Crisis Averted, For Now

The U.S. Treasury started leaking plans of a game changing solution yesterday.  In essence, the government will buy many of mortgage securities which are depleting the system's capital.  As we have discussed, the writedowns of debt everywhere from community banks to large national banks to investment banks has greatly impaired capital, which reduces lending and starves the economy of funds. 

As the crisis peaked this week, everyone stopped lending to anyone regardless of their credit.  For example, I saw 2-yr GE bonds trade at obscenely low prices yesterday morning.  GE is a top-notch, truly AAA-rated, credit worthy company.  Normally their bonds will pay only a slight premium to Treasury bonds because they are deemed almost as safe.  Generally the premium is around 0.2-0.4%, but yesterday these bonds offered 5.3% compared to the Treasury at 1.7%- a 3.6% premium!  Folks, this is unheard of except when the system siezes and people value nothing but cash.

When ALL lending ceases, even money market funds run into trouble, banks can't function and economic activity grinds to a halt.  Treasury Secretary Paulson knows this, so does Bernanke.  Together they agreed that the situation was so extreme, not acting was going to end in a crash and probably a Depression.  Their solution?  To form a government fund to purchase a great portion of the assets causing this problem.  Doing so would inject cash into financial system, freeing capital for new lending and remove the items impairing capital.  In a crisis as we experienced this week, confidence is everything.  The plan has reintroduced confidence, halting the vicious cycle from spiraling out of control.  Essentially, it buys time to work out a detailed solution.

The Secretary's plan is amazingly devoid of detail.  What assets is the Treasury willing to buy?  Subprime?  What will they pay for it?  Exactly how much will the fund be, $200 billion? $400? $600? $800 billion?  $1 trillion even?  How will purchasing be allocated across banks and investment banks?  All of these factors matter tremendously in the long run and even the short run such as the coming weeks, but do not matter at all yesterday or today.  All that matters right now, is that the system is not collapsing.

The next question is whether this is a moral hazard and should the government bail out the entire financial system with taxpayer dollars?  As proposed, this is indeed a massive bailout with severe moral hazard consequences.  Yet the alternative is another depression.  Opinions will obviously differ, but which is worse?  And the moral hazard can be neutralized to some extent in a) how the details of the plan emerge and b) the changes in legislation to come in the following year or so.  The plan as (hopefully)approved by Congress next week may buy all assets at $0.50 on the dollar or less; it may require banks to absorb the losses eventually, just not for a few years; in other words the plan will hopefully make those who borrowed, lent and bought these loans to eventually pay for their mistakes. Or not.  We don't know.

We also don't know how or if Congress will change the system.  They could regulate investment banks or declare maximum leverage the same as banks or some other threshold.  Congress might require all mortgages to have recourse back to the original lender or even mortgage broker.  If Fannie bought a loan and securitized it, Fannie was responsible for the credit of that loan- neither the mortgage broker who did the paperwork or the bank who originally funded it is on the hook.  That may and probably should change.  In sum, there are many things that can be done to alleviate the moral hazard and make the sytem more robust for the future while retaining most of the benefits of free markets.  The question is will they be done or will politics get in the way leaving a system no better than before?