Big buyout of bad debt gets closer

01 September 2009 - 16:40

By unknown

LAST Sunday, US Treasury secretary Henry Paulson tried to draw a line in the sand against further bail outs 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 there was no bail out for the investment bank, Lehman Brothers, was not the plunge in the Dow Jones, it was the reaction of the credit markets.

Lenders went on strike: US government debt, which is still perceived as the safest of all investments, 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 slightly above the interest rate on US Treasury bills. But last Thursday morning, the average interest rate on three-month interbank borrowing was 3.2percent, while the interest rate on the corresponding treasuries was 0.05percent.

This flight to safety has cut off credit to many businesses, including major players in the financial industry. That, in turn, is setting the US up for more big failures and further panic. It is also depressing business spending, a bad thing as signs gather that the economic slump is deepening.

The Federal Reserve, which normally takes the lead in fighting recessions, cannot do much, 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 has not kept the situation from deteriorating.

There is only one bright spot in the picture: interest rates on mortgages have come down sharply since the US government took over Fannie Mae and Freddie Mac, and guaranteed their debt.

And there's a lesson there for those who are ready to hear it: government take-overs might be the only way to get the financial system working again.

Some people have been making that argument for some time. Most recently, former Federal Reserve chairman Paul Volcker and two other veterans of past financial crises published an op-ed in The Wall Street Journal. It declared that the only way to avoid "the mother of all credit contractions" was 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.

Last Thursday, Charles Schumer, the chairman of the Senate Finance Committee said : " The Federal Reserve and the Treasury are realising that we need a more comprehensive solution."

Federal Reserve chairman Ben Bernanke and Paulson metcongressional leaders on Thursday night 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 that 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 policy makers 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 bail out of stockholders as well as the market, in effect rescuing the financial industry from the consequences of its own greed.

Even a well-designed rescue would cost a lot of money. The Swedish government laid out 4percent of its gross domestic product , which in the US case would be a cool $600-billion.

But it's no use whining about the prospect of a financial rescue plan. Today's US political system isn't going to follow Andrew Mellon's infamous advice to Herbert Hoover: "Liquidate labour. Liquidate stocks. Liquidate the farmers. Liquidate real estate."