If a tall building collapses because of poor construction, where do you start rebuilding? On the 50th floor, to inspire confidence among potential tenants that you can build high again? No, you start with the foundation. The same principle applies to the credit crisis. The White House initially aimed too high in its marquee $700 billion bailout plan, which President Bush signed last Friday. Thankfully, though, the Federal Reserve is now aiming much lower.
The credit systems all-important foundations are the old-fashioned commercial banking system and the relatively new money-market mutual funds. Old-fashioned banks, of course, lend out depositors money. Policymakers and regulators already shield the economymore or lessfrom the most catastrophic effects of bank failures. Federal deposit insurance largely protects banks from the panicked flight of customers. Banks ability to borrow directly from the Fed also protects them, for the most part, from capital crunches born of market panic.
The problem is that for the past 40 years, money-market mutual funds have come to serve the same vital function that banks have long served, but they enjoy no protections from panics. High-quality borrowers like universities, corporations, small businesses, states, and cities have grown accustomed to borrowing at reasonable rates from these mutual fundsby selling them something called commercial paperfor day-to-day needs. Over the years, this business has grown from negligible to 30 percent as large as commercial-bank lending. So it quickly became a crisis for the marketsand the broader economywhen, three weeks ago, two such funds lost up to 3 percent of their investors money on high-grade bond investments in financial institutions like Lehman Brothers and Washington Mutual. Terrified investors pulled $200 billion out of this $3.3 trillion market, and the high-quality borrowers found that they could no longer get money at a reasonable price. The Treasury Departments temporary guarantee of some existing money market investments, announced after the failures, didnt do much to halt investors flight.
President Bushs signing of the Treasury Departments $700 billion bailout bill last week was designed in part to relieve this crisis. Purchasing toxic mortgage-related assets from flailing financial institutions, the bills supporters argued, would lead outside investors to regain confidence in them and start lending to them again. In addition, these investorsconfident that the money markets wouldnt face fresh losses from new financial-institution failurewould put their money back into the money markets, allowing high-quality companies to borrow again.
But there was no assurance that this strategy would work speedily, if at all. To buy toxic mortgage assets from financial institutions, Treasury has to hire managers, design auctions, and set about purchasing hundreds of billions of dollars in opaque securities from institutions that first have to consider what, if anything, to sell and when to start participating in the auctions. None of these things can, or should, happen overnight. Then, once some financial institutions have eventually swapped their low-quality mortgages and the like for higher-quality cash and bonds, they must figure out what to do with this inflow of funds from the government. It wont be an easy job, especially since they have seen the last decades business model of complex lending collapse, and have no idea how, and to whom, to lend money now. Its possible, even probable, that when the institutions get their money from the Treasury, theyll just give it back by investing in safe government bonds, putting us right back where we started.
And as for the idea that buying $700 billion worth of toxic securities can stop the poisoning of the rest of the system, including the money markets, consider that between 2005 and 2007, American financial institutions issued $5.4 trillion of asset-backed and mortgage-backed securities not guaranteed by any agency like Fannie Mae or Freddie Mac. Not all, or even most, of those assets are bad, but the figure includes far more than $700 billion worth of auto loans, credit-card debt, and mortgage debt whose value could continue to deteriorate, possibly precipitously, in the next few years. Trying to throw cash at this side of the problem is a losing game; the line of attack must be from a different angle.
Its good, then, that the Federal Reserve, with Treasury help, now is aiming at the most acute problem for the economy: those all-important money markets. The worlds investors are fleeing to safety, and they still perceive that safety to be in the American governments bonds. The Fed and the Treasury have determined that they must wash money back into the private money markets until those markets settle down. On Tuesday, the Fed said that it would start directly buying huge amounts of commercial paper from municipalities, universities, and companies, making up for the money markets decreased purchases. The Treasury will provide money for this program. The Fed is providing taxpayer capital so that high-quality institutions can borrow on a day-to-day basis again. Money markets wont have to wait for government money and public confidence to trickle down from purchases of the toxic assets that reside dozens of layers up in the credit system.
In this action, the Fed is supplementing its sustained aggressive lending to the other foundational level of the credit system: the old-fashioned banks. Because private-sector banks wont lend to each other, the Fedalong with its global counterpartsis essentially taking those private-sector banks money and parceling it out to fellow private-sector banks that need it. This arrangement is not ideal, but in a more cumbersome way, it achieves the same result as direct lending among banks.
This two-pronged strategy will have a more immediate impact than Paulsons original plan. But Paulson should supplement the Feds program by putting Treasury money directly into the money-market mutual funds. Why? By cutting out the middle manthe private money-market fund managersand lending directly to good credit risks, the Fed is acting expediently. But that middle man is important. These funds managers are already accustomed to working in the simplest, broadest credit markets, and government decision makers shouldnt crowd them out. So its good news that Congresss passage of the bailout bill has given the Treasury broad discretion to buy, besides mortgage-related assets, any other financial instrument from almost any entity, from public pension funds to cash-strapped banks.
Ultimately, though, the government cant replace private money-market investors indefinitely. Shoring up the money markets buys only time. Paulson should wisely use that time, and the leverage hes gained over the financial community, as he attacks the problem of toxic mortgage-related assets. The problem with these assets, everyone says, is not that theyre worthless but that theyre opaque: nobody can find out what theyre worth.
But the main part of Treasurys planto help markets find a price for these securities through its own direct purchasesmay actually impede progress on this front. By definition, the government cant set a market price for something, and neither can private asset managers when theyre using the governments money rather than their own. The governments intervention could delay the markets setting its own price and generating returns from such assets. Just last week, for example, private-equity firm Cerberus said it would pay Canadian bank CIBC $1.2 billion for mortgage-backed securities once valued at $6 billion. Too low? Maybebut its a real price. When portfolios are priced reasonably, private sector money is available, Leslie Rahl, a CIBC board member, told the Financial Times about the likely deal.
Treasury can help get these markets going in another way, though. It should abandon the pretense that its trying to set market prices for bad securities, a strategy that will confuse market participants. Instead, it should clearly announce that it will buy such securities at arbitrary values, and then pump capital directly into struggling financial firms as it makes such purchases. (It has the authority to do this: the law directs Treasury to use market mechanisms in its asset purchases only where appropriate.)
In return, Treasury should mandate that any financial institution that desires such capital open its entire portfolio up to independent forensic investigators. The investigators should start going through those institutions complex mortgage-backed and derivative securities, loan by loan and obligation by obligation. They should unravel the securities to figure out whos still paying what amounts each month on which mortgages in which markets, as well as assign their best estimates of current property values. The feds investigators should also parse the books of financial firms to ascertain whether the companies still face the risk that theyll have to come up with more cash collateral if the value of derivatives falls further. Its unacceptable that such surprises likely still lurk within these firms.
As the feds uncover this information, they should post it on the Internet in real time, loan by loan and risk by risk (blacking out homeowners and other borrowers names and specific street addresses). Only such transparencynot murky government auctions of assets whose values often arent comparable to one anotherwill help the markets slowly set a price for these assets. If private asset managers want a job, heres one for them. If not, there are plenty of unemployed bankers willing to work for the government on a month-to-month contract basis.