Beyond the Bailouts

“It’s a slippery slope,” said Barry Ritholtz, a Wall Street analyst and hedge fund manager, who has been critical of such government interference. “Once you bail out Lockheed for $250 million under the guise of national defense, it’s a short line to Chrysler and to the S&L crisis and to Fannie and Freddie. It just gets worse and worse.”

Institutions on Uneasy Street: Click Here to View Chart

The dollar amounts have only grown larger, as has the likelihood that taxpayers will wind up footing the bill, Ritholtz said. And the will to draw the line has weakened.

Some see a distinction between the financial institution bailouts of today and those earlier transactions, which left the corporations mostly intact and allowed loan guarantees from the federal government to substitute for private capital.

“These are not really bailouts,” said Litan. “You could call them onerous rescues.” In the cases of Bear Stearns, Fannie and Freddie, and AIG, the government’s action inflicted pain on at least some of the people who made the original bad decisions. “The shareholders got killed, the interest rate is exorbitant and the CEO lost his job,” Litan said.

Pieces of these corporations may survive intact and some employees may keep their jobs, mostly working in subsidiary units of other companies. But other pieces will be absorbed or just disappear entirely — liquidated for their component parts. In those cases, the outcome for the bailed-out company may be little different than that of Lehman’s bankrupt brokerage operations, which are being acquired by Barclays Capital Inc. and essentially sold for scrap.

The eventual outcome for Fannie and Freddie is hard to predict. But for Bear Stearns and AIG, the parent company isn’t likely to exist in the end.

Still, questions raised by the bailout decisions of the past weeks and months have yet to be answered. The timing of these actions and the choice of saving Bear Stearns while allowing Lehman to fail are certain to be debated on Capitol Hill and elsewhere.

These questions cut to the heart of concerns about the government picking winners and losers in the marketplace and to the central notion that a capitalist economy will have to endure rough patches. From the government’s point of view, the decision to act is at least in part tied to worries that the failure of a single institution might harm the broad economy.

“There’s no doubt in my mind that there’s some degree of politics in rescuing Fannie and Freddie right after both conventions and two months before the election,” Ritholtz said.

At the same time, both companies were probably going to wind up in the government’s hands at some point. “I also don’t disagree that it was an eventuality,” he said. “There’s certainly a legitimate argument to saying look, we did the hard thing so the next administration doesn’t have to.”

Likewise, the decision to prevent AIG’s collapse was probably correct, Ritholtz said. “There are so many banks that are teetering now that this could be the straw that broke the camel’s back. If any company in the United States is too big to fail, it’s AIG.”

More difficult to answer is why Bear Stearns was allowed to live and Lehman had to die. Paulson and Bernanke may one day explain their rationale, but so far the decision process has the appearance of being ad hoc.

Beyond the Bailouts

“Each one is different, and you know it when you see it,” said Litan.

Making this sort of choice puts government officials in a spot most have long said they want to avoid. “Now it’s going to be a big question looking forward,” said Princeton economics professor Stephen Morris. “What can the Fed credibly argue is going to be the limits of which institutions they will be providing assistance to?”

Beyond the bailouts, the Fed has provided an extraordinary level of cash assistance for months and increased that in the past week. “Maybe they will say it’s a once-in-100-years event: We’re never going to do something like AIG again, but we’re going to continue our liquidity assistance to investment banks,” Morris said. “But they might draw a line, and that might determine the limits of regulations.”

That issue — the layering of new regulations on institutions such as investment banks and hedge funds to forestall a similar crisis in the future — is on the minds of lawmakers, economists and investors. But so is the issue of how to prevent the “moral hazard” of granting bailouts from encouraging excessive risk-taking in the first place.

“I study behavioral economics,” said Ritholtz. “Essentially, we’re all a bunch of monkeys. Whenever somebody starts buying some crap piece of paper and making money, there’s no rationality. It’s somewhere between insanity and blood lust.”

In his view, if the potential for profit is jacked up by lack of supervision and the chance of a bailout, why wouldn’t people roll the dice?

Litan said the Fed might have tried to limit the moral hazard damage by letting Lehman fail. “This is a case where you make policy by example,” he said. “The Fed has a policy of constructive ambiguity: keep them guessing to impose some semblance of market discipline.”

The view that Paulson was trying to send a message with Lehman was echoed by Bill Gale, director of the economic studies program at Brookings. “They may not believe him the next time around when he says he’s not going to bail somebody out, but they’re at least going to have to pay attention,” Gale said.

Time for New Rules

It’s a completely different matter when the Fed opens its lending window to all manner of institutions that previously were unable to borrow from the central bank — as it has done this year. Or when the government considers a wholesale acquisition of toxic assets to save the financial system after one institution after another makes the same bad bets.

“To the extent that the Fed is going to be doing lending or taking even more drastic action in a wider range of institutions, the whole question is up for grabs,” said Morris. “I think there is definitely a political, practical argument that once a class of institutions is getting support from the Federal Reserve through liquidity provisions, they will be regulated. It’s a quid pro quo.”

Bailout Ups and Downs: Click Here to View Chart

The idea of a regulatory overhaul has gained increasing traction as the number of bailouts has mounted and the financial crisis has worsened.

Beyond the Bailouts

In late March, shortly after the collapse of Bear Stearns, Paulson released a blueprint for replacing the nation’s mishmash of financial oversight with a new system. While his timing may have been connected to the need to reassure the public in the wake of the Wall Street titan’s collapse, the proposal was one that the Treasury Department had been developing long before it became apparent that market forces alone weren’t going to ensure smooth operation of the nation’s credit system.

The Treasury plan largely reflected its original intent to streamline regulations and make the U.S. more competitive with other countries that have already adopted less complex systems of oversight. It suggested expanding the Fed’s role and consolidating the many agencies that watch financial institutions into three large overseers.

But the plan — crafted as it was in an era when the main regulatory debate centered on how corporations were chafing at the good-governance requirements imposed by the 2002 accounting law known as the Sarbanes-Oxley Act — was largely silent on the need for tighter rules for transactions, including those that involve newer and more opaque financial instruments that are at the heart of the current crisis. “I am not suggesting that more regulation is the answer,” Paulson said when he sent the plan to Congress.

And Paulson signaled last week that he still wants a debate over regulation. “When we get through this difficult period, which we will, our next task must be to improve the financial regulatory structure so that these past excesses do not recur,” he said. “This crisis demonstrates in vivid terms that our financial regulatory structure is suboptimal, duplicative and outdated.”

That view matches a growing consensus, particularly among economists, that after this financial hurricane passes a new regulatory system needs to be put in place to usher in an era of transparency and honest accounting. This new architecture would be built to protect not just individual companies and investors, but the entire interlaced and interdependent financial system.

“We need to rethink and maybe regulate from a more systemic perspective,” Gale said. “This is now the biggest opportunity to restructure the financial system since the 1930s.”

Gale’s colleague at Brookings, Douglas Elmendorf, in May told the Joint Economic Committee of Congress that doesn’t necessarily mean focusing on which federal agencies should be merged. “The highest priority, in my view, is not to change the boxes on the organization chart but to change what happens inside each box,” he said.

Key to that, he said, are measures that would expose the true value of assets, since a big part of the current crisis is the complete implosion of complex securities whose value was based on mortgages and other assets that turned out to be worth far less than initially assumed. Elmendorf recommended greater transparency in the mortgage origination process, more disclosure by credit rating agencies about the rationale behind their ratings, trading of derivatives on exchanges, and clearer accounting by commercial banks of the trading they conduct off their balance sheets.

Whether any independent investment banks are left standing at the end of this turmoil remains to be seen. But many economists say the regulatory system needs to be restructured to account for the changing nature of financial entities.

Right now, the system regulates commercial banks most heavily, imposing stronger oversight and reserve requirements than for any other type of financial institution. Investment banks, hedge funds, and other financial entities have operated with relatively little scrutiny. The current crisis illustrates that those entities may need more oversight simply because of the risks they pose to the rest of the financial system, economists say. But financial entities are increasingly becoming hybrids. Commercial banks may own investment arms with entirely different capital and regulatory requirements. Meanwhile, these entities are all increasingly linked by complex financial transactions, such as credit swaps, making it more important for them all to be similarly regulated.

Moreover, the requirements that financial entities must meet to ensure that they stay afloat must also change, many economists say. A simple capital reserve requirement may not be enough. In a paper on financial regulation released a couple of weeks ago, Morris and fellow Princeton economist Hyun Song Shin pointed out that Bear Stearns had enough assets to meet its liabilities when it failed. The problem was, it couldn’t sell those assets when it needed to raise cash.

Morris and Shin propose rules that govern an investment firm’s liquidity and its leverage — how easy it is to sell its assets and how much debt has been used to buy them in the first place. That would put an appropriate focus, they say, on how a firm’s positions could affect other financial institutions.

“Instead of just looking at having enough equity on your balance sheet, which is to make sure that the company won’t lose money if the creditors run into trouble, you should be worried about other things as well,” Morris said.

Beyond the Bailouts

In addition, he said, it matters where the company gets its capital. “Commercial banks are getting individual deposits, and that poses less systemic risk than if their liabilities are coming from other financial institutions,” he said. “At Bear Stearns, the whole issue was all these other financial institutions that were lending to them were very quick to start rolling over their money. Those are the channels by which financial crisis spreads.”

Some of these proposed regulatory changes could come through administrative action, but others would undoubtedly require congressional approval. Congress might start by imposing new leverage limits on investment banks, said Litan. And lawmakers will also need to sort out whether the Fed or the Securities and Exchange Commission or some other agency will have responsibility for this new scrutiny of investment firms.

“Who examines investment banks for safety and soundness, that’s crying out for congressional action,” Litan said.

Ultimately, the right kind of leverage limits could also act as a brake on future bailouts by imposing a stiffer cost on those companies that are inclined to take excessive risks.

Requiring companies to meet capital reserve requirements can fall short of that goal by encouraging the kind of off-balance-sheet transactions that got Wall Street into trouble this time around.

In August, at an annual gathering of central bankers and economists from around the world in Jackson Hole, Wyo., three academic economists circulated a proposal that banks buy what would essentially be disaster insurance. Anil Kashyap and Raghuram Rajan of the University of Chicago and Jeremy Stein of Harvard University suggested requiring the seller of such insurance policies to set the full payout amount in advance.

Stein said this would get the federal government out of its current de facto role as primary insurer. “Our whole idea, at some overall level, is that we’re going to try to do better with regulation and supervision, but we’re kidding ourselves if we think we’re never going to get in a situation where bad things happen,” he said. “We want to have it set up so not all the mopping up is done by the federal government. Maybe the first few hundred billion would be covered by insurance.”

Stemming the Slide

A regulatory fix won’t solve the current crisis, however, and it won’t prevent further institutional bailouts, if the situation is as bad as Paulson apparently conveyed to lawmakers in his Thursday night appearance on Capitol Hill.

“I gulped when I heard Paulson’s description of what could happen if we didn’t act,” said New York Democratic Sen. Charles E. Schumer .

That’s why the Treasury secretary has been so insistent that Congress take “further decisive action to fundamentally and comprehensively address the root cause of our financial system stresses.” He emphasized at his Friday news conference that his proposal for the government to take on the burden of managing worthless assets until they can be sold off years from now was a last resort to restore the health of the financial system.

“What began as a subprime lending problem has spread to other, less-risky mortgages and contributed to excess home inventories that have pushed down home prices for responsible homeowners,” leaving financial institutions unable to function, he said. “As a result, Americans’ personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment and job creation has been disrupted.”

Still, Paulson didn’t share with the public the thought process that led him to decide that this crisis had reached proportions requiring the most extreme government response in almost 80 years.

Beyond the Bailouts

He may have become convinced, however, by the loss of value in one money market mutual fund, a form of account that has been viewed as almost the safest investment possible. Only one other money fund has ever lost value, in 1994. On the same morning of his news conference, the Treasury unveiled a plan to insure individual holdings in money market accounts in an effort to discourage investors from pulling their money out of those accounts.

Talks with lawmakers about the Treasury proposal were expected to continue over the weekend, and House Speaker Nancy Pelosi said she had promised Bush that Congress would act in a “quick, bipartisan” way.

But that doesn’t mean the plan will be an easy sell. First of all, the price is likely to be enormous and to cause many lawmakers to blanch. And second, election-year politics might still get in the way.

Pelosi indicated that Democrats might seek the inclusion of language to reduce foreclosures and limit the impact of the plan on the federal debt. And many Republicans were balking at any further government intervention in the marketplace — particularly if it comes laden with Democratic amendments.

Meanwhile, Democratic presidential nominee Barack Obama said he supported giving the Treasury “broad authority” to intervene in the current crisis, although he said it should be temporary and should be accompanied by stronger oversight of Wall Street. And Republican presidential nominee John McCain criticized the Fed’s role in recent bailouts, saying it needs to stick to its role of managing monetary policy and the Treasury needs a consistent policy for supplying aid to troubled companies. McCain also outlined his own idea for a new federal entity that would intervene to help troubled financial institutions before they reached the point of bankruptcy, without commenting directly on the Paulson plan.

Moreover, no one really knows how this plan is supposed to work, although it was widely characterized on Capitol Hill as being modeled after the savings and loan bailout agency, the Resolution Trust Corporation (RTC).

That entity spent roughly $150 billion of taxpayer and industry money to manage and eventually sell off the assets of almost 750 failed thrifts in the early 1990s. And it was generally regarded as a success.

But experts familiar with the RTC and the savings and loan debacle aren’t so sure it applies. “It dealt with a well-defined class of institutions,” said Litan. “This is undefined,” he said, noting as have others that there is no certainty which institutions will be eligible and which bad assets the government will agree to buy.

“The devil is in details,” Litan said. “If you have a waste dump, who can drive their truck to it, and how toxic does it have to be?”

Even some conservative analysts said they understand this might be the time for extraordinary intervention, however. “I think there is a case for government involvement when the market is in panic mode like it is now,” said Peter J. Wallison, a one-time Treasury official and White House counsel who is now a senior fellow at the American Enterprise Institute. “When you have doubt about the stability and solvency of most of the financial institutions in the world, then every major failure can create runs.”

Even so, Wallison cautioned that Congress and the Bush administration ought to be deliberate in their actions.

“This could be the end of the problems. Or it could be only the beginning. There’s no way to actually know,” he said. “But right now I’m reluctant to adopt any sort of big-government program when we might have come to the end of the problems with what we’ve done this cycle.”

FOR FURTHER READING: The price of ignoring financial risks, CQ Weekly, p. 678; Bear Stearns bailout, p. 770; calls for stiffer U.S. regulation, pp. 858, 882, 1678; global regulatory issues, p. 1472; Fannie Mae, Freddie Mac and the housing crisis, pp. 768, 1970.