The federal government is embarking on a sweeping approach to fixing the country's rapidly unraveling financial system, offering few details but warning that failing to act could further endanger the economy. At the same time, regulators unveiled several narrower measures on Sept. 19 that are intended to reassure investors and protect financial stocks from being driven down by short-selling, coordinating their actions with governments overseas.
Treasury Secretary Henry Paulson said Administration officials and members of Congress met late on Sept. 18 to begin discussing "the need for a comprehensive approach to relieving the stresses on our financial institutions and markets."
Paulson said the talks concede the limits of the government's ad-hoc efforts of recent weeks—in which Washington assumed control of Fannie Mae and Freddie Mac, let investment bank Lehman Brothers (LEH) file for bankruptcy, and acquired most of insurer American International Group (AIG). "More is needed," Paulson said. "We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses." He acknowledged the plan would likely prove costly. "We're talking hundreds of billions of dollars—this needs to be big enough to make a real difference," Paulson said. "Until we get stability in the housing market, we're not going to get stability in the financial markets."
In the meantime, to keep the financial markets fluid, Fannie Mae and Freddie Mac would begin buying more mortgage-backed securities, the investments underlying much of the current turmoil. The Treasury would do the same. When the government assumed control of the two mortgage giants, it said both would continue increasing their portfolios for a time, and it announced a program by the Treasury to buy up securities directly from the market. Paulson's comments Friday appeared to indicate an expansion of both efforts.
The Treasury also said it would insure money-market mutual funds—low-risk funds that many consumers and businesses view as equivalent to cash—making available up to $50 billion to prevent losses in the funds in return for fees from the funds. Investors in one prominent fund saw their investments decline this week after Lehman Brothers failed, and at least one other fund's investment manager said it would provide cash to prevent similar losses.
Atop those developments, the Securities & Exchange Commission said it would completely ban short sales—or bets that share prices will fall—of 799 financial companies, following a similar move by British financial regulators on Thursday. The move goes well beyond restrictions adopted Thursday to limit a kind of abusive short-selling called "naked shorting," and some securities experts had warned that such a move could actually harm the market.
The talk of a sweeping solution is an about-face from three days ago, when Treasury officials said it had the tools needed to address the crisis. But the government's $85 billion bailout of AIG failed to calm the market, instead leading investors to wonder what other companies might suddenly plunge toward insolvency. Institutional lending all but ground to a halt, and the markets sank further—only to pick up as word of the talks between Congress and regulators spread. The Dow Jones industrial average was 416 points higher in afternoon trading, while the Standard & Poor's 500-stock index rose 4.2%, and the Nasdaq gained 3.3%.
It's unclear what approach the government will take, and Paulson said lawmakers and regulators would work through the weekend in hopes of devising legislation for a vote next week. The action is scheduled to happen before Congress adjourns late next week. Officials "are exploring all options, legislative and administrative," the Treasury said earlier.
The RTC Model
In recent days, policymakers have increasingly debated the need for a government-run entity—perhaps modeled on the Resolution Trust Corp. established amid the savings-and-loan crisis of the 1980s—that would take problem securities out of the market to improve liquidity, restore confidence, and prevent a wave of corporate collapses that could have far-reaching effects on the U.S. and world economy. "Lesson No. 1 from that era is: move quickly," says Richard Breeden, the RTC's architect and a former SEC chairman. "Troubled assets don't become more valuable over time; they become less valuable."
Among the idea's supporters so far: ex-Treasury Secretary Lawrence Summers and former Federal Reserve chairmen Alan Greenspan and Paul Volcker. 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 backed similar approaches. Senator John McCain (R-Ariz.) called for creating a "Mortgage & Financial Institutions Trust," a division of the Treasury to help financial institutions avoid bankruptcy by helping them identify bad loans, "provide funding, and eventually sell them at a profit" to taxpayers. Senator Barack Obama (D-Ill.) has called for the passage of "a Homeowner & Financial Support Act" to replace "the daily improvisations" of recent months. The original RTC restructured loans on the books of failed S&Ls, and then as the market improved, resold them over time rather than in a quick fire sale. As a result, the cost of the bailout to the economy and taxpayers was reduced. But the government had already taken over the insolvent banks when it created the RTC. That's not the case today: Instead, the government would presumably buy up bad mortgage-related assets from financial companies to prevent further insolvencies.
But the basic idea remains the same. The deepening housing crisis has forced banks and other institutions to repeatedly write down 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 shed their toxic assets, the fire sales put further downward pressure on prices, weakening their capital more—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. Like the old RTC, the new entity would not face a short-term need to sell, allowing it potentially to fetch higher prices.
The government may already have the tools it needs to buy problem assets out of the marketplace, Breeden noted. By taking over Fannie Mae (FNM) and Freddie Mac (FRE), Washington 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, when 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.
Some policymakers, including Senator Chuck Schumer (D-N.Y.), chairman of the Joint Economic Committee, have called on any new government entity to go further. Any plan that shifts bad loans from corporate books to the government does little to address the underlying problems of homeowners struggling under mortgages they can no longer afford, Schumer says. He advocates more measures, including letting borrowers renegotiate their mortgages in bankruptcy court. Such proposals have been before Congress for months, but banks and other financial institutions remain opposed.