, at 4,601.04.

Wall Street took its cue from Europe, with the Dow Jones industrials down 430.81 points, or 4.2 percent at 9,907.55 amid growing fears that the credit crisis is spreading around the world.

Meanwhile, the euro slid below the $1.36 mark for the first time in over a year.

The crisis engulfing Europe and its markets has fueled talk of coordinated interest-rate cuts by the world's leading central banks, possibly as early as Monday.

Analysts said they wouldn't be surprised if the U.S. Federal Reserve, the European Central Bank and the Bank of England instigate the first joint action on interest rates since the September 2001 terrorist attacks on the U.S.

"I think we will see interest-rate cuts this week," said ECU Group's Mackinnon.

So far, the banks have continued to flood the money markets with additional liquidity. On Monday, the ECB injected another $50 billion into money markets while the BoE added another $10 billion. The Swedish Central Bank increased its lending to 100 billion kronor ($14.2 billion).

Additionally, the Fed said that 28-day and 84-day cash loans being made available to banks will be boosted to $150 billion each, effective Monday. Those increases will eventually bring the amounts outstanding under the program to $600 billion.

British Prime Minister Gordon Brown planned a call to Merkel to discuss the crisis, and Britain's Treasury chief, Alistair Darling, was due to make a statement to Parliament later. So far, Britain has raised its deposit guarantee only to 50,000 pounds ($87,900), but was under pressure to guarantee all deposits.

French President Nicolas Sarkozy spoke by telephone in the morning with Brown, ECB President Jean-Claude Trichet and European Commission President Jose Manuel Barroso and was due to speak to Merkel later too.

"We need a coordinated response," Sarkozy said during a visit to a Renault car plant in Normandy. Meanwhile European Union finance ministers were set to begin two days of talks on the crisis in Luxembourg.

"This is a very serious situation and one that needs to be addressed," said EU spokesman Johannes Laitenberger.

"Obviously there is a great effort under way. Nobody is suggesting that this is business as usual, but it's true that there is not one single magic bullet that will solve this."

The renewed effort to coordinate a response came after the weekend commitment by Europe's four leading economic powers — Germany, France, Britain and Italy — to work together. That commitment fell apart on Sunday when Merkel announced that all 568 billion euros ($786 billion) worth of private deposits held in Germany would be guaranteed, alongside a new 50 billion euros ($69 billion) bailout package for Hypo Real Estate AG, Germany's second-biggest mortgage lender.

"The EU is liable to be exposed as a fair weather construction, lacking the means of swift response and the hold over its citizens' loyalties to survive really adverse conditions," said Stephen Lewis, an

analyst at Monument Securities.

In a joint statement Monday, Merkel and Finance Minister Peer Steinbrueck said the guarantee was "an important step at the right moment."

In response to the German move, the Danish Economy Ministry said commercial lenders had agreed to contribute up to 35 billion kroner, or about $6.4 billion over two years to a fund that will help insure account holders from losses. Austrian officials have indicated they might join in as well.

That was followed this afternoon by Iceland's guarantee of all deposits after trading was halted in six bank stocks. Icelandic banks' assets dwarf the rest of its economy and its currency has fallen sharply in the past week.

The markets are skeptical that Europe's piecemeal response to the crisis so far will work to stem the selling tide. "The main problem for Europe is that a coordinated response has proved impossible to reach, and the case-by-case approach that has so far been applied has clearly failed to restore confidence," said Dragana Ignjatovic, European analyst at Global Insight.

Meanwhile, Iceland halted trading in six bank stocks while the government drafted a crisis plan. Icelandic banks' assets dwarf the rest of its economy and its currency has fallen sharply in the past week.

Wall Street tumbles amid global sell-off Monday October 6

Stocks decline amid global worries credit crisis is spreading--Dow falls below 10,000 Financial markets took a bleak view of the future Monday, seeing contagion in a credit crisis that threatens to cascade through economies globally despite government efforts to provide relief. The Dow Jones industrials skidded more than 500 points and fell below 10,000 for the first time in four years, while the credit markets remained under strain. Investors around the world have come to the sobering realization that the Bush administration's $700 billion rescue plan won't work quickly to unfreeze the credit markets. Global banks, hobbled by wrong-way bets on mortgage securities, remain starved for cash as credit has dried up. That has sent stocks spiraling downward in the U.S., Europe and Asia, and driven investors to sink money into the relative safety of U.S. government debt. Fears about a global recession also caused oil to drop below $90 a barrel. "The fact is people are scared and the only thing they're doing is selling," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research. "Investors are cleaning out portfolios and getting rid of everything because nothing seems to be working." The selling was so extreme that only 98 stocks rose on the NYSE -- and 3,114 dropped. That's a telling sign considering the stock market is considered a leading economic indicator, with investors tending to buy and sell based on where they believe the economy will be in six to nine months. Monday's steep decline on Wall Street indicates that investors are becoming more convinced that the country is leading a prolonged economic crisis that is spreading to other nations. Over the weekend, governments across Europe rushed to prop up failing banks, while the governments of Germany, Ireland and Greece also said they would guarantee bank deposits. As the U.S. tries to repair its battered banking system, the German government and financial industry agreed on a $68 billion bailout for commercial-property lender Hypo Real Estate Holding AG. And France's BNP Paribas agreed to acquire a 75 percent stake in Fortis's Belgium bank after a government rescue failed.

The Fed also took fresh steps to help ease credit markets. The central bank said Monday it will begin paying interest on commercial banks' reserves and will expand its loan program to squeezed banks. Joseph V. Battipaglia, chief investment officer at Ryan Beck & Co., said government intervention certainly might help. However, he believes investors are sensing that what's happening in the economy is a shift in the extent to which consumers and businesses take on debt, a change that will take years to play out. "This is a global deleveraging of many economies," he said. "It might appear that you're going into the abyss where the economy grinds to a halt and the financial system goes into complete disarray. But, what the market is really reading here is that this is a global phenomenon, and when you delever like this, it is a process that takes a very long period of time measured in years, not quarters." That, he said, is being reflected in major stock indexes being repriced significantly lower. In early afternoon trading, the Dow Jones industrial average fell 446.49, or 5.39 percent, to 9,768.89, dropping below 10,000 for the first time since Oct. 29, 2004. At one point, the Dow was down nearly 600. Broader indexes also tumbled. The Standard & Poor's 500 index shed 65.13, or 5.93 percent, to 1,034.10; and the Nasdaq composite index fell 128.88, or 6.62 percent, to 1,818.51. The Russell 2000 index of smaller companies dropped 36.45, or 5.88 percent, to 582.95. In Asia, the Nikkei 225 closed 4.25 percent lower. Europe's stock markets also declined, with the FTSE-100 down 5.20 percent, Germany's DAX down 7.07 percent, and France's CAC-40 down 9.04 percent. The anxiety was again obvious in the credit markets. The yield on the three-month Treasury bill slipped to 0.42 percent from 0.50 percent late Friday. Demand for bills remains high because of their safety; investors are willing to take extremely low returns just to have their money in a secure place. Investors also moved into longer-term Treasury bonds. The yield on the 10-year note fell to 3.49 percent from 3.60 percent late Friday. Anthony Sabino, a professor of law and business at St. John's University, said the "market is displaying one of its worst traits with a herd mentality, and investors have an appetite for feeding on fear." He cautions that, while there are deep economic and financial problems being faced, it is still not a nightmare scenario. "Most certainly, this is not the Great Depression of the 1930s, but (is like) the savings and loan crisis of the 1980s -- and we bailed them out," he said. "Once people catch their breath, they'll see this is the proper analogy and this will breathe life back into banking institutions." Banks' hesitation to lend to one another and to many businesses and individuals is the result of the bad mortgage debt that the financial rescue is supposed to sweep up. But it's still unclear how quickly financial institutions will be able to hand that debt to the U.S. government and convince the markets they are healthy again. There has been some hope that perhaps the Fed, in concert with other central banks, might cut interest rates to help stimulate the economy. With oil prices well off their midsummer highs and indicators pointing to a slower economy, the Fed's worries about inflation are less than they had been, making it easier to justify a rate cut.

Investors might get some indication about a potential rate cut with several policymakers slated to speak this week. Dallas Fed President Richard Fisher and Chicago Fed President Charles Evans will speak on the U.S. economy on Monday. Federal Reserve Chairman Ben Bernanke is due to speak on Tuesday. Frederick Dickson, chief market strategist at D.A. Davidson & Co., believes investors are eager for any signs about the well being of the economy. He doesn't believe that will happen until Wall Street overhauls its expectations for growth of corporate earnings and the overall economy. "Wall Street at this point is shifting its attention from whether Congress was going to act on the emergency stabilization bill to the realization that the economy is slowing significantly faster than most analysts had expected," he said. "The downturn has shifted from first gear to about third gear in about two weeks.

U.S. Implements Bailout as Global Markets Plunge October 6, 2008

U.S. officials began putting the newly approved financial bailout plan into effect this morning, even as global stock markets plummeted on new concerns about the health of the European banking system and the likelihood of a global recession.

The Federal Reserve announced steps to funnel more money into the banking system while the U.S. Treasury said it would increase its bond sales to pay for the $700 billion rescue package signed Friday by President Bush.

The Fed today used its newly granted authority to begin paying interest on the reserves that banks must keep with it -- a step meant to encourage banks to keep more funds on hand with the Fed, and in turn give the Fed more leeway in putting cash back into the banking system. At the same time, the Fed said that during the next two months it would double, to $900 billion, the short-term loans it would make available to financial institutions.

In a statement, the President's Working Group on Financial Markets, a consortium of such key agencies as the Fed and the Treasury, said that U.S. agencies in coming days would be "moving with substantial force on a number of fronts" to try to shore up confidence in global markets.

But on the first day of trading since the bailout package was signed into law, the focus instead seemed to rest on developing problems among European banks, as well as worry in Asia that a global recession will undercut that continent's export-dependent economies.

The Dow Jones industrial average dropped below 10,000 for the first time in four years, at one point falling by more than 700 points, or just under 6.9 percent. However, shortly after 3 p.m. the markets staged a modest recovery and the Dow was off 5 percent, about 552 points, at 3:45 p.m. The Nasdaq was down about 5.6 percent and the Standard & Poor's 500-stock index was off 5.4 percent at 3:45 p.m.

Losses in Asia were comparable, but European indexes suffered even steeper declines. London's FTSE 100 and Germany's DAX 30 closed down more than 7 percent, while Paris's CAC 40 had lost 9 percent of its value.

In Washington today, World Bank President Robert B. Zoellick said that the financial crisis could dampen global enthusiasm for free markets and proposed a new approach to international cooperation on financial issues.

In addition to the seven major developed countries whose finance ministers meet regularly to plot a course for the global economy, major developing nations should be part of such efforts, Zoellick said in a speech at the Peterson Institute for International Economics.

He suggested that Brazil, China, India, Mexico, Russia, Saudi Arabia and South Africa be involved in these collaborations, which now occur among the Group of Seven, or G-7, finance ministers. The G-7 includes the United States, Japan and large Western European nations.

The group must work to identify problems in the global economy early and aggressively, he said. "We need this mechanism," Zoellick said, "so that global problems are not just mopped up after the fact, but anticipated."

In Europe, officials and investors focused on the cracks appearing in European companies, with some officials wondering if the region needed its own comprehensive rescue package.

Leaders of the G-7 group of industrialized nations are expected to meet this week in Washington to discuss the global financial system. But in the meantime European governments moved to convince depositors and investors that the banking system was safe.

Germany, Denmark, Sweden and Austria expanded guarantees for private bank accounts, while other steps were taken to help ailing companies. Officials in Iceland announced plans for its banks to sell their large overseas holdings as a way to raise cash; Russian stock markets were shuttered temporarily after a 14 percent drop in a major index, the Reuters wire service reported.

German Chancellor Angela Merkel announced deposit guarantees in her country Sunday, in an attempt to calm depositors as officials tried to resurrect a failed bailout plan for a blue-chip lender. "We want to tell savers that their deposits are safe," Merkel told reporters at a hastily called news conference a day after she returned from an emergency summit of European leaders in Paris. "The government will vouch for that."

The German government's guarantee was prompted by the collapse of a $50 billion plan to rescue Hypo Real Estate, a large commercial-property lender, after its liabilities were discovered to be worse than expected, German officials said.

Saudi Arabia's stock market, the Arab world's largest, suffered one of its worst trading days on record as Persian Gulf investors returned from last week's Eid al-Fitr holiday to face the local and global glut of bad news. The Saudi market fell 9.8 percent, ending the day at 6,726.60 points. All of the 124 stocks traded Monday suffered a loss at or near 10 percent, the daily maximum allowed under Saudi law.

The stock market in Dubai, the boomtown of the Persian Gulf's United Arab Emirates, fell 7.6 percent today after posting nearly as great a loss yesterday. Property developers led losses as overseas investors pulled out. Emaar, Dubai's property giant, lost more than 10 percent for a second day.

Kuwait's stock exchange, the region's second-largest after Saudi Arabia's, sank by 3.45 percent. Abu Dhabi's exchange dropped 5.6 percent.

Until late in this year, the biggest worry for the Gulf's government financial officials was how to handle record surpluses from oil profits. Gulf officials went into the long holiday saying publicly they still believed their economies were immune from the West's financial turmoil.

But liquidity problems, withdrawal of foreign cash and fears of sagging demand for oil all were bringing the crisis home. Crude oil fell below $90 a barrel today, its lowest price since February.

In Dubai, the weekend announcement of merger talks between two of the emirates' biggest mortgage lenders and government offers of cash infusions for local banks failed to ease local traders' worries.

In Asia, pessimism about a prolonged recession in Japan, where business confidence was

measured last week at a record low, pushed Tokyo's two leading stock indexes to their lowest levels in nearly five years. The 225-issue Nikkei average was off 4.25 percent and the broader Topix was down 4.67 percent.

Hiroichi Nishi, equities chief at Nikko Cordial Securities Inc., told the Kyodo news service that Washington's approval on Friday of a $700 billion bailout package is not enough to calm nervous investors. The market "is now concerned about the new law's effectiveness" in easing the crisis in the U.S. credit market, he said.

Stocks in Shanghai, where markets had been closed for a week because of a Chinese holiday, fell about 5 percent, as did Hong Kong's Hang Seng index, which closed at its lowest level in more than two years. India's Mumbai stock exchange fell 724 points, or more than 4 percent.

Unlike the United States or much of Europe, anxiety about tight credit does not appear to be driving Asian stock markets down, analysts say. With large reserves of cash and relatively limited exposure to toxic U.S. mortgage securities, most Asian banks are in much better shape than those in the United States or in much of Europe.

What has alarmed investors in Japan and across Asia is a rapid falloff in exports, especially to the United States. Friday's report that American employers cut 159,000 jobs, the largest cuts since 2003, deepened concern here that a recession in the United States would depress exports well beyond 2009.

The concern was reflected in the stock price of Toyota, down nearly 6 percent and Sony, down just over 6 percent. Exporters were also hurt by the rising value of the yen against the dollar, which was up about 2 percent this afternoon.

Japan's largest banks and investment firms were among the biggest losers today. Mitsubishi UFJ Financial Group, Japan's largest bank, was down more than 9 percent, while Nomura Holding, the largest investment house, fell nearly 8 percent.

Europe Struggles for a Response to the Bank Crisis Oct. 07, 2008

European bank stocks continued to take a beating on Tuesday following a series of ad hoc steps by national governments to try to shore up confidence in financial institutions. By the day's close, Britain's troubled HBOS was down 41.5%, and the Royal Bank of Scotland's shares had lost 39% of their value; Germany's Commerzbank fell 14% and Deutsche Bank was down 8.9%. The pummeling followed a black Monday in which stock exchanges across Europe dropped by up to 9%, suggesting that the markets were casting a doleful eye on the $700 billion U.S. bailout package passed by Congress on Friday. Europe was looking askance not just at the U.S., but also at tiny Iceland, whose government on Monday completed what amounts to an emergency seizure of its oversized banking sector. Prime Minister Geir Haarde went on television Monday night to warn his compatriots that "the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could be bankruptcy." That's not just talk: Iceland's GDP amounts to less than a tenth of the total assets of its three biggest banks, all of which are in trouble. British financial authorities warned on Tuesday that Icesave, a subsidiary of Landsbanki, Iceland's second biggest bank, might not be able to pay out the estimated $7.8 billion in deposits of some 300,000 British customers, who would then have to file claims to deposit guarantees set by Iceland and Britain, which would cover up to $87,000 of an individual's savings. One London-based customer said she had tried over a week ago to withdraw her money from Icesave, but was told she could not. "I didn't think it was exposed to the mortgage market," she says. "Where did all that money go?"

But scary conditions elsewhere hardly drew attention away from the underlying weakness in Europe's own supervision of its financial institutions. Most of the continent is conjoined into a political union of 27 countries, 15 of which use the euro under the monetary authority of the European Central Bank. But as the recent days' fraught activity proved, coordination between governments on fiscal and supervisory measures remain strictly voluntary. Europe's bank-by-bank, country-by-country fixes of its endangered banks have so far failed to bolster the confidence of investors and depositors. "Europe must prepare to put in place a collective line of defense," Dominique Strauss-Kahn, director general of the International Monetary Fund, said in a speech in Paris on Monday. "The stability of the world economy is at stake." European governments can certainly talk the talk of coordination. Following a meeting with Italian Prime Minister Silvio Berlusconi in Berlin yesterday, German Chancellor Angela Merkel said: "We both agree that Europeans of course need to display a coherent course of action." President Nicolas Sarkozy of France, which currently holds the rotating E.U. Presidency , read on television a common statement from all 27 members pledging to adopt "all necessary measures to protect the stability of the financial system." But those words have been notably lacking in any concrete policy to back them up, particularly with the crisis moving so rapidly. "Uncoordinated rescue operations, far from restoring confidence, are further fueling fears among savers and investors," said Daniel Gros, director of the Center for European Studies in Brussels. Such actions are pushing Europe "toward a full-fledged banking crisis," he said, with the "likelihood of a serious economic downturn [looming] ever larger." There was a modicum of cooperation on Tuesday, when E.U. finance ministers, meeting in Luxembourg, agreed to increase the minimum value of deposits guaranteed by member states to $68,000 from a previous floor of $20,000. But beyond that there appeared little movement toward international coordination. On Monday Germany reaffirmed its determination not to participate in France's plan for a Europe-wide bank bailout plan, modeled on the U.S.'s $700 billion effort. Without Germany's participation, no such plan can proceed. "The Chancellor and I reject a European shield," German Social Democrat Finance Minister Peer Steinbrück told German radio on Monday in reference to the plan, "because we as Germans do not want to pay into a big pot where we do not have control and where we do not know where German money might be used." The comments came a day after Merkel befuddled her neighbors by announcing a guarantee on 100% of all private deposits — the largest such guarantee in history, according to one leading banking expert. The fact that Ireland had previously issued an even more sweeping guarantee hardly shielded Germany from criticism: as Europe's biggest economy, it sets a massive precedent. Indeed, since Merkel's announcement, Denmark, Sweden and Austria have taken steps to offer stronger guarantees to their depositors. Spain is reportedly considering a move to follow suit and British politicians were in talks with banks on Monday night about a stopgap measure to inject government funds into selected institutions. German officials say that the guarantee was necessary to shore up confidence, not least because Germans hold a higher proportion of their savings in banks than many industrialized nations — and still harbor a deep collective memory of the perils of economic uncertainty from the interwar years of the Weimar Republic. "We had to do it," says Reinhard Schmidt, a professor of international banking and finance at Goethe University in Frankfurt. "I have friends. I have neighbors. I have family. You wouldn't believe how many people have been calling me to ask about their deposits. The fears are extremely strong now." Germany's refusal to sign on to a continent-wide bailout plan was no less necessary, says Schmidt. Such a plan would have triggered a backlash in Germany against the E.U., egged on by the ready arguments of the anti-Europe German press that Germans were paying to bail out other Europeans, he says. "It would have destroyed the idea of European integration," he says.

Which still leaves the problem of how to address the broader crisis now that the country-by-country approach appears to be failing. Gros recommends a common European scheme to shore up capital of distressed banks and the establishment of a "clear center of joint responsibility for the supervision and liquidity support of cross-border European banks," which he says should be housed in the European Central Bank. (At present the chief tool available to the ECB is lowering interest rates.) If a shock is what is needed to restructure the banking rules in Europe, one may be underway. Economists are warning that the continent is facing its biggest crisis since the Depression — when Europeans also first mistakenly thought the problem would remain confined to the U.S. One leading German politician, Interior Minister Wolfgang Schäuble, even raised the specter of the kind of longer term economic dislocation that led to the rise of Adolf Hitler. "Four months ago," says economist Schmidt, "I might have said that it may not get worse. But we have not seen anything like this before. I cannot say that we have reached the bottom," he says. "I am afraid that may not be the case."�

Fed to buy massive amounts of short-term debt Fed in bold move to thaw credit markets says it will buy massive amounts of short-term debt

October 7th The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debt in a dramatic effort to break through a credit clog that is imperiling the economy. Invoking Depression-era emergency powers, the Fed will buy commercial paper, a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls. In more normal times, about $100 billion of these short-term IOUs were outstanding at any given time, sold by companies to buyers that included money market mutual funds, pension funds and other investors. But this market has virtually dried up as investors have become too jittery to buy paper for longer than overnight or a couple days. That has made it increasingly difficult and expensive for companies to raise money to fund their operations. Commercial paper is a way of borrowing money for short periods, typically ranging from overnight to less than a week. The unstable situation has left many companies vulnerable. The notion under the plan is for the government to provide a "backstop" that would give companies a new place to get cash, the Fed said. The action makes the Fed a crucial source of credit for nonfinancial businesses in addition to commercial banks and investment firms. The Fed's action initially helped lift investors' spirits, although concerns about the economy dampened their enthusiasm. The Dow Jones industrials -- which gained about 145 points just after the open -- fell nearly 40 points in late morning trading. Monday, a huge sell off put the Dow below 10,000 for the first time in four years. Concerns about the credit markets pushed investors into longer-term Treasury bonds, considered a secure place to park money in times of turmoil. The rush to safety drove yields lower, though. European stocks posted modest gains on hopes that central banks around the globe would coordinate on rate cuts. Share prices in Britain and in Germany, Europe's largest economy, rose. Iceland, however, is facing the prospect of bankruptcy, according to the Prime Minister Geir H.

Haarde, after its banks went on a buying spree across Europe, accumulating massive debts in the process. The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program up and running soon, Fed officials said. Fed officials said they’d buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify. "The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors" have become increasingly reluctant to buy commercial paper, especially longer-dated maturities. As the market for commercial paper shrank, the Fed said rates on the longer-term debt "increased significantly," making it more expensive for companies to borrow. The Treasury Department, which worked with the Fed on the program, said the action is "necessary to prevent substantial disruptions to the financial markets and the economy." The Treasury will provide money to the Federal Reserve Bank of New York to support the new program, the Fed said. Fed officials would not say how much but believed it would be substantial. The money would not come from the $700 billion financial bailout President Bush signed into law on Friday. If a company's commercial paper is not backed by assets or other forms of security acceptable to the Fed, the company could pay an upfront fee, the central bank said. The amount of such a fee has not yet been determined. The Fed said it hoped its effort would jolt the commercial paper market back to life. "This facility should encourage investors to once again engage in term lending in the commercial paper market," the Fed said. That should eventually spur financial companies to lend to each other and to their customers, including consumers, the Fed said. The Fed said it planned to stop buying commercial paper on April 30, 2009, unless the Federal Reserve board agrees to extend the program. The Fed created a separate entity to pool and hold the commercial paper it buys. The Fed said this should allow the central bank to more easily manage the program and better control risk. There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of last Wednesday, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion. Pressure also is growing on the Fed to reverse course and order a deep reduction in its key interest rate, now at 2 percent. Such a move would be aimed at reviving the moribund economy by encouraging consumers and businesses to boost their spending. Many predict the Fed will act on or before its next meeting on Oct. 28-29. And, some believe it could be part of a broader coordinated move with central banks in other countries.

Fed Chairman Ben Bernanke may offer clues on the Fed's next move when he speaks Tuesday afternoon on the economic outlook and developments in financial markets. President Bush also was set to talk about the government's bailout effort, which lets the government buy rotten mortgages and other bad debts from banks and other financial institutions. By getting these bad debts off bank's balance sheets, they might be in a better position to raise capital and more willing to lend to each other and to customers. As the number of failed banks has gone up sharply this year, Sheila Bair, head of the Federal Deposit Insurance Corp., wants to boost fees to financial institutions to replenish the insurance fund that backs the nation's deposits. The increase would double the average paid by U.S. banks and thrifts next year. The Fed pledged Monday to take "additional measures as necessary" to battle the worst credit crisis in decades. Treasury Secretary Henry Paulson has tapped a former Goldman Sachs executive to be director of the government's bailout program. Neel Kashkari, who has worked with Paulson at the department since July 2006, was chosen Monday as the interim head of the government's unprecedented effort to unclog the credit markets. Kashkari, who was a vice president in Goldman's San Francisco office before joining the department, is one of four former executives from the firm now working feverishly to resolve the financial crisis. The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital investments. Consumers have retrenched.

The unintended consequences October 7, 2008

Running through Heathrow Airport this spring, late for a flight connection, my eye briefly caught a tabloid newspaper with the glaring headline: "End of 105-percent Mortgages!!!" Recovering my sanity on the plane a half-hour later, I began to ponder what that meant. And it wasn't a pleasant discovery.

What 105-percent mortgages meant was that foolish banks had lent to foolish people (at very low interest rates) not only the entire capital for buying a house or apartment without the purchaser putting up funds, but an extra 5 percent to, say, improve the kitchen.

This foolishness was not confined to Britain, although its habits of excess may have gone beyond all others. And, truth be told, if only the British home-lending system had been badly hurt that would not have raised many eyebrows in Singapore or Dubai.

The problem was that the same sort of fiscal recklessness was rampant in the world's largest economy and, more importantly, that this cancer of home-loans-without-responsibility had sucked in banks and investors across most of the globalized world.

Sub-prime mortgages in the United States had been eagerly funded by hitherto austere Swiss banks and normally Dickensian North-Yorkshire building societies. They had also been funded indirectly (but what is "indirectly" these days?) by Norwegian and Chinese investment corporations. And the physical result was as plain as a pikestaff; it can now be seen in all those photographs of hundreds of half-built McMansions running straight into the cactus fields of Arizona. Here was the equivalent of the early-18th-century Dutch tulip bulb frenzy. And now it has collapsed, and rightly so.

But it is not just those foolish banks and foolish borrowers who have been hurt by the sub-prime meltdown, the collapse of venerable financial institutions, and the clumsy reactions of legislators (none of whom seem to understand how modern capital markets work). The so-called "ripple effect" is surging much further afield, inflicting a lot of damage.

One is reminded, with mixed feelings, of the great Austrian economist Joseph Schumpeter's phrase about "the perennial gale of creative destruction" that accompanies all capitalism. Some of the casualties have been at the forefront of all media headlines: Bear Stearns, Northern Rock, Lehman Brothers, Washington Mutual, the Halifax Bank of Scotland. Others, like Morgan Stanley and Goldman Sachs, have had to turn themselves into a different sort of financial creature to survive.

Even those entities with capital assets enough to pick through and purchase parts of their fallen comrades in this gigantic yard sale (I'm thinking here of Barclays, Lloyds, Goldman Sachs, Bank of America, Morgan Stanley, Warren Buffett) are themselves diminished in their absolute capital standings, though they will surely stand stronger in a couple of years.

It is unlikely that this board game of "roadkill and vultures" will stop soon, since a lot more medium-sized banks are on the verge and probably wouldn't have received much help from the Congress' first gigantic, ill-focused recovery package, which rightly met its nemesis Monday afternoon.

In the meantime, tens of thousands of highly paid traders and bank employees are losing their jobs and their spending habits are contracting, which in turn will hit many more jobs further down the pecking order. Small businesses that hoped to expand, or young couples wanting to buy their first apartment will find themselves hampered. Small and big people are hurt. The Chinese investment agency, which put many billions into Fannie Mae and Freddie Mac, is licking its wounds, too.

But cast a glance at some of the other unintended consequences of the sub-prime debacle. As the so-called globalized economy contracts, many of the companies that provide its underpinnings will feel the pain. Expect to read that Boeing and Airbus have accepted significantly longer delivery schedules to various airlines for their super-long-range jetliners; and expect that Korean shipbuilders will note a marked reduction in future container-ship orders.

Expect that the providers of high-tech office equipment, desktops and super-computers will see a tumbling of orders. This is not a time to be in Silicon Valley. Better by far to be producing single-malt Scotch whiskey. At least you can sip it.

This contraction is also witnessing a tumble in the price of all commodities, especially oil. It is not a bad thing to have the future per-barrel oil price fall to, say, a mere $85, especially as winter approaches. Moreover, those tumbling oil prices will also, and more sharply, hit the arrogant petroleum-peacock-states of Chávez's Venezuela and Putin's Russia. They, too, will recognize more than they ever did before that they have become to a large extent dependent upon the London Interbank Offered Rate (the mysterious Libor) and the forward market price of West Texas Intermediate crude. Having to close the Russian stock market, as happened again last week, and yet also watch venture capital flow out of that country, may prove to be a nice curb on Kremlin foreign-policy posturings.

Even the rising Chinese superpower is being blasted by these distant capitalistic convulsions. How could its Finance Ministry, seduced by the advice of Wall Street bankers and consultants to place billions of dollars into American so-called "safe havens," not be badly shaken by the financial tumults of the past few weeks?

Should China trust the Yankee capitalist system? What will happen to its vital exports to that enormous, volatile consumer market? Already The People's Daily in Beijing has published a noteworthy piece by the economist Shi Jianxun calling upon the world to create "a diversified currency and financial system and (a) fair and just financial order that is not dependent on the United States." Where goes the dollar then, and its reputation as a safe haven?

At the end of the day, then, the biggest loser may well be the United States itself, and by that I mean not just the standards of living of tens of millions of its citizens but its relative military-diplomatic "heft" in world affairs.

If a country's great-power status is underpinned by its economic muscle, then the present credit-market crisis cannot be anything other than detrimental, one late blow at the end of an eight-year presidency that has already weakened America's position in many other ways. One can only admire John McCain and Barack Obama for their courage (or worry at their lack of imagination) for actively desiring to get into a White House so full of broken china.

And such a lot of this has to do with those 105-percent mortgages and the arrogance, greed and foolishness of those who handed them out, those who took them, and the legislatures who dismantled prudent fiscal oversight.

Ruefully, and as I cast a glance at my own pension holdings, I see I was right to worry about what that tabloid headline meant. In this globalized, interconnected world of ours, no man is an island. So, in John Donne's immortal words, "Never send to know for whom the bell tolls. It tolls for thee."

What is commercial paper, and why does it matter? October 7, 2008

Why is the commercial paper market so pivotal to easing the credit crunch that the Federal Reserve announced Tuesday it will intervene to prop up the market? The Associated Press offers some insight based on interviews with experts:

Q: What exactly is the commercial paper market?

A: It's a low-cost source of cash for companies to meet short-term financial needs. A key advantage is that it's cheaper than tapping a line of credit from a bank. The market really began to grow in the 1970s with the emergence of money-market mutual funds that became large buyers of commercial paper.

Q: What type of companies raise money on the commercial paper market, and what do they do with it?

A: The big and financially sound firms that typically issue commercial paper have plenty of revenue to fund long-term needs. But they also sometimes need short-term cash to cover everything from buying supplies, paying vendors and making payroll, so they turn to the commercial paper market.

When such a firm temporarily has extra cash and wants to get a decent return to offset inflation, it can switch roles and serve as a buyer of commercial paper to make cash available to other companies.

Such borrowing is often unsecured, with no assets serving as collateral. Such transactions are backed by the borrowing company's high credit ratings and regular cash flow, and expectation that it can make repayment once it receives money due from its own customers. It's less common, but asset-backed commercial paper can be secured by assets such as consumer loans.

Companies with low credit ratings generally raise cash through bond offerings rather than short-term commercial paper.

Q: How long do companies borrowing in the commercial paper market have to make repayment, and what are the terms?

A: Commercial paper carries shorter repayment dates than bonds, with maturities running anywhere from overnight to as long as nine months. The longer the maturity, the higher the interest rate. Because of their short maturities, commercial paper is exempt from registering with the

Securities and Exchange Commission, which helps keep borrowing costs low. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.

Q: Besides corporations with extra cash, who supplies the money to the commercial paper market?

A: Money-market mutual funds and other funds open primarily to institutional investors buy about 60 percent of the commercial paper in the market, according to Peter Crane, president of fund-tracking firm Crane Data. "Money-market funds are the 800-pound gorilla in the commercial paper market," Crane said. By participating, money funds typically generate a higher yield than from investing in safer government debt such as Treasury bills.

Q: What's happened to commercial paper amid the recent volatility?

A: While commercial paper is still generally a safe investment, its risks were highlighted last month as a large money-market fund called the Reserve Primary Fund "broke the buck" — meaning the value of its underlying assets fell below $1 for each investor dollar put in. Investors were exposed to losses after the fund conceded that $785 million it had invested in debt of Lehman Brothers became worthless after the investment bank's bankruptcy. That instance, and the broad turmoil in markets, have made investors wary of even the smallest risk that a borrower may default.

The commercial paper market has shrunk to about $1.6 trillion in outstanding borrowing, down from $2.2 trillion in July 2007. Institutional investors in money-market funds, such as pension funds, have led the pullout. Over the four-week period ended Friday, assets in so-called "prime" money-market funds investing in commercial paper dropped by more than $514 billion, or about 25 percent, according to fund-tracking firm iMoneyNet. Meanwhile, reflecting a shift to security, assets in money-market funds investing in government debt gained $380 billion during the same four weeks.

Q: How are the commercial paper market's troubles affecting businesses?

A: The flight of money funds and other participants from commercial paper has left companies facing higher interest rates to raise short-term cash, especially for borrowing with repayment periods of weeks or months rather than days. That means they must rely on higher-cost credit from banks, or forgo borrowing at all.

Consequently, as the freeze persists, companies could have to scramble to find cash for short-term needs. The Federal Reserve's move Tuesday to begin buying three-month unsecured and asset-backed commercial paper directly from eligible companies is intended to head off such problems.

"Until last week, the word of a company like Chevron or Toyota was good enough for the commercial paper market," said Crane, of Crane Data. "It still is, but investors are demanding a premium, and the money-market funds are having to deal with forced liquidations, and panic outflows."

Crane and Ben Garber, an economist with Moody's Investors Service, said they have not yet heard of instances of major companies being unable to meet short-term obligations because of the freeze in the market. But such instances would likely begin to crop up in coming weeks, absent any catalyst to thaw the market, they said.

"The odds of a company like Chevron or IBM not being able to meet payroll is ridiculously low, but after a while it might become an issue," Crane said. "It's like you're an ocean liner approaching an iceberg. You have to adjust your course from a long way off to avoid hitting it."

The danger of ignoring reality October 8, 2008

Thirty billion dollars to keep Bear Stearns from collapsing. Another $85 billion for AIG. Hundreds of billions, here and there, lent to banks.

All told, the U.S. Federal Reserve has pumped $800 billion into the financial system, Ben Bernanke, its chairman, estimated on Tuesday. That figure doesn't include the untold sum that the Fed now plans to spend buying short-term debt so that companies can continue to pay for their daily operations. And it doesn't include any of the money the Treasury Department is laying out, like the $700 billion bailout fund or the $200 billion that could be spent propping up Fannie Mae and Freddie Mac.

After 14 months of financial crisis, the U.S. government - which means the U.S. taxpayers - has put serious money on the line. As a point of comparison, the entire annual U.S. budget is about $3 trillion.

Just how are Americans going to pay for all this?

The short answer is that the budget problems the country seemed to have a year ago are now even worse. Next year's deficit (relative to the economy's size) will probably be the biggest since 1992, and maybe since 1983. Taxes will have to rise or government spending will have to fall, if not both. Trying to contain the mess created by a bubble costs serious money.

Yet this is also a case in which the short answer isn't the full answer, or even the best answer.

As expensive as the damage control may be, it isn't likely to cost anywhere near as much as the headline numbers suggest. More to the point, the alternative - not spending some serious money to deal with the crisis - would probably end up costing a lot more. As it is, the various bailouts are not the main reason next year's deficit is growing. The deteriorating state of the economy is.

So if you want to conjure up some doomsday stories about the U.S. budget, I'm happy to play along (and will do so momentarily). But those stories aren't mainly about the credit crisis. They're about the dangers of ignoring economic realities - which, when you think about it, is how we ended up in this credit crisis in the first place.

The most newsworthy part of Bernanke's lunchtime speech on Tuesday was his sober overview of the economy. He called the financial crisis "a problem of historic dimensions" and indicated that the Fed would soon cut its benchmark interest rate once again, as it did Wednesday.

But the bulk of the speech was a catalog of the extraordinary steps that the Fed and the Treasury have taken since August and the delicate line they have tried to walk along the way. To try to restore some confidence to the credit markets, they have lent enormous amounts of money to banks and trumpeted those efforts. Fed officials have pointed out that they are nowhere close to being out of bullets, either. They work for the central bank, after all. They can always print money.

But Bernanke and Henry Paulson Jr., the Treasury secretary, have also emphasized that they're not being too generous. They are mainly making loans and investments, and they expect to recoup much of the money they're spreading around.

Outside the government, economists differ about whether Bernanke and Paulson have been too aggressive or not aggressive enough and whether they have been aggressive in the right ways. But there is not much concern that they are taking on additional debt - or even about the amount of it.

"The policy actions are not likely to have a large effect on the budget over the next 5 or 10 years," Douglas Elmendorf, who has become a go-to Democratic economist during the crisis, told me.

John Makin of the rightist American Enterprise Institute said: "The last thing I'm worried about right now is additional government indebtedness. There really isn't an alternative."

Makin pointed out that during the long malaise in Japan, the government passed a stimulus package almost every year that was equal to more than 2 percent of the country's gross domestic product (equivalent to about $400 billion in the United States today). But interest rates in Japan remained low, a sign that economic weakness, not deficits, was still the problem.

That being said, today's ever-expanding bailouts do create some dangers. You've probably heard the term moral hazard, which is shorthand for the idea that the government's rescues may lead investors to take new, unwise risks - and ultimately require yet more rescues.

The Fed is also setting itself up for tough decisions about when to end its various emergency programs. If it waits too long, it could leave so much money sloshing around the economy that inflation will take off. Fed officials have suggested they understand that they made precisely this mistake after the 2001 recession, when they kept interest rates low and added to the mania in the housing market.

Finally, there is the net cost of the bailouts, which may well be bigger than Bernanke has acknowledged. Under the program announced Tuesday, the Fed will own the commercial paper that serves as short-term loans for companies. If some of those companies go bankrupt, the Fed could suffer some losses.

The Treasury's $700 billion bailout fund, meanwhile, is based on the premise that investors are collectively undervaluing assets and that the government can pay above current market prices without losing much money.

"One has to be at least a bit skeptical," Greg Mankiw, the Harvard economics professor, says, "about the idea that government policy makers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own."

After talking with budget analysts, I think it's reasonable to assume that the bailouts will end up costing several hundred billion dollars, spread over several years. Perhaps $100 billion of that cost may come next year. Add in another $100 billion or so for the weakening economy - specifically the fall in tax revenues, increases in spending on social programs and the possibility of another stimulus package.

Even before the crisis, President George W. Bush was set to bequeath a $550 billion deficit in the coming year to his successor. Now, a better estimate appears to be $750 billion - or 5 percent of gross domestic product. The only years since the 1960s that the deficit has been nearly so large were the early 1990s (almost 4.5 percent of GDP) and the mid-1980s (with a peak of 6 percent in 1983).

Obviously, next year's deficit is a problem. And if you assume the credit crisis isn't about to lift - which seems smart at this point - the ultimate cost of the bailouts could conceivably go higher. Whatever the final figure, it should still be put in some context.

Despite everything, the biggest fiscal problem remains, far and away, health care. Based on the rate that medical spending has been rising, the Congressional Budget Office forecasts that Medicare and Medicaid will make up 10 percent of GDP within two decades, up from about 4 percent now. In today's terms, that would be the equivalent of adding at least $900 billion to the deficit every single year, in perpetuity. It makes the cost of the bailouts look like a rounding error.

When it comes to health care, the United States has a situation that is blatantly unsustainable. With the right choices, we can prevent that. But so far, we instead seem to be hoping that the situation will magically resolve itself, which is a recipe for big problems and perhaps even a crisis.

Let's see. That doesn't sound familiar, does it?

Globalizing the Crisis Response Op-ed in the Washington Post� October 8, 2008

The financial crisis has gone global. Stock indexes have fallen and credit markets are seizing up around the world. In recent days, as most Americans focused on the political drama of the rescue package, a number of European banks have failed or been taken over. Several in Russia and Eastern Europe are teetering on the verge of insolvency. Many Latin American countries are newly vulnerable because foreign banks are big players there. Few nations can escape the financial contagion.

Global oversight of both financial regulation and currencies can no longer be neglected. Also looming is an even more virulent form of contagion: decreased levels of economic activity because of contracting trade flows. Japan and several European countries are already in recession. If the United States and the entire European Union sink further, as looks increasingly possible, emerging markets and developing countries will face lower exports and less growth. Even China will experience a sharp slowdown because of its heavy reliance on overseas markets. Unemployment will soar almost everywhere.

Globalization of the crisis requires a globalized response. While the consequences of financial crises are clearly international, the regulation of finance remains almost wholly national. And national efforts, including the US rescue plan and European governments' remedies for their nations' bank problems, will continue to be the first responses.

Yet an internationally coordinated strategy, ranging far beyond the heroic efforts of the world's leading central banks, is essential now that the US rescue plan is in place. When finance ministers convene in Washington this week for the annual International Monetary Fund meeting, they should adopt several initial components of such a strategy. Not doing so would be almost as serious as if Congress had adjourned without passing the rescue legislation.

First, heading off a precipitous decline in world economic activity requires a global stimulus program. Different governments can use different policy tools. China has room for fiscal expansion, while Europe could ease monetary policy. The United States can combine the two. A coordinated effort should boost confidence and would deter individual countries from attempting to escape the downturn via trade controls and other beggar-thy-neighbor policies.

Second, coordination of the parallel national efforts to recapitalize tottering banking systems would pack a powerful psychological punch. The United States, European Union, and some others are moving rapidly to shore up their financial institutions. But countries need both to do more and to avoid gaps in their rescue programs by agreeing on how to handle cross-border loans and financial institutions that operate across jurisdictions. Widespread international participation in the recapitalization effort, including by the highly liquid sovereign wealth funds, could be of substantial help.

Third, as the United States and some Europeans are already doing, many countries will need to expand coverage of their deposit insurance programs to discourage bank runs. Parallel or uniform policy steps through which unlimited insurance is provided for at least a temporary period, as Germany and Ireland have done for their banks and the Treasury has for US money market funds, will be mutually reinforcing and help prevent panic.

Beyond the short term, countries will need to develop a cooperative framework to prevent and resolve such crises, most urgently within Europe. There is inherent tension as finance becomes global but its regulation remains national. The current crisis originated in the United States but was importantly affected by massive savings surpluses in some countries and the resulting surfeit of liquidity, which drove down interest rates and encouraged irresponsible lending here. Those international imbalances were in turn partly caused by misaligned exchange rates. Global oversight of both financial regulation and currencies can no longer be neglected.

Our policy responses must reflect the interdependent vulnerability of the world economy. Although the Europeans rebuffed a recent US initiative for a cooperative strategy and are having trouble getting their region-wide act together, it is too late to assign blame over responsibility for the crisis, within or among countries. The traditional Group of Seven industrial countries have mounted coordinated economic programs of this type in the past, with considerable success; now they must be joined by the chief emerging markets, particularly China. The G-7 finance ministers should fully include the five or six main emerging markets in their upcoming meeting and seek to forge a global strategy. This week's IMF conclave offers a unique opportunity to add a critical international dimension to the crisis response.

By: C. Fred Bergsten and Arvind Subramanian, Peterson Institute

The credit crunch

Saving the system Economist--Oct 9th 2008

At last a glimmer of hope, but more boldness is needed to avert a global economic

catastrophe

CONFIDENCE is everything in finance. Until this week the politicians trying to tackle the credit crunch had done little to restore this essential ingredient. In America Congress dithered over the Bush administration’s $700 billion bail-out plan. In Europe governments have casually played beggar-my-neighbor politics, with countries launching deposit-guarantee schemes that destabilized banks elsewhere. This week, however, saw the first glimmers of a comprehensive global answer to the confidence gap.

One clear sign was an unprecedented co-ordinated interest-rate cut on October 8th by the world’s main central banks, including the Federal Reserve, the European Central Bank, the Bank of England and (officially a coincidence) the People’s Bank of China. Various continental European countries also set about recapitalizing their banks. But the most astounding developments were in America and Britain. The Fed doubled the amount of money available to banks on a short-term basis to $900 billion and announced that it would buy unsecured commercial paper directly from corporate borrowers. More surprisingly, Gordon Brown’s government, hitherto the ditherer par excellence, produced the first systemic plan for dealing with the crisis, not just providing capital and short-term loans to banks but also offering to guarantee new debt for up to three years

This is certainly progress, but it is not enough. The world’s finance ministers and central bankers, gathering in Washington, DC, this weekend for the annual meetings of the IMF and World Bank, should deliver a simple message: more will be done. The world economy is plainly in a poor state, but it could get a lot worse. This is a time to put dogma and politics to one side and concentrate on pragmatic answers. That means more government intervention and co-operation in the short term than taxpayers, politicians or indeed free-market newspapers would normally like.

The patient writhing on the floor If the panic that has choked the arteries of credit across the globe is not calmed soon, the danger will increase that output in rich economies will not simply shrink, but collapse. The same could happen in many emerging markets, especially those that rely on foreign capital. No country or industry would be spared from the equivalent of a global financial heart attack.

Stockmarkets are in a funk. But the main problem remains the credit markets. In the interbank market the prices banks pay to borrow money from each other are still near record highs. Meanwhile corporate borrowers have found it hard to issue commercial paper, as money-market funds have fled from all but the safest assets. In emerging markets bond spreads have soared and local currencies plunged. And whole countries have begun to get into trouble. The government of Iceland has had to nationalize two of its biggest banks and is frantically seeking a lifeline loan from Russia. Robert Zoellick, president of the World Bank, says there could be balance-of-payments problems in up to 30 developing countries.

The damage to the real economy is becoming apparent. In America consumer credit is now shrinking, and around 159,000 Americans lost their jobs in September, the most since 2003. Some industries are hurting badly: car sales are at their lowest level in 16 years as would-be buyers are unable to get credit. General Motors has temporarily shut some of its factories in Europe. Across the globe forward-looking indicators, such as surveys of purchasing managers, are horribly gloomy.

If the odds of a rich-world recession have risen towards a near certainty, the emerging world as a

whole is slowing rather than slumping. China still seems fairly resilient. Taken as a whole, though, growth in the world economy seems likely to slow below 3% next year—a pace that many count as recessionary. So the prospects are grim enough, but a continuing credit drought would make this much worse.

Lessons old and new The lesson of history is that early, decisive government action can stem the pain and cost of banking crises. In the 1990s Sweden moved to recapitalize its banks quickly and recovered quickly; in Japan, where regulators failed to tackle toxic debt, the slump lasted for most of the decade. The twist is that this credit crisis is deeper (it affects many more types of markets) and broader (many more countries). Any solution has to be both more systemic and more global than before. One country trying to mend one part of its banking system will not work.

The idea of a comprehensive solution sounds simple, if expensive. But politicians have found it hard to grasp. Europeans have remained stubbornly wedded to the notion that the mess was “Made in America”; John McCain and Barack Obama talk as if it was all down to the greed of modern bankers. But financial excesses existed centuries before a brick had been laid on Wall Street. As our special report this week lays out, today’s bust—and the bubble that preceded it—had several causes besides dodgy lending, including a tide of cheap money from emerging economies, outdated regulation, government distortions and poor supervision. Many of these failures were as evident outside America as within it.

With a flawed diagnosis of the causes of the crisis, it is hardly surprising that many policymakers have failed to understand its progression. Today’s failure of confidence is based on three related issues: the solvency of banks, their ability to fund themselves in illiquid markets and the health of the real economy. The bursting of the housing bubble has led to hefty credit losses: most Western financial institutions are short of capital and some are insolvent. But liquidity is a more urgent problem. America’s decision last month to let Lehman Brothers fail—and the losses that implied to money-market funds that held its debt—prompted a global run on wholesale credit markets. It has become hard for banks, even healthy ones, to find finance; large companies with healthy cash flows have also been cut off from all but the shortest-term financing. That has increased worries about the real economy, which itself adds to the worries about banks’ solvency.

This analysis suggests that governments must attack all three concerns at once. The priority, in terms of stemming the panic, is to unblock clogged credit markets. In most cases that means using central banks as an alternative source of short-term cash. This week the Fed took another step in that direction: by buying commercial paper, it is now in effect lending direct to companies. The British approach is equally bold. Alongside the Bank of England’s provision of short-term cash, the Treasury says it will sell guarantees for as much as £250 billion ($430 billion) of new short-term and medium-term debts issued by the banks. That is risky: if left for any length of time, those pledges give banks an incentive to behave recklessly. But a temporary guarantee system offers the best chance of stemming the panic, and if it were internationally co-ordinated it would be both more credible and less risky than a collection of disparate national promises.

The second prong of a crisis-resolution strategy must aim to boost banks’ capital. A new IMF report suggests Western banks need some $675 billion of new equity to prevent banks from rapidly reducing the number of loans on their books and hurting the real economy. Although there is plenty of private capital sloshing around, there is a chicken-and-egg problem: nobody wants to buy equity in an industry without enough capital. It is becoming abundantly clear that government funds—or at least government intervention—will be necessary to catalyze the rebuilding of banks’ balance sheets. Initially, America focused more on buying tainted assets from banks; now it seems keener on the “European” approach of injecting capital into their banks. Some degree of divergence is inevitable, but more co-ordination is needed.

Third, policymakers should act together to cushion the economic fallout. Now that commodity prices have plunged, the inflation risk has dramatically receded across the rich world. With asset prices

plummeting and economies shrinking, deflation will soon be a bigger worry. The interest-rate cuts are an important start. Ideally, policymakers would not use only monetary policy. For instance, China could do a lot to help the rest of the world economy (and itself) by loosening fiscal policy and allowing its currency to appreciate more quickly.

A long wait Even in the best of circumstances, the consequences of the biggest asset and credit bubble in history will linger. But if the panic is stemmed, it could be a manageable problem, cushioned by the economic strength in the emerging world. Efforts at international economic co-operation have a patchy record. In the 1980s the Plaza and Louvre accords, designed respectively to push the dollar down and to prop it up, met with mixed success. Today’s problems are deeper and more countries are involved. But the stakes are also much higher.

The End Of American Capitalism? October 10, 2008

The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism.

Since the 1930s, U.S. banks were the flagships of American economic might, and emulation by other nations of the fiercely free-market financial system in the United States was expected and encouraged. But the market turmoil that is draining the nation's wealth and has upended Wall Street now threatens to put the banks at the heart of the U.S. financial system at least partly in the hands of the government.

The Bush administration is considering a partial nationalization of some banks, buying up a portion of their shares to shore them up and restore confidence as part of the $700 billion government bailout. The notion of government ownership in the financial sector, even as a minority stakeholder, goes against what market purists say they see as the foundation of the American system.

Yet the administration may feel it has no choice. Credit, the lifeblood of capitalism, ceased to flow. An economy based on the free market cannot function that way.

The government's about-face goes beyond the banking industry. It is reasserting itself in the lives of citizens in ways that were unthinkable in the era of market-knows-best thinking. With the recent takeovers of major lenders Fannie Mae and Freddie Mac and the bailout of AIG, the U.S. government is now effectively responsible for providing home mortgages and life insurance to tens of millions of Americans. Many economists are asking whether it remains a free market if the government is so deeply enmeshed in the financial system.

Given that the United States has held itself up as a global economic model, the change could shift the balance of how governments around the globe conduct free enterprise. Over the past three decades, the United States led the crusade to persuade much of the world, especially developing countries, to lift the heavy hand of government from finance and industry.

But the hands-off brand of capitalism in the United States is now being blamed for the easy credit that sickened the housing market and allowed a freewheeling Wall Street to create a pool of toxic investments that has infected the global financial system. Heavy intervention by the government, critics say, is further robbing Washington of the moral authority to spread the gospel of laissez-faire capitalism.

The government could launch a targeted program in which it takes a minority stake in troubled banks, or a broader program aimed at the larger banking system. In either case, however, the move could be seen as evidence that Washington remains a slave to Wall Street. The plan, for instance, may not compel participating firms to give their chief executives the salary haircuts that some in Congress intended. But if the plan didn't work, the government might have to take bigger stakes.

"People around the world once admired us for our economy, and we told them if you wanted to be like us, here's what you have to do -- hand over power to the market," said Joseph Stiglitz, the Nobel Prize-winning economist at Columbia University. "The point now is that no one has respect for that kind of model anymore given this crisis. And of course it raises questions about our credibility. Everyone feels they are suffering now because of us."

In Seoul, many see American excess as a warning. At the same time, anger is mounting over the global spillover effect of the U.S. crisis. The Korean currency, the won, has fallen sharply in recent days as corporations there struggle to find dollars in the heat of a global credit crunch.

"Derivatives and hedge funds are like casino gambling," said South Korean Finance Minister Kang Man-soo. "A lot of Koreans are asking, how can the United States be so weak?"

Other than a few fringe heads of state and quixotic headlines, no one is talking about the death of capitalism. The embrace of free-market theories, particularly in Asia, has helped lift hundreds of millions out of poverty in recent decades. But resentment is growing over America's brand of capitalism, which in contrast to, say, Germany's, spurns regulations and venerates risk.

In South Korea, rising criticism that the government is sticking too close to the U.S. model has roused opposition to privatizing the massive, state-owned Korea Development Bank. South Korea is among those countries that have benefited the most from adopting free-market principles, emerging from the ashes of the Korean War to become one of the world's biggest economies. It has distinguished itself from North Korea, an impoverished country hobbled by an outdated communist system and authoritarian leadership.

But the repercussions of crisis that began in the United States are global. In Britain, where Prime Minister Margaret Thatcher joined with President Ronald Reagan in the 1980s to herald capitalism's promise, the government this week moved to partly nationalize the ailing banking system. Across the English Channel, European leaders who are no strangers to regulation are piling on Washington for gradually pulling the government watchdogs off the world's largest financial sector. Led by French President Nicolas Sarkozy, they are calling for broad new international codes to impose scrutiny on global finance.

To some degree, those calls are even being echoed by the International Monetary Fund, an institution charged with the promotion of free markets overseas and that preached that less government was good government during the economic crises in Asia and Latin America in the 1990s. Now, it is talking about the need for regulation and oversight.

"Obviously the crisis comes from an important regulatory and supervisory failure in advanced countries . . . and a failure in market discipline mechanisms," Dominique Strauss-Kahn, the IMF's managing director, said yesterday before the fund's annual meeting in Washington.

In a slideshow presentation, Strauss-Kahn illustrated the global impact of the financial crisis. Countries in Africa, including many of those with some of the lowest levels of market and financial integration and openness, are now set to weather the crisis with the least amount of turbulence.

Shortly afterward, World Bank President Robert Zoellick was questioned by reporters about the "confusion" in the developing world over whether to continue embracing the free-market model. He replied, "I think people have been confused not only in developing countries, but in developed countries, by these shocking events."

In much of the developing world, financial systems still remain far more governed by the state, despite pressure from the United States for those countries to shift power to the private sector and create freer financial markets. They may stay that way for some time.

China had been resisting calls from Washington and Wall Street to introduce a broad range of

exotic investments, including many of the once-red-hot derivatives now being blamed for magnifying the crisis in the West. In recent weeks, Beijing has made that position more clear, saying it would not permit an expansion of complex financial instruments.

With the U.S. government's current push toward intervention and the soul-searching over the role of deregulation in the crisis, the stage appears to be at least temporarily set for a more restrained model of free enterprise, particularly in financial markets.

"If you look around the world, China is doing pretty good right now, and the U.S. isn't," said C. Fred Bergsten, director of the Peterson Institute for International Economics. "You may see a push back from globalization in the financial markets."

THE ECONOMIST SPECIAL REPORT ON THE FINANCIAL CRISIS

(WITHOUT GRAPHICS)

When fortune frowned Oct 9th 2008

From The Economist print edition The worst financial crisis since the Depression is redrawing the boundaries between government and markets, says Zanny Minton Beddoes (interviewed here). Will they end up in the right place? AFTER the stockmarket crash of October 1929 it took over three years for America’s government to launch a series of dramatic efforts to end the Depression, starting with Roosevelt’s declaration of a four-day bank holiday in March 1933. In-between, America saw the worst economic collapse in its history. Thousands of banks failed, a devastating deflation set in, output plunged by a third and unemployment rose to 25%. The Depression wreaked enormous damage across the globe, but most of all on America’s economic psyche. In its aftermath the boundaries between government and markets were redrawn.

During the past month, little more than a year after the financial storm first struck in August 2007, America’s government made its most dramatic interventions in financial markets since the 1930s. At the time it was not even certain that the economy was in recession and unemployment stood at 6.1%. In two tumultuous weeks the Federal Reserve and the Treasury between them nationalized the country’s two mortgage giants, Fannie Mae and Freddie Mac; took over AIG, the world’s largest insurance company; in effect extended government deposit insurance to $3.4 trillion in money-market funds; temporarily banned short-selling in over 900 mostly financial stocks; and, most dramatic of all, pledged to take up to $700 billion of toxic mortgage-related assets on to its books. The Fed and the Treasury were determined to prevent the kind of banking catastrophe that precipitated the Depression. Shell-shocked lawmakers caviled, but Congress and the administration eventually agreed.

The landscape of American finance has been radically changed. The independent investment bank—a quintessential Wall Street animal that relied on high leverage and wholesale funding—is now all but extinct. Lehman Brothers has gone bust; Bear Stearns and Merrill Lynch have been swallowed by commercial banks; and Goldman Sachs and Morgan Stanley have become commercial banks themselves. The “shadow banking system”—the money-market funds, securities dealers, hedge funds and the other non-bank financial institutions that defined deregulated American finance—is metamorphosing at lightning speed. And in little more than three weeks America’s government, all told, expanded its gross liabilities by more than $1 trillion—almost twice as much as the cost so far of the Iraq war.

Beyond that, few things are certain. In late September the turmoil spread and intensified. Money

markets seized up across the globe as banks refused to lend to each other. Five European banks failed and European governments fell over themselves to prop up their banking systems with rescues and guarantees. As this special report went to press, it was too soon to declare the crisis contained.

Anatomy of a collapse That crisis has its roots in the biggest housing and credit bubble in history. America’s house prices, on average, are down by almost a fifth. Many analysts expect another 10% drop across the country, which would bring the cumulative decline in nominal house prices close to that during the Depression. Other countries may fare even worse. In Britain, for instance, households are even more indebted than in America, house prices rose faster and have so far fallen by less. On a quarterly basis prices are now falling in at least half the 20 countries in The Economist’s house-price index.

The credit losses on the mortgages that financed these houses and on the pyramids of complicated debt products built on top of them are still mounting. In its latest calculations the IMF reckons that worldwide losses on debt originated in America (primarily related to mortgages) will reach $1.4 trillion, up by almost half from its previous estimate of $945 billion in April. So far some $760 billion has been written down by the banks, insurance companies, hedge funds and others that own the debt.

Globally, banks alone have reported just under $600 billion of credit-related losses and have raised some $430 billion in new capital. It is already clear that many more write-downs lie ahead. The demise of the investment banks, with their far higher gearing, as well as deleveraging among hedge funds and others in the shadow-banking system will add to a global credit contraction of many trillions of dollars. The IMF’s “base case” is that American and European banks will shed some $10 trillion of assets, equivalent to 14.5% of their stock of bank credit in 2009. In America overall credit growth will slow to below 1%, down from a post-war annual average of 9%. That alone could drag Western economies’ growth rates down by 1.5 percentage points. Without government action along the lines of America’s $700 billion plan, the IMF reckons credit could shrink by 7.3% in America, 6.3% in Britain and 4.5% in the rest of Europe.

Much of the rich world is already in recession, partly because of tighter credit and partly because of the surge in oil prices earlier this year. Output is falling in Britain, France, Germany and Japan. Judging by the pace of job losses and the weakness of consumer spending, America’s economy is also shrinking.

The average downturn after recent banking crises in rich countries lasted four years as banks retrenched and debt-laden households and firms were forced to save more. This time firms are in relatively good shape, but households, particularly in Britain and America, have piled up unprecedented debts. And because the asset and credit bubbles formed in many countries simultaneously, the hangover this time may well be worse.

But history teaches an important lesson: that big banking crises are ultimately solved by throwing in large dollops of public money, and that early and decisive government action, whether to recapitalize banks or take on troubled debts, can minimize the cost to the taxpayer and the damage to the economy. For example, Sweden quickly took over its failed banks after a property bust in the early 1990s and recovered relatively fast. By contrast, Japan took a decade to recover from a financial bust that ultimately cost its taxpayers a sum equivalent to 24% of GDP.

All in all, America’s government has put some 7% of GDP on the line, a vast amount of money but well below the 16% of GDP that the average systemic banking crisis (if there is such a thing) ultimately costs the public purse. Just how America’s proposed Troubled Asset Relief Program (TARP) will work is still unclear. The Treasury plans to buy huge amounts of distressed debt using a reverse auction process, where banks offer to sell at a price and the government buys from the

lowest price upwards. The complexities of thousands of different mortgage-backed assets will make this hard. If direct bank recapitalization is still needed, the Treasury can do that too. The main point is that America is prepared to act, and act decisively.

For the time being, that offers a reason for optimism. So, too, does the relative strength of the biggest emerging markets, particularly China. These economies are not as “decoupled” from the rich world’s travails as they once seemed. Their stockmarkets have plunged and many currencies have fallen sharply. Domestic demand in much of the emerging world is slowing but not collapsing. The IMF expects emerging economies, led by China, to grow by 6.9% in 2008 and 6.1% in 2009. That will cushion the world economy but may not save it from recession.

Another short-term fillip comes from the recent plunge in commodity prices, particularly oil. During the first year of the financial crisis the boom in commodities that had been building up for five years became a headlong surge. In the year to July the price of oil almost doubled. The Economist’s food-price index jumped by nearly 55%. These enormous increases pushed up consumer prices across the globe. In July average headline inflation was over 4% in rich countries and almost 9% in emerging economies, far higher than central bankers’ targets (see chart 2).

High and rising inflation coupled with financial weakness left central bankers with perplexing and poisonous trade-offs. They could tighten monetary policy to prevent higher inflation becoming entrenched (as the European Central Bank did), or they could cut interest rates to cushion financial weakness (as the Fed did). That dilemma is now disappearing. Thanks to the sharp fall in commodity prices, headline consumer prices seem to have peaked and the immediate inflation risk has abated, particularly in weak and financially stressed rich economies. If oil prices stay at today’s levels, headline consumer-price inflation in America may fall below 1% by the middle of next year. Rather than fretting about inflation, policymakers may soon be worrying about deflation.

The trouble is that because of its large current-account deficit America is heavily reliant on foreign funding. It has the advantage that the dollar is the world’s reserve currency, and as the financial turmoil has spread the dollar has strengthened. But today’s crisis is also testing many of the foundations on which foreigners’ faith in the dollar is based, such as limited government and stable capital markets. If foreigners ever flee the dollar, America will face the twin nightmares that haunt emerging countries in a financial collapse: simultaneous banking and currency crises. America’s debts, unlike those in many emerging economies, are denominated in its own currency, but a collapse of the dollar would still be a catastrophe.

Tipping point What will be the long-term effect of this mess on the global economy? Predicting the consequences of an unfinished crisis is perilous. But it is already clear that, even in the absence of a calamity, the direction of globalization will change. For the past two decades the growing integration of the world economy has coincided with the intellectual ascent of the Anglo-Saxon brand of free-market capitalism, with America as its cheerleader. The freeing of trade and capital flows and the deregulation of domestic industry and finance have both spurred globalization and come to symbolize it. Global integration, in large part, has been about the triumph of markets over governments. That process is now being reversed in three important ways.

First, Western finance will be re-regulated. At a minimum, the most freewheeling areas of modern finance, such as the $55 trillion market for credit derivatives, will be brought into the regulatory orbit. Rules on capital will be overhauled to reduce leverage and enhance the system’s resilience. America’s labyrinth of overlapping regulators will be reordered. How much control will be imposed will depend less on ideology (both of America’s presidential candidates have promised reform) than on the severity of the economic downturn. The 1980s savings-and-loan crisis amounted to a sizeable banking bust, but because it did not result in an economic catastrophe, the regulatory

consequences were modest. The Depression, in contrast, not only refashioned the structure of American finance but brought regulation to whole swathes of the economy.

That leads to the second point: the balance between state and market is changing in areas other than finance. For many countries a more momentous shock over the past couple of years has been the soaring price of commodities, which politicians have also blamed on financial speculation. The food-price spike in late 2007 and early 2008 caused riots in some 30 countries. In response, governments across the emerging world extended their reach, increasing subsidies, fixing prices, banning exports of key commodities and, in India’s case, restricting futures trading. Concern about food security, particularly in India and China, was one of the main reasons why the Doha round of trade negotiations collapsed this summer.

Third, America is losing economic clout and intellectual authority. Just as emerging economies are shaping the direction of global trade, so they will increasingly shape the future of finance. That is particularly true of capital-rich creditor countries such as China. Deleveraging in Western economies will be less painful if savings-rich Asian countries and oil-exporters inject more capital. Influence will increase along with economic heft. China’s vice-premier, Wang Qishan, reportedly told his American counterparts at a recent Sino-American summit that “the teachers now have some problems.”

The enduring attraction of markets The big question is what lessons the emerging students—and the disgraced teacher—should learn from recent events. How far should the balance between governments and markets shift? This special report will argue that although some rebalancing is needed, particularly in financial regulation, where innovation outpaced a sclerotic supervisory regime, it would be a mistake to blame today’s mess only, or even mainly, on modern finance and “free-market fundamentalism”. Speculative excesses existed centuries before securitisation was invented, and governments bear direct responsibility for some of today’s troubles. Misguided subsidies, on everything from biofuels to mortgage interest, have distorted markets. Loose monetary policy helped to inflate a global credit bubble. Provocative as it may sound in today’s febrile and dangerous climate, freer and more flexible markets will still do more for the world economy than the heavy hand of government.

Taming the beast Oct 9th 2008

From The Economist print edition How far should finance be re-regulated? “WALL STREET got drunk.” “Bankers deserve D.” A few years ago those phrases might have appeared on placards held by purple-haired protesters at anti-globalization rallies. Now they come from the president of the United States and a former chairman of the Federal Reserve. Thinking the microphones were off, George Bush told a group of Republicans in July that Wall Street needed to “sober up” and wean itself from “all these fancy financial instruments”. And long before September’s events, Paul Volcker gave financiers their D grade along with a devastating critique. “For all its talented participants, for all its rich rewards,” he said in April, the “bright new financial system” has “failed the test of the marketplace”.

In light of the events of recent weeks, it is hard to disagree. A financial system that ends up with the government taking over some of its biggest institutions in serial weekend rescues and which requires the promise of $700 billion in public money to stave off catastrophe is not an A-grade system. The disappearance of all five big American investment banks—either by bankruptcy or

rebirth as commercial banks—is powerful evidence that Wall Street failed “the test of the marketplace”. Something has gone awry.

But what exactly, and why? The fashionable answers come in sweeping indictments of speculators, greedy Wall Street executives and free-market ideologues. France’s president, Nicolas Sarkozy, recently said that the world needed to “bring ethics to financial capitalism”. Brazil’s president, Luiz Inácio Lula da Silva, wants to combat the “anarchy of speculation”. A more serious analysis, however, needs to distinguish between three separate questions. First, what is Mr Volcker’s “bright new financial system”? Second, how far was today’s mess created by instabilities that are inseparable from modern finance, and how far was it fuelled by other errors and distortions? Third, to the extent that modern finance does bear the blame, what is the balance between its costs and its benefits, and how can it be improved?

An Anglo-Saxon invention Put crudely, the bright new finance is the highly leveraged, lightly regulated, market-based system of allocating capital dominated by Wall Street. It is the spiffy successor to “traditional banking”, in which regulated commercial banks lent money to trusted clients and held the debt on their books. The new system evolved over the past three decades and saw explosive growth in the past few years thanks to three simultaneous but distinct developments: deregulation, technological innovation and the growing international mobility of capital.

Its hallmark is securitisation. Banks that once made loans and held them on their books now pool and sell the repackaged assets, from mortgages to car loans. In 2001 the value of pooled securities in America overtook the value of outstanding bank loans. Thereafter, the scale and complexity of this repackaging (particularly of mortgage-backed assets) hugely increased as investment banks created an alphabet soup of new debt products. They pooled asset-backed securities, divided the pools into risk tranches, added a dose of leverage, and then repeated the process several times over.

Meanwhile, increasing computer wizardry made it possible to create a dizzying array of derivative instruments, allowing borrowers and savers to unpack and trade all manner of financial risks. The derivatives markets have grown at a stunning pace. According to the Bank for International Settlements, the notional value of all outstanding global contracts at the end of 2007 reached $600 trillion, some 11 times world output. A decade earlier it had been “only” $75 trillion, a mere 2.5 times global GDP. In the past couple of years the fastest-growing corner of these markets was credit-default swaps, which allowed people to insure against the failure of the new-fangled credit products.

The heart of the new finance is on Wall Street and in London, but the growth of cross-border capital flows vastly extended its reach. Financial markets, particularly in the rich world, have become increasingly integrated. Figures compiled by Gian Maria Milesi-Ferretti, an economist at the IMF, show that the stock of foreign assets and liabilities held by rich countries has risen fivefold relative to GDP in the past 30 years and doubled in the past decade. The financial integration of emerging economies has been more modest, but has also increased considerably in recent years—though with a peculiar twist. Emerging economies, in net terms, have exported capital to the rich world as their central banks have built up vast quantities of foreign-exchange reserves.

The innovations of modern finance generated great profits for its participants. But were these innovations the root cause of today’s mess? That depends, in part, on whether you begin from the premise that financial markets are efficient, or that they are inherently prone to irrational behavior and speculative excess.

The rationale behind financial deregulation was that freer markets produced a superior outcome. Unencumbered capital would flow to its most productive use, boosting economic growth and improving welfare. Innovations that spread risk more widely would reduce the cost of capital, allow more people access to credit and make the system more resilient to shocks.

Today, however, a different premise has become popular: that financial markets are inherently unstable. Periods of stability always lead to excess and eventual crisis, and freer financial markets only lead to greater damage. This view was famously expounded by Hyman Minsky, a 20th-century American economist. Minsky argued that economic stability encouraged ever-greater leverage and ambitious debt structures. Stable finance was an illusion.

The trouble is that financial innovation did not occur in a vacuum but in response to incentives created by governments. Many of the new-fangled instruments became popular because they got around financial regulations, such as rules on banks’ capital adequacy. Banks created off-balance-sheet vehicles because that allowed them to carry less capital. The market for credit-default swaps enabled them to convert risky assets, which demand a lot of capital, into supposedly safe ones, which do not.

Politicians also played a big part. America’s housing market—the source of the greatest excesses—has the government’s fingerprints all over it. Long before they were formally taken over, the two mortgage giants, Fannie Mae and Freddie Mac, had an implicit government guarantee. As Charles Calomiris of Columbia University and Peter Wallison of the American Enterprise Institute have pointed out, one reason why the market for subprime mortgages exploded after 2004 was that these institutions began buying swathes of subprime mortgages because of a political edict to expand the financing of “affordable housing”.

History also shows that financial booms tend to occur when money is cheap. And money, particularly in America, was extremely cheap in the past few years. That was partly because a long period of low inflation and economic stability reduced investors’ perception of risk. But it was also because America’s central bank kept interest rates too low for too long, and a flood of capital swept into Western financial instruments from high-saving emerging economies.

So modern finance should not be indicted in isolation. Its costs and benefits are, at least in part, the result of the incentives to which the money men were responding. But given those distortions, did the new-fangled finance boost economic growth, welfare and stability?

Costs versus benefits Critics answer no on all three counts. Mr Volcker, for instance, points out that the American economy expanded as briskly in the financially unsophisticated 1950s and 1960s as it has done in recent decades. But plenty of things other than finance were different in the 1950s, so such a simple comparison is hardly fair. And although economists have long been divided on the theoretical importance of finance for growth, the balance of the evidence suggests that it does matter.

According to Ross Levine, an economist at Brown University who specializes in this subject, numerous cross-country studies show that countries with deeper financial systems tend to grow faster, particularly if they have liquid stockmarkets and large, privately owned banks. Growth is boosted not because savings rise but because capital is allocated more efficiently, improving productivity.

Within America several studies have shown that states which did most to deregulate their banking systems in the 1970s grew faster than other states. In 2006 economists at the IMF compared deregulated Anglo-Saxon financial systems with more traditional bank-dominated systems, such as Germany’s or Japan’s, and found that Anglo-Saxon systems were quicker to reallocate resources from declining sectors to new, fast-growing ones.

Many economists argue that financial innovation, and the quick reallocation of capital that it promotes, was one reason why America’s productivity growth accelerated in the mid-1990s. Technology alone cannot explain that advance, because inventions such as the internet and wireless communications were available to any country. What set America apart was the strong incentives it offered for deploying the new technology. Corporate managers knew that if they

adapted fast, America’s flexible financial system would reward them with access to cheaper capital.

Just because financial innovation can boost growth does not mean it always will. Not every technological breakthrough improves productivity. The bonanza in mortgage-backed securities helped create a glut of new homes that did little to promote long-term growth. But finance’s recent focus on housing, rather than more productive forms of investment, may have had more to do with the government guarantees inherent in housing than finance itself.

What about people’s lives? Even if financial innovation does not boost growth, it is a good thing if it improves welfare. Modern finance improved people’s access to credit. Computers enabled lenders to use standardized credit scores, and the risk-spreading from securitisation made it safer to lend to less creditworthy borrowers. This “democratization of credit” let more people own homes (and even now it is worth remembering that most subprime borrowers are keeping up with their payments). It enabled more households to smooth their consumption over time, reducing their financial hardship in lean times. Studies show that consumers in Anglo-Saxon economies cut their spending by less when they suffer temporary shocks to their income than those in countries with less sophisticated financial systems. Smoother household consumption often means a smoother economic cycle, too. Many economists believe that financial innovation, including easier access to credit, is one reason for the “Great Moderation” in the business cycle in the past few decades.

Still, in the light of today’s bust that welfare calculus needs revisiting, not least because broader access to credit plainly fuelled the housing bubble. Demand for complex mortgage securities led to a loosening of lending standards, which in turn drove house prices higher. Wall Street’s fancy computer models, based on recent price histories, underestimated how much the innovation was pushing up house prices, understated the odds of a national house-price decline in America and so encouraged an unsustainable explosion of debt. The country’s household debt rose steadily, from just under 80% of disposable income in 1986 to almost 100% in 2000. By 2007 it had soared to 140%. Once asset prices started to come down and credit conditions tightened, this borrowing binge left households—and the broader economy—extremely vulnerable. Not surprisingly, the “wealth effect” (the extent to which a change in asset prices affects people’s spending) is bigger in the indebted Anglo-Saxon economies than elsewhere. If financial innovation fuelled the bubble, so it will exaggerate the bust.

That leads to the critics’ third point: that far from enhancing economies’ resilience, modern finance has added to their instability. Mr Volcker, for instance, points to the absence of financial crises just after the second world war. At that time finance was tamed by the rules and institutions introduced after the Depression. But the 1950s were unusual. In a forthcoming book, “This Time is Different: Eight Centuries of Financial Folly”, Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard University survey eight centuries of financial crises. Their numbers suggest that, despite all that financial innovation, recent years have seen a surprising period of quiet—at least until the current crash.

Sowing the storm The incidence of crashes is only one measure of risk, however: their severity also matters. In theory, derivatives, securitisation and a choice of financing should spread risk, increase the financial sector’s resilience and reduce the economic damage from a shock. Before securitisation, the effect of a crash was intensely concentrated. A property bust in Texas meant mortgages held by Texan banks failed, starving Texan companies of capital. The expectation was that today’s decentralized and global system would spread risk and reduce the economic impact of a financial shock. In his book, “The Age of Turbulence”, Alan Greenspan points to the aftermath of the telecoms bust in the late 1990s, when billions of dollars went up in smoke but no bank got into trouble.

At first that resilience seemed to be on display during this crisis too. The fact that mortgage defaults in Cleveland or Tampa triggered bank losses in Germany was a sign of the system working. But

that resilience proved ephemeral. One reason was that risk was more concentrated than anyone had realized. Many banks originated mortgage-backed securities but then failed to distribute them, holding far too much of the risk on their own balance-sheets. That was a perversion of securitisation, rather than an indictment of it.

More troubling to proponents of modern finance was the crippling impact on market liquidity of uncertainty about the scale of risks and who held them. To work efficiently, markets must be liquid. Yet the past year has shown that uncertainty breeds illiquidity. High leverage ratios and a reliance on short-term wholesale funding rather than retail deposits, two features of the new finance, left the system acutely vulnerable to such a panic. Forced to shrink their balance-sheets faster than traditional banks, the investment banks, hedge funds and other creatures of the new finance may have made the economy less resistant to a financial shock, not more.

That is the conclusion of a new analysis by Subir Lall, Roberto Cardarelli and Selim Elekdag, published in the IMF’s latest World Economic Outlook, which argues that the economic impact of financial shocks may be bigger in countries with more sophisticated financial markets. The study looks at 113 episodes of financial stress in 17 countries over the past three decades and assesses the effect they had on the broader economy. Financial crises, the authors find, are as likely to cause downturns in countries with sophisticated financial systems as in those where traditional bank lending dominates. But such downturns are more severe in countries with the Anglo-Saxon sort of financial system, because their lending is more procyclical. During a boom, highly leveraged investment banks encourage a credit bubble, whereas in a credit bust they have to deleverage faster.

Excessive and excessively pro-cyclical leverage is clearly dangerous, but was it caused by the new financial instruments and deregulation? Again, not alone. Financial excesses often occur in the aftermath of innovation: think of the dotcom bubble or the 19th-century railways boom and bust. But throughout history, loose monetary conditions have fuelled the cycle: cheap money encourages leverage which boosts asset prices, which in turn encourage further leverage. Sophisticated finance meant that havoc spread in a new way.

Tackling leverage Given the past year’s calamity, how far must Anglo-Saxon finance be remade? The market itself has already asked for dramatic changes—away from highly geared investment banks towards the safety of lower leverage and more highly regulated commercial banks. Some sensible improvements to the financial infrastructure are already in the works, such as the creation of a clearing house for trading credit-default swaps, so that the collapse of a big force in the market, such as AIG, does not threaten to leave its counterparties with billions of dollars in worthless contracts.

The harder question is where—and by how much—financial regulation should be extended. Proposals for reform are pouring out from central banks, securities regulators, finance ministries, bank and universities, much as securitized mortgage debt once poured out from Wall Street. But just as financial innovation bears only part of the blame, so regulatory reforms will, at best, yield only part of the solution.

Indeed, some popular suggestions will not yield much. There is a lot of talk, for instance, of reforming credit-rating agencies, which encouraged the creation of mortgage securities by publishing misleading assessments of their quality. But the problem with credit-rating agencies lies in the tension between their business model and their use as a regulatory tool. The markets and regulators use ratings to determine the riskiness of an asset. Yet credit-rating agencies are paid by the issuers of securities and so have an inbuilt incentive to tailor their ratings to their clients’ needs.

Another popular suggestion is to change the incentive structures within financial institutions to discourage reckless and short-term behavior. The American government’s bail-out will include curbs on the pay of the bosses of troubled banks that benefit from it. This is a poor route to follow.

Governments are ill placed to micromanage the incentive structure within banks. Besides, even firms with compensation systems that encouraged their managers to lend carefully got into trouble. In both Bear Stearns and Lehman Brothers, for instance, employees owned a large part of the firms’ shares.

Could tighter government oversight produce better results? No one doubts that America’s complicated, decentralised and overlapping system of federal and state financial supervisors could be improved. (AIG, for instance, is technically supervised by New York state.) Nor that the enormous new markets, such as the $55 trillion global market in credit-default swaps, need more oversight. Nor that better disclosure and transparency are necessary in many of the newest financial instruments. But it would be unwise to expect too much. An entire government agency was devoted to overseeing the housing-finance giants, Fannie Mae and Freddie Mac, but that did not stop them behaving recklessly. So far, at least, a striking feature of the crisis has been that hedge funds, the least regulated part of the finance industry, have proved more stable than more heavily supervised institutions.

Similarly, re-regulation should proceed cautiously and with an eye to unintended consequences. Just as many of the innovations of modern finance, such as credit-default swaps, have been used to avoid the strictures of today’s bank regulation, so tomorrow’s innovations will be designed to arbitrage tomorrow’s rules. Even after today’s bust, bankers will be better paid and more highly motivated than financial regulators. The rule-makers are fated to be one step behind.

Nonetheless, improvements are possible. The most promising avenue of reform is to go directly after the chief villain: excessive and excessively procyclical leverage. That is why regulators are now rethinking the rules on banks’ capital ratios to encourage greater prudence during booms and cushion deleveraging during a bust. It also makes sense for financial supervisors to look beyond individual firms, to the stability of the financial system as a whole—and not just at the national level.

Leverage can be tackled in other ways too. For a start, governments should stop subsidising it. America, for example, should no longer allow homeowners to deduct mortgage interest payments from their taxable income. And governments should stop giving preferential treatment to corporate borrowing as well. Private-equity firms and the like are encouraged to load up companies with debt because tax codes favour debt over equity.

The bigger point is that governments should not view financial reform in a vacuum. Modern finance arose in an environment created by regulators and politicians. As Hank Paulson, the treasury secretary, told Congress during hearings about the American government’s bail-out plan: “You’re angry and I’m angry that taxpayers are on the hook. But guess what: they are already on the hook for the system we all let happen.” Whether that system is improved depends in part on whether politicians recognise their own role in shaping—and distorting—financial markets. The example of another recent crisis—in commodities—does not bode well.

Of froth and fundamentals

Oct 9th 2008 From The Economist print edition

The real lesson from volatile commodity prices CLIMB a steep flight of stairs down a small side street in Fatehpuri, part of the bustling commercial hub of Old Delhi, and you will come to a set of rooms overlooking an imposing internal courtyard. In one of them, half a dozen men lounge on mats beneath a poster of Lakshmi, the Hindu goddess of wealth. Next to them is a clutch of telephone sets, each on a long wire cord. Outside hangs a blackboard with prices scrawled in chalk. This is the trading floor of the Rajdhani Oils and Oilseeds Exchange, where futures contracts for soyabean oil, mustard seed and jaggery (sugar) are bought and sold.

It seems a long way from the New York Mercantile Exchange, but the political heat on both places has been much the same of late. Over the past couple of years India’s government has banned futures trading on commodities that include rice, wheat and lentils to rein in prices and stop what it sees as dangerous speculation. And in recent months America’s Congress has been mulling a series of measures to discourage similar speculation in oil markets. On September 18th the House of Representatives passed a bill that would limit how much speculative traders, such as hedge funds or pension funds, could invest in commodities, and closed the “Enron loophole”, which allows energy traders to escape government regulation when buying and selling over the counter or on electronic platforms. Japan’s government has tightened controls on futures trading and China has restricted foreign trading in its commodities markets.

Speculators have long been a popular target for politicians frustrated by volatile commodity prices. In 1947, when wartime controls ended and food prices soared, Harry Truman raised margin requirements (the share of the value of a futures contract that a trader must post upfront with an exchange) to 33%, vowing that food prices should not be a “football to be kicked about by gamblers”. In 1958 America’s Congress banned futures trading in onions for much the same reason.

But this time politicians are not the only ones who blame financiers for distorting prices. George Soros, a veteran investor, declared earlier this year that commodities were a “bubble”. Michael Masters, a hedge-fund manager, caused a storm when he told a congressional committee in June that the price of oil (then $130 a barrel) might be halved were it not for financial speculation. Even Shyam Aggarwal, the chief executive of the Rajdhani exchange, says futures trading in food products should be banned, at least temporarily.

Broadly, these men all make the same argument: that the flood of money from pension funds, hedge funds and the like that has poured into commodity futures in recent years is distorting spot markets for physical commodities. Rather than helping producers and consumers to hedge their risks and set commodity prices more transparently and efficiently, futures markets have become dominated by hedge funds, sovereign-wealth funds and so on seeking to diversify their portfolios. The speculative tail is wagging the spot dog.

If that argument were true, the consequences would be profound. Commodity prices have a more immediate impact on people’s lives than do stock or bond prices, particularly in poorer countries, where many households spend much of their budgets on food. If speculators are distorting commodity prices rather than improving price discovery, there may be good reason to shift the balance between government and market.

Speculating about speculators At first sight the finger does seem to point to the speculators. Commodities have become a popular alternative asset class for investors. According to Barclays Capital, institutional investors had around $270 billion in commodity-linked investments at the end of June, up from only $10 billion six years ago. The number of futures contracts on commodities exchanges has quadrupled since 2001. The notional value of over-the-counter commodity derivatives has risen 15-fold, to $9 trillion (see chart 6).

The timing of this increase coincides neatly with the long commodities boom. Prices since 2002 have soared by any yardstick. The climb has been most pronounced in dollars, the currency in which most globally traded commodities are priced, because the dollar itself has weakened. But over the past six years commodity prices have also risen in euros or indeed any other currency.

Speculation might also explain the extraordinary volatility of prices since the financial turmoil struck last August. As large swathes of debt instruments suddenly became illiquid and risky, investors—so the argument goes—sought safety in commodities. As America’s Federal Reserve slashed interest rates, so money managers, fearful of inflation, fled to hard assets, particularly oil. That surge of

cash created a new bubble that has recently burst.

On closer inspection, however, the speculation theory stands up less well. First, there is no consistent pattern between the scale of investors’ purchases of a commodity and the behavior of spot prices. For example, as investment funds piled into hog futures the price fell sharply—even as prices of other commodities rose. Second, many of the commodities in which prices have soared over the past few years, from iron ore to molybdenum, are not traded on exchanges and thus offer less opportunity for investors. Third, much of the surge of cash that has gone into commodities futures is due to rising prices. As the price of a commodity goes up, so does the value of a commodity-linked fund, even without any new money.

Lastly, stocks of most commodities have been low compared with their historical averages. This is important, because rising stocks are the channel through which speculation in futures markets affects the spot price. When speculators push up the futures prices of oil, for instance, they create an incentive for someone to buy oil in the spot market, sell a futures contract on it and store the oil until delivery is due. This hoarding should show up in higher stocks of unsold oil, but official oil stocks are well below their average of the past five years. The same is true for many other commodities.

The absence of hoarding is not conclusive proof of speculators’ innocence. As Roger Bootle of Capital Economics has pointed out, arbitrageurs must simply want to hold bigger stocks; they do not have to succeed. In markets where supply is constrained, their attempts to hoard could push up spot prices without any increase in physical stocks, at least temporarily. Moreover, in some commodities, particularly those that are mined or pumped, producers can reduce supply simply by holding back production. Oil producers, for instance, can simply pump less. But there is scant evidence that this has happened. As prices soared in the first half of this year, oil experts reckoned that most producers were pumping at full capacity. Saudi Arabia is the only large producer with spare capacity; if anything, it pushed up production this year.

All told, the case that speculators drove the commodity boom is weak. To be sure, futures markets can overshoot, and investors may have added temporary fuel, particularly in the first half of 2008. But the long rise in commodity prices—and their recent decline—can be explained much more easily by economic fundamentals.

Too much, too little, too late Over the past 50 years commodity prices have, on average, fallen relative to other goods and services as their supply has more than kept up with demand. As population growth and greater affluence increased the world’s demand for calories, for instance, agricultural productivity grew, which in turn increased supply. But this broad downward trend included plenty of volatility and several big shocks, notably in the 1970s when commodity prices of all sorts soared for several years.

One reason for those price swings was that neither the supply of nor the demand for commodities can change quickly. People have to eat, even if a bad harvest temporarily reduces the world’s grain stocks. It takes years to develop an oil field. In economists’ jargon, the price elasticity of both demand and supply is low in the short term. So any surprises on either side quickly translate into big price changes.

The 1970s commodity shocks were mostly set off by unexpected shortfalls in supply. Culprits included the Arab oil embargo of 1973, catastrophic harvests in 1972 and 1974 and the Iranian revolution in 1979. This decade’s boom, by contrast, was due largely to unexpectedly strong demand.

The world economy grew faster for longer than anyone foresaw. In its forecasts of April 2003, for instance, the IMF expected average global growth below 4% a year over the following three years. In fact, the world economy grew at an annual average of 4.5% between 2003 and 2007. This boom

was driven by emerging economies, which grew at an average pace of 7.3% a year. In 2003 the IMF expected China’s economy, for example, to grow by 7.5% a year, but in fact it has grown at an average annual rate of 10.6% a year since then. Not only did emerging economies grow unexpectedly fast, but at this stage of development their use of commodities becomes more intense as they get richer. The result was a dramatic rise in demand, particularly for energy and industrial commodities.

Take oil. In the four years from 1998 to 2002 world oil demand grew at an average rate of 1.1% a year. Between 2003 and 2007 the pace almost doubled, to an average of 2.1%, and almost all the increase came from the emerging world (oil demand in the OECD countries has been falling since 2006). In 2007 China alone accounted for one-third of the increase in global oil demand. In products such as most metals it made up an even bigger share.

Where governments have gone wrong Rising prosperity, however, is not the whole story behind stronger demand. Government-induced distortions have also blunted price signals. In many emerging economies governments control the prices of important fuels, such as diesel, and keep them below world-market levels. Oil-exporting countries are the worst offenders. Whereas the American price is close to a dollar per litre, for instance, Saudi Arabia sells petrol at 13 cents and Venezuela at 16 cents. Tellingly, the Middle Eastern oil exporters have seen a big increase in oil consumption. In 2007 they accounted for a quarter of the rise in global oil demand even though they represent a far smaller share of the world economy.

As oil prices rose, some countries decided to start unwinding these distortions. Oil-importing countries such as Malaysia, Taiwan, Indonesia, China and India have pushed up fuel prices in recent months. China has raised prices twice, in November 2007 and again in June this year. Its petrol prices are now not far off America’s (though other energy prices in China are still artificially low). But many other countries kept prices fixed and increased the size of their subsidies. This has hurt their government finances and, more importantly, has made price volatility worse by obstructing the route from higher prices to weaker demand.

The distortions that governments introduce are even more evident in foodstuffs, and this time the culprits are rich countries, particularly America and Europe. Ostensibly to reduce carbon emissions, governments in both places have introduced policies to encourage biofuels (corn-based ethanol in America and biodiesel in Europe). Thanks to these subsidies and regulations, demand for maize and vegetable oils (on which biodiesel is based) has exploded and these crops have displaced others, such as wheat.

Analysts from the OECD to the World Bank argue that biofuel demand is the biggest single reason why food prices have soared in the past couple of years, accounting for as much as 70% of the rise in maize prices and 40% of the rise in soyabean prices. Higher energy prices have also made a difference as fertilizer and other input costs have risen.

Rather than recognize their own role in creating the food-price spike, many Western politicians (notably President George Bush) have pointed to rising affluence in emerging economies. Richer Indian and Chinese consumers are indeed eating more meat than they did—though a lot less than people do in the West—but that shift has not been sudden enough to explain the price surges since 2006. It is biofuels that have made the difference.

Demand shocks and misguided government policies go a long way towards explaining the behavior of commodity prices in recent years. But supply surprises have also played a role, particularly in oil, where the supply response to higher prices has been sluggish even by its standards.

After years of low oil prices in the 1990s the OPEC group of producers began the recent boom with plenty of spare capacity. That spare capacity has all but disappeared, largely because production outside OPEC has been disappointing. Again, government policy played a part. The vast majority of

the world’s oil reserves are in the hands of government-owned oil companies. Too often these firms use their revenues for political purposes rather than invest it to raise output.

In agriculture emerging governments restricted supply, aggravating the problems caused by demand in the rich world. Panicked by rising food prices in 2007, more than 30 governments, from Ukraine to China, introduced export restrictions for farm produce. This cut the supply of food on world markets, sending prices even higher. Rice was worst hit because only 4% of its global crop is traded across borders, compared with 13% for maize and 19% for wheat. On news of bans in China, Vietnam, Cambodia, India and Egypt (which between them grew 40% of world rice exports in 2007), the price tripled within a few weeks.

In this panicked environment, futures prices for all food commodities shot up. At times investment funds may have exacerbated fears about scarcity. But for food, as for fuel, the main reason for the price rises of recent years has been unexpected demand growth, often compounded by government distortions.

Contrary to what the critics of speculation suppose, the main task of futures markets has been to signal these fundamentals to firms and households, speeding up their adjustment to the changing balance of supply and demand for physical commodities. In the absence of such signals, it would have taken even bigger and more extended swings in the prices of physical commodities to bring supply and demand into balance.

The same mix of fundamentals and government action, but in reverse, helps explain the easing of prices in recent months. The drop in commodity prices in dollar terms partly reflected a strengthening of the greenback. Oil prices in euros, for instance, have fallen by 25% less from their peak than oil prices in dollars. A series of sensible moves by governments, such as the decision by some big exporters to lift export controls, helped ease the panic in food markets. The prospect of bumper cereal crops has boosted confidence about short-term supply. The Economist’s food-price index at end-September was down 23% from its peak. Yet nobody is denouncing speculators for driving prices down.

The oil market is also adjusting. A new Saudi field has come on stream, improving the prospect of a supply boost. On the demand side, consumers have started to respond. Faced with petrol at $4 a gallon, American drivers changed their habits faster than expected, switching to smaller cars, driving less and using public transport more.

Most important, the world economy has suddenly slowed, and its prospects have darkened dramatically. Thanks, in part, to the shock of higher oil prices, output growth in Japan and Europe ground to a halt at the beginning of the summer. By August even the big emerging economies were showing signs of slowing from their breakneck pace. As the scale of the global slowdown became clearer, so commodity prices weakened.

If persistent and unexpected demand fuelled much of the commodities boom, so surging prices may, at least in part, have been a symptom of a global economy that was overheating. That is now changing fast. But it suggests that the world’s politicians, rather than point the finger at speculators, might look first at their own policies—and then at the mistakes of their central bankers.

A monetary malaise Oct 9th 2008

From The Economist print edition Central bankers helped cause today’s mess. Will they be able to clean it up? FOUNDED in 1930, the Bank for International Settlements (BIS) is the oldest and chummiest of the international financial institutions. Based in Basel (with its famously good food), the central bankers’ club is the nerve centre for international co-operation on monetary technicalities. How ironic, then, that the BIS’s economists put much of the blame for the current mess on central bankers and

financial supervisors.

For years, BIS reports have given warning about excess global liquidity, urged central bankers to worry about asset bubbles even when consumer-price inflation was low, encouraged policymakers in a global economy to pay more attention to global measures of economic slack, and argued that banking supervisors needed to look beyond individual firms to the soundness of the financial system as a whole. Today’s calamity, in the BIS’s view, stems from one fundamental source: a world where credit-driven excesses went on for too long. “The unsustainable has run its course,” thundered the organization’s annual report in June.

The case against central bankers comes in two parts. The first is that they, along with other financial regulators, were asleep at the wheel, failing to appreciate the scale of risks being built up in the “shadow” banking system that modern finance had created. The second is that they fuelled a credit bubble by keeping money too cheap for too long.

The criticisms are most often directed at the Fed. This is because America is the world’s biggest economy; because its interest-rate decisions affect prices across the world; because the Fed has shown a penchant for cheap money in recent years; and because America’s mortgage mess fed the financial crisis. The Fed carries a disproportionately large weight among America’s patchwork of financial regulators.

Supervision cannot work miracles, but the Fed clearly could have done better. It did not have direct jurisdiction over the independent mortgage brokers who were making the dodgiest loans during the height of the housing boom (they were notionally supervised by their states). But it had plenty of chances to sound the alarm and could have calmed the frenzy by tightening federal rules designed to protect consumers. However, Alan Greenspan, the Fed’s chairman during the bubble years, saw little risk in the housing boom and followed his hands-off instincts. His successors now admit that was a mistake. Supervision has been tightened.

What about monetary policy? Here the problem is the Fed’s asymmetric approach. By ignoring bubbles when they were inflating, whether in share prices or house prices, but slashing interest rates when those same bubbles burst, America’s central bankers have run a dangerously biased monetary policy—one that has fuelled risk-taking and credit excesses.

In the most recent episode the Fed stands accused of three main errors. Mistake number one was to loosen the monetary reins too much for too long in the aftermath of the 2001 recession. Fearing Japan-style deflation in 2002 and 2003, the Fed cut the federal funds rate to 1% and left it there for a year. Mistake number two was to tighten too timidly between 2004 and 2006. Mistake number three was to lower the funds rate back to 2% earlier this year in an effort to use monetary policy to alleviate financial panic. The first two failures fuelled the housing bubble. The third aggravated the commodity-price surge.

With hindsight, there is merit to the first two charges. The Fed did worry unduly about Japanese-style deflation in the early part of this decade, though it was a defensible decision at the time. The failure to tighten policy more quickly from 2004 onwards was a bigger mistake. Low short-term rates encouraged the boom in adjustable-rate mortgages that added to the housing bubble, and the predictability and gradualness of the Fed’s eventual tightening encouraged broader risk-taking on Wall Street.

From a narrowly American perspective, the case against the Fed’s rate cuts this year is weaker. Long before last month’s calamities, the turmoil on Wall Street kept overall financial conditions tight even as the Fed slashed the price of short-term money. Because risk spreads have soared, borrowing costs for firms and individuals have barely budged even as lending standards have tightened dramatically. Given the economy’s weakness, it is now hard to argue that the Fed was wrong to cut rates so enthusiastically this year.

But should the Fed be judged just by American criteria? Its actions—both during the bubble and the subsequent bust—took place against the backdrop of rapid financial globalization and choices made by central bankers elsewhere. The most important of these was the emergence of large saving surpluses in many big emerging economies, especially China, and their (related) decision to link their currencies to the dollar, in a system often called the Bretton Woods II regime. (Bretton Woods I was the global monetary system in force between 1944 and the early 1970s under which countries fixed their currencies to the dollar, which in turn was tied to gold.)

Wall of money The large saving surplus in emerging economies caused a flood of capital to rich ones, largely America. That surplus had several causes. Investment in many Asian economies collapsed after their financial crises in the late 1990s. The rapid increase in the price of oil over the past few years shifted wealth to oil exporters, such as Saudi Arabia and Russia, faster than they could spend it. But policy choices, especially emerging-economies’ currency management, played a big role. The rapid rise in China’s saving surplus between 2004 and 2007 stemmed in part from an undervalued exchange rate. Emerging-economy central banks now hold over $5 trillion in reserves, a fivefold increase from 2000 (see chart 9).

This flood of capital fuelled the financial boom by pushing long-term interest rates down. Long rates fell across the rich world and stayed perplexingly low even as the Fed (and other rich-world central banks) began raising short-term rates in 2004. Mr Greenspan famously dubbed this a “conundrum” but did nothing to counter it by increasing rates more quickly.

Eventually Bretton Woods II began to fuel credit booms and economic overheating in the emerging world. That is no surprise. When capital is mobile, countries that fix their currencies lose control over their domestic monetary conditions. When foreign capital flows in they must buy foreign currency and pay out their own one, increasing the money supply and stoking inflation. Central banks can try to keep foreign capital out, and can “sterilize” the effect of buying foreign currency by selling bonds or forcing banks to hold higher reserves. Some countries, particularly China, have been surprisingly successful at this. But none of these methods works perfectly: eventually domestic credit takes off and inflation accelerates.

That is particularly likely when there is a large divergence in economic conditions between the anchor country (in this case America) and those that shadow its currency. The Fed’s interest-rate cuts in late 2007 and early 2008 may have been appropriate for a weak and financially stressed American economy. But they sent the dollar tumbling and left monetary conditions far too loose in many emerging markets whose economies had long been growing beyond their sustainable pace.

By 2008, according to the IMF’s estimates, emerging economies were growing above their trend rate for the fourth year in a row and had more than exhausted their spare capacity. Underlying inflation (excluding food and fuel) was beginning to rise. Everything pointed to the need to raise interest rates. Yet by March of this year short-term real interest rates in emerging economies (based on the weighted average of 26 central-bank policy rates) were negative (see chart 10). That suggests rising inflation was the consequence of a “decoupled” world economy in which emerging economies were booming even as America stumbled, and a misguided monetary regime that linked the two.

The upshot was a commodity-price spike and a rise in inflation the world over even as the financial crisis was deepening in rich countries. Ordinarily a banking crisis leads to disinflation (or even deflation) as asset prices fall, credit shrinks and economies slow. Yet in America, the centre of the storm, inflation rose this summer to levels not seen in almost two decades.

The role of commodity prices made the inflation risk hard to interpret. Central bankers had to decide whether the accelerating prices of food and fuel were a temporary surge in their price relative to other goods (in which case economic damage would be minimized by temporarily allowing overall inflation to rise); or whether the rising prices were a symptom of generalized price pressure (which

would argue for higher interest rates).

Central bankers responded to this challenge in a variety of ways. Some emerging economies, particularly in Latin America, took an orthodox approach, raising interest rates quickly to get inflation back towards its target. Others, especially in Asia, took longer to adjust, even though wages were rising fast and demand was strong. Worried by double-digit inflation, some countries, such as India, eventually began to tighten sharply. Others, such as Malaysia, with inflation at 8.5%, did not budge.

In the rich world, central bankers in Europe were more worried about inflation than the Fed, partly because many pay deals in Europe are set centrally and wages have been more inclined to rise along with prices. The ECB raised interest rates in July, and Sweden’s Riksbank increased them as recently as September. But everybody was perplexed by the combination of financial crisis and rising inflation. “I don’t understand what the hell is going on,” said one honest official in June.

In recent weeks those tensions have abated, though not in a comforting way. Global demand dropped sharply over the summer and the outlook for the world economy darkened. That slowdown helped to bring commodity prices down, transforming the inflation outlook in rich countries. Simple mathematics suggests that if oil prices stay around $100 a barrel, headline inflation in the euro area could fall towards 2% within a year; in America it could be down to 1%. Since both these regions are in, or close to, recession, economic slack is increasing fast, which in turn will bring down inflation further. Add in September’s financial calamities and the risk of entrenched and out-of-control inflation seems slim. Suddenly the idea of deflation—a generalized drop in prices—no longer seems far-fetched.

From inflation to deflation? That is a worrying prospect. Deflation that reflects a slump in demand and excess capacity is always dangerous. Falling prices can cause consumers to put off purchases, leading to a downward spiral of weak demand and further price falls. That outcome is particularly pernicious in economies with high levels of debt, as Japan painfully discovered in the 1990s. The real value of the debt burden grows as prices fall—precisely the opposite of what a country needs when it is weighed down by excessive debts already.

The rich world’s economies are already suffering from a mild case of this “debt-deflation”. The combination of falling house prices and credit contraction is forcing debtors to cut spending and sell assets, which in turn pushes house prices and other asset markets down further. Irving Fisher, an American economist, famously pointed out in 1933 that such a vicious downward spiral can drag the overall economy into a slump. A general fall in consumer prices would make matters even worse. Since central banks cannot cut nominal interest rates below zero, deflation raises real interest rates, slowing the economy further and raising the real value of debts. Private-sector debts are now much larger than they were in the 1930s, so a modern depression could be even nastier. But there are four reasons why a deflationary spiral should be still a remote risk—and a risk that policymakers can avoid.

First, although food and fuel prices are volatile, most other prices do not drop so easily. In most rich countries “core” inflation is still a long way from zero. That will not change quickly. In Japan deflation did not set in until four years after that country’s financial bubble burst.

Second, central bankers—at least outside America—have plenty of monetary ammunition left. At 4.25%, the ECB’s policy rate still leaves plenty of scope for downward adjustment.

Third, American policymakers, at least, have understood that public money is necessary to counter a spiral of debt-deflation. They are now spraying taxpayers’ money at the financial crisis like firemen with hoses. This will help slow the deleveraging.

Lastly, and less happily, several years of rising oil prices may have slowed the rich world’s underlying economic speed limit, by reducing the productivity of energy-guzzling machinery and

raising transportation costs. Economic weakness may therefore be less disinflationary than it used to be.

All in all, then, the rich world’s policymakers have plenty of tools with which to beat off deflation. But just as the bubble was inflated by the interaction of monetary policy in the rich and the emerging world, so today’s macroeconomic outlook will be influenced by decisions made outside America, Japan and Europe.

So far, emerging economies have been playing a positive role. If, as still seems likely, the biggest among them slow but do not slump, then some sort of floor will be put under commodity prices and robust consumers in the emerging world will prop up exports from fragile debt-laden rich countries.

But the emerging markets’ resilience cannot be taken for granted. They suffered their own version of the cycle that Bretton Woods II inflicted on the rich world: surplus savings flowed in, stoking asset prices. Now many stockmarkets and currencies have plunged as the pendulum has swung back again. Investors worry about continuing high inflation (in emerging Asia) and lower commodity prices (in Latin America). Countries, especially in eastern Europe, that built up current-account deficits when cheap money made these easy to finance now look vulnerable. But the biggest economies, notably China’s, appear robust. And if the world economy darkens further, China will emerge as the likeliest savior.

China to the rescue? China’s government has already shown concern about its economic slowdown, lowering reserve requirements for small banks and cutting interest rates. But from a global perspective it would be best for China to loosen fiscal policy and allow the currency to strengthen. The country has ample room to boost spending. And by allowing its currency to rise faster, it would counter the deflationary risks in the rich world as both the dollar and the euro weaken against the yuan.

Misguided currency rigidity helped cause today’s mess; enlightened flexibility could help solve it. And in the longer term the lessons that emerging economies draw from today’s turmoil will help define the direction of global finance.

Charting a different course Oct 9th 2008

From The Economist print edition Will emerging economies change the shape of global finance? “THE United States has been a model for China,” says Yu Yongding, a prominent economist in Beijing. “Now that it has created such a big mess, of course we have to think twice.”

The future of global finance depends on what kind of rethinking takes place in Beijing and the rest of the emerging world. So far the signals have been mixed, even within the same country. In India, for instance, the central bank—long a reluctant liberalizer—recently changed its mind about allowing credit-default swaps, arguing that the subprime crisis showed the time was not “opportune” for such innovations. But at the end of August India launched exchange-traded currency derivatives, giving people a means to hedge against fluctuations in the rupee.

Chinese officials have been unusually outspoken about Wall Street’s failures. But just as several rich countries, from Britain to Australia, have banned or reined in short-selling (selling borrowed shares) in a misguided effort to stop share prices falling, China’s cabinet agreed to allow investors to buy shares on credit and sell shares short.

By and large, emerging economies’ attitude to Anglo-Saxon finance is deeply pragmatic, defined more by the lessons of their own financial crises in the 1990s than by today’s calamities on Wall Street. Those crises inflicted far greater economic pain than anything the rich world has seen so far. Mexico’s GDP, for instance, fell by 6% in 1995 and Indonesia’s by 13% in 1998.

Those collapses held powerful lessons: foreign-currency debt was dangerous, the IMF was to be avoided at all costs and prudence demanded the build-up of vast war chests of foreign-exchange reserves. Rich countries typically have foreign-currency reserves worth about 4% of their GDP. The level in emerging economies used to be much the same, but over the past decade that ratio has risen to an average of over 20% of GDP. China has a whopping $1.8 trillion, and eight other emerging economies have more than $100 billion apiece.

At first sight, fat cushions of reserves have stood emerging economies in good stead. They are one reason why these countries have proved so resilient in today’s global turmoil. But, as this special report has argued, these war chests introduced many distortions and rigidities that helped to inflate the global financial bubble and stoke domestic inflation. The challenge for emerging economies is to create a system of global finance that is more flexible yet still safe.

The academic evidence is not reassuring. After the 1990s crisis economists began to look closely at what poor countries gained from integration with global capital markets. The answer appeared to be not much. An influential study for the Brookings Institution in 2007 by Eswar Prasad of Cornell University, Raghu Rajan of the University of Chicago and Arvind Subramanian of the Peterson Institute showed that poor countries that relied on domestic savings to finance their investment grew faster than those that relied more on foreign money.

Nor did foreign capital seem to help emerging economies to cope better with sudden income shocks. In another paper Mr Prasad, together with Ayhan Kose and Marco Terrones of the IMF, showed that the volatility of consumption in emerging economies has increased in recent years. Poor countries with weak financial systems, it appears, cannot cope with floods of foreign capital. The money is often channeled to unproductive areas such as property. Such inflows seem to make boom-bust cycles worse.

The news was not all bad. Studies also showed that foreign direct investment and equity flows brought in know-how and improved corporate governance. And the evidence also suggests that competition from foreign banks and foreigners’ money in stockmarkets can improve emerging economies’ own financial systems. But long before Mr Volcker questioned the wisdom of globalized finance in America, academics were having second thoughts about the wisdom of financial globalization for the emerging world.

Ignore the ivory tower Ironically, this intellectual backlash was taking place even as emerging economies were becoming financially ever more integrated with the rest of the world. All in all, the citizens of emerging countries now have some $1 trillion deposited in foreign banks, a threefold increase since 2002. By every measure, the gross flows of capital involving emerging economies have grown since the mid-1990s and accelerated in the past few years. The composition of those flows has changed: foreign direct investment and equity flows have risen much faster than debt. But the overall level of financial integration is up significantly.

Financial globalization sped up partly because governments did not listen to the academic skeptics. Most continued to open up, particularly to equity and foreign direct investment. According to the IMF’s index of capital controls, only two emerging economies closed their capital accounts between 1995 and 2005, whereas 14 countries opened up fully. The rest came somewhere in-between but were mostly moving towards greater openness.

At the same time foreign banks were playing an ever bigger role. By 2007 almost 900 foreign banks had a presence in developing countries. On average they accounted for some 40% of bank lending, up from 20% a decade earlier. In some places, particularly in eastern Europe and Latin America, foreign banks dominate the domestic financial system. Even China and India, which have been slow to allow in foreign banks, have opened up more in the past decade.

More important, financial integration was accelerating regardless of any deliberate policy choices. In

a fast-globalizing world even countries with strict capital controls saw an increase in actual capital flows. One explanation is that more trade inevitably produces more capital integration. A financial infrastructure grows up to support global supply chains. Larger trade flows make it easier for firms to evade capital controls, by over- or under-invoicing their transactions. And fast growth has made emerging economies an attractive target for foreign investors and their own citizens living abroad, who can find ways to get around capital controls.

The distortions and costs associated with capital controls are rising as emerging economies become more globalized. Temporary taxes to discourage sudden surges of capital may still have a role to play, even though they can sometimes prove counterproductive. Thailand, for example, imposed a tax on foreign capital inflows into its stockmarket in 2006 but saw the market plunge and quickly reversed the decision. In the longer term the distortions caused by such measures become more burdensome. China, for instance, has some of the strictest controls among large emerging economies, partly insulating itself from global capital markets, but the controls needed to deter speculative capital are becoming ever more intrusive. Since July the State Administration of Foreign Exchange (SAFE) has demanded more information on export earnings. For many small-scale exporters that is a big burden. Globalized finance, it turns out, is an inextricable part of global integration.

That means the right question for emerging economies to ask is not whether global finance is a good thing but how to maximize the gains and minimize the costs. The answer is to rely more on markets, not less, but try to avoid the mistakes that the rich world made.

At home that means adopting more of the new finance. Emerging economies vary enormously in their domestic financial development, but some of the biggest are still surprisingly primitive. India, for instance, has highly sophisticated equity markets but its banking system is underdeveloped and distorted by government edicts. Some 40% of India’s bank loans are directed to “priority sectors” such as agriculture, and the main source of credit for the typical citizen is the informal moneylender.

The harder question is how to deal with foreign capital. Top of the list should be greater currency flexibility. The risk for emerging economies that open themselves up to global capital flows is destabilization. Money will slosh in and out, driving underdeveloped local asset markets up and down and affecting the level of demand in the real economy. Countries that allow foreign banks to enter their markets will be affected by these banks’ fortunes elsewhere in the world. Losses that European banks make on American mortgage products, for instance, may cause tighter credit in Hungary.

To deal with such volatility, emerging markets need to manage demand in the way that rich nations do: through more flexible interest rates and exchange rates. By allowing their exchange rates to rise and fall as capital flows wax and wane, emerging economies should be able to keep a measure of control over their domestic monetary conditions. Firms and investors in developing countries also need the risk-sharing derivatives developed by Anglo-Saxon finance. Some already have them. Brazil’s market for foreign-exchange derivatives, for instance, is one of the most sophisticated and transparent in the world. Others, particularly in Asia, have much further to go, though India’s recent innovations are encouraging.

By removing the need to accumulate vast foreign-exchange reserves, greater currency flexibility would also create a more stable global monetary system. The war chests of reserves could be used to boost domestic financial development. In the summer 2008 issue of the Journal of Economic Perspectives, Messrs Prasad and Rajan offer an intriguing proposal. Countries with plenty of reserves, such as China or India, could allow mutual funds (domestic or foreign) to issue shares in domestic currency with which they could buy foreign exchange from the central bank. These mutual funds would then invest abroad on behalf of domestic residents.

The result would be a controlled liberalization of capital outflows, along with the creation of new financial institutions and instruments at home. Oil-exporting countries could achieve much the same

effect by issuing their citizens with an oil dividend that could be invested abroad through similar mutual funds. Under both models the management of emerging economies’ foreign assets would be shifted increasingly to the private sector. That would allow private investors from China or Saudi Arabia to pick over the carcass of Wall Street.

The heavy hand of the state At present, though, the trend is still in the opposite direction. Governments in Asia and emerging oil exporters already control some $7 trillion of financial assets, most of it in currency reserves, the rest in sovereign-wealth funds. Analysts at the McKinsey Global Institute reckon that the total could reach $15 trillion by 2013. That would make government-controlled funds a large force in global capital markets, with the equivalent of 41% of the assets of global insurance companies, 25% of global mutual funds and a third of the size of global pension funds (see chart 11).

There is an irony here. By and large, emerging economies shut their ears to the anti-market skeptics who argued that global capital flows were dangerous. But in resisting one statist temptation they have succumbed to another: they have accumulated vast sums of capital in government hands, transforming the nature of global finance long before Wall Street’s implosion. However professionally these funds are managed, such huge government-controlled assets will change the balance between state and market. They will also add to the biggest risk for global integration: rising protectionism.

Beyond Doha Oct 9th 2008

From The Economist print edition Freer trade is under threat—but not for the usual reasons DURING a summer when the economic shadows darkened so dramatically, few paid attention to the collapse—yet again—of the Doha round of global trade talks. Champions of liberal trade, such as this newspaper, wrung their hands, but no one else cared much. The failure in Geneva, where the World Trade Organization (WTO) is based, seemed something of a sideshow.

In a global survey of business executives, conducted for this special report by the Economist Intelligence Unit, a sister company to The Economist, over half the respondents regarded the Doha round as minimally or not at all important, and only 10% thought it very important. One in ten saw protectionism as the biggest threat to the world economy, but far more were worried about recession, inflation and the financial crisis.

At first sight that seems a reasonable judgment to make. With so many barriers already removed, the immediate economic stakes in the Doha round are modest: gains of some $70 billion a year, according to one recent estimate, little more than 0.1% of global GDP. Add in the likely boost to productivity growth and the eventual impact will be higher, but it is still hard to argue that the Doha round, taken in isolation, could dramatically change the world’s fortunes.

That is partly because the negotiations were about “bound” tariff rates—the maximum permitted by global trade rules. But most countries have already slashed their tariffs unilaterally to well below the bound rates—and it is actual trade barriers, not the highest permissible ones, that businesspeople worry most about. Tellingly, the scale of corporate lobbying around the Doha negotiations has been much lower than in previous global talks, such as the Uruguay Round.

Nor is it hard to see why many companies discount the risks of protectionism. Rich countries, particularly America, have grumbled a lot about trade with China, but nothing much has happened to obstruct the spread of commerce. Congress has threatened to punish China’s currency policy with tariffs and to “get tough” with other supposedly unfair trade behavior, but no laws have emerged. Globally, the use of anti-dumping duties, a popular protectionist tool, has fallen. With supply chains so integrated, it is tempting to conclude that multilateral negotiations are no longer necessary and new trade barriers have become implausible.

Tempting but wrong. In an increasingly integrated world, multilateralism matters more than ever. The inability to get a Doha deal done is a worry not because of the modest amount of freer trade forgone but because of the symbolic importance of the talks and the reasons for the impasse. This trade round is the first international forum in which big emerging economies, such as India, Brazil and China, have played an influential role. Failure to reach agreement thus bodes ill for future multilateral co-operation of any sort.

If the talks continue to flounder, negotiating momentum will shift to (far less desirable) regional and bilateral trade deals, of which there are already some 400 in place or under negotiation. The WTO itself may be weakened. India signed a regional trade deal with the ASEAN group of Asian countries less than a month after the Doha talks fell. If countries lose faith in multilateral negotiations as a means to achieving better market access, they may turn to litigation to reach their trade goals.

Perhaps most worrying, the Doha impasse in part reflects the intellectual shifts that this special report has described. The July summit failed because of China’s and India’s insistence on maintaining the right to impose “safeguard” tariffs to protect their own farms in case of a sudden surge in food imports. India, which has over 200m farmers, has long been reluctant to expose them to international competition. China, which had kept a low profile throughout Doha’s six years of tortured talks, swung behind India’s position at the last minute, worried about food security in the wake of the commodity-price surge.

Security-conscious The centerpiece of the Doha trade round is freer trade in farm goods, a shift that will benefit poor countries disproportionately. But the round was launched in 2001, well before the commodities boom, so its main emphasis was on government policies that kept prices artificially low, such as production and export subsidies in rich countries. Today, the main concern is policies that push prices up: unilateral export bans, subsidies for consumers and the pursuit of biofuels. The fear is about security of supply. Food self-sufficiency has become a political rallying cry.

That instinct is plainly misguided. The food with the most volatile price over the past year is rice, precisely because it is the least traded. Freer trade in food is the best way to ensure stable access and prices. But an efficient global market needs strictures against unilateral barriers to exports as much as imports, and the WTO’s current rules do little to control export restrictions. Nor are current trade rules much use for controlling the use of regulations to boost biofuels. Fixing that requires multilateral talks of a different sort.

The irrelevance of the global negotiating agenda to today’s trade concerns goes beyond agriculture. In a provocative new paper, Aaditya Mattoo of the World Bank and Arvind Subramanian of the Peterson Institute argue that global talks should concentrate on fears over “security”—of food, energy, environment and income. They point out that there are strikingly few rules governing trade in oil, the world’s single most important commodity. The WTO prohibits export quotas, but not the production quotas on which the OPEC oil cartel is based. More broadly, the WTO, at least in its present form, is ill-equipped to deal with other potential flashpoints, from “green tariffs” (barriers imposed against countries that do not take action on climate change) to complaints about undervalued currencies or investment protectionism, particularly the backlash against sovereign-wealth funds and other investors owned by the state.

The risk of a wholesale retreat into beggar-thy-neighbor tariffs may be remote, but a proliferation of new kinds of barriers is all too plausible. Take green tariffs. The most prominent climate-change bill in America’s Congress makes reference to trade restrictions against countries that do not take equivalent actions to control carbon emissions. European leaders, too, have talked of trade sanctions to punish the laggards in the fight against global warming. As tools to promote global carbon reduction, such tariffs have a theoretical rationale. But in practice they would almost certainly set back the cause of global co-operation on climate change.

Although capital-starved Western banks are desperately seeking cash infusions from sovereign-wealth funds and other state-owned investors, the threat of investment protectionism is growing, with control of natural resources being a prime worry. Many commodity-rich countries are becoming increasingly jittery about China’s thirst for direct control of natural resources. Faced with a surge in applications for foreign direct investment from China, most of them in the mining industry, Australia is now “closely examining” those that involve government-controlled entities and natural resources.

A new study for the Council on Foreign Relations by Matthew Slaughter of Dartmouth College and David Marchick of the Carlyle Group points out that in the past two years at least 11 big economies, which together made up 40% of all FDI inflows in 2006, have approved or are considering new laws that would restrict certain types of foreign investment or expand government oversight. A “protectionist drift”, they conclude, is already under way. If state-based investors play an ever bigger role in global capital markets, that protectionist drift may become irresistible.

Many of the politicians’ fears about foreign investors are surely misguided. Most sovereign-wealth funds are run by professional managers to maximize returns, and international codes to improve their transparency are in the process of being drawn up. Countries already have plenty of rules to prevent foreign control of strategic assets. And provided that markets are competitive and well regulated, it does not make much difference who owns the firms concerned.

A question of leadership At a macroeconomic level, however, it is reasonable to fret about the growing clout of state-based investors, not least because most of this money will be held by a small group of (authoritarian) countries including China, Saudi Arabia and Russia. China is piling up foreign-exchange reserves so fast that if it were to put them into American shares instead of bonds, it would already be buying more than all other foreigners put together. As Brad Setser of the Council on Foreign Relations points out in a new report, concentrated ownership by authoritarian governments is a strategic as well as an economic concern, particularly for America.

Both the risks of this new protectionism and the odds of it being countered depend heavily on the relationship between America and the biggest emerging economies. As the Doha malaise has shown, active American leadership, although no longer sufficient, is still necessary for multilateral progress. Yet the politics of trade has become increasingly difficult in America, compromising the country’s ability to take the lead. Support for more open markets is weaker than almost anywhere else in the world. According to this year’s Pew Global Attitudes Survey, only 53% of Americans think trade is good for their country, down from 78% in 2002. Several other surveys in America suggest that supporters have become a minority. In other countries support is far higher. Some 87% of Chinese and 90% of Indians say trade is good for their country, along with 71% of Japanese, 77% of Britons, 82% of French and 89% of Spaniards.

America’s popular disillusionment has been accompanied by a growing intellectual one. Several well-known American economists, including Paul Krugman, a professor at Princeton and prominent New York Times columnist, Alan Blinder of Princeton and Larry Summers, a Harvard economist and former treasury secretary, have begun to doubt whether increased globalization is good for the American middle class. Rather than improving typical Americans’ living standards, they suggest, global integration may be causing wage stagnation, widening inequality and greater insecurity.

Mr Blinder worries that offshoring—the outsourcing of services to countries such as India—will pose problems for tens of millions of Americans over the coming decades. Mr Krugman, who pioneered research in the 1990s that found trade played only a small part in explaining wage inequality, now believes that the effect is much bigger, because America trades more with poorer countries and more tasks can be traded. Mr Summers has similar concerns, arguing that the increasing mobility of global capital limits the government’s ability to act as firms move away from America in search of low-tax regimes.

These economists all eschew protectionism as a solution, arguing instead for domestic changes,

such as health-care and education reform as well as greater redistribution through the tax system. But they have helped change the terms of the political debate in America—a shift that has not been lost on policymakers in the emerging world, many of whom are irritated by America’s double standards. One Indian official talks of an “intellectual climate change” and a “betrayal” by globalization’s erstwhile champions.

Middle-class Americans’ living standards have stagnated over the past few years and income inequality has widened. Globalization could be a culprit, because the integration of hundreds of millions of workers from emerging economies increases the global supply of labour and presents less skilled American workers with more competition. But academic analyses suggest that this effect is modest compared with other factors, such as the decline of trade unions and, particularly, technological innovation that has raised the demand for skilled workers.

Nor is there much evidence to support the revisionist view. In a recent Brookings paper Mr Krugman searched for statistics to show that trade now plays a bigger role in wage inequality but failed to find them. Several other new studies point in the opposite direction. A paper by Runjuan Liu of the University of Alberta and Dan Trefler of the University of Toronto shows that the effect on American workers of outsourcing service work to India and China has been tiny and, if anything, modestly positive.

In a recent book, “Blue-Collar Blues”, Robert Lawrence of Harvard University shows that the chronology of America’s widening income inequality makes it hard to blame trade with poorer countries. Low-skilled workers lost out in the 1980s, long before trade with China surged. Most of the latest rise in inequality is due to the soaring incomes of the very rich. A study by Christian Broda and John Romalis of the University of Chicago argues that trade with China has helped reduce inequality in living standards, because poorer folk benefit disproportionately from lower prices for manufactured goods (though higher commodity prices have recently been pushing in the opposite direction).

But whether or not the evidence justifies it, America’s intellectual climate has shifted. Advocates of globalization are on the defensive, particularly in the Democratic party. That, alas, augurs badly for the new kind of multilateralism that the world economy urgently needs.

Shifting the balance Oct 9th 2008

From The Economist print edition More than a new capitalism, the world needs a new multilateralism JUST under ten years ago, during the emerging-market financial crises, Time magazine ran a cover headlined “The committee to save the world”. It showed Alan Greenspan, then chairman of the Federal Reserve; Robert Rubin, the treasury secretary; and Larry Summers, his deputy. Inside was a breathless account of how this trio of Americans had saved the world economy from calamity by masterminding IMF rescue packages for cash-strapped Asian countries through weekend meetings and late-night conference calls.

Today the threats facing the global economy are graver than they were a decade ago, yet it would be hard to know whom to put on such a cover. Wall Street is at the centre of the mess, so America’s stature and intellectual authority has plunged. Rather than staving off defaults in Asia, Mr Paulson, today’s treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, are battling to prevent the implosion of their own financial system. Instead of dictating tough terms to Asian governments, they have been begging Congress for public money to deal with Wall Street’s most toxic securities.

But even as the crisis spreads far beyond America, few others have so far shown much sign of leadership. Europe is rife with Schadenfreude at America’s travails but its politicians have been slow to recognize the scale of their own problems. China, the biggest, most resilient emerging

economy and the one with the deepest pockets, has stood quietly on the sidelines. The IMF provides useful analysis but has no political clout.

The only institutions that have co-operated, and creatively so, are the rich world’s central banks. Even as many politicians have grandstanded and pointed fingers, the ECB, the Fed, the Bank of England and others have tried to stem panic by flooding financial markets with liquidity, lending eye-popping sums of money against all manner of collateral.

Unfortunately, central bankers—however creative—cannot sort out this mess with injections of liquidity alone. That is because it is a crisis of solvency as well as liquidity. The bursting of the biggest housing and credit bubble in history has caused a banking bust that will probably turn out to be the biggest since the Depression, affecting many countries simultaneously. Across the rich world banks are short of capital; many are insolvent. As they deleverage, they will force down asset prices and weaken economies that are already stumbling, so the mess will only worsen. Uncertainty and panic have already amplified the problem as banks hoard cash.

The urgent task is to prevent a grave multi-country banking crisis from becoming a global economic catastrophe. That ought not to be too hard. Thanks to the growing importance of emerging markets, the world economy has become more resilient to trouble in its richer corners. Capital is plentiful outside Western finance. Now that commodity prices have tumbled, the rich world’s central banks have plenty of room to cushion their weakened economies with lower interest rates. And although public-debt burdens are already heavy, notably in Italy, Europe’s governments, like America’s, have enough public funds to prevent a capital-starved banking system dragging their economies down.

This has already started to happen, most strikingly with the American government’s $700 billion plan to take over mortgage-backed securities. But other governments too are stepping in. Five European banks were nationalized or bailed out with public funds in the last week of September. Several European governments have guaranteed the deposits and in some cases the debts of their banks.

Yet these disparate rescues are likely to be more expensive and less effective than a more co-ordinated policy that reaches beyond the financial system alone. The panic in the markets would be stemmed if the rich world’s governments agreed on a common approach for stabilizing and recapitalizing banks. Equally, a co-ordinated interest-rate cut would boost confidence and make economic sense: the inflation threat is receding simultaneously across the rich world.

Any such policy co-ordination must include the big emerging markets as well. By boosting domestic spending and allowing its currency to appreciate faster, China could counter deflationary pressures in the rest of the world economy and help support growth in Europe and America just when this is needed most.

There are precedents for high-profile international economic co-operation, notably the Plaza and Louvre Accords in the 1980s. Designed, respectively, to push the dollar down and to prop it up, these agreements met with mixed success. Today’s problems are deeper, and the number of parties is larger. But if there were ever a time for a new multilateralism, this, the biggest financial crisis since the 1930s, is surely it.

Learning the right lessons A successful multilateral strategy to staunch the crisis would also make it more likely that the world will rise to the second challenge: learning the right lessons. Too many people ascribe today’s mess solely to the excesses of American finance. Putting the blame on speculators and greed has a powerful appeal but, as this special report has argued, it is too simplistic. The bubble—and the bust—had many causes, including cheap money, outdated regulation, government distortions and poor supervision. Many of these failures were as evident outside America as within it.

New-fangled finance has its flaws, from the procyclicality of its leverage to its fiendish complexity.

But the crisis is as much the result of policy mistakes in a fast-changing and unbalanced world economy as of Wall Street’s greedy innovations. The rapid build-up of reserves in the emerging world fuelled the asset and credit bubbles, and rich-world central bankers failed to counter it. Misguided monetary rigidity caused financial instability. Much though people now blame deregulation, flawed regulation was more of a problem. Banks set up their off-balance sheet vehicles in response to capital rules.

It is the same story with the spike in food and fuel prices over the past year. To be sure, commodities markets can overshoot—but rather than pointing the finger at speculators, governments should look in the mirror. Rich countries’ biofuel policies pushed up the cost of food. Poor countries’ food-export bans and fuel subsidies compounded the problems. In many ways today’s mess is a consequence of policymakers’ misguided reactions to globalization and the increasing economic heft of the emerging world.

If markets are not always dangerous and governments not always wise, what policy lessons follow? In the aftermath of the crisis the battle will be to ensure that finance is reformed—and in the right way. The pitfalls are numerous. Banning the short-selling of stocks, for instance, makes for a good headline; but it deprives markets of liquidity and information, the very things that they have lacked in this crisis. Even if the easy mistakes are avoided, improving supervision and regulation is hard. Financial regulators must look beyond the leverage within individual institutions to the stability of complex financial systems as a whole. Wherever the state has extended its guarantee, as it did with money-market funds, it will now have to extend its oversight too. As a rule, though, governments would do better to harness the power of markets to boost stability, by demanding transparency, promoting standardization and exchange-based trading.

Over-reaction is a bigger risk than inaction. Even if economic catastrophe is avoided, the financial crisis will impose great costs on consumers, workers and businesses. Anger and resentment directed at modern finance is sure to grow. The danger is that policymakers will add to the damage, not only by over-regulating finance but by attacking markets right across the economy.

That would be a bitter reverse after a generation in which markets have been freed, economies have opened up—and prospered. Hundreds of millions have escaped poverty and hundreds of millions more have joined the middle class. As the world reconsiders the balance between markets and government, it would be tragic if the ingredients of that prosperity were lost along the way.

Mixed Signals for Mortgage Giants Despite Exceeding Requirements, Firms Called Undercapitalized

October 10, 2008

Reading the latest report from the federal regulator running mortgage finance giants Fannie Mae and Freddie Mac could give you whiplash.

Fannie Mae and Freddie Mac had said at the end of June that they had billions of dollars more of a financial cushion than required by their regulator. The report by the Federal Housing Finance Agency yesterday reaffirmed that, saying Fannie Mae had $9.4 billion and Freddie Mac had $2.7 billion more capital than required.

But, even though the companies were adequately capitalized, the regulator yesterday declared them undercapitalized. How did it square that circle?

The regulator, in essence, said capital wasn't a good enough barometer of the companies' financial footing. The law gives the regulator the authority to designate the companies undercapitalized even if they technically have enough capital. In its report, the FHFA said that the sharp downturn in the mortgage market over the summer "raised significant questions about the sufficiency of capital."

The report listed six points supporting the regulator's determination, citing concerns about the

companies' overall "safety and soundness."

For the first time, the regulator expressed concerns about whether too much of the capital was made up of what it called "intangible assets." Analysts raised questions about these assets, which included tax credits due the companies, in the weeks leading up to the takeover. In the case of the tax credits, they were useful as capital only if the companies had profits; instead, the companies were posting big losses.

The regulator's conclusion comes after it used the companies' capital position to bolster confidence in the firms over the summer.

"They had a bunch of safety and soundness issues in the second quarter, but at that point [the regulator] was putting the sunniest possible face on it," said Karen Shaw Petrou, an analyst at Washington-based Federal Financial Analytics.

Some believe that the government's actions in the weeks leading up to the takeover put the companies in a worsened capital position by making it difficult to raise money by issuing new stock.

"I believe the conservatorship of Fannie and Freddie became almost necessary because secretary of Treasury [Henry M.] Paulson [Jr.] was indicating that if the government had to intervene, they would be sure to wipe out the shareholders," said Dwight Jaffee, a finance professor at the University of California at Berkeley. "This made it impossible for Fannie and Freddie to raise any more capital."

The companies' third quarter closed at the end of September. Financial results will not be released for another month. But the decision to declare them undercapitalized suggests the numbers won't be pretty.

"One has to believe that the government came to understand that the financial situation of Fannie and Freddie was much more distressed than the reports of June 30 had indicated," Jaffee said.

Usually, being declared undercapitalized would subject the companies to modest penalties, but none will be exacted while they are under government control. The FHFA also has suspended the capital requirements, though the companies will continue to disclose capital figures in their quarterly reports. The government set up a program to lend money or inject capital if the companies falter.

"As a practical matter, the government is now running Fannie and Freddie to bail out a sinking economy and a sinking housing market," Jaffee said. "And they're going to do everything reasonable to achieve those goals, and that may involve taking more risks than they would ordinarily do and accepting a lower return on the assets than they normally do."

A report from Federal Financial Analytics, called "Don't Ask, Don't Tell," noted that ambiguities still surround the firms. For instance, their debt is backed fully by the U.S. government, but the cost of their debt is much greater than government debt such as Treasury bills. That suggests investors don't have full confidence in the companies.

Taking a hard look at a Greenspan legacy October 9, 2008

"Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient." — Alan Greenspan, former Federal Reserve chairman, 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives "because we don't really understand how they work." Felix Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential "hydrogen bombs."

And Warren Buffett presciently observed five years ago that derivatives were "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street.

"What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so," Greenspan told the Senate Banking Committee in 2003. "We think it would be a mistake" to more deeply regulate the contracts, he added.

Today, with the world caught in an economic tempest that Greenspan recently described as "the type of wrenching financial crisis that comes along only once in a century," his faith in derivatives remains unshaken.

The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as "the pharmacist who fills the prescription ordered by our physician."

But others hold a starkly different view of how global markets unwound, and the role that Greenspan played in setting up this unrest.

"Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives," said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation.

The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

If Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted.

Over the years, Greenspan helped enable an ambitious American experiment in letting market forces run free. Now, the nation is confronting the consequences.

Derivatives were created to soften — or in the argot of Wall Street, "hedge" — investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value "derives" from underlying assets like stocks, bonds and commodities.) Many individuals own a common derivative: the insurance contract on their homes.

On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid — for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with U.S. officials, celebrated appearances on Capitol Hill and heavily attended speeches, Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions.

Ever since housing began to collapse, Greenspan's record has been up for revision. Economists from across the ideological spectrum have criticized his decision to let the nation's real estate market continue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out price increases with higher rates. Others have criticized Greenspan for not disciplining institutions that lent indiscriminately.

But whatever history ends up saying about those decisions, Greenspan's legacy may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and calamitous bust in derivatives trading.

Faith in the System

Some analysts say it is unfair to blame Greenspan because the crisis is so sprawling. "The notion that Greenspan could have generated a totally different outcome is naïve," said Robert Hall, an economist at the conservative Hoover Institution, a research group at Stanford.

Greenspan declined requests for an interview. His spokeswoman referred questions about his record to his memoir, "The Age of Turbulence," in which he outlines his beliefs.

"It seems superfluous to constrain trading in some of the newer derivatives and other innovative financial contracts of the past decade," Greenspan writes. "The worst have failed; investors no longer fund them and are not likely to in the future."

In his Georgetown speech, he entertained no talk of regulation, describing the financial turmoil as the failure of Wall Street to behave honorably.

"In a market system based on trust, reputation has a significant economic value," Greenspan told the audience. "I am therefore distressed at how far we have let concerns for reputation slip in recent years."

As the long-serving chairman of the Fed, the nation's most powerful economic policy maker, Greenspan preached the transcendent, wealth-creating powers of the market. A professed libertarian, he counted among his formative influences the novelist Ayn Rand, who portrayed collective power as an evil force set against the enlightened self-interest of individuals. In turn, he showed a resolute faith that those participating in financial markets would act responsibly.

An examination of more than two decades of Greenspan's record on financial regulation and derivatives in particular reveals the degree to which he tethered the health of the nation's economy to that faith. As the nascent derivatives market took hold in the early 1990s, and in subsequent years, critics denounced an absence of rules forcing institutions to disclose their positions and set aside funds as a reserve against bad bets.

Time and again, Greenspan — a revered figure affectionately nicknamed the Oracle — proclaimed that risks could be handled by the markets themselves.

"Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people in the Treasury," recalled Alan Blinder, a former Federal Reserve board member and an economist at Princeton University. "I think of him as consistently cheerleading on derivatives."

Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, says Greenspan opposes regulating derivatives because of a fundamental disdain for government. Levitt said that Greenspan's authority and grasp of global finance consistently persuaded less financially sophisticated lawmakers to follow his lead. "I always felt that the titans of our legislature didn't want to reveal their own inability to understand some of the concepts that Greenspan was setting forth," Levitt said. "I don't recall anyone ever saying, 'What do you mean by that, Alan?' "

Still, over a long stretch of time, some did pose questions. In 1992, Edward Markey, a Democrat from Massachusetts who led the House subcommittee on telecommunications and finance, asked what was then the General Accounting Office to study derivatives risks.

Two years later, the office released its report, identifying "significant gaps and weaknesses" in the regulatory oversight of derivatives.

"The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole," Charles Bowsher, head of the accounting office, said when he testified before Markey's committee in 1994. "In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers."

In his testimony at the time, Greenspan was reassuring. "Risks in financial markets, including derivatives markets, are being regulated by private parties," he said. "There is nothing involved in federal regulation per se which makes it superior to market regulation."

Greenspan warned that derivatives could amplify crises because they tied together the fortunes of many seemingly independent institutions. "The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence," he said.

But he called that possibility "extremely remote," adding "risk is part of life."

Later that year, Markey introduced a bill requiring greater derivatives regulation. It never passed.

Resistance to Warnings

In 1997, the Commodity Futures Trading Commission, a federal agency that regulates options and futures trading, began exploring derivatives regulation. The commission, then led by a lawyer named Brooksley Born, invited comments about how best to oversee certain derivatives.

Born was concerned that unfettered, opaque trading could "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it," she said in Congressional testimony. She called for greater disclosure of trades and reserves to cushion against losses.

Born's views incited fierce opposition from Greenspan and Robert Rubin, the Treasury secretary then. Treasury lawyers concluded that merely discussing new rules threatened the derivatives market. Greenspan warned that too many rules would damage Wall Street, prompting traders to take their business overseas.

"Greenspan told Brooksley that she essentially didn't know what she was doing and she'd cause a financial crisis," said Michael Greenberger, who was a senior director at the commission. "Brooksley was this woman who was not playing tennis with these guys and not having lunch with these guys. There was a little bit of the feeling that this woman was not of Wall Street."

Born declined to comment. Rubin, now a senior executive at the banking giant Citigroup, says that he favored regulating derivatives — particularly increasing potential loss reserves — but that he saw no way of doing so while he was running the Treasury. "All of the forces in the system were arrayed against it," he said. "The industry certainly didn't want any increase in these requirements. There was no potential for mobilizing public opinion."

Greenberger asserts that the political climate would have been different had Rubin called for regulation.

In early 1998, Rubin's deputy, Lawrence Summers, called Born and chastised her for taking steps

he said would lead to a financial crisis, according to Greenberger. Summers said he could not recall the conversation but agreed with Greenspan and Rubin that Born's proposal was "highly problematic."

On April 21, 1998, senior federal financial regulators convened in a wood-paneled conference room at the Treasury to discuss Born's proposal. Rubin and Greenspan implored her to reconsider, according to both Greenberger and Levitt.

Born pushed ahead. On June 5, 1998, Greenspan, Rubin and Levitt called on Congress to prevent Born from acting until more senior regulators developed their own recommendations. Levitt says he now regrets that decision. Greenspan and Rubin were "joined at the hip on this," he said. "They were certainly very fiercely opposed to this and persuaded me that this would cause chaos."

Born soon gained a potent example. In the fall of 1998, the hedge fund Long Term Capital Management nearly collapsed, dragged down by disastrous bets on, among other things, derivatives. More than a dozen banks pooled $3.6 billion for a private rescue to prevent the fund from slipping into bankruptcy and endangering other firms.

Despite that event, Congress froze the Commodity Futures Trading Commission's regulatory authority for six months. The following year, Born departed. In November 1999, senior regulators — including Greenspan and Rubin — recommended that Congress permanently strip the CFTC of regulatory authority over derivatives.

Greenspan, according to lawmakers, then used his prestige to make sure Congress followed through. "Alan was held in very high regard," said Jim Leach, an Iowa Republican who led the House Banking and Financial Services Committee at the time. "You've got an area of judgment in which members of Congress have nonexistent expertise."

As the stock market roared forward on the heels of a historic bull market, the dominant view was that the good times largely stemmed from Greenspan's steady hand at the Fed.

"You will go down as the greatest chairman in the history of the Federal Reserve Bank," declared Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee when Greenspan appeared there in February 1999. Greenspan's credentials and confidence reinforced his reputation — helping him to persuade Congress to repeal Depression-era laws that separated commercial and investment banking in order to reduce overall risk in the financial system.

"He had a way of speaking that made you think he knew exactly what he was talking about at all times," said Senator Tom Harkin, a Democrat from Iowa. "He was able to say things in a way that made people not want to question him on anything, like he knew it all. He was the Oracle, and who were you to question him?"

In 2000, Harkin asked what might happen if Congress weakened the CFTC's authority. "If you have this exclusion and something unforeseen happens, who does something about it?" he asked Greenspan in a hearing.

Greenspan said that Wall Street could be trusted. "There is a very fundamental trade-off of what type of economy you wish to have," he said. "You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either," he said.

Later that year, at a Congressional hearing on the merger boom, he argued that Wall Street had tamed risk. "Aren't you concerned with such a growing concentration of wealth that if one of these huge institutions fails that it will have a horrendous impact on the national and global economy?" asked Representative Bernard Sanders, an independent from Vermont.

"No, I'm not," Greenspan replied. "I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged."

The House overwhelmingly passed the bill that kept derivatives clear of CFTC oversight. Senator Gramm attached a rider limiting the CFTC's authority to an 11,000-page appropriations bill. The Senate passed it. President Bill Clinton signed it into law.

Pressing Forward

Still, savvy investors like Buffett continued to raise alarms about derivatives, as he did in 2003, in his annual letter to shareholders of his company, Berkshire Hathaway. "Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers," he wrote. "The troubles of one could quickly infect the others."

But business continued.

And when Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street was using derivatives, he said in a 2004 speech, to share risks with other firms. Shared risk has since evolved from a source of comfort into a virus. As the housing crisis grew and mortgages went bad, derivatives actually magnified the downturn.

The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers, and imperiled the insurance giant American International Group, has been driven by the fact that they and their customers were linked to one another by derivatives.

In recent months, as the financial crisis has gathered momentum, Greenspan's public appearances have become less frequent.

His memoir was released in the middle of 2007, as the disaster was unfolding, and his book tour suddenly became a referendum on his policies. When the paperback version came out this year, Greenspan wrote an epilogue that offers a rebuttal of sorts.

"Risk management can never achieve perfection," he wrote. The villains, he wrote, were the bankers whose self-interest he had once bet upon.

"They gambled that they could keep adding to their risky positions and still sell them out before the deluge," he wrote. "Most were wrong."

No federal intervention was marshaled to try to stop them, but Greenspan has no regrets.

"Governments and central banks," he wrote, "could not have altered the course of the boom."

U.S. considers taking stakes in banks

October 9, 2008 Having tried without success to unlock frozen credit markets, the U.S. Treasury Department is considering taking ownership stakes in many U.S. banks to try to restore confidence in the financial system.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks' balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

"These capital injections are something that" Secretary Henry Paulson Jr. "is actively considering," the White House press secretary, Dana Perino, said Thursday.

The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks, government officials said earlier.

The proposal resembles one announced Wednesday in Britain. Under that plan, the British government would offer banks like Royal Bank of Scotland, Barclays and HSBC Holdings up to $87 billion to shore up their capital in exchange for preference shares. It also would provide a guarantee of about $430 billion to help banks refinance debt.

"The market for medium term funding is currently frozen across the globe, with potentially serious economic consequences," Prime Minister Gordon Brown wrote in a letter to the French president, Nicolas Sarkozy, who currently holds the EU's rotating presidency. "This is an area where a concerted international approach could have a very powerful effect."

The letter, dated Wednesday, was seen by the International Herald Tribune on Thursday.

At his news conference Wednesday, Brown hinted that Washington also would have to follow suit. Yet word that the United States was considering doing just that did little to cheer global markets on Thursday. Major indexes in Asia and Europe all ended lower. Wall Street opened higher but quickly fell and remained volatile in afternoon trading. Morgan Stanley shares fell as much as 25 percent as a ban on short selling expired.

With the spiral of fear unbroken, leaders were scrambling to find some way to restore confidence.

Perino said President George W. Bush would take the unusual step of meeting at the White House on Saturday with the Group of 7 finance ministers and the heads of the International Monetary Fund and the World Bank.

The Italian Prime Minister, Silvio Berlusconi, said Bush had proposed holding an extraordinary summit meeting of the Group of 8 leaders next Tuesday, according to Reuters, but Berlusconi said Sarkozy was "cautious" about the date.

EU leaders are to meet for a scheduled summit meeting in Brussels next Wednesday and Thursday, which is expected to be dominated by the financial crisis.

Still, the U.S. ambassador to France, Charles Stapleton, said Thursday that Bush and Sarkozy were "talking on a regular basis about the status of financial institutions in the world," according to Reuters.

The American recapitalization plan, officials say, has emerged as one of the most favored new options being discussed in Washington and on Wall Street. The appeal is that it would directly address the worries that banks have about lending to one another and to customers.

This new interest in direct investment in banks came after the Federal Reserve and five other central banks on Wednesday marshaled their combined firepower to cut interest rates but failed to stanch the global financial panic.

The muted market response sent U.S. policy makers and outside experts scrambling for additional remedies to stabilize the banks and reassure investors.

There is no shortage of ideas, ranging from the partial nationalization proposal to a guarantee by the Fed of all lending between banks.

On Wednesday, Senator John McCain, the Republican presidential candidate, refined his proposal

- announced in a debate with the Democratic nominee, Senator Barack Obama, the night before - to allow millions of Americans to refinance their mortgages with government assistance.

As Washington casts about for Plan B, investors are clamoring for the Fed to lower interest rates to nearly zero. Some are also calling for governments worldwide to provide another round of economic stimulus through expensive public works projects.

Yet behind the scramble for solutions lies a hard reality: The financial crisis has mutated into a global downturn that economists warn will be painful and protracted, and for which there is no quick cure.

"Everyone is conditioned to getting instant relief from the medicine, and that is unrealistic," said Allen Sinai, president of Decision Economics, a forecasting firm in Lexington, Massachusetts. "As hard as it is for investors and jobholders and politicians in an election year, this crisis will not end without a lot more pain."

One concern about the Treasury's bailout plan is that it calls for limits on executive pay when capital is directly injected into a bank.

The law directs Treasury officials to write compensation standards that would discourage executives from taking "unnecessary and excessive risks" and that would allow the government to recover any bonus pay that was based on stated earnings that turned out to be inaccurate. In addition, any bank in which the Treasury holds a stake would be barred from paying its chief executive a "golden parachute" severance package.

Treasury officials worry that aggressive government purchases, if not done properly, could alarm bank shareholders by appearing to be punitive or could be interpreted by the market as a sign that target banks were failing.

At a news conference Wednesday, Paulson, the Treasury secretary, pointedly named the Treasury's new authority to inject capital into institutions as the first in a list of new powers included in the bailout law.

"We will use all the tools we've been given to maximum effectiveness," Paulson said, "including strengthening the capitalization of financial institutions of every size."

The idea is gaining support even among longtime Republican policy makers who have spent most of their careers defending laissez-faire economic policies.

"The problem is the uncertainty that people have about doing business with banks, and banks have about doing business with each other," said William Poole, a staunchly free-market Republican who stepped down as president of the Federal Reserve Bank of St. Louis, Missouri, on Aug. 31. "We need to eliminate that uncertainty as fast as we can, and one way to do that is by injecting capital directly into banks. I think it could be done very quickly."

Paulson acknowledged that the flurry of emergency steps had done little to break the cycle of fear and mistrust, and he pleaded for patience.

"The turmoil will not end quickly," he said. "Neither the passage of this law nor the implementation of these initiatives will bring an immediate end to the current difficulties."

Paulson will play host to finance ministers and central bankers from the Group of 7 on Friday. But he cautioned against expecting a grand plan to emerge from the gathering.

More likely, the participants will compare notes about the measures they are adopting in their own countries. David McCormick, the Treasury's under secretary for international affairs, said there was

no "one size fits all" remedy for the crisis, though countries were cooperating through the coordinated cuts in interest rates, with guarantees on bank deposits and in regulations.

In the past month, both the Treasury and the Fed took extraordinary steps toward nationalizing three of the biggest financial companies in the country. Last month, the Treasury took over Fannie Mae and Freddie Mac, the giant government-sponsored mortgage finance companies that were on the brink of collapse. A week later, the Fed took control of American International Group, the failing insurance conglomerate, in exchange for agreeing to lend it $85 billion.

On Wednesday, the Federal Reserve announced that it would lend AIG an additional $37.8 billion.

But neither the individual corporate bailouts nor the Fed's enormous emergency lending programs - including up to $900 billion through its Term Auction Facility for banks - have succeeded in jump-starting the credit markets.

"The core problem is that the smart people are realizing that the banking system is broken," said Carl Weinberg, chief economist at High Frequency Economics. "Nobody knows who is holding the tainted assets, how much they have and how it affects their balance sheets."

Global crisis erupted because many underestimated damage By Floyd Norris--October 9, 2008

Imagine what Republicans would have said a few months ago had someone proposed that the government should lend money to companies that could not get credit in the free market.

Imagine what Democrats would have said if it turned out that those loans were to be made at low interest rates, with no equity for the government and with no controls on how the money was spent.

Then contemplate how both would have reacted to the idea that plan would be imposed without Congressional approval.

That all happened this week, and neither of the two presidential candidates deemed it worth mentioning in their debate.

It ought to make anyone nervous to have the government allocating capital, which in this environment could mean it is making the decision to let companies live or fail.

The Federal Reserve could avoid that dilemma by agreeing to buy all the commercial paper it is offered, up to the amount any company had outstanding before the market caved in, and its public announcements make it sound as if that is possible. The only sure way a company can be cut off is if one of the rating agencies downgrades it.

Doesn't it make you feel better to know that the Fed has subcontracted its investment decisions to Moody's and its competitors?

Ideologically, this is not what either party wanted. But desperate times produce desperate tactics.

"The central bankers all learned the lesson of the 1930s," said Robert Barbera, the chief economist of ITG, a Wall Street firm. That lesson was that if the choice is between allowing the system to collapse and writing a lot of checks, you write the checks and forget about ideology.

Unfortunately, none of them learned the lesson of the 1920s, which is that when asset prices soar, it is not a good idea to sit around doing nothing, as the Fed did for most of the housing boom. Cheerleading, which it sometimes did, is even worse.

One aspect of the story of this financial meltdown is that the people in charge of the financial system - in the banks, at the Fed and other central banks and at the Treasury Department and

other finance ministries - consistently underestimated the damage, both to the system and to the world economies. At first, many thought the damage would be limited to losses from a small group of mortgages. Banks raised a little capital, but not nearly enough.

As the problems spread, they kept offering reassuring words, which they may well have believed. Those words provided brief comfort for some, but destroyed a lot of credibility.

As recently as Sept. 18, after Lehman Brothers had gone broke and it was clear that consumers were cutting back, the Federal Open Market Committee thought the economy could come through.

"Participants agreed that economic growth was likely to be sluggish in the second half of 2008," said the minutes of the meeting. "Several participants had marked down their near-term outlook for economic activity and some judged that downside risks had increased, but most continued to expect a gradual recovery in 2009."

We should be so lucky as to get sluggish growth for the remainder of 2008. The gross domestic product seems likely to show significant declines.

The real problem, which many preferred to ignore because they had no ready answer, was that the financial system was breaking down. The excesses of lending and gambling had destroyed the new financial system - the one built on securities as an alternative to bank lending - and left the old commercial banks too weakened to step in.

Or, in the words of Paul Volcker, a former Fed chairman: "In the U.S., the market took over. The market has flopped."

Now, he added, "everybody is running back to Mother, the commercial banking system."

Unfortunately, Mother is very ill. Even worse, her children do not trust each other. In normal times, loans between banks are viewed as virtually risk-free. Now banks deem them too risky to make.

The eventual, and very expensive, solution will be to recapitalize the banking system. The sovereign wealth funds that provided the first round of capital now feel like they were played for suckers, and there are good regulatory reasons not to let private equity funds buy banks. It looks like it will be the public that pays the tab.

The bailout passed by Congress supposedly was going to provide capital indirectly, by having the Treasury purchase dodgy assets for more than current market value. Now few are confident that will work. That also would have the odd side effect of giving the most money to the banks with the largest amount of bad assets. It might make more sense to funnel money to the banks whose managements were the smartest, or at least the least dumb.

Europe was slower to realize it had a problem, and slower still to admit it was not all the Americans' fault. It still seems to be unable to agree on any coordinated action, but individual countries are doing more than the United States.

In Denmark, the government stepped up to guarantee not only deposits, but interbank lending. It also put limits on the banks. It ordered them to stop paying dividends or buying back shares, and not to begin new stock option programs for executives.

It is absurd that American banks now are paying any dividends at all. Even after reductions, most big American bank shares now yield more than 3 percent, and some more than 7 percent. None of them are confident they have enough capital, or that their competitors do, which is why they are reluctant to lend.

In that atmosphere, does it make any sense to reduce capital by paying dividends? Should the

government funnel money to companies whose owners are getting big payouts while the banks report large losses?

Britain announced its government will buy preferred stock in banks, and a few hours later the American Treasury secretary, Henry Paulson Jr., was saying that he might do the same. That is probably what will happen, eventually if not immediately.

In 1933, when Franklin Roosevelt became president amid a panic, he declared a bank holiday that closed the banks while federal examiners went over their books. When the holiday was over, the government closed some banks and declared the rest were healthy.

In reality, there was no way the government could be sure of that. But the public accepted it, and the bank runs stopped. This time, the government has offered too many assurances that turned out to be false. It will take cash to persuade the public - and the other banks - that the survivors are safe.

The World’s Banks Could Prove Too Big to Fail — or to Rescue By FLOYD NORRIS--October 10, 2008

As the banking system quaked this week in many countries, and various governments took steps to bail out their banks or at least guarantee deposits, one question was asked quietly: Can the governments afford it?

That is not a question for the United States, which can print dollars and has a banking system that is the largest in the world but is small in relation to the national economy.

The country where that worry first surfaced was Iceland, whose three major banks had greatly expanded overseas, including starting substantial retail operations in a number of European countries. The government has taken control of all three banks, and is not guaranteeing that foreign customers will be protected.

Iceland is also the only country to have its sovereign debt rating downgraded so far as a result of the financial crisis.

The accompanying chart shows the size of national banking systems relative to their countries’ economies, measured in two ways, and also show how well capitalized the banks appear to be, through the latest reported data.

In general, higher figures in any of the graphics indicate increased danger. They do not pretend to show what shape the banks are in, but they do reflect the size of the problem each country would face if its banking system did get into trouble.

The first two charts look not at deposits but at short-term debt carried by the banks. The banks usually have long-term debt as well. But by its nature, that debt cannot be withdrawn if worries about a bank’s solvency suddenly increase. They also have deposits, but deposits are less likely to flee, at least if deposit guarantee systems are trusted. Short-term debt, on the other hand, matures within a year and may not be available to a bank that is in trouble.

The first comparison — the tinted circles — looks at the size of bank short-term debt as a percentage of a country’s gross domestic product. Such figures are not directly comparable, since one is the total amount of income in a country over a year, and the other is the amount owed by banks that may have to be paid over that year. But the comparisons do show relative sizes.

In the United States, the banks have total short-term debt that is equal to 15 percent of G.D.P. But in some countries where banking systems have grown to international proportions, the debt exceeds G.D.P. That is true in Switzerland, Belgium, Iceland and Britain.

The second comparison — the open circles — looks at the short-term bank debt in relation to each country’s national debt. Again, the relationship is not direct, because a country may have excellent credit that would enable it to borrow much more, but large numbers still raise questions.

“Can they guarantee the deposits if the bank owes 3.5 times the national debt?” asked Bob Prince, the co-chief investment officer of Bridgewater Associates, which provided the data.

For countries in the euro zone, there is an additional consideration. They do not have the right to print money. That may also be true for some other banking systems, if the liabilities are primarily in currencies other than their own. Those countries could face special problems if they needed to come up with huge amounts of cash to rescue banks.

Finally, the leverage ratio gives a rough indication of how risky a nation’s banking system might be. It is the ratio of total bank assets to the net worth of the bank. That could be misleading if the assets are very safe — government bonds, for example, versus subprime mortgage loans — but in general the higher the ratio the smaller the margin of safety.

There again, the United States appears to face a relatively small problem, with an average leverage ratio of 12. The figures range up to 52 in Germany. Theoretically, a 2 percent drop in the value of all German bank assets would wipe out the net worth of the banking system.

These figures will be meaningless if the governments retain the trust of depositors and creditors. “It becomes a matter of psychology,” Mr. Prince said. If governments say the deposits are safe “and the market believes them, then they don’t have to have any money to back up their promises.”

White House overhauling rescue plan October 12, 2008

As international leaders gathered here on Saturday to grapple with the global financial crisis, the Bush administration embarked on an overhaul of its own strategy for rescuing the foundering financial system. Two weeks after persuading Congress to let it spend $700 billion to buy distressed securities tied to mortgages, the Bush administration has put that idea aside in favor of a new approach that would have the government inject capital directly into the nation's banks — in effect, partially nationalizing the industry. As recently as Sept. 23, senior officials had publicly derided proposals by Democrats to have the government take ownership stakes in banks.

The Treasury Department's surprising turnaround on the issue of buying stock in banks, which has now become its primary focus, has raised questions about whether the administration squandered valuable time in trying to sell Congress on a plan that officials had failed to think through in advance. It has also raised questions about whether the administration's deep philosophical aversion to government ownership in private companies hindered its ability to look at all options for stabilizing the markets. Some experts also contend that Treasury's decision last month to not use taxpayer money to save Lehman Brothers worsened the panic that quickly metastasized into an international crisis. The administration's new focus was announced late Friday as part of a rescue plan in coordination with six of the world's richest nations. It came during a week when the Dow Jones industrial average plummeted 18 percent, one of the worst weeks in stock market history. While the Treasury says it still plans to buy distressed assets, the scope of that plan is unclear. Treasury Secretary Henry Paulson Jr. has refused to say whether the capital infusion program for banks would be bigger than the original plan to buy troubled assets. Still, Treasury has directed Fannie Mae and Freddie Mac, the government-controlled mortgage giants, to ramp up their purchases of hard-to-sell mortgage bonds, in what could be a speedier and less formal process than the auctions proposed by the Treasury. Underscoring the gravity of the situation, President George W. Bush convened an early morning meeting at the White House on Saturday with finance ministers from the Group of 7 industrialized countries. "All of us recognize that this is a serious global crisis, and therefore requires a serious global response, for the good of our people," Bush said afterward in the Rose Garden, flanked by the ministers, who are in Washington for the annual meetings of the International Monetary Fund and the World Bank. Bush said the countries had agreed to general principles to respond to the crisis, including working to prevent the collapse of important financial institutions and protecting the deposits of savers. But he offered no details on other measures, suggesting that there were still differences among countries about which steps to take to shore up their respective financial systems. To some extent, the effort to agree on a coordinated plan is being driven less by the hope that such measures will carry more punch than by the fear that nations acting alone could destabilize the system. Those worries grew in recent days when Iceland seized its three major banks, which were failing, and appeared to guarantee the deposits of Icelanders over those of foreigners. That provoked a fierce reaction from Britain, which is now in talks with Iceland to get back the deposits of British citizens. With the United States and Europe working together on ways to secure their banking systems, economists are concerned that money may flow out of other countries, particularly emerging markets, to Western countries if investors decide that those markets are not as safe. The United States sought to reassure these countries in a meeting on Saturday evening of the Group of 20, which includes countries with large emerging markets, like China and Russia. "We want to reaffirm, reinforce our commitment that we're going to take these actions in a way that doesn't undermine the economies of other countries," said David McCormick, the under secretary of the Treasury for international affairs. Like the United States, Britain plans to provide capital directly to banks. But the United States and other countries have not adopted Britain's proposal to guarantee lending between banks as a way to unlock the credit market. Germany has been reluctant to put state capital directly into banks, though officials said there were signs of movement in that position on Saturday. Europeans leaders were scheduled to meet in Paris on Sunday, amid reports that Germany may announce a large rescue plan of its own.

Some experts said the delay in carrying out the Bush administration's $700 billion bailout plan had only hurt its prospects for success. "Even if it was adequate before, it's not adequate now," said Frederic Mishkin, a professor of economics at Columbia University's business school who stepped down as a Federal Reserve governor at the end of August. "If you delay and create uncertainty, the amount of money you have to put up goes up." As recently as late September, the idea of letting the government buy part of the banking system had been unthinkable in the Bush administration. To many officials, such intervention seemed like a European-style government intrusion in the markets. "Some said we should just stick capital in the banks, take preferred stock in the banks. That's what you do when you have failure," Paulson told the Senate Banking Committee on Sept. 23. "This is about success." Paulson told lawmakers it made more sense to jumpstart the frozen credit markets with "market measures," by which he meant buying up assets rather than institutions. He staunchly resisted Democratic proposals to require that the government receive an equity stake in the companies it was helping. But on Friday, Paulson not only confirmed his intention to buy stakes in banks but gave the idea central billing. "We can use the taxpayer's money more effectively and efficiently, get more for the taxpayer's dollar, if we develop a standardized program to buy equity in financial institutions," Paulson said. Treasury officials said they hoped to make the first capital investments within the next two weeks. That would be earlier than any government purchases of unwanted mortgage-backed securities. One reason for Paulson's rapid reconsideration was that global financial markets have been going downhill faster than anyone had seen before. Credit markets seized up and all but stopped functioning, making it impossible for most companies to borrow money on more than an overnight basis. Bank stocks plummeted, making it much more difficult to shore up their balance sheets by raising more capital from investors. Investors panicked as the House initially rejected the bailout bill on Sept. 29. They panicked even more after Congress passed a bill on Oct. 3 that was packed with sweeteners that added $110 billion to the price tag. By the closing bell last Friday, the Standard & Poor's 500-stock index had suffered its worst week since 1933. A growing number of analysts argue that Paulson's original plan, called the Troubled Assets Relief Program, would have been unhelpful and possibly unworkable. Some noted that Paulson presented Congress a proposal that was only three pages long and that Treasury officials have yet to provide details how the auctions will work. As envisioned, the Treasury or its agents would hold so-called "reverse auctions" in which financial institutions are invited to compete against each other in offering to sell their mortgage-backed securities at a low price. Though auctions are common for all sorts of products, including electricity that utilities sell one another, experts said that mortgage-backed securities would pose difficult headaches because they are extraordinarily complex, difficult to value and come in almost limitless varieties. The bonds for a single pool of mortgages are divided into more than a dozen "tranches," or slices, which have different seniority, different credit ratings and different rules for being paid off. The performance of the underlying mortgages varies greatly from one pool to another, even if both pools are made up of seemingly similar loans. "I am not aware that the Treasury Department presented any evidence on auctions that have been successful when they are used for assets that are so heterogeneous," said William Poole, who retired in August as president of the Federal Reserve Bank of St. Louis.

Because Fannie Mae and Freddie Mac, the mortgage giants, buy and sell mortgage securities every day, they could absorb some of the hard-to-sell securities without going through the untested auction process. The Federal Housing Finance Agency, which last month seized the companies and placed them into a conservatorship, lifted capital restrictions on them last week and effectively gave them a green light to buy more mortgage securities of all types, including those backed by subprime loans, given to borrowers with weak credit. The companies have a lot of money; Congress authorized Treasury to lend them as much as $100 billion each as part of the rescue plan created for them. That could free up money in the separate $700 billion bailout plan for injecting capital directly into the banks. People familiar with the early planning efforts for a systemic bailout said the chairman of the Federal Reserve, Ben Bernanke, argued that it would be easier and more efficient to inject capital directly into banks. But Treasury officials balked, in part because they were ideologically opposed to direct government involvement in business. But as the financial markets spiraled further downward during the last 10 days, a growing number of top-tier institutions, including Goldman Sachs and Morgan Stanley, became worried about their survival. "The crisis in confidence goes way beyond the actual losses that will be incurred from debt securities," Mickey Levy, chief economist for Bank of America, said in an interview on Friday. "It's truly incumbent on policy makers to address that crisis." Treasury officials began canvassing banks and investment firms about the possibility of having the government buy stakes in them. The new bailout law gave the Treasury the authority to buy up almost any kind of asset it wanted, including stock or preferred shares in banks. Industry executives quickly told Paulson that they liked the idea, though they warned that the Treasury should not try to squeeze out existing shareholders. They also begged Paulson not to impose tough restrictions on executive pay and golden-parachute deals for executives who are fired. Paulson heeded those pleas. In his remarks on Friday, he carefully noted that the government would acquire only "nonvoting" shares in companies. And officials said the law lets the Treasury write most of its own restrictions on executive pay, and those restrictions can be lenient if they are applied to a set of fairly healthy companies.

European banks share blame October 13, 2008

On the evening of Oct. 4, Italy's prime minister made abundantly clear just who he thought was to blame for the global credit crisis. From risk-taking Wall Street bankers to home buyers who borrowed more than they could afford, Silvio Berlusconi declared that Americans had embraced "the capitalism of adventurers."

By contrast, "Europeans set aside money in savings," he added, as the leaders of Britain, Germany and France looked on following a crisis meeting of European officials. "Europe is not facing and has never faced the risks in the American system."

Gordon Brown, the British prime minister, pointedly added that the crisis had "come from America."

The next 24 hours would dramatically undercut that view.

On Oct. 5 the board of Italy's second-largest bank called an emergency meeting to raise $9 billion in fresh capital, while German authorities hastily agreed to guarantee all bank accounts held by ordinary consumers and provide $67 billion to save a stricken property lender, Hypo Real Estate.

And within days, the British government would roll out a plan to commit £150 billion, or $256 billion, in government funds to shore up its own shaky banking system.

Europe's leaders have repeatedly pointed fingers at the United States since the latest wave in the credit crisis crossed the Atlantic this month. But the reality is that many European banks emulated the riskiest characteristics of their American counterparts, bulking up on what turned out to be toxic debt and relying on short-term loans, rather than deposits, to finance their operations.

By some measures, in fact, European banks exposed themselves to even higher levels of risky debt than American banks did.

While most European institutions don't face the kind of losses that brought down everybody from Lehman Brothers to Washington Mutual in the United States, heavy borrowing has made them vulnerable now that easy credit is a thing of the past, while plunging stock prices make it all but impossible to raise money without government help.

And though they did not provide mortgages to borrowers with dubious credit like their American counterparts, giants like UBS of Switzerland bought tens of billions in American subprime debt in a bid for higher yields.

In Germany, Hypo's loans exceeded its deposit base by more than eight times, forcing it to rely on short-term borrowing that dried up when credit markets tightened in recent months.

Two other troubled institutions, Royal Bank of Scotland and Fortis, a Dutch-Belgian lender, took on huge amounts of debt to finance expansions. "Our balance sheets are overleveraged," said Vasco Moreno, who tracks European banks for Keefe, Bruyette & Woods, a research firm.

By one commonly used yardstick to measure borrowing, the ratio of assets to equity, European banks employed more than twice as much leverage as their American counterparts, according to Moreno. To make matters worse, an ocean of short-term debt issued by European banks is coming due soon, with $375 billion maturing in the fourth quarter of 2008 and another $339 billion in the first quarter of 2009. "We do not see an easy solution to this problem, and more importantly, neither do the authorities," Moreno added.

The deposit guarantees and capital injections deployed in Britain, Ireland and now across the rest of Europe might allay the immediate panic, but they will not free up credit for businesses already hard-hit by the global economic slowdown.

"If the banks do not manage to roll over" the debts coming due over the next few quarters, Moreno said, "we may witness balance sheet contraction with major negative implications for the real economy or more bank failures."

Even as excessive leverage emerges as the most pressing concern, the decision by some European institutions to wade into the market for complicated, mortgage-backed American securities and other derivatives overhangs the system.

After Fortis was divided up earlier this month, with the Dutch government nationalizing local operations, and Belgian authorities selling most of the remainder to BNP Paribas of France, experts found that it owned more than 10 billion, or $13.4 billion worth of toxic, illiquid securities.

The mostly American asset-backed securities have been placed within a separate "ring-fenced" entity. As part of the deal, Belgian taxpayers got stuck with nearly a quarter of this hard-to-sell portfolio.

The failure of Dexia, a French-Belgian lender to municipalities that was saved by a government-led $9.2 billion capital injection, can be traced to a similar mix of American troubles and European

missteps.

In 2000, Dexia entered the fast-growing market for municipal bond insurance in the United States, acquiring Financial Security Assurance. To lift profit, the unit relied on credit default swaps and other now beaten-down derivatives, ultimately draining Dexia's capital and forcing the recent government intervention. "Using credit-default swaps was cheaper, but it was opaque, and the board of Dexia couldn't follow all that," said one government official who was involved in the rescue. Officials from Dexia and Fortis declined to comment.

Even worse, added this official, who spoke on condition of anonymity because he was not authorized to discuss internal matters, oversight of Dexia was split between Paris and Brussels. French regulators oversaw the unit of the company that included FSA, while Belgian authorities were responsible for monitoring the entire company.

"Nobody understood it," the government official said.

THE LAST WORD

First, Let's Stabilize Home Prices (with emphasis and underlines added)

OCTOBER 2, 2008

By R. GLENN HUBBARD and CHRIS MAYER

We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank capital, thereby tightening lending and causing house prices to fall further. The cycle has spread beyond housing, but the housing market is at the source of this problem and the best place to break up the adverse sequencing of cause and effect events that have evolved from it. (This is the key to ‘stopping the bleeding’ and stabilizing the housing market.) Housing starts are at their lowest level since the early 1980s, while simultaneously there are now more vacant houses than at any time since the Census Bureau started keeping such data in 1960. Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating. House prices continue to fall, weakening household balance sheets and the balance sheets of financial institutions. But this can stop. The price of a home is partially dependent on the mortgage interest rate -- lower mortgage rates will raise housing prices over time. (However, this will only occur with dynamic market conditions in which houses are bought and sold on a regular basis in a rationale, steady and not speculation driven, housing market) We propose that the Bush administration and Congress allow all residential mortgages on primary residences (the key here is owner-occupied primary residences only! No vacation homes or condos bought for speculation would qualify) to be refinanced into 30-year fixed-rate mortgages at 5.25%; matching the lowest mortgage rate in the past 30 years, and place those mortgages with Fannie Mae and Freddie Mac. Corporate investors and speculators in real estate should not be allowed to qualify. The historical spread of the 30-year, fixed-rate conforming mortgage over 10-year Treasury bonds is about 160 basis points. So a rate of 5.25% would be close to where mortgage rates would be today with normally functioning mortgage markets. One of us (Chris Mayer) recently published a study showing that -- assuming normally functioning mortgage markets -- the cost of buying a house is now 10% to 15% below the cost of renting across most of the country. Rising mortgage spreads and down-payment requirements are both factors that are still driving down housing prices. We need to

stop this decline. The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes less on the house than it is worth. (This could be a sticking point, as the entire property appraisal system has to be restructured away from the valuation based on comparable neighborhood sales and controlled through more direct regulation) Lower interest rates would have a positive impact on stopping the slide in values and mean higher overall house prices. The present day reality is that the government now controls nearly 90% of the mortgage market and can (and should) act on this realization. Remove the refinancing option and you can have lower rates without substantial cost to the taxpayer. Homeowners would have to give up the right to refinance their mortgage if rates fall, although homeowners could pay off their mortgage by selling their home (no prepayment penalties). For borrowers with lower credit scores, the mortgage rate would be greater than 5.25%, but it would be less than their current rate. (Individual credit scores, if truly important to the lenders, could also be adjusted upwards by a pre-determined factor for any previous diminution that can be shown as directly related to the current housing crisis.) Now, what about mortgages on homes that are worth less than the total amount of the loan? These mortgages could be refinanced into a 30-year fixed-rate loan to be held by a new agency modeled on the 1930s-era Homeowners Loan Corporation. New mortgages would be made of up 95% of the current value of a home. (95% loan-to-value is probably necessary under the circumstances; I’d prefer the more traditional and conservative 80% LTV. If a borrower is able to meet such a level, then the interest rate could be adjusted downward) The government might use two approaches to mitigate its losses. It could offer owners and servicers the opportunity to split the losses on refinancing a mortgage with the new agency. Servicers would have to agree to accept these refinancings on all or none of their mortgages, to avoid cherry-picking. (Yes) Or the government should take an equity position in return for the mortgage write-down so that the taxpayers profit when the housing market turns around. (Careful—a temporary government ownership position in the banks is acceptable but if they mean the loan service industry-this would unnecessarily complicate the structure of this work-out and keep the government bureaucracy involved in the private sector far longer than required. The loan servicing on any refinanced mortgages should stay with the banks for further market discipline) Our calculations based on deeds and Census data suggest that the total amount of negative equity for all owner-occupied houses is $593 billion. However, capping an individual's write-down to $75,000 would reduce the government's total liability to $338 billion and cover 68% of individuals with negative equity. (this is quite similar to the work-out we designed for depositors in Maryland—it shows that on an individual basis the negative equity is not that great and that no one would received an inequitable level of relief over most others in the same deteriorating situation. Raising the $75,000 to a maximum of $100,000 would probably ‘capture’ over 85% of the borrowers eligible for this program. Variations on this theme could be structured to include retirees and perhaps include some state cost-sharing and/or property tax relief programs). Even this loss will be reduced as the proposal spelled out here raises housing values and economic activity, and contemplates loss sharing with lenders, hopefully matching the experience of the old Homeowners Loan Corporation. While the net cost is modest compared with many plans on the table, it would require that the government could assume trillions of dollars of additional mortgages on its balance sheet. But we have already crossed this bridge with the explicit "conservatorship" of Fannie Mae and Freddie Mac. In any event, these mortgages would be backed by houses and the verified ability to repay the debt by millions of Americans. (This is by far the most important facet to any bad loan work out. Collateral (i.e. foreclosures) has never been a primary or effective source of repayment—loans must be repaid through earnings and cash flow). In addition, by putting a floor under house prices, this proposal would raise the value to taxpayers of trillions of existing (no one seems to wants to remember this fact—these loans have already been disbursed and they are the basis for all the mortgage-backed

securities that have been created since!) home mortgage assets already owned or guaranteed by the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others. Improvements in household and financial institution balance sheets will increase investment and consumer spending, which will mitigate the extent of the current downturn. Americans, on average, spend about 5% of the equity of their homes on consumer goods and services. So if home prices increased 10% above where they would have been without government intervention, we estimate consumers will have an additional $100 billion annually to spend. (¿ Where is the actual cash for this presumed increase in consumer spending to come from?) In addition to focusing on the very real problem in the housing market, the plan could be implemented immediately. As a result of the U.S. government's conservatorship of Fannie Mae and Freddie Mac, origination of new mortgages can be financed quickly. Congress would have to raise the overall borrowing limit and approve the new federal purchases of negative equity loans. But it will likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would have to seek the involvement of many additional private actors, as opposed to using vehicles already in place. The decline in housing prices remains the elephant in the room in the discussion of the credit market deterioration. Let's start there.

Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Mr. Mayer is a professor of finance and economics and senior vice dean of Columbia Business School.

Mel’s Cogitations

I’m sure many uninformed conservatives will see this proposal as a socialist program with overtones of nationalization—shades of FDR and all that. Most conservative Republicans will probably scream that this is a bailout of people who got into mortgages that they couldn’t afford in the first place and is rewarding their ‘bad behavior’ This is simply not true for the majority of people who find themselves on the brink of foreclosure—too many other economic factors enter into this debacle to make this obdurate claim stick. If one wants to get to the root of the problem, blame has to go all the way back to that uniquely American concept of homeownership—the entrenched belief that the great ‘American dream’ is some sort of constitutional right. Mix this belief with the greed of capitalism and worship to the false God of Ever Increasing Home Value, and there is more than enough blame for every participant. There is an element of moral hazard hidden in this proposal as regards the ‘unfairness’ of treating homeowners who; while they may be upside-down in their mortgage to value ratio—are nonetheless keeping current on their existing mortgages differently than those who must refinance in this manner or face foreclosure. Eligibility criteria and some sort of upside profit cap must be incorporated into to the program so that homeowners who do take advantage of this refinancing program (at lower rates and decreased values) do not gain unfairly over others when the market stabilizes and home values begin their predictable upward trend once again. This can easily be done with the involvement of Fannie and Freddie—who have not gone away. In fact using these two GSEs as the lender of last resort for weak mortgage assets (and forcing them to hold them on their books instead of immediately creating mortgage-backed securities) would effectively recapitalize them as well. Fannie and Freddie will be very significant partners in any mortgage workout program now that they are essentially wards of the state exempt from the capital and market discipline constraints. They can immediately purchase assets out of the TARP, doing so with considerably more flexibility than anyone else of size

The way the $700 billion ‘solution’ has been structured so far this approach may look to some like a bailout on top of a bailout. BUT this is not really the case as the Treasury already has the authority to allocate its new-found dollars into purchasing primary mortgages instead of the villainous third-level Credit Default Swaps (CDS) and other toxic derivatives that only covered up the true level of basic credit risk. The only question is whether or not Secretary Paulson will actually approach the problem on multiple fronts and exercise this option as part of a comprehensive plan or stick with the his stated goal to resolve the crisis through the credit markets as currently structured. In reality this approach is exactly the opposite of the current Save Wall Street program that has been falsely sold to the public as helping Main Street—and then could only pass Congress with the inclusion of an additional $100billion + in earmarks designed to help their cronies and get themselves re-elected. It should be better understood by all that the stockmarket. with all its direct and indirect investment assets, is merely a vehicle, even a side-show, for the banking system to operate in today’s era of instant communications and globalization of risk. We must return to the fundamentals here and attack the problem, not only at the level of the capital markets, but at the level of the individual bank which originated the original primary mortgage and is critical to the financial well-being of the average person. Without consumer faith in the fundamental soundness in his local bank, the financial panic will rapidly become endemic. This type of program should be an integral component of the resolution as it is exactly what the whole bailout program should have been designed to do in the first place—Stop the bleeding and save the homeowners, not the investment bankers! In addition to directly involving the very people most affected by the collapse of the housing market, we should begin to see a revival of bank lending in all markets. Nonetheless, all should realize that instituting a program to resolve the multi-faceted mortgage market issues will, in itself, not provide the desired quick fix panacea that many desire. The long-term stabilization and possible recovery of the global capital markets will take years of further government interventions, both in terms of cash and a re-regulation of future activities. The critical slowdown in inter-bank funding and new credit extensions to small businesses would be reversed--although banks had best return to the fundamentals and be more conservative in whom they lend to and on what terms. The Federal Reserve has already taken steps to address this aspect of the problem, pledging to fund banks directly and/or buy several billion dollars worth of commercial paper themselves. Combined with the raising of the deposit insurance limits to $250,000.00 and the announced plans to invest in the recapitalization of commercial banks through direct equity purchases, these programs should go a long way in restoring faith in the financial sector from the true foundation of the system—the American consumers and taxpayers. It is politically interesting—but totally disingenuous; that McCain is trying to take credit for this ‘plan’ by declaring in the latest debate that he would ‘order’ the Treasury secretary to buy up all the ‘bad’ mortgages to ‘save the taxpayer’. As can be expected in this period of bizarre campaign rhetoric, his ‘idea’--half-baked and poorly expressed as it is, has hastily been politicized and is now so bastardized from the intention of the model proposed, as to be totally unrealizable. This is not his idea and in fact is not a new idea at all. I, as well as many others, have been thinking along these lines since late last year and these two professors have succeeded in structuring and articulating the main issues involved much better than I have ever been able to. In this time of crisis it is important that this process not be further politicized and that the operational details not be allowed to deter the serious consideration of the type of mortgage refinancing program proposed by professors Hubbard and Mayer as an integral part of the overall solution. At least under this program, there would be no extravagant costs for mortgage holders to attend a ‘work-out’ retreat at a spa resort, as did the AIG executives last month.

Mel Brown October 2008