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 system’s 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 economy—more or less—from 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 funds—by selling them something called “commercial paper”—for 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 markets—and the broader economy—when, 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 Department’s temporary guarantee of some existing money market investments, announced after the failures, didn’t do much to halt investors’ flight.
President Bush’s signing of the Treasury Department’s $700 billion bailout bill last week was designed in part to relieve this crisis. Purchasing toxic mortgage-related assets from flailing financial institutions, the bill’s supporters argued, would lead outside investors to regain confidence in them and start lending to them again. In addition, these investors—confident that the money markets wouldn’t face fresh losses from new financial-institution failure—would 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 won’t be an easy job, especially since they have seen the last decade’s business model of complex lending collapse, and have no idea how, and to whom, to lend money now. It’s possible, even probable, that when the institutions get their money from the Treasury, they’ll 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.
It’s 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 world’s investors are fleeing to safety, and they still perceive that safety to be in the American government’s 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 won’t 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 won’t lend to each other, the Fed—along with its global counterparts—is 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 Paulson’s original plan. But Paulson should supplement the Fed’s program by putting Treasury money directly into the money-market mutual funds. Why? By cutting out the middle man—the private money-market fund managers—and 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 shouldn’t crowd them out. So it’s good news that Congress’s 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 can’t replace private money-market investors indefinitely. Shoring up the money markets buys only time. Paulson should wisely use that time, and the leverage he’s 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 they’re worthless but that they’re opaque: nobody can find out what they’re worth.
But the main part of Treasury’s plan—to help markets find a price for these securities through its own direct purchases—may actually impede progress on this front. By definition, the government can’t set a market price for something, and neither can private asset managers when they’re using the government’s money rather than their own. The government’s intervention could delay the market’s 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? Maybe—but it’s 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 it’s 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 who’s 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 they’ll have to come up with more cash collateral if the value of derivatives falls further. It’s 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 transparency—not murky government auctions of assets whose values often aren’t comparable to one another—will help the markets slowly set a price for these assets. If private asset managers want a job, here’s one for them. If not, there are plenty of unemployed bankers willing to work for the government on a month-to-month contract basis.