To cool a market meltdown, apply aid carefully
The immediate dilemma: How to let markets learn from mistakes but keep a lid on problems.
from the November 30, 2007 edition
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In response, banks are moving to set up a so-called "superfund," with as much as $75 billion in voluntary contributions, to buy at least the higher-quality assets. Treasury Secretary Henry Paulson backed this move in October. Banks hope the fund will be up and running before the end of the year.
In the best scenario, the fund would nurture wider buying and selling of SIV assets. A fundamental problem now is that, without active trading, no one really knows what the investments are worth.
Some economists worry that the manager of the new superfund will buy assets at artificially high prices – perhaps in deference to the sponsoring banks.
"If people think that this is creating fake prices ... then it's just postponing true price discovery" and a wider market for SIV assets, says Raghuram Rajan, a University of Chicago economist. Disclosure is needed not just for the SIV problem, but more broadly for the financial position of banks in general, he adds.
For now, lenders and stock investors remain on edge because of uncertainty.
Banks like Citigroup and investment houses like Merrill Lynch have seen big declines in share price, but no major institutions have gone bankrupt so far.
"Eventually, the banks that hold these SIVs will have to start selling off these assets at distressed prices, says Peter Wallison, a finance expert at the American Enterprise Institute, a conservative think tank in Washington.
But the worst policy response, he says, would be to provide too much help. That would send a signal causing more irresponsible borrowing or investing in the future. Indeed, some experts say that periodic financial crises offer a vital cleansing mechanism for the economy, preventing the buildup of future financial bubbles.
But others say that long-term policy responses are needed to make the financial system safer. This could include closer supervision of banks and hedge funds.
•Previous articles ran Nov. 28 and 29.
Past financial crises have spurred US reforms
Panic of 1907
Short term: US declared bank holiday in five states in wake of major bank run.
Long term: Federal Reserve system established in 1913.
Great Depression
Short term: Government declared four-day bank holiday and passed Emergency Banking Relief Act to stabilize the banking system.
Long term: Glass-Steagall Act (1933) and other legislation passed, separating commercial from investment banks, and initiating the Federal Deposit Insurance Corp. (FDIC), which provided federal guarantees for bank deposits.
'Black Monday' 1987
Short term: The Federal Reserve injected cash into the market and eased short-term credit after the Dow Jones Industrial Average dropped 23 percent Oct. 19. The dive was caused by computerized trades intended, ironically, as "portfolio insurance."
Long term: The Securities Exchange Commission implemented market "circuit breakers," which postpone trading for unusually volatile stocks.
Savings and loan crisis of 1989
Short term: US shifted S&L deposit insurance from insolvent Federal Savings and Loan Insurance Corporation to the FDIC and created Resolution Trust Corp. to handle the closures of hundreds of S&Ls.
Long term: Federal bailout cost taxpayers $150 billion.
Sources: Congressional Research Service, EH.net, Federal Reserve Bank of St. Louis, "Manias, Panics and Crashes" by Charles Kindleberger
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