Behind congressional maneuvering over the shape of a banking-system bailout lies a crucial question: Will it work?
Doubts on that point, along with concerns over the price tag and competing rescue ideas, were a central factor in prompting a midweek slowdown in the rush toward handing the US Treasury $700 billion to buy up troubled mortgage investments.
The plan urged by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke would push the US government into all but uncharted territory – trying to tackle a systemic financial crisis with a system-wide purchase of problem assets. It might work, but there's no guarantee. And whatever plan is put in place is almost sure to evolve beyond a one-step crisis fixer.
At the same time, finance experts say such doubts aren't an argument for inaction. Billionaire Warren Buffett infused a measure of hope into roiled financial markets Tuesday, showing the confidence to buy a stake in investment bank Goldman Sachs. But the risk of continued chaos remains significant.
"We're dealing with a market that is right now panicked and riddled with uncertainty," says Carmen Reinhart, an economist at the University of Maryland. "What I think the current tactic does is it makes [government intervention] blanket. It is a more generalized market approach to the bailout, and that is to be preferred."
Some sort of blanket approach appears needed, many economists say, following a series of ad hoc responses by the Fed and Treasury to crises at specific firms.
An unprecedented crisis
Mr. Paulson's plan aims to restore confidence by moving the most troubled assets off the balance sheets of banks and into a TARP – troubled asset relief program.
At a Senate hearing Tuesday, Paulson expressed optimism that it would work. By removing uncertainty about impending mortgage-related losses, he said, the program could pave the way for banks to keep lending and get new infusions of private capital.
Joining Paulson to defend the plan, Mr. Bernanke said a novel approach to this crisis is warranted. "The situation we have now is unique and new," Bernanke said. "The firms we're dealing with now are not necessarily failing, but they are contracting…. And they will be unwilling to make credit available as long as these market conditions [persist]."
He asserted that past crises, from the Great Depression to Japan in the 1990s, were different in that they typically involved failed institutions – with government taking on bad loans in receivership, not by purchase.
The plan is controversial among those specializing in financial regulation. Some argue that it would be better – and cheaper for taxpayers – if officials waited to act until firms were entering bankruptcy.
But Bernanke argued that case-by-case intervention was not working. He cited concern on the part of other potential investors that if they invest in a bank, that the government's going to come in and take away their value."
Ms. Reinhart, who has studied the history of financial crises around the world, says one lesson of history is to act quickly. "The longer crises last, the bigger the bailout," she says. "Asset prices continue to decline, wealth continues to be destroyed, and … economic activity begins to reflect these developments."
Concerns stall plan
Still, the rush to pass a plan ran into hurdles starting Tuesday, as lawmakers and others raised concerns.
The Treasury plan does not necessarily preclude some of the alternatives proposed by experts, such as forcing banks to stop paying dividends (to raise capital) or for the government to inject capital in return for equity in banks. Paulson and Bernanke defend the asset-purchase plan as the best idea available, since doubts about the value of these assets lie at the heart of recent chaos.
Credit markets seemed to amplify the urgency, showing signs of continued and extreme stress. Banks are reluctant to lend to one another – normally a routine part of their business.
Against this climate of fear, a positive sign in recent days has been the arrival of some willing investors in financial firms. Mr. Buffett's move Tuesday made the biggest splash. Private equity investor J. Christopher Flowers got clearance from bank regulators to buy a Missouri bank. Mitsubishi UFJ is buying a 20 percent stake in Morgan Stanley. And Barclays bought parts of the failed Lehman Brothers investment bank.
To some economists, this raises questions of whether a big rescue is needed. Yet Barclays didn't move in for Lehman until the bad assets had been removed. Describing the conditions as an "economic Pearl Harbor," Buffett said, according to a Bloomberg news report Wednesday that his investment in Goldman is a vote of confidence in the Treasury's plan.
The Treasury's program must find prices for the assets it wants to buy. It has to pay a high enough price that banks come forward to sell them. But overpaying imposes high costs on the taxpayer.
And the assets are complex, which makes a fair price hard to determine. Paulson said he'll pursue "reverse auctions" in which sellers provide offer prices for the securities.
Brian Battle, vice president of Performance Trust Capital Partners, a bond trading firm based in Chicago, says the Treasury plan intends to gather up bad assets, and it will pay high enough prices to do so. "They're going to succeed" on that front, Mr. Battle says. But "does this cure the disease?"
The question, he says, is to what extent that will resolve the underlying problem of sagging home prices. The further home prices fall, the less the complex mortgage securities are worth.
Some bond experts are optimistic that the Treasury's plan will not only ease financial stress but also make a profit for taxpayers. A team of bond analysts led by Laurie Goodman at the investment firm UBS, says the program "has a good chance of making money for the government."
But banks will still need to raise new capital. UBS analysts say the plan may "remove one major hurdle … [and] stop the downward spiral in the credit markets."