It's doubtful that Princeton University economist Ben Bernanke and former Goldman Sachs CEO Hank Paulson imagined what awaited them when they took charge of the Fed and the Treasury, respectively, in 2006. Since then, they have put their agencies on a wartime footing, trying to avert the financial equivalent of an army's collapse. As in war, there have been repeated surprises. As in war, the responses have involved much improvisation -- for instance, the $85 billion rescue of American International Group. But last week their hastily built defenses seemed to be crumbling, so Paulson proposed a radical solution of having the government buy vast amounts of distressed debt to shore up the financial system.
It's all about confidence, stupid. Every financial system depends on trust. People have to believe that the institutions they deal with will perform as expected. We are in a crisis because financial managers -- the people who run banks, investment banks, hedge funds -- have lost that trust. Banks recoil from lending to each other; investors retreat. The ultimate horror is when everyone wants to sell and no one wants to buy. Paulson's plan aims to avoid that calamity.
As is well known, the crisis began with losses in the $1.3 trillion market for "subprime" mortgages, many of which were "securitized" -- bundled into bonds and sold to investors. With all U.S. stocks and bonds worth about $50 trillion in 2007, the losses should have been manageable. They weren't, because no one knew how large losses might become or which institutions held the suspect subprime securities. Moreover, many financial institutions were thinly capitalized. They depended on borrowed funds; losses could wipe out their modest capital.
So the crisis spread because the initial losses were multiplied. AIG, the nation's largest insurer, is a case in point. Although most of its businesses -- insurance, aircraft leasing -- were profitable, it had written "credit default swaps" (CDS's) on some subprime mortgage securities. These contracts obligated AIG to cover other investors' losses. In the first half of 2008, AIG itself lost about $15 billion on its CDS contracts, and through the summer losses mounted, resulting in downgrades of the company's credit rating and a need to post more collateral. AIG didn't have the cash.
Since August 2007, the Fed has done three things to prevent eroding confidence from becoming panic. The first was standard: Cut interest rates. By April, the overnight Fed funds rate had fallen from 5.25 to 2 percent. The aim was to promote lending and prop up the economy. By contrast, the second and third responses broke new ground.
If banks remained reluctant to make routine short-term loans -- fearing unknown risks -- then the Fed would act aggressively as lender of last resort. Bernanke created several "lending facilities" that allowed banks and investment banks (such as Goldman Sachs) to borrow from the Fed. They received cash and safe U.S. Treasury securities in return for sending "securitized" mortgages and other bonds to the Fed. In this manner, the Fed has lent more than $300 billion.
Next, the Fed and the Treasury prevented bankruptcies that might otherwise have occurred. With the Fed's backing, the investment bank Bear Stearns was merged into JP Morgan Chase. Fannie Mae and Freddie Mac, the mortgage giants, were taken over by the government; their subprime losses had also depleted their meager capital. And now AIG has been rescued.
How much all this will cost taxpayers is unclear. It could be many billions -- or nothing. For example, the Fed is charging AIG a hefty interest rate and expects to be repaid from sales of the firm's businesses. But turning the Fed into a massive lending agency supporting specific firms and types of credit (mortgages, bonds) was a dramatic shift from its role of regulating interest rates and credit conditions. The official justification: Intervention prevented a disastrous chain reaction. Securities didn't get dumped onto markets, depressing prices; companies that lent to and traded with these firms didn't suffer further losses.
But the more these confidence-building exercises occurred, the less effect they had. As today's surprise followed yesterday's, it became less convincing that Paulson and Bernanke understood or could control the crisis. Practical problems also loomed. The Fed has financed its lending program by reducing its massive holdings of U.S. Treasury securities. It cannot do this indefinitely without exhausting all its present Treasuries. The Fed might then resort to old-fashioned -- and potentially inflationary -- money creation.
Against that backdrop, Paulson suggested something resembling the Resolution Trust Corporation that disposed of distressed real estate during the savings-and-loan crisis. The Treasury would buy up mortgage securities to stabilize the financial system. Both residential and commercial mortgages (for office buildings, shopping centers, hotels) would be eligible. But hard questions aren't answered by the Treasury proposal. What prices would the government pay? Suppose a weaker economy creates new classes of bad debt -- say, credit card securities? Would that lead to demands for more purchases?
Objections to Paulson's proposal abound. It would rescue some financial institutions from bad decisions and erode the normal discipline of potential losses. Some investors doubtlessly bought subprime securities at huge discounts and would reap massive profits by reselling to the government. That might trigger a public backlash. The program would be huge ($700 billion) and could burden future taxpayers. The Treasury secretary would receive almost total freedom in running the program, inviting favoritism for some investors and types of securities. To which Paulson has one powerful retort: It's better than continued turmoil. But that presumes success and raises an unsettling question: If this fails, what -- if anything -- could the government do next?
Robert J. Samuelson