Nightmare on Wall Street

A Compendium of Articles and Editorials on the US Financial Meltdown

Give me $700 billion, or I'd hate to see anything bad happen to

that nice economy of yours

A month of financial madness September-October2008

 The financial crisis
Sep 18th 2008
From The Economist print edition

“THINGS are frankly getting out of hand and ridiculous rumors are being repeated, some of which if
I wrote down today and re-read tomorrow, I’d probably think I was dreaming.” So said an
exasperated Colm Kelleher, Morgan Stanley’s finance chief, during a hastily arranged conference
call on September 16th.

The carnage of the past fortnight may have an unreal air to it, but the damage is all too tangible—
whether the seizure of Fannie Mae and Freddie Mac by their regulator, the record-breaking
bankruptcy of Lehman Brothers (and the sale of its capital-markets arm to Barclays), Merrill
Lynch’s shotgun marriage to Bank of America or, most shocking of all, the government takeover of
a desperately illiquid American International Group (AIG).

The rescue of the giant insurer was justified on the grounds that letting it fail would have been
catastrophic for financial markets. As it happened, even AIG’s rescue did not stop the bloodletting.
On September 17th shares in Morgan Stanley and the other remaining big investment bank,
Goldman Sachs, took a hammering. Even though both had posted better-than-expected results a day
earlier, confidence ebbed in their stand-alone model, with its reliance on flighty wholesale funding.
An index that reflects the risk of failure among large Wall Street dealers has climbed far above its
previous high, during Bear Stearns’s collapse in March (see chart).

It is a measure of the scale of the crisis that, by the evening of September 17th, all eyes were on
Morgan Stanley, and no longer on AIG, which only 24 hours before had thrust Lehman out of the
limelight. After its share price slumped by 24% that day, and fearing a total evaporation of
confidence, Morgan attempted to sell itself. Its boss, John Mack, reportedly held talks with several
possible partners, including Wachovia, a commercial bank, and Citic of China. As contagion spread
far and wide, on September 18th central banks launched a co-ordinated attempt to pump $180 billion
of short-term liquidity into the markets. HBOS, Britain’s biggest mortgage lender, also sold itself to
Lloyds TSB, one of the grandfathers of British banking, for £12.2 billion ($21.9 billion) after its
share price plunged. The government was so anxious to broker a deal that it was expected to waive a
competition inquiry.

Financial panics have been around as long as there have been organized economies. There are
common themes. The cause of today’s crunch—the buying of property at inflated prices in the hope
that some greater fool will take it off your hands—has featured many times in the past. And the
withholding of funds by institutional investors is merely the modern version of an old-fashioned
bank run.

The same, and yet different

But each has its own characteristics, which makes it difficult for students of past crises to apply
lessons. Ben Bernanke, the chairman of the Federal Reserve, may be a scholar of the Depression, but
the vastness and complexity of the financial system, and the speed with which panic is spreading,
create a daunting task.

Though they are putting on a brave face, officials could be forgiven for feeling at a loss as one great
name buckles after another and investors flee any financial asset with the merest whiff of risk. Even
the politicians have been stunned into inactivity. Congress probably will not pass new financial
legislation this year, admitted Harry Reid, the Senate majority leader, because “no one knows what
to do.”

At times, the responses appear alarmingly piecemeal. Amid a fresh clam our against short-sellers—
Morgan Stanley’s Mr Mack accused them of trying to wrestle his stock to the ground—the Securities
and Exchange Commission, America’s main markets regulator, brought back curbs on “naked”, or
potentially abusive, shorts. It also rushed out a proposal forcing large investors, including hedge
funds, to disclose their short positions. Calstrs, America’s second-largest pension fund, said it would
stop lending shares to “piranhas”.

As in August 2007, when the crisis began in earnest, money markets were this week seizing up. The
price at which banks lend each other short-term funds surged, leaving the spread over government
bonds at a 21-year high. A scramble for safety pushed the yield on three-month Treasury bills to its
lowest since daily records began in 1954—the year President Eisenhower introduced the world to
domino theory.

Aptly enough, the crisis is spreading from one region to the next. Asian and European stockmarkets
suffered steep falls. Japan was fretting that Lehman’s potential default on almost $2 billion of yen-
denominated bonds would send a chill through the “samurai” market. Russia suspended share
trading and propped up its three largest banks with a handy $44 billion, as emerging markets lost
their allure.

Another weak spot is the $62 trillion market for credit-default swaps (CDSs), which has given
regulators nightmares since the loss of Bear Stearns. It did not fall apart after the demise of Lehman,
another big dealer. But it remains fragile; or, as one banker puts it, in a state of “orderly chaos”.

CDS trading volumes reached unprecedented levels this week, and spreads widened dramatically, as
hedge funds and dealers tried to unwind their positions. But as margin requirements rise, few
participants are taking on much risk, according to Tim Backshall of Credit Derivatives Research.
The turmoil will embolden those calling for the opaque, over-the-counter market to move onto
exchanges. Nerves on Wall Street would be jangling less if a central clearinghouse, planned for later
this year, was already up and running.

The CDS market may have figured in the government’s calculations of whether to save AIG, given
that its collapse would have forced banks to write down the value of their contracts with the insurer,
further straining their capital ratios. But officials also had an eye on Main Street. Some of AIG’s
largest insurance businesses serve consumers; its failure would have shaken their confidence. As it
was, thousands lined up outside its offices in Asia, with some looking to withdraw their business.

Consumers are already twitchy in America, where bank failures are rising and the nation’s deposit-
insurance fund faces a potential shortfall. The failure of Washington Mutual (WaMu), a troubled
thrift, could at the worst wipe out as much as half of what remains in the fund, reckons Dick Bove of
Ladenburg Thalmann, a boutique investment bank. WaMu was said this week to be seeking a buyer.

No less worrying are the cracks appearing in money-market funds. Seen by small investors as utterly
safe, these have seen their assets swell to more than $3.5 trillion in the crisis. But this week Reserve
Primary became the first money fund in 14 years to “break the buck”—that is, to expose investors to
losses through a reduction of its net asset value to under $1—after writing off almost $800m in debt
issued by Lehman.
Any lasting loss of confidence in money funds would be hugely damaging. They are one of the last
bastions for the ultra-cautious. And they are big buyers of short-term corporate debt. If they were to
pull back, banks and large corporations would find funds even harder to come by.

Coming to a bank near you

At some point the Panic of 2008 will subside, but there are several reasons to expect further strain.
Banks and households have started to cut their borrowing, which reached epic proportions in the
housing boom, but they still have a long way to go. By the time they are finished, the pool of credit
available across the markets will be smaller by several trillion dollars, reckons Daniel Arbess of
Perella Weinberg Partners, an advisory boutique. A recent IMF study argued that the pain of
deleveraging will be felt more keenly in Anglo-Saxon markets, because highly leveraged investment
banks exacerbate credit bubbles, and are then forced to cut their borrowing more sharply in a
downturn.

Furthermore, it is far from clear, even now, that banks are marking their illiquid assets
conservatively enough. Disclosures accompanying third-quarter results, for instance, showed a lot of
disparity in the valuation of Alt-A mortgages (though definitions of what constitutes Alt-A can
vary). “Level 3” assets, those that are hardest to value, will remain under pressure until housing
stabilizes—and that may be some time yet. Jan Hatzius of Goldman Sachs expects house prices in
America to fall by another 10%. Builders broke ground on fewer houses than forecast in August,
suggesting the housing recession will continue to drag down growth.

The pain is only now beginning in other lending. “We may be moving from the mark-to-market
phase to the more traditional phase of credit losses,” says a banker. This next stage will be less
spectacular, thanks to accrual accounting, in which loan losses are realized gradually and offset by
reserves. But the numbers could be just as big. Some analysts see a wave of corporate defaults
coming. Moody’s, a rating agency, expects the junk-bond default rate, now 2.7%, will rise to 7.4% a
year from now. Like many nightmares, this one feels as if it will never end.

Beyond crisis management

Bold ideas for solving America’s financial mess

EVERY financial crisis involves a tug of war between the tacticians and the strategists. The
tacticians dash from skirmish to skirmish trying to control a crisis, deciding in each case whether
taxpayers should bail out a distressed bank, firm or country. The strategists call for a more
comprehensive approach to resolving the mess—often involving new government bodies to
recapitalize banks or take over troubled assets.

The present crisis in America conforms to this pattern. So far, the government’s response has been
ad hoc and focused on crisis containment. The tacticians at the Federal Reserve and the Treasury
have put plenty of taxpayers’ money on the line—whether through the huge expansion in the central
bank’s liquidity facilities, the loan to Bear Stearns in March, or the government takeover of Fannie
Mae and Freddie Mac, the mortgage giants, and, now, of AIG, a huge insurer. But they have focused
on staving off catastrophe one bailout at a time.

Now the strategists are pushing back. From across the political spectrum people are arguing that it is
time for America to shift to a more systematic approach. In the past week Barney Frank, the leading
Democrat on financial matters in the House of Representatives, Paul Volcker, a former chairman of
the Fed, as well as writers of the editorial pages of the Wall Street Journal, have suggested that
Congress may need to create a new agency to deal with the mess. All have pointed to the Resolution
Trust Corporation (RTC), a government body set up in 1989 to deal with the fallout of the savings
and loan (S&L) bankruptcies.

Americans focus on the RTC because it is the country’s most recent example of a comprehensive
government plan to deal with a financial crisis. Between 1980 and 1994 almost 1,300 specialized
mortgage lenders, known as thrifts, failed. Their combined assets amounted to more than $600
billion. By 1986 these failures had bankrupted the Federal Savings and Loan Insurance Corporation,
the federal insurer for the thrift industry. At first the government tried to muddle through by trying to
recapitalize the insurer. But the S&L mess escalated. In 1989 Congress created the RTC, an entirely
new organization, to dispose of the failed thrifts’ assets in a way that minimized downward pressure
on financial and property markets.

The RTC is not a perfect parallel for today’s needs. It was set up—years after the S&L crisis
began—to deal with the aftermath of widespread bank failures. Those who advocate comprehensive
action today want to minimize the mess, not just clean up afterwards. Their proposals vary, but many
who cite the RTC envisage an institution that buys troubled mortgage-backed securities (not only
from failing institutions), putting a floor under their price. Some propose that the putative new
agency should manage and write down the underlying mortgages, in effect combining the functions
of the RTC with a Depression-era institution, called the Home Owners’ Loan Corporation, which
bought and restructured defaulting mortgages. Details are in short supply, but intellectual momentum
is building for a broader solution.

Not a moment too soon, suggest the results of a new study by Luc Laeven and Fabian Valencia, two
IMF economists.* They examined all systemically important banking crises between 1970 and 2007,
creating a database on how much financial crises cost and how they are resolved. The evidence is
clear. Tactical crisis containment is expensive and frequently inadequate. In most financial
meltdowns a comprehensive solution was required, and the sooner it was provided the better.

The study looks at 42 crises in all, spanning 37 countries. Like America today, most governments
began with ad hoc crisis management. In 74% of cases, for instance, governments pumped
emergency loans into failing banks or guaranteed their liabilities. An equally common tactic has
been regulatory forbearance. Governments allowed banks to hold less capital than was normally
required or softened their rules in other ways. These tactical responses, however, often did not work
and ended up increasing the overall bill from a crisis. “All too often”, the economists conclude,
“central banks privilege stability over cost in the heat of the containment phase.”

No such thing as a free crunch

Sooner or later most governments realize the need for a comprehensive solution to the crisis,
involving public funds. This can take different forms, from bank recapitalization to forgiveness of all
the underlying debts. In three-quarters of the cases, governments shored up bank capital by, for
instance, injecting preferred stock. About 60% of the time, governments set up institutions to
manage distressed assets.

The evidence from these attempts is sobering for proponents of an RTC II. Some institutions worked
well. In the early 1990s, for instance, Sweden successfully set up an asset-management company to
take over and sell the bad loans from its biggest banks. But, in general, the paper argues, such
government-owned asset-management firms are ineffective—often because politicians try to push
them around.
On average, the study finds that government attempts to stanch systemic banking crises over the past
three decades have cost 16% of GDP. That average hides enormous variation, much of which
depends on how crises were handled. America’s mess, even if it has already led to the demise of
famous Wall Street firms, is far from finished. That is why the international lessons are worth taking
seriously. Resolving a financial mess is cheaper, quicker and less painful if governments take a
rounded approach. For the moment, the bailout tacticians are in overdrive. But the strategists’
moment is approaching.

* “Systemic Banking Crises: a new database”. IMF Working Paper. September 2008.

What next?
Global finance is being torn apart; it can be put back together again

FINANCE houses set out to be monuments of stone and steel. In the widening gyre the greatest of
them have splintered into matchwood. Ten short days saw the nationalization, failure or rescue of
what was once the world’s biggest insurer, with assets of $1 trillion, two of the world’s biggest
investment banks, with combined assets of another $1.5 trillion, and two giants of America’s
mortgage markets, with assets of $1.8 trillion. The government of the world’s leading capitalist
nation has been sucked deep into the maelstrom of its most capitalist industry. And it looks
overwhelmed.

The bankruptcy of Lehman Brothers and Merrill Lynch’s rapid sale to Bank of America were
shocking enough. But the government rescue of American International Group (AIG), through an
$85 billion loan at punitive interest rates thrown together on the evening of September 16th, marked
a new low in an already catastrophic year. AIG is mostly a safe, well-run insurer. But its financial-
products division, which accounted for just a fraction of its revenues, wrote enough derivatives
contracts to destroy the firm and shake the world. It helps explain one of the mysteries of recent
years: who was taking on the risk that banks and investors were shedding? Now we know.

Yet AIG’s rescue has done little to banish the naked fear that has the markets in its grip. Pick your
measure—the interest rates banks charge to lend to each other, the extra costs of borrowing and of
insuring corporate debt, the flight to safety in Treasury bonds, gold, financial stocks: all register
contagion. On September 17th HBOS, Britain’s largest mortgage lender, fell into the arms of Lloyds
TSB for a mere £12 billion ($22 billion), after its shares pitched into the abyss that had swallowed
Lehman and AIG. Other banks, including Morgan Stanley and Washington Mutual, looked as if they
would suffer the same fate. Russia said it would lend its three biggest banks 1.12 trillion rubles ($44
billion). An American money-market fund, supposedly the safest of safe investments, this week
became the first since 1994 to report a loss. If investors flee the money markets for Treasuries, banks
will lose funding and the contagion will suck in hedge funds and companies. A brave man would see
catharsis in all this misery; a wise man would not be so hasty.

The blood-dimmed tide

Some will argue that the Federal Reserve and the Treasury, nationalizing the economy faster than
you can say Hugo Chávez, should have left AIG to oblivion. Amid this contagion that would have
been reckless. Its contracts—almost $450 billion-worth in the credit-default swaps market alone—
underpin the health of the world’s banks and investment funds. The collapse of its insurance arm
would hit ordinary policyholders. At the weekend the Fed and the Treasury watched Lehman
Brothers go bankrupt sooner than save it. In principle that was admirable—capitalism requires
people to pay for their mistakes. But AIG was bigger and the bankruptcy of Lehman had set off
vortices and currents that may have contributed to its downfall. With the markets reeling,
pragmatism trumped principle. Even though it undermined their own authority, the Fed and the
Treasury rightly felt they could not say no again.

What happens next depends on three questions. Why has the crisis lurched onto a new, destructive
path? How vulnerable are the financial system and the economy? And what can be done to put
finance right? It is no hyperbole to say that for an inkling of what is at stake, you have only to study
the 1930s.

Shorn of all its complexity, the finance industry is caught between two brutally simple forces. It
needs capital, because assets like houses and promises to pay debts are worth less than most people
thought. Even if some gain from falling asset prices, lenders and insurers have to book losses, which
leaves them needing money. Finance also needs to shrink. The credit boom not only inflated asset
prices, it also inflated finance itself. The financial-services industry’s share of total American
corporate profits rose from 10% in the early 1980s to 40% at its peak last year. By one calculation,
profits in the past decade amounted to $1.2 trillion more than you would have expected.

This industry will not be able to make money after the boom unless it is far smaller—and it will be
hard to make money while it shrinks. No wonder investors are scarce. The brave few, such as
sovereign-wealth funds, who put money into weak banks have lost a lot. Better to pick over their
carcasses than to take on their toxic assets—just as Britain’s Barclays walked away from Lehman as
a going concern, only to swoop on its North American business after it failed.

The center cannot hold

Governments will thus often be the only buyers around. If necessary, they may create a special fund
to manage and wind down troubled assets. Yet do not underestimate the cost of rescues, even
necessary ones. Nobody would buy Lehman unless the government offered them the sort of help it
had provided JPMorgan Chase when it saved Bear Stearns. The nationalization that, for good reason,
wiped out Fannie’s and Freddie’s shareholders has made it riskier for others to put fresh equity into
ailing banks. The only wise recapitalization just now is an outright purchase, preferably by a retail
bank backed by deposits insured by the government—as with Bank of America and Merrill Lynch,
Lloyds and HBOS and, possibly, Wachovia with Morgan Stanley. The bigger the bank, the harder
that is. Most of all, each rescue discourages investors from worrying about the creditworthiness of
those they trade with—and thus encourages the next excess.

For all the costs of a rescue, the cost of failure to the economy would sometimes be higher. As
finance shrinks, credit will be sucked out of the economy and without credit, people cannot buy
houses, run businesses or as easily invest in the future. So far the American economy has held up.
The hope is that the housing bust is nearing its bottom and that countries like China and India will
continue to thrive. Recent falls in the price of oil and other commodities give central banks scope to
cut interest rates—as China showed this week.

But there is a darker side, too. Unemployment in America rose to 6.1% in August and is likely to
climb further. Industrial production fell by 1.1% last month; and the annual change in retail sales is
at its weakest since the aftermath of the 2001 recession. Output is shrinking in Japan, Germany,
Spain and Britain, and is barely positive in many other countries. On a quarterly basis, prices are
falling in half of the 20 countries in The Economist’s house-price index. Emerging economies’
stocks, bonds and currencies have been battered as investors fret that they will no longer be
“decoupled” from the rich countries.
Unless policymakers blunder unforgivably—by letting “systemic” institutions fail or by keeping
monetary policy too tight—there is no need for today’s misery to turn into a new Depression. A
longer-term worry is the inevitable urge to regulate modern finance into submission. Though
understandable, that desire is wrong and dangerous—and the colossal success of commerce in the
emerging world (see article) shows how much there is to lose. Finance is the brain of the economy.
For all its excesses, it allocates resources to where they are productive better than any central planner
ever could.

Regulation is necessary, and much must now be done to improve the laws of finance. But it must be
the right regulation: an end to America’s fragmented system of oversight; more transparency; capital
requirements that lean against booms and flex with busts; supervision of giants, like AIG, that are
too big and too interconnected to fail; accounting that values risks better and that everyone accepts;
clearing houses and exchanges to make derivatives safer and less opaque.

All that would count as progress. But naive faith in regulators’ powers creates ruinous false security.
Financiers know more than regulators and their voices carry more weight in a boom. Banks can
exploit the regulations’ inevitable blind spots: assets hidden off their balance sheets, or insurance
(such as that provided by AIG) which enables them to profit by sliding out of the capital
requirements the regulators set. It is no accident that both schemes were at the heart of the crisis.

This is a black week. Those of us who have supported financial capitalism are open to the charge
that the system we championed has merely enabled a few spivs to get rich. But it helped produce
healthy economic growth and low inflation for a generation. It would take a very big recession
indeed to wipe out those gains. Do not forget that in the debate ahead.

Investment banking--Is there a future?

The loneliness of the independent Wall Street bank

IN THE early years of this decade, when banks did quaint things like making money, the mantra on
Wall Street was: “Be more like Goldman Sachs”. Bank bosses peered enviously at the profits and
risk-taking prowess of the venerable investment bank. No longer. “Be less like Goldman Sachs” is
the imperative today.

Of the five independent investment banks open for business at the start of the year, only Goldman
and Morgan Stanley remain. Doubts about the sustainability of the model are rife. In earnings
conference calls on September 16th, the chief financial officers of both firms had to bat away
analysts’ questions about their ability to survive on their own. Spreads on their credit-default swaps,
which protect against the risk of default, soared as investors digested the implications of Lehman
Brothers’ demise (see chart).

Universal banks, which marry investment banking and deposit-taking, are in the ascendant. Bear
Stearns and Merrill Lynch found shelter in the arms of two big universal banks, JPMorgan Chase
and Bank of America. Barclays, a British universal bank, is picking at the carrion of Lehman
Brothers. The mood at Citigroup, seen until now as one of the biggest losers from the crisis, is
suddenly bullish: insiders talk up the stability of its earnings and the advantages of deposit funding.

Regulatory antipathy to universal banks has also eased. Although the 1933 Glass-Steagall act, which
separated investment banks and commercial banks, was repealed in 1999, the universal model is still
viewed with suspicion in America. Among measures announced on September 14th, the Federal
Reserve temporarily suspended rules restricting the amount of money that banks can lend to their
investment-banking affiliates. Many are skeptical that this rule makes much practical difference.
Even if the investment-banking arms of universal banks nominally have to raise money separately,
their parents’ ratings still make their funding cheaper. By the same token, if they get into trouble, the
effects ripple through the entire balance sheet. Even so the suspension, and the dramatic reshaping of
Wall Street, represents the final repeal of Glass-Steagall.

Can Goldman and Morgan Stanley survive as independents? In normal times, the question would
seem ludicrous. Both banks had profitable third quarters, with Morgan Stanley beating expectations
comfortably. Rivals’ disappearance should allow them to grab new business and has already helped
to increase pricing power: Morgan Stanley hauled in record revenues in its prime-brokerage
business. Both have reduced their most troubling exposures; both can call on decent amounts of
capital and strong pools of liquidity. And both can marshal strong arguments that they are better
managed than their erstwhile peers.

The problem, of course, is that these are not normal times. Although the firms condemn the rumor-
mongering, stories that Morgan Stanley was looking for a partner continued to swirl. As The
Economist went to press, Wachovia, an American bank, and Citic of China were among the names
in the frame.

Three doubts hang over the independent model. The first concerns the risk of insolvency. Investment
banks have higher leverage than other banks (in America at least), which worsens the impact of
falling asset values. They do not have the safety-valve of banking books, where souring assets can
escape the rigors of mark-to-market accounting. And they lack the stable earnings streams of
commercial and retail banking. In other words, they have less room for error. Goldman’s reputation
for risk management is excellent, Morgan Stanley’s a bit patchier. But asking investors to take
valuations and hedging processes on trust is getting harder by the day.

The second, related doubt concerns their funding profile. As a group, the pure-play investment banks
have relied heavily on short-term funding, particularly repo transactions in which counterparties take
collateral as security against the cash they lend. Both survivors say they are nowhere near as exposed
to the risk of a sudden dearth of liquidity as Bear Stearns was. They could also argue that retail
deposits can be as flighty as the wholesale markets: just ask Northern Rock and IndyMac, both of
which suffered rapid withdrawals. Even so, a further shift towards longer-term unsecured financing
will be the price of survival for Morgan Stanley in particular.

That would increase costs, which in turn raises the third doubt, profitability. As well as dearer
funding and lower leverage, the investment banks face the prospect of weakened demand for their
services. As and when the market for structured finance revives, it will be smaller and less rewarding
than before. Demand for many services will not go away, but in a world of scarcer credit, universal
banks will be tempted to use their lending capacity to win juicier investment-banking business from
companies. “Don’t give me the bone,” says one European bank boss. “Leave some meat on it.”

By these lights, universal banks appear to offer clear advantages to both shareholders and regulators.
Yet some of those advantages are illusory. For regulators, larger, diversified institutions may be
more stable than investment banks but they pose an even greater systemic risk. “The universal bank
is the regulatory equivalent of the super-senior mortgage-backed bond,” says one analyst. “The risks
may look lower but they do not go away.” And deposit funding is cheaper than wholesale funding in
part because those deposits are insured. Measures to protect customers may end up allowing banks to
take on risks that endanger customers.

For shareholders, too, the universal bank may offer false comfort. A model that looks appealing in
part because assets are not valued at market prices ought to ring alarm bells. Sprawling
conglomerates are just as hard to manage as turbo-charged investment banks. And shareholders at
UBS and Citi will derive little comfort from the notion that the model has been proven because their
institutions are still standing. If the independent investment banks survive, they will clearly need to
change. But they are not the only ones.

Looking for the bright side

Are there any signs that this could be a buying opportunity?

WHEN Winston Churchill lost the 1945 election, his wife remarked that the defeat might be a
blessing in disguise. “At the moment”, replied the great man, “it seems quite effectively disguised.”

It is possible, when investors view recent events in retrospect, they will see them as a turning point
for markets. But if there are immediately bullish implications, they seem to be quite effectively
disguised. The American authorities sacrificed Lehman Brothers “to encourage the others”, only to
find the others were simply encouraged to deny funding to weak-looking institutions.

Risk aversion reached extremes this week as the money markets froze. Overnight dollar rates
doubled in the interbank market while the rate paid by the American government for three-month
money fell to its lowest in more than 50 years. In addition, the caning the authorities gave to
shareholders in Fannie Mae, Freddie Mac and AIG, however hard to argue with, will make it tough
for financial institutions to raise new equity. Wall Street did not even bother to rally after the AIG
deal as it had after previous government interventions.

Bad news seems to be coming from all sides, leaving Hank Paulson, America’s treasury secretary,
increasingly resembling a one-armed wallpaper hanger as he valiantly seeks to cope with the mess.
Another problem emerged this week; a $65 billion money-market fund, Reserve Primary, suspended
redemptions and warned that it would “break the buck”, i.e, repay investors at less than face value.
That could cause a flight out of other money-market funds. Meanwhile, credit spreads over risk-free
rates have widened sharply and emerging markets have taken a hammering.

The “great deleveraging” is working its way through the markets, as institutions, unable to roll over
their debts, are forced to sell assets. The resulting fall in prices raises doubts about the solvency of
other businesses, giving the spiral another downward lurch.

So what good news can be found in the midst of all this gloom? The first, curiously enough, is that
sentiment is very depressed. The latest poll of global fund managers by Merrill Lynch found that risk
appetite is at its lowest level in over a decade. Such extremes are normally a bullish sign.

The second is that the government is not the only buyer. After Merrill Lynch’s sale to Bank of
America, HBOS, a British mortgage lender, has also sought refuge within a bank, Lloyds TSB. That
suggests executives see value in today’s prices. Whether this is out of shrewd bargain hunting, state
arm-twisting or over-ambitious empire-building remains to be seen.

The third is that the inflation threat has receded, thanks to the sharp fall in commodity prices.
Eventually, that will allow central banks to cut interest rates. In addition, it will relieve the pressure
on consumer demand and corporate profit margins.

The fourth factor is that central banks are also willing to undertake quite extraordinary market-
support measures, including the Fed’s decision to accept equities as collateral against lending at its
discount window. That would have been unthinkable 18 months ago.
The fifth issue is that valuations in equity markets have improved substantially. In Britain on
September 17th, the yield on the FTSE All-Share index was higher than the yield on ten-year gilts.
This has happened only once before since the late 1950s—in March 2003, which proved to be the
start of a long rally.

However, it would be a brave investor that acted on those bullish signals today. Those who believed
that the Bear Stearns collapse in March marked a turning point in the credit crunch were
disappointed. The Vix, or volatility index, a measure of market preparedness for shocks, has been
lower than in past peaks—though it shot up on September 17th.

While the money markets are frozen, other financial institutions may get into trouble. Buyers will be
tempted to wait until asset prices fall further, a strategy that worked for Barclays, which was able to
choose the slice of Lehman Brothers it desired. And the economy will surely have been harmed by
this week’s turmoil; consumer sentiment will have been hit and banks will inevitably prove even
more cautious about their lending. A recession seems more likely than it did at the start of the month.

Perhaps there will be no climactic sell-off to signal the end of the bear market. Instead share prices
may simply bounce around in a choppy range near today’s values. It is quite plausible that those who
buy shares today will look smart in five years’ time. It is much less certain they will look smart six
months from now.

Saving Wall Street--The last resort

The American government’s bailouts are less arbitrary than they appear

SIX months after the American government supported the sale of Bear Stearns to JPMorgan Chase,
leading to the end of one of Wall Street’s “Big Five”, it tried to make it clear last weekend that there
would be no further bail-outs, and let Lehman Brothers fail. Two days later, that line in the sand had
all but blown away.

The Treasury’s decision on September 16th to take over American International Group (AIG), one
of the world’s biggest insurers, in exchange for an $85 billion credit line from the Federal Reserve,
was momentous. More so than allowing Lehman Brothers, which was even bigger than Bear Stearns,
to go bust the day before; more so, even, than the takeover of Fannie Mae and Freddie Mac, the big
mortgage agencies, just over a week before. With AIG, the stakes were higher for both the financial
system and the authorities’ credibility.

Fannie and Freddie always had implicit federal backing, so when they tottered, the federal
government had little choice but to make that support explicit. Bear Stearns was a regulated
investment bank whose demise was so sudden that its collapse could have caused a maelstrom.

AIG is an insurer, not a bank, and as such had neither federal backing nor much federal oversight.
Yet it quietly built itself into a juggernaut in the global financial system by using derivatives to
insure hundreds of billions of dollars of corporate loans, mortgages and other debt. Holders of these
assets ranged from the world’s biggest banks to retired people’s money-market funds. Allowing AIG
to fail could have panicked small investors, forced banks to take steep write-downs, and introduced a
terrifying new phase to the financial crisis.

To some, the institution-by-institution approach to bailouts seems haphazard. “Mr Secretary...you’re

picking and choosing. You have to have a set policy,” Richard Shelby, the leading Republican on the
Senate banking panel, complained to Hank Paulson, the treasury secretary.
In fact, back in July Mr Paulson had argued in favor of a formal mechanism to take over and wind
down non-banks, such as investment banks and insurers, in an orderly way, much as already exists
for retail banks. But Congress was only prepared to consider that as part of a bigger regulatory
overhaul under the next president. That forced Mr Paulson, Ben Bernanke, the Fed’s chairman, and
Timothy Geithner, the president of the New York Fed (the three are virtually joined at the hip) to
pursue rescues ad hoc. Yet a certain logic has governed their actions.

It is possible to detect a pattern of sorts emerging in Mr Paulson’s interventions. First, establish if a

firm is so large or so entangled within the financial system that its unexpected failure could be
catastrophic. If the answer is “no”, as the authorities concluded it was in Lehman’s case, encourage a
private sale but commit no public money. If the answer is “yes”, as with Bear, Fannie and Freddie,
and AIG, then make sure that taxpayers get first claim on the assets, common and preferred
shareholders pay a steep price, and management is replaced. Mr Paulson argues that the approach
combines pragmatism with an intense focus on moral hazard, or letting people pay for failure. “I
don’t believe in raw capitalism without regulation. There’s got to be a balance between market
discipline, allowing people to take losses, and protecting the system,” he says.

Assuming the markets eventually right themselves, the bailouts may hasten healthy consolidation.
American economic growth has been heavily dependent on borrowing and leverage for the last
decade. AIG had used its unregulated status to supply cheap credit protection to regulated entities.
But that business thrived in a period of easy credit and low defaults. When those conditions ended, it
produced enough losses to nearly bankrupt AIG.

Lehman’s bankruptcy and AIG’s failure suggest Wall Street has too much leverage and too much
capital devoted to products of questionable economic utility. The bailouts will facilitate a
deleveraging. The Fed expects AIG to repay its loan by selling off its healthy businesses, while
winding down its derivatives book. Mr Paulson wants Fannie and Freddie to reduce much of their
mortgage portfolios.

“The necessary shrinking of the financial system is taking place in real time,” says Kenneth Rogoff
of Harvard University. It could go too far. If the cycle of falling asset prices, insolvency and credit
constriction is excessive, the government may have to step in and buy up bad assets en masse, as has
often occurred in other financial meltdowns (see article).

Even without such drastic action, the economy and the financial system are becoming dependent on
the taxpayer. Bank of America was in a position to buy Merrill Lynch in part because the Federal
Deposit Insurance Corporation, which guarantees deposits, insulates a large share of the bank’s
funding from crises of confidence.

With federal backing comes federal oversight. Even the most free-market policymakers will be
reluctant ever to see another company get as large and interconnected as AIG without tougher
regulation. Just as the Fed insisted on more oversight of investment banks when it agreed to lend to
them in March, it will now have the authority to inspect the books of AIG any time it chooses.

This poses risks to the Fed. Thrust to the fore during the crisis, its role in the financial system has
expanded. It has so far balanced these responsibilities with its attention to inflation. On September
16th it defied market hopes for lower interest rates and kept its short-term target at 2%. It judged that
for now, expanding its loans to banks and securities dealers, and broadening the collateral it accepts
from banks, addresses the crisis better than looser monetary policy would, though it may yet decide
further rate cuts are necessary.
Still, the Fed has lent so heavily to the most beleaguered financial firms that it is running out of
bonds. The government has promised to help with a special issuance of Treasury bills, which,
through the machinations of reserve management, will result in a larger Fed balance sheet but no
impact on interest rates.

The Fed needs to be sure it does not become a crutch for insolvent financial firms, distorting credit
allocation and risk taking. For the time being, though, that concern is far less important to it than
keeping the financial system intact.

Emerging markets--Beware falling BRICs

Emerging countries are not the havens some people thought

SO MUCH for decoupling. In the wake of Lehman Brothers’ failure, emerging markets have
suffered one of their biggest sell-offs in years. On September 18th Russia’s main bourses suspended
trading in shares and bonds for a third day in a row after the largest one-day stock market fall for a
decade; the central bank poured billions into big banks and the money market in a forlorn bid to
calm fears. JPMorgan’s emerging-markets bond index fell by more than 5% in the week to
September 16th, giving up in a few days all the gains it had made this year. Prices of Argentina’s
credit-default swaps, a gauge of credit risk, rose to their highest-ever level. Unexpectedly, the
People’s Bank of China cut its benchmark lending rate by 27 basis points on September 15th, to
7.2%, the first cut for six years.

These actions reflected a variety of concerns, such as a darkening economic mood in China and
political worries in Russia. But they all have something in common: investors may be changing their
minds about emerging markets.

For the past few years, China, Brazil and others, with their high growth rates and large current-
account surpluses, began to seem like desirable alternatives to developed markets. For part of last
year, the MSCI emerging-markets index was even trading at a higher multiple of earnings than the
index of rich-world shares.

That is changing as investors lose their appetite for risk. Merrill Lynch’s most recent survey of fund
managers found that they are now holding more bonds than normal for the first time in a decade
(indicating a flight to safety). They also have smaller positions in emerging-market equities than at
any time since 2001. In the past three months, says Michael Hartnett of Merrill Lynch, emerging-
market funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the
previous five years.
Reuters
Reuters

The ruble in the rubble

Falling oil and commodity prices are partly to blame. When these were rising, money poured into
Brazil and Russia, which became targets of the “carry trade” (investors borrow in low-yielding
currencies and buy high-yielding ones). Now oil prices are falling (dipping almost to $90 a barrel
this week), they are undermining the carry trade and forcing Russia to prop up the ruble. Indebted
investors are also being forced by their banks to sell as falling prices reduce the value of their
collateral.

Lower oil and commodity prices ought to benefit China and India, by lowering import bills and
assuaging worries about inflation. Yet India’s foreign-exchange reserves fell by $6.5 billion in the
first week of September as the central bank sold dollars to slow the fall of the rupee. In China,
worries are growing about weakening export demand (growth in export volumes has fallen by almost
half over the past year to 11%) and falling property prices, which seem to play a role similar to
equity prices elsewhere. In the past three months, property sales in big cities were 40-50% lower
than a year ago, according to figures tracked by Paul Cavey of Macquarie Securities. An agent for
one of Hong Kong’s largest property companies says “confidence ended this week with the fall of
Lehman.”

All these countries have the comfort of huge foreign-exchange reserves. On September 16th the new
governor of India’s central bank said he would continue to cushion the rupee’s fall; he also raised the
interest rate Indian expatriates can earn on deposits at home and let banks borrow a bit more from
the central bank. China’s interest-rate cut shows that its government, too, has room for maneuver.
But the cut will have little direct impact on the economy because lending is limited by quotas. It was
intended to boost confidence at a time of falling share and house prices. Too bad that among
emerging-market investors, confidence is in short supply.

Accounting--All’s fair
The crisis and fair-value accounting

SO CONTROVERSIAL has accounting become that even John McCain, a man not known for his
interest in balance sheets, has an opinion. The Republican candidate for the American presidency
thinks that “fair value” rules may be “exacerbating the credit crunch”. His voice is part of a chorus
of criticism against mark-to-market accounting, which forces banks to value assets at the estimated
price they would fetch if sold now, rather than at historic cost. Some fear that accounting dogma has
caused a cycle of falling asset prices and forced sales that endangers financial stability. The fate of
Lehman Brothers and American International Group will have strengthened their conviction.

In response America’s Financial Accounting Standards Board (FASB), and the London-based
International Accounting Standards Board (IASB) have not budged an inch. So, for example, banks
will have to mark their securities to the prices Lehman receives as it is liquidated. The two
accounting bodies already act cheek by jowl, and America will probably soon adopt international
rules. Are they guilty of obstinately pursuing an abstract goal that is causing mayhem in financial
markets?

Banks’ initial attack on fair value was self-serving. In April the Institute of International Finance
(IIF), a lobbying group, sent a confidential memorandum to the two standard-setters. This said it was
“obvious” markets had failed and that companies should be allowed to suspend fair value for
“sound” assets that had suffered “undue valuation”. Even at the time this stance lacked credibility;
Goldman Sachs resigned from the IIF in protest at “Alice in Wonderland accounting”. Today it is
abundantly clear that those revelations were not a figment of accountants’ imagination. For example,
in July Merrill Lynch sold a big structured-credit portfolio at 22% of its face value—less than what
was entered on its balance sheet. Bob Herz, FASB’s chairman, argues that fair value is “essential to
provide transparency” for investors.

Yet not all criticism of fair value can be so easily dismissed. The credit crunch has raised three
genuinely awkward questions. The first of these concerns “procyclicality”. Bankers say that in a
downturn fair-value accounting forces them all to recognize losses at the same time, impairing their
capital and triggering fire sales of assets, which in turn drives prices and valuations down even more.
Under traditional accounting, losses hit the books far more slowly. Some admire Spain’s system,
which requires banks to make extra provision for losses in good times, so that when loans turn sour
their profits and thus capital fall by less.
It is too soon to know if prices exaggerate the ultimate losses on credit products. Some people argue
that swift write-downs in fact help to re-establish stability: Yoshimi Watanabe, Japan’s minister for
financial services, says Japanese banks exacerbated their country’s economic woes by “avoiding
ever facing up to losses”. But the principle defense of standard-setters is that enhancing financial
stability is not the purpose of accounting.

Over to the regulators

In other words, if procyclicality is a problem, it is someone else’s. Already central banks have
relaxed their rules on what they will accept from banks as collateral, which has helped to support the
prices of risky assets. And the mayhem in the swaps market has shown the importance of on-
exchange trading, so that trading remains orderly in times of stress.

Ultimately, though, responsibility for interposing a circuit-breaker between market prices and banks’
capital adequacy falls on bank regulators, not accountants. They are already examining
“countercyclical” regimes, which would force banks to save more capital in years of plenty. They
could go further by suspending capital rules during times of stress if they think asset prices have
overreacted. Europe’s national regulators already use some discretion when defining capital
adequacy. There is a precedent in pension regulation, where corporate schemes are marked to market
but the cash payments companies make to keep them solvent are smoothed over time. Banks’
financial statements could be modified to show assets at cost as well as fair value, so that if
regulators or investors wanted to use traditional accounting to form a view, they could.

Even if they leave procyclicality to bank regulators, standard-setters still have a lot on their plates.
The second—and immediate—question is how to value illiquid (and sometimes unique) assets. A
common solution is to use banks’ own models. But some investors are concerned that this gives
banks’ managers too much discretion—and no wonder, because highly illiquid (or “Level 3”) assets
are worryingly large relative to many banks’ shrunken market values. Such is the complexity of
many such assets that it may not be possible to find a generally acceptable method. The best answer
is to disclose enough to allow investors to form their own views. This week IASB gave new
guidance that should help in this regard.

The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of
a financial asset is determined by the intention of the company. If it is to be traded actively, its
market value must be used. If it is only “available for sale” it is marked to market on the balance
sheet, but losses are not recognized in the income statement. If it is to be “held to maturity”, or is a
traditional loan, it can be carried at cost, subject to impairment. This is a dog’s breakfast. Different
banks can hold the same asset at different values. According to Fitch, a ratings agency, at the end of
2007, Western banks carried about half of their assets at fair value, but the dispersion was wide:
from 86% at Goldman Sachs to 27% at Bank of America (see chart).

The obvious solution is to use fair value for all financial assets and liabilities. This is exactly what
both FASB and IASB propose. In parallel they want to clean up the income statement, so that
changes in the value of assets or liabilities are separated clearly from recurring revenues and costs.

For low-risk banks, this would make little difference: both HSBC and Santander report that the fair
value of their loan books is slightly above their carrying value. But it could mean big losses for
riskier institutions. When Bank of America bought Countrywide, a big mortgage lender, it was
forced, under another quirk, to mark its troubled acquisition’s loans at fair value, wiping out
Countrywide’s equity. Bankers are therefore likely to resist the idea of fair value for loans fiercely:
one executive calls it “lunacy”. Here standard setters’ quest for intellectual consistency will run into
a political quagmire.

Marks out of ten

Has accounting had a good credit crunch? The last year has shown that standard-setters are now truly
independent and focused on investors’ needs rather than the wishes of management, regulators and
the taxman. Reforms to IASB’s governance should bolster this independence. That is to be
welcomed. For all fair value’s flaws, banks ought not to have license to carry their dodgy credit
exposures at cost.

At the same time the fair-value revolution is incomplete. Regulators may need to abandon the
traditional, mechanistic link between accounting and capital adequacy rules if they really want to try
to fight banking crises. That is no bad thing either. Investors and regulators should be able to share a
market-based language to describe financial problems, even if they disagree about what needs to be
done.

European banks--Cross-border contagion

HBOS’s troubles give everyone a bit extra to worry about

JOHN PIERPONT MORGAN, it is said, whiled away the time while orchestrating a plan to avert
the financial crisis of 1907 by steadfastly playing solitaire. A century later, the game du jour
involves toying with dominoes. Funds and traders are casting about for the next banks to fall (and
enthusiastically selling their shares).

So far most of the falling stones have been American. But some European banks are also teetering.
The latest is HBOS, a well-capitalized but weakly funded British bank that will lose its
independence. On September 18th HBOS, Britain’s biggest mortgage lender, said it had agreed to be
taken over by Lloyds TSB, another of the country’s leading banks. There was government pressure,
but both sides denied there had been a bailout. Any hint of one would infuriate shareholders of
Northern Rock, another British mortgage lender that was nationalized last year. They were largely
wiped out.

Worries about the wholesale markets intensified, not just for HBOS, but all European banks, on
September 16th, when Reserve Primary, a money-market fund, froze withdrawals for a week. Its
troubles caused huge surges in the cost of borrowing money overnight (see chart). “I don’t want to
sound alarmist, but the liquidity squeeze we’re experiencing now is worse than it was in August
2007 [at the start of the credit crunch],” observes one trader.

Although the shortage of money is most acute for dollar-denominated loans, some of Europe’s
biggest banks are also exposed to this market because they generally do not have dollar deposits and
rely largely on money and capital markets to fund their investment banks. Among those affected are
Barclays, Royal Bank of Scotland, Deutsche Bank and UBS, all of which saw huge jumps in the
price of insuring their debt against default.

This reflected not just the spike in rates they have to pay to borrow dollars (with some smaller outfits
said to be paying as much as 12% for three-month money, according to money-market traders).
There was also the worry that they face losses on loans and derivatives contracts with firms that are
either bankrupt, such as Lehman, or suddenly less than creditworthy, such as AIG. Arturo De Frias
of Dresdner Kleinwort estimates that European banks may end up with losses of about $31 billion on
short-term loans to Lehman.
Just as big a concern for banks in Britain and Europe is whether the hotchpotch of regulatory
systems across the continent could cope with a bank failure. The American authorities have been
nimble enough, yet their agility has not quelled the panic. Their European counterparts are still
arguing about who should be in charge and what should be done.

The trials of HBOS, which owns the Halifax, a building society, highlight a particular uncertainty
faced by British banks. Even as the bank’s share price and bond spreads weakened this week, the
Bank of England dithered over whether to renew its facility for letting British banks swap mortgages
for funds. It announced an extension on September 17th, after news of HBOS’s talks with Lloyds
had leaked out. British banks are also lobbying against parts of a long-overdue proposal by the
authorities to deal with ailing banks.

For other European banks, there is trepidation not about whether their governments or central banks
are willing to support them, but whether they can. Some of Europe’s biggest banks, such as UBS,
ING and Fortis, are based in some of its smallest countries such as Switzerland, the Netherlands and
Belgium. If one were to fail, the fallout might well make America’s recent upheavals look orderly.

Derivatives--A nuclear winter?

The fallout from the bankruptcy of Lehman Brothers

WHEN Warren Buffett said that derivatives were “financial weapons of mass destruction”, this was
just the kind of crisis the investment seer had in mind. Part of the reason investors are so nervous
about the health of financial companies is that they do not know how exposed they are to the
derivatives market. It is doubly troubling that the collapse of Lehman Brothers and the near-collapse
of American International Group (AIG) came before such useful reforms as a central clearing house
for derivatives were in place.

A bankruptcy the size of Lehman’s has three potential impacts on the $62 trillion credit-default
swaps (CDS) market, where investors buy insurance against corporate default. All of them would
have been multiplied many times had AIG failed too. The insurer has $441 billion in exposure to
credit derivatives. A lot of this was provided to banks, which would have taken a hit to their capital
had AIG failed. Small wonder the Federal Reserve had to intervene.

The first impact concerns contracts on the debt of Lehman itself. As a “credit event”, the bankruptcy
will trigger settlement of contracts, under rules drawn up by the International Swaps and Derivatives
Association (ISDA). Those who sold insurance against Lehman going bust will lose a lot. But
Lehman had looked risky for some time, so investors should have had the chance to limit their
exposure.

The second effect relates to deals where Lehman was a counterparty, i.e, a buyer or seller of a swaps
contract. For example, an investor or bank may have bought a swap as insurance against an AIG
default, with Lehman on the other side of the deal. That protection could conceivably be worthless if
Lehman fails to pay up. Until the Friday before its bankruptcy, Lehman would have posted
collateral, which the counterparty can claim. After that day, the buyer will have been exposed to
price movements before it could unwind the contract.

The third effect will be on the collateralized-debt obligation (CDO) market, which caused so many
problems last year. So-called synthetic CDOs comprise a bunch of credit-default swaps; a Lehman
default may cause big losses for holders of the riskier tranches.
Insiders say the biggest exposure may be in the interest-rate swaps market, which is many times
larger than those for credit derivatives. In a typical interest-rate swap, one party agrees to exchange a
fixed-rate obligation with another that has a floating, or variable, rate exposure. Depending on
whether floating rates rise or fall, one will end up owing money to the other. Again, those banks that
dealt with Lehman should have been fine until Friday, when the bank was still posting collateral. But
not afterwards.

Although there are ISDA rules to cover such events, the sheer size of Lehman in the market (its
gross derivatives positions will be hundreds of billions of dollars) makes this default a severe test.
There will inevitably be legal disputes as well. The good news is that the swaps markets did not
utterly seize up after it went bust on September 15th. But the reaction may be a delayed one. Mr
Buffet’s WMD could leave behind a cloud of toxicity.

AIG’s rescue--Size matters

Why one of the world’s biggest insurers needed a government rescue

EVEN by the recent standards of Wall Street bailouts, that of American International Group is
colossal. At its peak the insurance firm was the world’s largest with a market value of $239 billion.
Its assets are bigger than those of either Lehman Brothers or Fannie Mae. Yet size alone does not
explain the rescue. Nor do the images of customers queuing to cancel their policies as far away as
Singapore. AIG posed a systemic risk because of its investment bank, tucked away behind the dull
business of writing insurance contracts, which has lost it both a fortune—and now its independence
(see chart).

At one stage, this unit contributed over a quarter of profits. It has played the role of schmuck in one
of finance’s most dangerous games by writing credit-default swaps (CDSs), a type of guarantee
against default, with a giant notional exposure of $441 billion as of June. Of this, $58 billion is
exposed to subprime securities which have already generated huge mark-to-market losses. For
regulators, the real horror story may be the $307 billion of contracts written on instruments owned
by banks in America and Europe and designed to guarantee the banks’ asset quality, thereby helping
their regulatory capital levels.

How much pain taxpayers will ultimately bear is an open question. The official line is that AIG only
suffered a liquidity crisis. As subprime losses mounted, it had to put up more collateral with its
counterparties, in turn prompting credit-rating downgrades, which in turn triggered more margin
calls. It is probable that operating cash flow was drying up too as big risk-sensitive commercial
customers stopped doing business with the insurer. On September 16th the Federal Reserve extended
a two-year, $85 billion credit facility at a penal rate. The government will get a 79.9% stake in the
company in return. The idea is that this buys time for AIG to improve its liquidity in an orderly way.
The bail-out’s structure should also avoid a technical bankruptcy, which could force the unwinding
of many of those CDS contracts.

Yet might the government be taking over a company that is insolvent as well as illiquid?
Extrapolating from AIG’s own test, but adjusting fully for mark-to-market losses and stripping out
goodwill and hybrid capital, even at the end of June AIG might have had about $24 billion less book
equity than it needed to be safely capitalized. And some of its equity may be “trapped” within its
insurance subsidiaries, whose capital positions are ring fenced by insurance regulators. That might
leave the holding company that taxpayers have backed in a far worse state. On September 17th Eric
Dinallo, New York’s insurance regulator, vouched for the solvency of AIG’s insurance subsidiaries
but was more circumspect on the company overall.
Ultimately, though, AIG may turn out be worth something after all: in June it had $67 billion of
tangible equity, a much bigger buffer relative to assets than existed at Lehman or Bear Stearns. And,
says Andrew Rear of Oliver Wyman, a consultancy, AIG’s insurance assets will attract a lot of
interest. That raises the chances of their being sold at a premium, raising cash for the holding
company. If the government holds on long enough, perhaps even AIG’s CDS contracts might make
money.

Massive Shifts on Wall St.--Troubled Investment Bank to File for Bankruptcy

Lehman Brothers announced early Monday morning that it will file for bankruptcy, becoming the
largest financial firm to fail in the global credit crisis, after federal officials refused to help other
companies buy the venerable investment bank by putting up taxpayer money as a guarantee.

The failure of the nation's fourth-largest investment firm offers a profound test of the global financial
system, and government and private officials had been bracing Sunday night for an upheaval in a
range of financial markets that have never before experienced the bankruptcy of such a large
player. To keep cash flowing normally through these markets, the Federal Reserve announced new
lending procedures, while 10 major banks combined to create a new $70 billion fund.

After a marathon series of negotiations over the weekend, Federal Reserve and the Treasury
stepped aside to allow a wrenching transformation of Wall Street to proceed. After galloping to the
rescue of other major financial institutions in recent months, the federal government drew the line
with Lehman Brothers, ignoring pleas from would-be buyers of the company who insisted on
receiving federal backing for its troubled assets.

Leaders of the Federal Reserve and Treasury Department decided that Lehman was unlike the
investment bank Bear Stearns, whose sudden collapse in March threatened the world financial
system, or Fannie Mae and Freddie Mac, whose potential insolvency did the same.

In betting that Lehman could be allowed to fail without catastrophic consequences, New York
Federal Reserve President Timothy F. Geithner, Fed Chairman Ben S. Bernanke, and Treasury
Secretary Henry M. Paulson Jr. were making it clear that struggling financial firms cannot count on
a bailout.

The decision not to intervene carries the risk that the ripples of Lehman's failure will prove
impossible to contain. What worries regulators and Wall Street is a massive, multitrillion-dollar
lattice of interlocking financial instruments known as derivatives. The most worrisome to bankers
are "credit default swaps," in essence a form of insurance against corporate failures. If the financial
firms themselves fail, the value of the insurance they have written will be tested as never before.

So would the market for "triparty repo" -- a form of debt that funds all sorts of financial firms and is
held in the money market mutual funds of ordinary Americans -- which is also looking at potential
losses from the Lehman bankruptcy.

It was that fear that led the Fed specifically to broaden the types of collateral it will accept at its
lending window for investment banks, so that cash can keep flowing through the repo market. Even
with that move, they are were steadying themselves for a tumultuous week in that market.

The steps the Fed announced last night, Bernanke said in a statement, "are intended to mitigate the
potential risks and disruptions to markets."

"Bankruptcy is a perfectly natural thing, but you hope that the firm is in a position so that it can be
an orderly bankruptcy and not cause other problems," said Susan Phillips, dean of the George
Washington University School of Business and a former Federal Reserve governor.
Government officials drew a sharp contrast with the threat posed by the difficulties of Bear Stearns.
In that situation, in March, Fed and Treasury leaders were convinced that its abrupt demise would
have caused extensive damage across the financial system resulting in economic distress in the
United States and beyond. For that reason, senior federal officials strongly encouraged J.P. Morgan
Chase to buy Bear Stearns and backed $29 billion worth of its risky assets to make the deal
happen.

Several firms, especially Bank of America and the British bank Barclays, wanted control of
Lehman's investment banking and asset management businesses. However, they wanted no part of
billions in shaky real estate and other investments on Lehman's books, and wanted either taxpayers
or other financial firms to assume part of that risk.

But other companies decided they didn't want to take over the distressed assets, leaving only the
good ones for Bank of America or Barclays. They concluded that they would rather risk potential
problems in the financial markets on Monday than plow their limited cash into a venture that would
be expected to have poor returns. And the Fed and Treasury refused to make government money
available.

On Capitol Hill, key lawmakers either declined to comment on the Lehman's fate or did not return
calls. A spokesman for Sen. Charles E. Schumer (D-N.Y.), for whom the day's events represent a
hometown crisis, said Schumer, who chairs the Joint Economic Committee, was withholding
comment until the status of Lehman Brothers became clear.

Lehman confirmed early Monday that its holding company intends to file for Chapter 11 with the
U.S. bankruptcy court for the Southern District of New York, and will make motions that would allow
the firm to continue to pay employees and to keep its operations running.

Lehman also said it is exploring a sale of its broker-dealer operations, and confirmed it remains in
advanced talks with "a number of potential purchasers" for its investment-management division,
which includes Neuberger Berman and Lehman Brothers Asset Management. Those two
subsidiaries will conduct business as usual and will not be subject to the bankruptcy case, Lehman
said. Customers of Lehman and Neuberger Berman can continue to trade in their accounts, the
company said.

Lehman's rank-and-file employees were unsure what they would find when they went to their offices
Monday morning. "There's no word. It's not clear what's happening or what's going to happen," said
a Lehman bond trader who spoke on condition of anonymity because of the sensitivity of the
situation. On Friday, "we thought the options were clear, that either we got bought or we got sold off
in small pieces. Nobody thought it was actually going to go to bankruptcy."

Lehman's dissolution has been gradual, over several months. If Bear Stearns experienced a run on
the bank, Lehman has experienced a walk on the bank. That means that its various business
partners have had time to bolster themselves for potential losses, and, in the view of these
government officials, the risks to the system as a whole are therefore less.

It likely means the end of a Wall Street titan, a firm with 24,000 employees and 158 years of history.
Lehman Brothers dates back to 1850, to a general store that Henry Lehman and two siblings
opened in Montgomery, Ala. The brothers accepted cotton for cash and started a trading business
on the side.

A century ago, the firm helped arrange financing for Sears Roebuck. It expanded globally through
the twentieth century and became one of the top investment banks. A decade ago, chief executive
Richard S. Fuld Jr. faced down rumors that the firm was on the brink of insolvency and put Lehman
on an aggressive expansion course. In 2001, with its trading floors destroyed by the terrorist attacks
in New York, he regrouped quickly, and the firm managed the first initial public offering to come to
market after the attacks.

Fuld's aggressive and competitive nature is not uncommon on Wall Street, but friends and rivals
have said the intensity with which Fuld expresses those traits are unmatched.

Lehman, which was outmuscled in merger advising and other traditional investment banking
businesses, seized on the mortgage market as an area it could dominate in recent years.

Lehman, the number one underwriter of mortgage-backed bonds last year, amassed a giant
portfolio of properties and mortgage-related securities. But the value of the assets began to sink last
year amid a spike in mortgage defaults by homeowners with subprime credit.

Lehman shares have fallen from a high of $86.18 in February 2007, when the company's stock
market value was approaching $50 billion, to Friday's closing price of $3.65, which left the firm with
a market capitalization of $2.5 billion.

"Six months to the day since Bear Stearns went under, I'm viewing our experience in a whole new
light," said John Ryding, a former Bear Stearns economist. "We were lucky to be first. We got out
with $10 a share, which looked really bad at the time, but it looks a whole lot better than what
Lehman shareholders are likely to get."

Weekend Merger Struck With Bank of America

September 15, 2008;

Bank of America struck a $50 billion deal yesterday to buy Merrill Lynch, a merger that will unite
the nation's largest consumer bank with one of its most celebrated investment banking firms,
according to sources familiar with the negotiations.

Both boards approved the deal and it was being reviewed by lawyers late last night, the sources
said. Bank of America will pay about $29 for each share of Merrill Lynch stock, which closed at
$17.05 on Friday. A formal announcement is expected this morning.

The acquisition came at the end of a historic weekend in New York. Senior federal officials and Wall
Street executives cloistered themselves at the Federal Reserve Bank of New York and urgently
discussed how to minimize the damage to global financial markets from the looming bankruptcy of
investment bank Lehman Brothers.

Merrill Lynch's chief executive, John Thain, had been among the Wall Street chieftains who had
been summoned to the extraordinary session to help fashion a rescue for Lehman. But as the
weekend went on, it became increasingly clear that Merrill Lynch could be badly injured by a
Lehman bankruptcy and needed to find its own way to ride out the gathering storm.

Initially, Bank of America had been a leading suitor for Lehman, but backed out after federal
regulators refused to put government money behind the deal. Merrill Lynch is in better shape
financially than Lehman, and Bank of America views the company as a better fit.

Merrill Lynch's crown jewel is the nation's largest retail brokerage. Bank of America views that
business as a good addition to its own consumer financial businesses. The company already was
the nation's largest retail bank, credit card company and mortgage lender. Now it will become the
nation's largest retail brokerage, too.

Arguably no other American company sits closer to the heart of the consumer economy.
For Bank of America, which is based in Charlotte, Merrill Lynch also offers the prestige of owning
one of the nation's great investment banks. Bank of America has struggled to build its own
operation. Chief executive Ken Lewis declared last fall that he had "all the fun I can stand," as he
announced that the company would slow its efforts to grow its own investment bank. It now appears
the firm never relinquished the underlying ambition, and Bank of America will now be a major player
on Wall Street.

Bank of America is in a position to buy Merrill Lynch because until now the company has been a bit
player on Wall Street. Instead it has set its sights on consumers, running the nation's largest retail
bank, a business that remains highly profitable. That gave it the cash to go shopping for an
investment bank, continuing a long tradition of opportunistic acquisitions.

Merrill Lynch was one of the largest producers and sellers of complex securities at the heart of the
economic crisis. Merrill Lynch sold collateralized debt obligations, which are securities that package
a large number of mortgage bonds and other debt, to investors around the world.

But Merrill and other Wall Street banks created many more of these complex securities than they
could sell. As mortgage defaults started to rise, the value of the CDOs plummeted, forcing Merrill to
write down their value. The mounting losses threatened Merrill's survival.

Merrill's shares dropped 36 percent last week, reducing its market value by $15 billion, to $26
billion.

Bank of America was one of the few bidders to show up at what turned out to be a historic fire sale.
The company initially sought direct government support if it were to buy Lehman, but instead chose
to buy Merrill Lynch. Sources familiar with the company's thinking compared the choice to fighting a
fire. Executives felt that Merrill Lynch could be saved, but Lehman was lost already.

Bank of America, by contrast, remains relatively strong because its core banking business is
healthy.

During the marathon New York meetings, federal regulators also assisted another one of the
nation's biggest financial institutions, American International Group, the largest insurer in the
country. AIG had too been battered by the mortgage meltdown.

Leaders of AIG were scrambling to pull together a sweeping restructuring plan to save their firm,
said sources who spoke on condition of anonymity because of the fluid nature of the unfolding
events.

The plan is likely going to include selling subsidiaries to raise cash, according to sources familiar
with the restructuring.

AIG sells a type of insurance known as credit default swaps to cover losses on investments in
certain kinds of securities. AIG made a big business of selling these swaps to cover losses in
securities backed by mortgages.

As the mortgage market has melted down, AIG has been on the line to cover more of the losses,
eating away at the firm's capital. Over the past nine months, AIG has posted $18.5 billion in losses.

Last week, its shares fell sharply on fears that it would have to raise tens of billions of dollars more
capital to offset losses. The company's shares fell 31 percent alone on Friday.

After the market closed Friday, Standard & Poor's warned that it might lower its ratings on AIG's
debt. S&P ratings are used by investors around the world to judge the safety of certain kinds of
debt.
Lowering the rating would probably force AIG to pay more for loans and could force the company to
come up with more collateral to back some of its complex insurance policies.

Possible financial crisis fix sends stocks soaring

The stock market finally found reason to rally Thursday, and Congress promised quick action as the
Bush administration prepared a plan to rescue banks from the bad debt at the heart of the worst
crisis on Wall Street since the Great Depression.

Details of the plan were still being worked out, but Treasury Secretary Henry Paulson emerged from
a nighttime meeting on Capitol Hill to say he hoped to have a solution "aimed right at the heart of
this problem."

As word of a government plan began to reach Wall Street earlier in the day, the Dow Jones
industrial average jumped 410 points, its biggest percentage gain in nearly six years.

The rebound also came after an infusion of billions of dollars by the Federal Reserve and world
governments aimed at getting nervous banks to stop hoarding money and lend again.

Stocks had fluctuated throughout the day, without severe swings in either direction, until CNBC
reported the administration might back a new agency to take bad assets off the books of struggling
financial institutions, much like it did in the aftermath of the savings and loan crisis of the 1980s.

After the discussions Thursday night, Paulson said the goal was to come up with a "comprehensive
approach that will require legislation" to deal with the bad debts, or illiquid assets, on bank's
balance sheets. He did not provide any details, but the plan taking shape called for Congress to
give the administration the power to buy distressed bank assets.

Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, said that
probably would not mean creating a new government agency.

"It will be the power — it may not be a new entity. It will be the power to buy up illiquid assets,"
Frank said. "There is this concern that if you had to wait to set up an entity, it could take too long."

Frank said his committee could begin drafting legislation as early as Wednesday.

Paulson, Fed Chairman Ben Bernanke and other officials planned to work through the weekend on
a solution. House Speaker Nancy Pelosi said that once the administration had presented its
proposal, "we hope to move very quickly" to come to an agreement.

There was no immediate word how much the rescue plan might cost.

The banks still standing are staggering under the weight of billions of dollars of bad loans and
mortgage debt arising from the wave of home foreclosures in the United States, and lending has
tightened around the world in response.

Before the sun rose on Wall Street on Thursday, the Fed said it would boost by as much as $180
billion the amount of cash it would supply to foreign counterparts that are short on dollars. For
banks in the United States, the Fed supplied $105 billion in short-term loans later in the day.

But, at least initially, those efforts did little to unfreeze the global credit markets. Banks remained
extremely reluctant to lend money.
The No. 2 official at the International Monetary Fund, John Lipsky, said the past few days were
"searing manifestations of a financial crisis that has expanded to historic proportions." He predicted
the turbulence would continue for "some time to come."

British financial regulators also banned short-selling the stock of financial companies listed on the
London Stock Exchange. U.S. regulators tightened rules on short-selling Wednesday.

Christopher Cox, chairman of the securities and Exchange Commission, told lawmakers the SEC
may put in a temporary emergency ban on all short-selling — not just the aggressive forms it
already has targeted, according to a person familiar with the matter, speaking on condition of
anonymity because no final decision had been made.

The ban might apply to stocks of selected financial companies, to all financial companies or even
possibly to all public companies. Short-selling, which has been practiced on Wall Street for
decades, is not illegal per se.

The Fed said it had authorized the expansion of swap lines, the process by which it supplies
reserves to other central banks, to include amounts up to $110 billion for the European Central
Bank and up to $27 billion for the Swiss National Bank.

The Fed also said new swap facilities had been authorized with the Bank of Japan for as much as
$60 billion, $40 billion for the Bank of England and $10 billion for the Bank of Canada.

For more than a year, investors around the world have watched with growing alarm as the U.S.
economy, the world's largest, has struggled to right itself amid massive home foreclosures, many of
them from mortgages issued to homeowners with bad credit.

The turmoil has swallowed some of the most storied names on Wall Street. Three of its five major
investment banks — Bear Stearns, Lehman Brothers and Merrill Lynch — have either gone out of
business or been driven into the arms of another bank.

The Dow's gain of nearly 4 percent on Thursday sent the average back above 11,000 and nearly
erased its losses from a day before.

But as the uncertainty wore on, investors continued to flock to Treasury securities, considered a
haven in times of crisis, and the price of gold rose yet again. And worries about even the safest
investments intensified as Putnam Investments abruptly closed a $15 billion money market fund
because institutional investors had pulled their cash.

Bush canceled out-of-town fundraising trips to Alabama and Florida to stay in Washington and
huddle with Paulson and the heads of the Fed and the Securities and Exchange Commission.

In an appearance earlier in the day, the president acknowledged "serious challenges" in the
markets and said: "The American people can be sure we will continue to act to strengthen and
stabilize our financial markets and improve investor confidence."

The credit troubles reverberated around the globe. Asian stocks closed lower. European stocks
rose but struggled to hold on to the gains. Russia closed its stock exchanges for a second day, and
President Dmitry Medvedev pledged a $20 billion injection into financial markets.

In the United States, investors worried for another day about the health of the banks still standing.
Earlier in the week, venerable Lehman Brothers was forced into bankruptcy, and Merrill Lynch was
driven into the arms of Bank of America.

On Thursday, Morgan Stanley scrambled to strike a major deal or raise more cash that will reassure
investors and prevent more damage to its battered stock. Its CEO, John Mack, reached out to
China's Citic Group overnight about a possible investment, according to a person familiar with the
talks.

Morgan Stanley is also considering a combination with retail bank Wachovia Corp. and an
investment from Singapore Investment Corp., one of the world's biggest sovereign wealth funds,
said the person, who spoke on the condition of anonymity because the discussions were still
ongoing.

On Capitol Hill, lawmakers in both parties became increasingly vocal about their concerns with the
Bush administration's handling of the current crisis.

Administration officials refused to attend a closed-door briefing with House Republicans this
morning, leaving their congressional allies in the dark about the government's $85 billion
emergency loan to insurer American International Group, House GOP leader John A. Boehner said.

And Sen. Chris Dodd, D-Conn., the Banking Committee chairman, was irritated that Paulson twice
canceled appearances he was to have made before the panel this week.

To Plan B, With All Deliberate Speed

In an effort to restore investor confidence, ease the anxieties of election-year voters and get out
ahead of a financial crisis that threatens to spin out of control, Washington is moving toward
creation of a new government entity to . . . .

Well, that's the question, isn't it: to do what?

Judging from the sobering statements of administration and congressional leaders last night, there
is a strong political instinct at the White House and on Capitol Hill to do something. Everyone
agrees that there's a better solution than having the Treasury and the Federal Reserve continue to
do these ad-hoc, midnight rescues, stretching their balance sheets and their legal authority. And
everyone agrees that we had better do something quickly, before there's even more of a run on the
money markets and the stock market does another nosedive.

As it now appears, the mission of the new entity would probably be as buyer of last resort for
securities that are now almost impossible to sell but are weighing heavily on the balance sheets of
banks, investment banks, pension funds, insurance companies and even hedge funds. Once the
government takes these securities off the books of these institutions, new investors presumably
would be willing to come in with additional capital to restore them to financial health. The aim would
be for the government to eventually make money by buying only those securities priced well below
the value of the underlying assets and waiting for the markets and the economy improve.

Alternatively, there's the idea put forward yesterday by Sen. Chuck Schumer (D-Wall Street).
Schumer would have the new agency inject capital directly into struggling financial institutions, in
exchange for a government ownership stake and a promise to renegotiate troubled mortgage loans
rather than pushing them to foreclosure. The obvious downside, of course, is that his plan would
blur the line between public and private ownership and put the government in the position of
deciding which enterprises to save and which to sacrifice. But it's a solution that's particularly
attractive to Wall Street. (SHADES OF INDONESIA AND THE IMF!!)

Once the mission is nailed down, there's still a question of how to structure the agency and how
much money to give it. (SON OF IBRA)

The simplest approach would be to create a new office within the Treasury, reporting directly to the
secretary of the Treasury. Or you could create a new independent agency with its own director and
an independent board. That's the way its been done in the past.
But the more modern variation would be to create a public-private entity and require that half the
capital come from elsewhere -- private equity funds, hedge funds, pension funds, even sovereign
wealth funds. These investors would get the same deal as the taxpayers, participating equally in all
the risks and the rewards. The government would need to borrow less money and reduce its risk.

As for funding levels, you can figure it could be anywhere from $200 billion to $500 billion, on top of
the money already committed for Fannie Mae, Freddie Mac, AIG and Bear Stearns. That's a pretty
good indication of how serious a problem we have on our hands.

On a less serious note, finding someone with experience to run this new agency ought to be a piece
of cake, given the large number of unemployed Masters of the Universe who now spend their days
perfecting their golf swings. On Wall Street, losing $30 billion of your shareholders' money is never
a disqualification for the next job -- hey, it could happen to anyone, right? But getting Stan O'Neal or
Jimmy Cayne through confirmation hearings might be a problem. Maybe now that Hank Paulson
has gotten used to working nights and weekends cleaning up after his former colleagues on Wall
Street, he'd be willing to re-up for another tour of duty here in Washington.

Finally there is the all-important question of what to call this new agency. Democrats like Schumer
like the ring of the old New Deal agency, the Reconstruction Finance Corp., while Republicans take
their model from the Resolution Trust Corp. set up by President George H.W. Bush to dispose of
assets taken over from failed savings and loan institutions.

Then again, given our great success with government-sponsored enterprises, maybe we could call
it something catchy, like Rescue Ray or Vulture Mac.

Stocks soar as investors bet on gov't rescue plan

Wall Street extended a huge rally Friday as investors stormed back into the market, relieved that
the government plans to restore calm to the financial system by rescuing banks from billions of
dollars in bad debt. The Dow Jones industrials rose about 370 points, giving them a massive gain of
about 780 over two days, and Treasurys fell as money flowed into equities.

The plan to rescue banks from billions of dollars in soured debt has reassured investors who
worried that a continuum of bad bets on mortgages would hobble more financial companies and
cause even further damage to the banking system and the overall economy.

"If a solid plan is put in place, it's definitely going to be a positive in easing the pain," said Stephen
Carl, principal and head of equity trading at The Williams Capital Group. He added, though, that the
set-up of any plan will determine how successful it is.

A new government ban on short selling, or placing bets that a stock will fall, likely added to the
market's gains as traders adjusted their positions. "A big chunk of this is scaring all the shorts to
cover their bets," said Joe Battipaglia, market strategist at Stifel, Nicolaus & Co.

Treasury Secretary Henry Paulson, speaking about the rescue plan, said a bold approach is
needed to remove troubled assets from the books of financial firms. He offered few details, but said
he would working through the weekend with congressional leaders.

The government's fix could help resolve a yearlong credit crisis that intensified this week,
pummeling the stock market and forcing lending to grind to a virtual standstill. Wall Street suffered
massive losses Monday and Wednesday, and credit markets seized up following this week's
bankruptcy of Lehman Brothers Holdings Inc. and the bailout of teetering insurer American
International Group Inc.
Analysts said it was the first government response decisive enough to restore confidence in the
markets.

"Everything they had done had been a Band-Aid approach, at the margins," said Jay Mueller,
economist at Strong Capital Management. "Now we're dealing with the root problem."

The government took other steps Friday to restore stability to the financial system. The Federal
Reserve said it will expand its emergency lending and let commercial banks finance purchases of
asset-backed paper from money market funds. The Fed injected another $20 billion in temporary
reserves into the U.S. financial system. The central bank also will buy short-term debt obligations
issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

And to help calm investors' anxieties, the Treasury Department has decided to use a Depression-
era fund to provide guarantees for U.S. money market mutual funds. Money market mutual funds
are typically considered safe, but many investors have been fleeing them, fearing that the funds'
holdings included souring corporate debt.

To help limit the freefall in financial stocks, the Securities and Exchange Commission on Friday
enacted a temporary ban on the short-selling of nearly 800 financial stocks. Short-selling is the
common practice of betting against a stock by borrowing shares and then selling them in the open
market. A short-seller's hope is the stock will fall; if it does, the stock can be bought back at the
lower price. Those cheaper shares can be returned to the lender, allowing the investor to pocket the
profits. Traders can lose, however, if the stock rises.

Wall Street observers have disagreed over the extent to which pressure from all those bets that a
stock will fall shaped investor sentiment and strangled some financial stocks, like those of Lehman
Brothers last week. Some say the fundamental problems with overleveraged financial companies
warranted the pessimism while others say the short selling was a death knell for some financial
names.

"The federal government has been petitioned by Wall Street to take evasive action in the money
markets, the stock and bond markets, to avoid a complete meltdown of the credit system," said
Battipaglia. "Once the credit system melts down, the economy falls. We can hand-wring about if this
is the proper thing for the government to do, or if Wall Street pulled the panic button too soon, but
that's something for the historians to sort out."

It's difficult to quantify how much of the market's gains reflected short sellers who are forced to step
in and cover their bets by buying now rising stocks that had predicted would fall. While that
appeared to play some role in the advances Thursday and Friday, the Nasdaq composite index —
dominated by big technology stocks, not financials — showed big gains along with the Dow and the
Standard & Poor's 500 index.

According to preliminary calculations, the Dow rose 368.75, or 3.35 percent, to 11,388.44 after
having been up as much as 463.36.

Friday was a quarterly "quadruple witching" day, which marks the simultaneous expiration of
options contracts, an event that often adds to volatility and heavy volume.

Broader stock indicators also surged Friday. The S&P 500 index rose 48.57, or 4.03 percent, to
1,255.08, and the Nasdaq composite index rose 74.80, or 3.40 percent, to 2,273.90.

Even with Friday's big gains, stocks didn't end the week with much change after the whipsaw
sessions. The Dow slipped 0.29 percent, the S&P 500 rose 0.27 percent and the NASDAQ added
0.56 percent.
Treasury prices dropped as investors poured money back into stocks. The yield on the 3-month
Treasury bill — a safe investment to which investors have rushed this week — rose to 0.95 percent
from 0.07 percent late Thursday. Yields move opposite from price. The yield on the benchmark 10-
year Treasury note shot up to 3.81 percent from 3.53 percent late Thursday.

The stock market's enormous swings during the week reveal how anxious investors have been
about the tightness in the credit markets the possibility that other financial companies might
succumb to the difficulties in the markets. Moves Thursday by the Fed and other major central
banks to inject billion into global money markets perhaps helped forestall steeper selloffs but didn't
diffuse the Sturm und Drang and overall loss of confidence hammering the markets as big financial
companies including Lehman and AIG stumbled.

The only lasting move in a week of intense volatility came late in Thursday's session when reports
emerged that the government was considering a plan that would shift soured debt off financials'
books. A wobbly market rocketed higher, giving the Dow a 410-point gain for the session.

The dollar rose against most other major currencies in Friday trading, while gold prices jumped.
Light, sweet crude rose $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange.

While stocks rose broadly, the financial sector was one of the strongest gainers. The two remaining
independent investment banks logged big advances as fears dissipated that they would be felled by
cash shortages and toxic debt.

Goldman Sachs Group Inc., jumped $21.80, or 20 percent, to $129.80, while Morgan Stanley
jumped $4.66, or 21 percent, to $27.21.

Advancing issues outnumbered decliners by about 7 to 1 on the New York Stock Exchange, where
volume came to a heavy 2.1 billion shares compared with 2.45 billion shares traded Thursday.

The Russell 2000 index of smaller companies rose 30.06, or 4.15 percent, to 753.74.

Overseas stock markets soared. Japan's Nikkei stock average jumped 3.8 percent, and Hong
Kong's Hang Seng index surged 9.61 percent. In Europe, Britain's FTSE 100 jumped 8.84 percent,
Germany's DAX index advanced 5.56 percent, and France's CAC-40 rose 9.27 percent.

Reckless? You’re in Luck

By FLOYD NORRIS

Allow me to propose a simple principle that the next president and Congress could follow as they
devise a new financial regulatory regime to replace the one that failed so badly:

If an activity is important enough to justify a government nationalization to prevent a default, it is

important enough to be regulated. The regulators need to know what risks are being taken, and by
which institutions, in time to act before a crisis develops.

Had the government bothered to do that in years past, it might not have faced the decisions it faced
this week. First, it let one big firm go down, and then it became scared enough to nationalize
another one to keep it afloat.

Now, showing no sign of embarrassment over how badly they failed before, the current crop of
regulators seem to be unified in their determination not to let the markets force them to make a
similar choice on some other big financial institution.

The result is a campaign against those who bet that the financial system was crumbling.
If the government is forced to decide whether to save another firm, it will face the same question it
faced with A.I.G. and Lehman Brothers. Would this failure cause systemic damage to the financial
system?

Lehman did not measure up because its chief executive, Richard S. Fuld Jr., simply was not
reckless enough as he ran Lehman into the ground.

Had he had the foresight to make a lot more bad bets in the derivatives market, the government
would have feared financial chaos and might have nationalized Lehman, just as it nationalized
A.I.G., Fannie Mae and Freddie Mac. Or it would have subsidized a takeover, as it did for Bear
Stearns.

The Paulson-Bernanke Doctrine is not “too big to fail.” It is “too reckless to fail.” If you get your
company into enough trouble to threaten the financial system, Ben Bernanke, the Federal Reserve
chairman, and Henry Paulson, the Treasury secretary, won’t let you collapse.

It may be that they miscalculated. Lehman’s default caused a money market fund to suffer losses,
and scared investors into pulling their money from similar funds. If those funds cannot find buyers
for their assets, there could be more defaults, and perhaps more failures.

The Paulson-Bernanke Doctrine was born not of theory or ideology, but instead from improvising as
each new crisis erupted. The Fed’s briefing on the nationalization of A.I.G. did not start until 9:15
p.m. on Tuesday night, which is not a sign of carefully thought-out decisions. When they met with
Congressional leaders Thursday night to seek a plan to get cash to banks before they fail, it was
almost as late.

If these nationalizations smack of socialism, it is closer to the Marxism of Groucho than of Karl.

The Cox Proviso to the Paulson-Bernanke Doctrine is that the rules will change, and change again,
if that is needed to avoid another failure.

On Wednesday morning, Christopher Cox, the chairman of the Securities and Exchange
Commission, announced new rules on short-selling. The market plunged anyway, and that night he
was back with a news release saying he would ask the commission to force short sellers to publicly
disclose their positions.

“The enforcement division will obtain disclosure from significant hedge funds and other institutional
traders of their past trading positions in specific securities,” he added.

By Thursday night, after Senator John McCain denounced him for not doing enough about short
selling, he was talking of banning the practice.

Had the S.E.C. gone over the records of Lehman and Bear Stearns with the vigilance it now
promises for the shorts, we might not be in this mess. But that was then, and it is clear that anyone
betting against the big banks now is fighting not just the Fed, but the S.E.C. and Treasury as well.

It is a sad commentary that the authorities are most worried about a market that they were unwilling
to do anything about when it was growing and growing. That market is credit-default swaps. The
people who developed that market hired good lobbyists, who got the law written to keep regulators
away. Alan Greenspan, then the chairman of the Federal Reserve, thought it would be wrong for
regulators to try to, as he frequently said, “outguess the market.” Now the country dares not risk
letting the market work its magic.

Credit-default swaps are a way of transferring the risk of owning a bond. If I own a bond issued by
General Motors, and have also purchased a credit default swap on G.M., then I am covered if G.M.
defaults. I can recover my losses on the bond from the institution that sold the swap to me.
There are now many more credit-default swaps outstanding than there are bonds for them to cover.
They became a way to gamble with almost no money down. For a small fee, my hedge fund can bet
that a company will go under. And your hedge fund can collect that fee, and produce instant profits.
Years down the road, you may have to pay, but big companies rarely default anyway, so the risk is
minimal. Or so people thought.

One way to think of the swaps market is as insurance that is issued by companies that do not have
to keep reserves and may be totally unregulated. I can’t legally buy fire insurance on your house,
since I have no stake in it, and letting me have insurance would give me an incentive to burn it
down. But I can buy a credit-default swap on G.M. even if a G.M. default would not cost me a
penny.

That brings up “counterparty risk.” If my hedge fund bought a G.M. swap from A.I.G., and sold one
to your hedge fund, then my fund has laid off the risk. If G.M. defaults, I will have the money to pay
you as soon as A.I.G. pays me.

But if A.I.G. has taken lots of those positions — and it did — then who knows which banks and
funds and investors will be in trouble if A.I.G. cannot honor its obligations? My fund may have a
perfectly matched book, but it is suddenly in deep trouble if a counterparty is defaulting. Since no
one keeps track of all the moving parts, no one knows just who may get into trouble if one
participant fails.

The theory that beguiled legislators and regulators was that the market could regulate itself. Each
bank would be careful to deal only with counterparties it could trust, and so the whole system would
be trustworthy. But even if you believe that, remember that most swaps are good for five years. Not
long ago, A.I.G. was a Triple A company, whose credit was viewed as sterling by everybody.

It is worth remembering that A.I.G.’s credit standing did not fall even after it was caught helping
other companies rig their financial statements. Nor was it hurt by evidence it had fudged its own
numbers. Discovering that a company is run by people with what we might call flexible integrity
should have been a red flag.

But who would have looked? The insurance subsidiaries were regulated by state insurance
departments, and activities of the parent were not their focus. Had anyone suggested an aggressive
audit to see what other games A.I.G. was playing, I am sure that neither the Fed nor the Treasury
would have thought they had jurisdiction.

Now they say the national interest required them to step in. “A disorderly failure of A.I.G.,” the Fed
said, “could add to already significant levels of financial market fragility and lead to substantially
higher borrowing costs, reduced household wealth and materially weaker economic performance.”

That may sound outrageous, but it is probably true. By the time A.I.G. was on the verge of failure,
the government’s options were limited. In letting Lehman default, the authorities wanted to send the
message that they were not going to bail out somebody every weekend, and that the damage from
a big brokerage failure could be contained. They may have been wrong on both counts.

I doubt anyone in government thought to wonder if a money market fund would have to “break the
buck” because it owned Lehman debt. But that did happen.

It is not easy to forecast the reverberations of one big failure, and the Fed may not have done it
well. But the biggest errors in Washington were made long before A.I.G. arrived at the Fed with its
hat in hand, and long before short sellers began to think the banks were in trouble.

How Will Banks Fare in the Bailout?

 Sept. 22nd
Here are the industry winners and losers that could emerge as the grand plan takes shape
The details still have to be worked out for the $700 billion fund the U.S. government will create to
take distressed mortgage-related assets off banks' hands in hopes of thawing the country's frozen
credit system.

The most obvious beneficiaries of the plan will be members of the "shadow banking system,"
including such surviving investment banks as Merrill Lynch (MER)— which has agreed to be
acquired by Bank of America (BAC)— and Morgan Stanley (MS), but even more conservative
commercial banks that don't have much to purge from their balance sheets are expected to gain as
the effects of the program spread through the economy.

A major question that will determine how helpful the bailout is: the price the government is willing to
pay, which could turn out to be as low the 22 cents on the dollar that Merrill Lynch got for $30 billion
in assets it sold to private equity firm Lone Star in July.

The financial companies that are holding distressed assets don't even necessarily have to sell them
to the U.S. Treasury in order to benefit from what many are calling the "mother of all bailouts." A
financial company might decide not to sell its distressed assets in the belief that there's more value
in holding onto them until the market recovers somewhat and prices for the assets increase,
predicts Gerard Cassidy, senior equity analyst at RBC Capital Markets (RY) in Portland, Me.

THE BUYER OF LAST RESORT

As Merrill Lynch's transaction with Lone Star showed, the discount on these assets has two
components: credit risk, which is based on the likelihood of defaults on the underlying mortgages,
and lack of liquidity discount, which stems from a dearth of potential buyers, says Cassidy.

By stepping in as the buyer of last resort, the U.S. government will be pumping liquidity into the
banking system, which is expected to boost the value of these securities, he says. As a result, the
liquidity discount in the price of the assets should narrow substantially as market participants
recognize there's a big buyer providing liquidity, which could help attract more buyers, Cassidy
adds.

One group that isn't likely to get any relief from the bailout are hedge funds that hold a large
quantity of the distressed debt products, says Jack Ablin, chief investment officer at Harris Private
Bank (BMO) in Chicago. "Here's a case where hedge funds, as unregulated entities, have no
recourse at the table," unlike the banking lobby and mutual-fund industry group Investment
Company Institute, both of which will likely have some influence over the legislation that ultimately
materializes, he says. He also believes the hedge funds were directly targeted by the Securities &
Exchange Commission's ban on shorting more than 800 financial stocks, which took effect on Sept.
22 and is due to last through Oct. 2.

GM MAY BE A LOSER
Other losers may include companies such as General Motors (GM), whose affiliated financing arm
GMAC likely has exposure to toxic securities but may not qualify for the government bailout
because it's not strictly a financial firm, says Ablin. "You certainly get into odd territory with GMAC,"
he says. "It's almost entirely owned by a private equity fund [Cerberus Capital Management]. So do
you want to bail out [Cerberus chairman] John Snow?"

Commercial banks, most of which have kept their balance sheets free of toxic assets, will probably
benefit indirectly as the increase in market liquidity will help push their borrowing costs lower, says
John Jay, senior analyst at the Aite Group, an independent financial services research firm in
Boston. "If [its funding costs] go low enough, their senior managers will start to look for businesses
to lend money to." In the end, their profit margins are expected to grow as the differential between
their borrowing costs and lending rates widens.
The shares of some financial players have had a strong run in spite of the market's attempts to
paint them with the same brush as the rest of the industry, says Jocelyn Drake, an equity analyst at
Schaeffer's Investment Research in Cleveland. PNC Financial Services (PNC), Wells Fargo (WFC),
and Hudson City Bancorp (HCBK) all steered clear of toxic assets and their shares hit one-year
highs last week before Treasury Secretary Henry Paulson announced the plan on Sept. 18. The
shares posted further gains after the announcement.

SKELETONS IN THE CLOSET

Schaeffer's tends to base its stock picks on technical performance and the degree of pessimism
directed at them. Market pessimism —which is reflected in analysts' ratings, the level of short
interest and the ratio of options betting on lower prices for certain stocks vs. bets on higher prices—
can give you a sense of how much investing money is sitting on the sidelines waiting for the right
signals to come into the market. "There are still some skeletons that could come out of the closet
[for the financial industry] and hinder the group," says Drake. But she's betting that as certain stocks
continue to buck the trend and outperform their peers, sidelined investors will cave in and start to
buy these stocks so as not to miss the boat.

There are also a couple of homebuilder stocks that Drake expects to benefit as liquidity returns to
the housing market and inventory begins to move. She likes Meritage Homes (MTH) and Toll
Brothers (TOL), both of which have been in an uptrend since the beginning of this year. She takes
the drop in mortgage rates after the government bailout of mortgage giants Fannie Mae (FNM) and
Freddie Mac (FRE) was announced two weeks ago as a positive sign, which she believes will help
stoke demand for houses.

U.S. taxpayers should expect

heavy losses

It looks as if we got through the weekend without another scramble to save a troubled financial
company with a trillion-dollar balance sheet.

But that does not mean U.S. taxpayers are out of danger.

No, sir. No, ma'am. Because lawmakers are at work on a bailout fund that would buy the kind of
distressed assets (defaulted mortgages, for example) that have ignited this firestorm.
Treasury Secretary Henry Paulson Jr. has called the fund the "troubled-asset relief program." I'll just
call it TARP for short (you know, the kind of thing they spread over muddy fields so you don't soil
your Guccis).
And depending on how TARP is operated, and how the assets are valued before taxpayers are
required to buy them, it could bloat our final bill for this mess while benefiting the very institutions
that got us into it.

Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running.
But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren't
visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky
mortgage securities that it currently values at 60 cents on the dollar. Let's assume that the most
recent actual trade between market participants for similar assets was struck at 30 cents on the
dollar.

So what's a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face
a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the
purchase if the assets performed better than expected over time.
But the bank would have to write down the value of the assets as a result of the sale, possibly
threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right
this very minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over
our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage
that drove us into this ditch. Such is our lot today: They break it. We own it.

Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned. If
government regulators and political leaders want to earn back some trust, they could do two things.
First, they could provide us with some transparency about whom precisely we are backing in the
recent bailouts.

Take, for example, the rescue on Tuesday of American International Group, once the world's
largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose
business models seem to consist of taking in premiums and stonewalling claims, deserve rescues
from beleaguered taxpayers?
Answer: Ever since the world became so intertwined that the failure of one company can topple a
host of others.

And ever since credit default swaps, those unregulated derivative contracts that allow investors to
bet on a debt issuer's financial prospects, loomed so big on balance sheets that they now drive
every bailout decision.

The deal to save AIG involves a two-year, $85 billion loan from taxpayers. In exchange, the new
owners - us - get 80 percent of the company. If enough of AIG's assets are sold for good prices, we
may get our money back.

Credit default swaps, which operate like insurance policies against the possibility that an issuer of
debt will not pay on its obligations, were the single biggest motivator behind the AIG deal. AIG had
written $441 billion in credit insurance on mortgage-related securities whose values have declined;
if AIG were to fail, all the institutions that bought the insurance would have been subject to
enormous losses. The ripple effect could have turned into a tsunami.

So, the $85 billion loan to AIG was really a bailout of the company's counterparties or trading
partners.

Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions
- counterparties to AIG's derivatives contracts - benefited from the taxpayers' $85 billion loan? Were
their representatives involved in the talks that resulted in the last-minute loan?

And did Lehman Brothers not get bailed out because those favored institutions were not on the
hook if it failed?

We'll probably never know the answers to these troubling questions. But by keeping taxpayers in
the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed
out, we will be justified in suspecting that a favored few are making gains on our dimes.

AIG's financial statements provided a clue to the identities of some of its credit-default-swap
counterparties. The company said that almost three-quarters of the $441 billion it had written on
soured mortgage securities was bought by European banks. The banks bought the insurance to
reduce the amounts of capital they were required by regulators to set aside to cover future losses.

Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance
company that sold them were bought by banks to get around their regulatory capital requirements
intended to rein in risk.

Got that?

Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit
default swaps does not need regulatory oversight. Warren Buffett was not engaging in hyperbole
when he called these things "financial weapons of mass destruction."

"The last eight years have been about permitting derivatives to explode, knowing they were
unregulated," said Eric Dinallo, the New York State superintendent of insurance. "It's about what the
government chose not to regulate, measured in dollars. And that is what shook the world."

And it will continue.

Will the bailout work?

As the U.S. government steps to the center of the financial crisis, crafting plans to take ownership of
up to $700 billion worth of bad mortgages, a pair of simple questions rises to the fore: Will this
intervention finally be enough to restore order? And what will this grand rescue cost U.S.
taxpayers?

The Treasury Department, as overseer of the American financial system, has in recent weeks
unleashed an astonishing array of initiatives in a bid to stave off catastrophe. It took over the
country's largest mortgage finance companies and put untold billions of taxpayer dollars on the line
to prop up other lenders.

Now, although the details are still being worked out, the government is dispensing with rescuing
one company at a time, and instead taking on a vast pile of bad debt in one gulp. If it all comes to
pass - if Uncle Sam becomes the repository for the radioactive leftovers of bad real estate bets - will
the crisis lift? Will the fear that has kept banks clinging to their dollars, starving the economy of
capital, give way to free-flowing credit?
There are many skeptics of the Treasury's proposal, though there is wide agreement that some kind
of broad intervention is necessary.

"It goes a long way. It ameliorates it very substantially," said Alan Blinder, an economist at
Princeton and a former vice chairman at the Federal Reserve, who has said for months that the
government must step in forcefully to buy mortgage-linked investments. "We're deep into Alice in
Wonderland's rabbit hole," he said.

But significant skepticism confronts the initiative. Under a proposal circulating Saturday, the
Treasury could spend as much as $700 billion to buy mortgage-linked investments, then sell what it
can as it works out the messy details of the loans. But no one really knows what this cosmically
complex web of finance will be worth, making the final price tag for the taxpayer unknowable. One
may just as well try to predict the weather three years from Tuesday.

Some question the prudence of adding to the nation's overall debt at a time when the Treasury
relies on the largess of foreigners to cover the bills. Most broadly, what are the longer-term costs of
the government stepping in to restore order after so many wealthy financiers have become so much
wealthier through what now seem like reckless bets on real estate - bets now covered with public
dollars?

Also, what message does that send to the next investment bank caught up in the next speculative
bubble and contemplating the risks of jumping in while wondering who is ultimately on the hook if
things go awry?

Many economists say such questions are beside the point. The United States is gripped by the
worst financial crisis since the Great Depression.

Before Thursday night, when the Treasury secretary, the Federal Reserve chairman and leaders on
Capitol Hill proclaimed their intentions to take over bad debts, the prognosis for the American
financial system was sliding from grim toward potentially apocalyptic.

"It looked like we might be falling into the abyss," Blinder said.

As the details of the government's plans are hashed out, no hallelujah chorus is wafting across
Washington, down Wall Street or through the glistening condos of the United States. Too many
households are having trouble paying their mortgages. Too many people are out of work. Too many
banks are bloodied.

Still, the prospect that the government is preparing to wade in deep - perhaps sparing families from
foreclosure and banks from insolvency - has muted talk of the most dire possibilities: a severe
shortage of credit that would crimp the availability of finance for many years, effectively halting
economic growth, both in the United States and around the globe.

"The risk of ending up like Japan, with 10 years of stagnation, is now much lessened," said Nouriel
Roubini, an economist at the Stern School of Business at New York University. "The recession train
has left the station, but it's going to be 18 months instead of five years."

If the plan works, it will attack the central cause of American economic distress - the continued
plunge in housing prices. If banks resumed lending more liberally, mortgages would become more
readily available. That would give more people the wherewithal to buy homes, lifting housing prices
or at least preventing them from falling further. This would prevent more mortgage-linked
investments from going bad, further easing the strain on banks. As a result, the current downward
spiral would end and start heading up.
"It's easy to forget amid all the fancy stuff - credit derivatives, swaps - that the root cause of all this
is declining house prices," Blinder said. "If you can reverse that, then people start coming out of
their foxholes and start putting their money in places they have been too afraid to put it."

For many Americans, the events that have transfixed and horrified Wall Street in recent days - the
disintegration of supposedly impregnable institutions, government bailouts with 11-figure price tags
- have been less stunning than inscrutable. The headlines proclaim that the taxpayer now owns the
mortgage finance giants Fannie Mae and Freddie Mac, along with the liabilities of a mysterious
colossus called the American Insurance Group, which, as it happens, insures against corporate
defaults. Much like the human appendix, these were organs whose existence was only dimly
evident to many until the pain began.

And yet these institutions are deeply intertwined with the American economy. When the financial
system is in danger, it stops investing and lending, depriving ordinary people of financing for
homes, cars and education. Businesses cannot borrow to start and expand.

"Wall Street isn't this island to itself," said Jared Bernstein, senior economist at the labor-oriented
Economic Policy Institute. "Even people with good credit histories are having a very hard time
getting loans at terms that make sense. If that gets worse, we're going to be stuck in the doldrums
for a very long time, because that directly blocks healthy economic activity."

Financial Regulation 101: The human factor

When the credit crisis ends, the inevitable post-mortems may reach two unsatisfying conclusions:
Banks had a lot of regulators but not much regulation, and there is little that regulators could, or
should, have done differently to avert the crisis or blunt its impact.

There is no shortage of agencies supervising financial institutions. The U.S. Federal Reserve,
because it has the keys to the Treasury and can make almost unlimited capital available to banks
when they are starving for it, is considered to have the most important role in the United States.

Other significant players in the ensemble cast include the Federal Deposit Insurance Corp., the
Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Securities and
Exchange Commission.

The European financial system has a byzantine regulatory system of its own. The European Central
Bank, which governs the euro countries and political and economic iconoclasts like Britain and
Switzerland, serve a function similar to the Fed's, and national Parliaments and quasi-independent
agencies are involved, too.

The authorities in the field point to several reasons that all those entities were unable to limit the
damage from bad debts and bad decisions. They converge on a crucial reality that is hard to
regulate around: The human mind is both remarkably creative and infuriatingly fallible.

In this realistic but somewhat depressing context, what may well emerge is a regulatory philosophy
that any institution that poses a risk to the system, whether it's called a bank or something else, will
face tighter regulation and more ample disclosure requirements - not so much to avert the inevitable
crisis, but to make it easier to make an informed investment decision and for rescuers to get
information once the crisis hits.

Bank regulation is like a game of cat and mouse in which the mouse is smarter, earns more money
and gets to make the first move. Institutions hire bright people to devise ways to exploit loopholes in
the system to try to increase profits and stay ahead of competitors and regulators alike. They often
succeed, and their success can cost a fortune.
"Coming up with structures to get around regulations has been a strategy of businesses for years,
and that's not going to change," said Jaime Peters, who follows banks for the research firm
Morningstar.

The principal regulation that American financial-service businesses tried to get around for most of
the 20th century was the Glass-Steagall Act. A response to the proliferation of bank failures during
the Great Depression, the 1933 law prevented deposit-taking institutions from owning investment
banks and limited the ability of banks to operate across state lines.

At least in theory. The formation of holding companies that owned consumer and investment banks,
as well as subsidiaries in multiple states, weakened Glass-Steagall, Peters said. So did the
flourishing in the 1970s of mutual funds and money-market funds that became substitutes for
conventional checking and savings accounts.

Picking up the story in the 1980s, Gary Gorton, a professor of finance at the Yale University School
of Management, noted that technological advances had enabled bankers to concoct derivative
instruments and so-called structured products like the notorious securitized mortgage loans. As he
put it, "The banking system isn't the banking system anymore."

These developments rendered Glass-Steagall all but moot, and the act was repealed in the 1990s.
That has led some observers to try to lay the credit crisis at the doorstep of the U.S. Congress, but
others see it as an acceptance of the reality that bankers were a step or two ahead of regulators.

Financial innovators may have an incentive to continue bending the rules: the fact that the
otherwise risky bets they make are not all that risky for them. If they win, they are rewarded with
huge bonuses; if they lose, they get fired, at worst, and try again somewhere else.

Lawrence Harris, a professor of finance at the University of Southern California, said he expected
regulators to continue to be "behind the ball." He sees no practical alternative.

"One way to improve things is to pay them more," he said. "You'll get better people, but they will still
be subject to political pressure. And if you give them tenure, they'll become little gods unto
themselves."

Political pressure - this is where Washington may bear some blame for the present mess, in his
view. The mortgage leviathans Fannie Mae and Freddie Mac were encouraged to sacrifice safety to
keep their great loan machines running at top speed, he said.

"Everyone in the administration and Congress wanted money to go into the housing industry," he
said. "There was a lot of pressure on them to look the other way when receiving undocumented
paper that they knew, or should have known, wasn't going to be good. They didn't feel they were all
that exposed to risk."

As government affiliates that benefited from a Treasury guarantee on their debt, Fannie and
Freddie were always special cases. In Europe, there is nothing special about the state authorities
taking vigorously active roles in the affairs of big business, ostensibly in the public interest.

The credit crisis has intensified calls there, by lawmakers and others, for an overhaul of the way
banks are regulated. Opinions vary widely on how to do it; some favor steps that would safeguard
the financial system but otherwise give banks freer rein, while others want to monitor lenders more
closely and curtail some of their activities, especially the riskier ones.
"Is the job of a regulator to ensure market stability or to keep the market from moving in the wrong
direction?" said Jonathan Herbst, a partner at the Norton Rose law firm in London, framing the
debate.

The more activist solution tends to be favored on the Continent. Jean-Claude Trichet, president of
the European Central Bank, indicated in a recent speech that limits on leverage - the amount that
can be borrowed for every unit of equity on the books - may need to be imposed on financial
services companies. Regulators in Switzerland have already called for such strictures.

Until now, the more laissez-faire approach to supervision has been preferred in Britain, whose
common-law legal history has evolved into a system that emphasizes broad guiding principles over
an extensive list of rules and regulations. This is now under discussion, however.

"The idea is that you have greater flexibility," said Peter Snowdon, another partner at Norton Rose.
"It's more future-proof."

It may also be more lawyer-proof, which is why the U.S. Treasury secretary, Henry Paulson Jr., is
thought to favor such an approach. Having a looser set of principles, paradoxically, may provide a
more secure regulatory framework than a set of explicit rules that legal eagles can navigate around
or through.

One fact that is often ignored amid the urgent calls for action to protect the public is that there is not
all that much, at least so far, to protect the public from.

Investors in several institutions, like Lehman Brothers, Bear Stearns and Countrywide Financial in
the United States and Northern Rock in Britain, have seen the value of their holdings wiped out or
nearly so. Pension funds are included in that group. But depositors with balances up to, and often
above, mandated ceilings have lost no money, even when the accounts were at banks whose
holding companies have gone bust.

That reality is one factor that persuades some observers that wholesale changes in bank regulation
are unnecessary and may do more harm than good. So is the futility that regulators face in trying to
anticipate what bankers will do next.

Peters, at Morningstar, still expects the attempt to be made. Investment banks are subject to little
regulation other than the brutal kind that can be inflicted by the markets, but they may come under
tighter supervision as the price for having gained access to government borrowing facilities.

An updating of accounting rules makes more sense to Gorton, the Yale professor. A good first step
might be devising uniform rules for calculating the value of exotic assets.

"An accounting system that originated in the Middle Ages can't keep track of things like derivative
instruments," he said.

Harris, at the University of Southern California, recommends measures to eliminate conflicts of

interest. Highlighting one example central to the unraveling of the subprime mortgage market, he
noted that agencies that rated the quality of debt instruments were paid by the issuers of that paper.
That led to overly generous ratings, which contributed to an inability of banks to gauge the risks
they were taking.

Instead of trying to compel banks to take fewer, or at least more sensible, risks, some authorities
contend that it might be more fruitful to make people who do business with them - depositors,
borrowers, investors - more aware of what those risks are.
"The loss of confidence was, in many ways, due to a lack of transparency and understanding, with
both sellers and buyers of products forgetting the golden rule of 'don't sell or buy a product you
don't understand,"' said Hector Sants, chief executive of the Financial Services Authority, the main
financial regulator in Britain.

Harris is a big believer in full disclosure. Credit crunches and bank failures are a cost of doing
business in a liberal economy, but that cost can be reduced by trying to make available all pertinent
facts needed to make sound decisions.

"The most important thing that regulators can do is make sure there's complete information so
people can understand what they're buying and be aware of the risks," he said. "If you ask for more
regulation, there is an excellent chance you will end up with a worse problem. The best regulator is
fear, and fear works when people are well informed. Sunlight is the best disinfectant."

Crashing banks and golden parachutes

Friday, September 19, 2008

With America's financial system teetering on a cliff, the compensation arrangements for executives
of the big banks and other financial firms are coming under new scrutiny. Bankers' excessive risk-
taking is a significant cause of this financial crisis and has contributed to others in the past. In this
case, it was fueled by low interest rates and kept going by a false sense of security created a debt-
fueled bubble in the economy.

Mortgage lenders blithely lent enormous sums to those who could not afford to pay them back,
dicing the loans and selling them off to the next financial institution along the chain, which took
advantage of the same high-tech securitization to load on more risky mortgage-based assets.

Financial regulation will have to catch up with the most irresponsible practices that led banks down
this road, in hopes of averting the next crisis, which is likely to involve different financial techniques
and different sorts of assets. But it is worth examining the root problem of compensation schemes
that are tied to short-term profits and revenue, and thus encourages bankers to take irresponsible
levels of risk.

The banks recognize that pay is a problem. "Some firms" used "compensation incentives that
exacerbated the weaknesses and contributed to the market turmoil," admitted the Institute of
International Finance, a lobby group for big banks.

One direct way to address this problem is for bankers to have more of their own money at risk in the
bets they are making.

The regulator of Fannie Mae and Freddie Mac set an example when the government took over the
mortgage finance companies last week, barring them from paying their former chief executives
severance packages worth millions that were stipulated in their contracts. It is proper for the federal
government to intervene in executive compensation or exit pay when it takes over a bank. When
the government assumed a huge ownership stake in American International Group, it fired the chief
executive.

But that was a drastic measure. Banks' boards of directors, encouraged by their shareholders, must
look hard at reforming the pay of top bankers. The core problem is this: Bankers get stellar rewards
in the good times and don't have to give money back when their strategy sinks the bank a few years
down the road. They might miss a bonus, or even get fired - and float down to earth on the "golden
parachute" negotiated in the flush years.
One way to change this would be for banks to hold a big chunk of bankers' pay in escrow, to be
doled out over several years. A bigger share of a bankers' pay could be made in restricted stock
that can only be sold over a fairly long period of time. Golden parachutes could depend on good
performance through the executive's tenure.

Now, there's a concept.

The fleecing of America

World leaders converge on a battered New York this week for the United Nations General
Assembly and my advice to them is: Think Damien Hirst.

It's not that I expect them to dwell on the British artist's giant tanks of dead sharks, zebras and
piglets at a time when the U.S. economy is being socialized to the tune of $700 billion ($2,000 for
every person in the country) as a result of a giant mortgage-related Ponzi scheme.

It's that the Hirst bull market in the midst of the most convulsive week for financial markets since
1929 says something important about the global economy and America's declining place in it. In
case you missed it, Hirst sold 223 works last week for just over $200 million, well above Sotheby's
pre-auction estimate.

Oliver Barker, the auctioneer, identified the Russians as major buyers. Sotheby's took a preview of
the sale to New Delhi, where it received a number of pre-auction bids. Jose Mugrabi, a New York
dealer, told my colleague Carol Vogel that Hirst is a "global artist" who can defy "local economies."

For local, read American.

Yes, folks, the cash is elsewhere. Asians have been saving rather than spending. Their consumers
are in better shape. Their banks are in better shape. The China Investment Corp. (CIC), a
sovereign wealth fund, is sitting on $200 billion (and a 9.9 percent stake in Morgan Stanley) while
China's central bank is managing another $1.8 trillion in reserves.

And what have we heard from the new centers of wealth and power - China, India, Brazil, Russia,
the Gulf states - about America's financial agony over the past week? Zilch. Well, not quite. When
asked about the crisis, Luiz Inácio Lula da Silva, the Brazilian president, said: "What crisis? Go ask
Bush."

Thanks, Lula. Brazil is sitting on $208 billion of its own in reserves, so perhaps Lula would say his
flippancy is justified. But I don't think it is.

Remember the last financial crisis in 1998? With the Russian economy in a free fall, Moscow
officials scurried to the U.S. Treasury to secure vital American support for $17.1 billion in new
International Monetary Fund loans. That steadied things.

The world has changed in the past decade. There's been a steady transfer of wealth away from the
United States in a shift most Americans have not yet grasped. But there has been no
accompanying transfer of responsibility. New powers are free-riding as if it were still the American
century.
It's not. Imagine if Hu Jintao, the Chinese president, had declared this week: "China has a deep
interest in the stability of the U.S. economy and the dollar. We stand ready to help in the essential
return of confidence to financial markets. Talks with the U.S. Treasury are ongoing." Or perhaps the
BRIC countries (Brazil, Russia, India and China) might have put out such a joint statement.

Let's be clear: This is an American mess forged by the American genius for newfangled financial
instruments in an era where the mantra has been that government is dumb and the markets are
smart and risk is nonexistent. The responsibility for undoing the debacle is chiefly American, too.

But toxic mortgage-backed securities were pedaled by plenty of foreign banks. And the decision to
pour $85 billion of U.S. taxpayers' money into the rescue of American International Group (AIG), the
insurance giant, followed appeals from foreign finance ministers to Henry Paulson, the Treasury
secretary, to save a global company.

Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial
Services Committee, told me: "Paulson said he was getting calls from finance ministers all around
the world saying, you have to save AIG. Well, they should have been asked to contribute to the
pot."

Frank has a point. (He should coach Barack Obama for the debates on how to put economics in
plain language.) As Frank said on the Charlie Rose show, "I don't think the European Central Bank
should be free to spend the Federal Reserve's money and not put any in."

I know, you reap what you sow. Nobody loves to help the Bush administration. World central banks
did inject billions in concerted action to help stabilize money markets, but the U.S. has essentially
been on its own. Now foreign banks with U.S. affiliates will want a slice of the $700 billion bailout.
That doesn't make sense until the burden of this rescue starts reflecting a globalized world.

I asked Frank why Paulson and Ben Bernanke, the Federal Reserve chairman, did not get more
foreign support. "I think it's a perverse pride thing," he said. "We don't ask for help. We're the big,
strong father figure. But let's be realistic: We're no longer the dominant world power."

It's time for a responsibility shift. Call it the Hirst reality check. If he can sell a formaldehyde-pickled
sheep with gold horns for millions while Lehman goes under, perhaps it's time for everyone to help
a little when Americans get fleeced.

Some hard truths about the bailout

The fifth major federal bailout this year - after Bear Stearns, Fannie Mae, Freddie Mac and
American International Group - is in the works. American taxpayers have every right to be alarmed
and angry. This crisis could have been avoided if regulators had enforced rules and officials had
dared to question risky lending and other dubious practices.

If done right, this bailout could succeed where the others have failed and remove the threat of a
system-wide financial collapse. But the cost will be enormous. So will the risk of losses in the long
run - on top of the risks already incurred.

The new plan would commit taxpayer money to buy hundreds of billions of dollars of troubled loans
and other mortgage-related securities from banks and Wall Street firms. It is based on the
reasonable premise that as long as institutions are stuck with those assets, the flow of credit, the
economy's lifeblood, will be constrained, or as in the past week, all but frozen.

Congress, with one eye on last week's volatile Dow and the other on November's election, could
authorize the plan as early as this week.
It is painfully clear that the financial system will not rebound on its own from the excessive lending
and borrowing of the Bush years. Lawmakers and administration officials must be prepared to tell
Americans some hard truths:

What is this going to cost the taxpayers and who decides? It's generally believed that many of the
troubled assets that the government would buy will, in time, be worth more than they can fetch in
today's chaotic markets. That's far from a sure thing. The assets are tied to housing, so their value
will depend on how far prices fall and how long it takes before housing rebounds - all big unknowns.

For those reasons, it's important for Americans to know who is going to decide what is the right
purchase price for these assets. Americans also need to know how the process will be monitored to
ensure that taxpayers' interests are protected. If the government gets the price right, the upfront
outlay could be recouped when it later sells. If it overpays, the taxpayer is stuck with the loss.

How will Congress balance the bailout of Wall Street and the needs on Main Street? Congress must
do more to provide direct help to struggling families. Lawmakers should use the bailout legislation to
extend unemployment benefits, bolster food stamps and provide aid to state and local governments
to provide other services.

The administration and lawmakers also need to tell Americans that the era of easy money is over
and that there are more tough times to come. Whose taxes will have to go up? How will the
government help to create jobs? How will the most vulnerable Americans be protected?

Finally, Americans need to be told a more fundamental truth: This crisis is the result of a systematic
failure by the government to regulate the activities of bankers, lenders and other market players.

The regulatory failure was grounded in the Bush administration's belief that the market, with its
invisible hand, works best when it is left alone to self regulate and self correct. The country is
paying the price for that delusion.

Bad Bank Rescue

September 21, 2008

With truly extraordinary speed, opinion has swung behind the radical idea that the government
should commit hundreds of billions in taxpayer money to purchasing dud loans from banks that
aren't actually insolvent. As recently as a week ago, no public official had even mentioned this
option. Now the Treasury, the Fed and congressional leaders are promising its enactment within
days. The scheme has gone from invisibility to inevitability in the blink of an eye.

This is extremely dangerous.

The plan is being marketed under false pretenses. Supporters have invoked the shining success
of the Resolution Trust Corporation as justification and precedent. But the RTC, which was created
in 1989 to clean up the wreckage of the savings-and-loan crisis, bears little resemblance to what is
being contemplated now. The RTC collected and eventually sold off loans made by thrifts that had
gone bust. The administration proposes to buy up bad loans before the lenders go bust.

This difference raises several questions:

The first is whether the bailout is necessary. In 1989, there was no choice. The federal government
insured the thrifts, so when they failed, the feds were left holding their loans; the RTC's job was
simply to get rid of them. But in buying bad loans before banks fail, the Bush administration would
be signing up for a financial war of choice. It would spend billions of dollars on the theory that
preemption will avert the mass destruction of banks. There are cheaper ways to stabilize the
system.
In the 1980s, the government did not need a strategy to decide which bad loans to take over; it
dealt with anything that fell into its lap as a result of a thrift bankruptcy. But under the current
proposal, the government would go out and shop for bad loans. These come in all shapes and
sizes, so the government would have to judge what type of loans it wants. They are illiquid, so it's
hard to know how to value them. Bad loans are weighing down the financial system precisely
because private-sector experts can't determine their worth.

The government would have no better handle on the problem.

In practice this means the government would make subjective choices about which bad loans to
buy, and it would invariably pay more than fair value. Particularly if the banks and their
lobbyists have any say in the matter. Billions in taxpayer money would be transferred to
the shareholders and creditors of banks, and the banks from which the government bought most
loans would be subsidized more than their rivals. If the government bought the most from the
sickest institutions, it would be slowing the healthy process in which strong players buy up the
weak, delaying an eventual recovery. The haggling over which banks got to unload the most would
drag on for months. So the hope that this "systematic" plan can be a near-term substitute for ad hoc
AIG-style bailouts is illusory. I agree

Within hours of the Treasury announcement Friday, economists had proposed preferable
alternatives. Their core insight is that it is better to boost the banking system by increasing its
capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose
of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into
a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to
raise capital without tapping the taxpayers. First, the government should tell banks to cancel all
dividend payments. Banks don't do that on their own because it would signal weakness; if everyone
knows the dividend has been canceled because of a government rule, the signaling issue would be
removed. Second, the government should tell all healthy banks to issue new equity. Again, banks
resist doing this because they don't want to signal weakness and they don't want to dilute existing
shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings
Institution have offered versions of another idea. The government should help not by buying banks'
bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to
value bad loans, banks have share prices you can look up in seconds, so government could inject
capital into banks quickly and at a fair level (through the sale or issuance of
government ‘recapitalization’ bonds that back non-performing loans at a
discount ratio and are tradable on the capital markets at whatever price the
market may set). The share prices of banks that recovered would rise, compensating
taxpayers for losses on their stakes in the banks that eventually went under.

Congress and the administration may not like the sound of these ideas. Taking bad loans off the
shoulders of the banks seems like a merciful rescue; ordering banks to raise capital (real Tier 1
capital) or buying equity stakes in them (as per above) that sounds like big-government
meddling. But we are in the midst of a crisis, and it shouldn't matter how things sound. The
Treasury plan outlined on Friday involves vast risks to taxpayers, huge complexity and no
guarantee of success.

There are better ways forward.

Present at the crash

On the subway, a stranger in a suit knowingly eyed my Lehman Brothers ID badge in its Bear
Stearns holster. With a look of detached curiosity, he expressed his condolences. This is not the
way I thought my Wall Street career would begin.

During college, I was an intern at Bear Stearns. There, I toiled at the lowest levels of Wall Street,
fetching coffee, moving boxes, filing papers.

In my final summer at Bear, I was promoted to intern in the marketing department of the asset
management division. There, I worked on some hedge funds that invested in stuff called "mortgage-
backed securities."

Several months later, the hedge funds went down the tubes, dragging Bear Stearns behind them.

After I graduated from college, Lehman Brothers hired me to help settle trades in complex
derivatives, the very derivatives that led to the company's demise. I helped resolve trading issues
involving tens - hundreds - of millions of dollars.

And now? Now from my desk here in the trenches, my colleagues and I watch CNBC reports on the
collapse of Wall Street. Over the months, we have watched our stock price plummet 99.8 percent,
from $65 per share to 15 cents.

The news provides grist for the rumor mill. I trade notes with my colleagues here. Though some
more senior people have lost their entire life savings, the steady stream of bad news and
uncertainty are also difficult for those of us at the bottom of the Wall Street food chain. It is dizzying.

Most of the time, in the office and out, I feel like I am on display, an object of pity or fascination.
Friends and family send frequent expressions of concern and empathy by phone, e-mail and text
message.

Even though I had little - nothing, actually - to do with the real estate losses that led to Lehman's
problems, or the hedge funds that precipitated Bear's demise, the only conclusion I can draw is that
I'm a jinx. Prospective employers will take one look at my résumé and call security to escort me out
the door lest my mere presence infect their otherwise healthy businesses.

Meanwhile, I sit at my desk. "Your password will expire in nine days," my computer informs me.
"Would you like to change it?" Each time, I click "No."

Krugman: Crisis endgame

By Paul Krugman
Friday, September 19, 2008

PRINCETON, New Jersey: On Sunday, U.S. Treasury Secretary Henry Paulson tried to draw a line
in the sand against further bailouts of failing financial institutions; four days later, faced with a crisis
spinning out of control, much of Washington appears to have decided that government isn't the
problem, it's the solution. The unthinkable - a government buyout of much of the private sector's
bad debt - has become the inevitable.

The story so far: The real shock after the feds failed to bail out Lehman Brothers wasn't the plunge
in the Dow, it was the reaction of the credit markets. Basically, lenders went on strike: U.S.
government debt, which is still perceived as the safest of all investments - if the government goes
bust, what is anything else worth? - was snapped up even though it paid essentially nothing, while
would-be private borrowers were frozen out.
Thus, banks are normally able to borrow from each other at rates just slightly above the interest rate
on U.S. Treasury bills. But Thursday morning, the average interest rate on three-month interbank
borrowing was 3.2 percent, while the interest rate on the corresponding Treasuries was 0.05
percent. No, that's not a misprint.

This flight to safety has cut off credit to many businesses, including major players in the financial
industry - and that, in turn, is setting us up for more big failures and further panic. It's also
depressing business spending, a bad thing as signs gather that the economic slump is deepening.

And the Federal Reserve, which normally takes the lead in fighting recessions, can't do much this
time, because the standard tools of monetary policy have lost their grip. Usually the Fed responds
to economic weakness by buying up Treasury bills, in order to drive interest rates down. But the
interest rate on Treasuries is already zero, for all practical purposes; what more can the Fed do?

Well, it can lend money to the private sector - and it's been doing that on an awesome scale. But
this lending hasn't kept the situation from deteriorating.

There's only one bright spot in the picture: interest rates on mortgages have come down sharply
since the federal government took over Fannie Mae and Freddie Mac, and guaranteed their debt.
And there's a lesson there for those ready to hear it: Government takeovers may be the only way to
get the financial system working again.

Some people have been making that argument for some time. Most recently, former Fed Chairman
Paul Volcker and two other veterans of past financial crises published an op-ed in The Wall Street
Journal declaring that the only way to avoid "the mother of all credit contractions" is to create a new
government agency to "buy up the troubled paper" - that is, to have taxpayers take over the bad
assets created by the bursting of the housing and credit bubbles. Coming from Volcker, that
proposal has serious credibility.

Influential members of Congress, including Senator Hillary Clinton and Representative Barney
Frank, the chairman of the House Financial Services Committee, have been making similar
arguments. And on Thursday, Senator Charles Schumer, the chairman of the Senate Finance
Committee (and an advocate of creating a new agency to resolve the financial crisis) told reporters
that "the Federal Reserve and the Treasury are realizing that we need a more comprehensive
solution."

Sure enough, Federal Reserve Chairman Ben Bernanke and Paulson met on Thursday night with
congressional leaders to discuss a "comprehensive approach" to the problem.

We don't know yet what that "comprehensive approach" will look like. There have been hopeful
comparisons to the financial rescue the Swedish government carried out in the early 1990s, a
rescue that involved a temporary public takeover of a large part of the country's financial system. It's
not clear, however, whether policymakers in Washington are prepared to exert a comparable
degree of control.

And if they aren't, this could turn into the wrong kind of rescue - a bailout of stockholders as well as
the market, in effect rescuing the financial industry from the consequences of its own greed.

Furthermore, even a well-designed rescue would cost a lot of money.

The Swedish government laid out 4 percent of gross domestic product, which in America's case
would be a cool $600 billion - although the final burden to Swedish taxpayers was much less,
because the government was eventually able to sell off the assets it had acquired, in some cases at
a handsome profit.
But it's no use whining (sorry, Senator Gramm) about the prospect of a financial rescue plan.
Today's U.S. political system isn't going to follow Andrew Mellon's infamous advice to Herbert
Hoover: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate."

The big buyout is coming; the only question is whether it will be done right.

Brooks: The post-Lehman world

By David Brooks
Friday, September 19, 2008

A few years ago, real estate was all the rage. Earlier this year, the business magazines were telling
us to invest in Lehman Brothers and Merrill Lynch, because those stocks were bound to zoom. Now
another herd is on the march.

We're in a paradigm shift, its members say. The current financial turmoil marks the end of the era of
wide-open global capitalism. Today's gigantic government acquisitions signal a new political era,
with more federal activism and tighter regulations.

This observation is then followed by a string of ethereal gottas and shoulds. We Americans gotta
have smart regulation that offers security but doesn't stifle innovation. We gotta have rules that
inhibit reckless gambling without squelching sensible risk-taking. We should limit excesses during
booms and head off liquidations when things go bad.

It all sounds great (like buying a house with no money down), but do you mind if I do a little due
diligence?

In the first place, the idea that America's problems stem from light regulation and could be solved by
more regulation doesn't fit all the facts. The current financial crisis is centered around highly
regulated investment banks, while lightly regulated hedge funds are not doing so badly. Two of the
biggest miscreants were Fannie Mae and Freddie Mac, which, in theory, "were probably the world's
most heavily supervised financial institutions," according to Jonathan Kay of The Financial Times.

Moreover, there is a lot of lamentation about Clinton-era reforms that loosened restrictions on
banks. But it's hard, as Megan McArdle of The Atlantic notes, to see what these reforms had to do
with rising house prices, the flood of foreign investment that fed the credit bubble and the global
creation of complex new financial instruments for pricing and distributing risk.

In other words, maybe there is something more going on here than just a bunch of laissez-faire
regulators asleep at the wheel. But even if it is true that America needs more federal activism, I'm a
little curious about what we're going to need to make the system work.

Surely, we're going to need lawmakers who understand what caused the current meltdown and who
can design rules to make sure it doesn't happen again. And yet there's no consensus about what
caused this bubble.

Some people blame the Fed's monetary policies, but some say the Fed had only a marginal effect.
Some argue a flood of foreign investment allowed us to live beyond our means, while others say
bad accounting regulations after Enron created a chain reaction of losses.

We don't even have a clear explanation about the past, yet we're also going to need regulators who
understand the present and can diagnose the future.
We're going to need regulators who can anticipate what the next Wall Street business model is
going to look like, and how the next crisis will be different than the current one. We're going to need
squads of low-paid regulators who can stay ahead of the highly paid bankers, auditors and analysts
who pace this industry (and who themselves failed to anticipate this turmoil).

We're apparently going to need an all-powerful Super-Fed than can manage inflation,
unemployment, bubbles and maybe hurricanes - all at the same time! We're going to need
regulators who write regulations that control risky behavior rather than just channeling it off into dark
corners, and who understand what's happening in bank trading rooms even if the CEOs themselves
are oblivious.

We're also going to need regulators who can overcome politics and human nature. As McArdle
notes, cracking down on subprime loans just when they were getting frothy would have meant
issuing an edict that effectively said: "Don't lend money to poor people." Good luck with that.

We'd need regulators who could spot a bubble and squelch a boom just when things seem to be
going good, who can scare away foreign investment and who could over-rule popularity-mongering
presidents. (The statements by the two candidates this week have been moronic.)

To sum it all up, this supposed new era of federal activism is going to confront some old problems:
the lack of information available to government planners, the inability to keep up with or control
complex economic systems, the fact that political considerations invariably distort the best laid
plans.

This doesn't mean there's nothing to be done. Martin Wolf suggests countercyclical capital
requirements. Everybody seems to be for some updated version of the Resolution Trust Corp.,
though disposing of complex debt securities has got to be more difficult than disposing of
commercial real estate.

It's just that there's a big difference between dreaming of some ideal regulatory regime and actually
putting one into practice. Everybody says we're about to enter a new political era, rich in global
financial regulation. The herd might just be wrong once again.

Radical change for Goldman and Morgan

Monday, September 22, 2008

Goldman Sachs and Morgan Stanley, the last two independent investment banks on Wall Street,
will transform themselves into bank holding companies subject to far greater regulation, the Federal
Reserve said Sunday night, a move that fundamentally reshapes an era of high finance that defined
the modern Gilded Age.

The firms requested the change themselves, even as Congress and the Bush administration rushed
to pass a $700 billion rescue of financial firms. It was a blunt acknowledgment that their model of
finance and investing had become too risky and that they needed the cushion of bank deposits that
had kept big commercial banks like Bank of America and JPMorgan Chase relatively safe amid the
recent turmoil.

It also marks a turning point for the high-rolling culture of Wall Street, with its seven-figure bonuses
and lavish perks for even midlevel executives. It effectively returns Wall Street to the way it was
structured before Congress passed a law during the Great Depression separating investment
banking from commercial banking, known as Glass-Steagall.
By becoming bank holding companies, the firms are agreeing to significantly tighter regulations and
much closer supervision by bank examiners. Now, the firms will look more like commercial banks,
with more disclosure, higher capital reserves and less risk-taking.

For decades firms like Morgan Stanley and Goldman Sachs thrived by taking bold bets, often using
enormous amounts of debt to juice their profits, with little outside oversight.

But that brash model was torn apart over the last several weeks as investors lost confidence in the
way they did business. Over several harrowing days, clients started pulling their money, share
prices plunged and these banks' entire enterprise, once considered the gold standard on Wall
Street, was brought to the brink.

In exchange for subjecting themselves to more regulation, the companies get access to the full
array of the Federal Reserve's lending facilities. It should help them avoid the fate of Lehman
Brothers, which declared bankruptcy last week, and Bear Stearns and Merrill Lynch — both of
which were acquired by big bank holding companies.

The decision also raises questions about whether the Federal Reserve will seek to regulate hedge
funds, many of the largest of which closely resemble investment banks like Goldman.

Just a year ago investment banks, the titans of global finance, considered bank regulation a
millstone to be avoided at all costs. Commercial banks have to subject themselves to restrictions on
how much money they can borrow and what kinds of businesses they can be in. Lobbyists for firms
like Goldman spent years fending off closer supervision of their business.

As bank holding companies, the two banks, which have seen their shares lose about half their value
this year, will have to reduce the amount of money they can borrow relative to their capital. That will
make them more financially sound but will also significantly limit their profits. Today, Goldman
Sachs has $1 of capital for every $22 of assets; Morgan Stanley has $1 for every $30. By contrast,
Bank of America's has less than $11 for every $1 of capital.

JPMorgan acquired Bear Stearns this spring in a fire sale brokered by the federal government,
while Bank of America has agreed to buy Merrill Lynch for $50 billion.

As bank holding companies, Morgan and Goldman will have greater access to the discount window
of the Federal Reserve, which banks can use to borrow money from the central bank. While they
have had access to temporary Fed lending facilities in recent months, they could not borrow against
the same wide array of collateral that commercial banks could. The discount window access for
investment banks is expected to be phased out in January.

It will take time for Goldman and Morgan to transform into fully regulated banks, because they
cannot quickly reduce how much money they borrow relative to their assets. The Fed and the
Securities and Exchange Commission have had examiners at investment banks since March, giving
regulators significant insight into their businesses.

Both banks already have retail deposit-taking businesses, which they plan to expand over time.
Morgan Stanley had $36 billion in retail deposits as of Aug. 31 and Goldman Sachs had $20 billion
in deposits.

"We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even
more secure institution with an exceptionally clean balance sheet and a greater diversity of funding
sources," Lloyd Blankfein, the chairman and chief executive of Goldman, said in a written statement
Sunday night.
John Mack, the chairman and chief executive of Morgan Stanley, said: "This new bank holding
structure will ensure that Morgan Stanley is in the strongest possible position — with the stability
and flexibility to seize opportunities in the rapidly changing financial marketplace."

In recent days, Morgan Stanley had sought other ways to bolster its capital, and had been in
advanced talks with China's sovereign wealth fund and others about raising billions of dollars,
people briefed on the matter said Sunday night. It had also been talking about a merger with
Wachovia, a large commercial bank based in Charlotte, North Carolina.

With their transition to operating as bank holding companies, those talks are likely to take a different
form, because now Morgan can buy a commercial bank.

Will the bailout work?

September 21, 2008

As the U.S. government steps to the center of the financial crisis, crafting plans to take ownership of
up to $700 billion worth of bad mortgages, a pair of simple questions rises to the fore: Will this
intervention finally be enough to restore order? And what will this grand rescue cost U.S.
taxpayers?

The Treasury Department, as overseer of the American financial system, has in recent weeks
unleashed an astonishing array of initiatives in a bid to stave off catastrophe. It took over the
country's largest mortgage finance companies and put untold billions of taxpayer dollars on the line
to prop up other lenders.

Now, although the details are still being worked out, the government is dispensing with rescuing
one company at a time, and instead taking on a vast pile of bad debt in one gulp. If it all comes to
pass - if Uncle Sam becomes the repository for the radioactive leftovers of bad real estate bets - will
the crisis lift? Will the fear that has kept banks clinging to their dollars, starving the economy of
capital, give way to free-flowing credit?

There are many skeptics of the Treasury's proposal, though there is wide agreement that some kind
of broad intervention is necessary.

"It goes a long way. It ameliorates it very substantially," said Alan Blinder, an economist at
Princeton and a former vice chairman at the Federal Reserve, who has said for months that the
government must step in forcefully to buy mortgage-linked investments. "We're deep into Alice in
Wonderland's rabbit hole," he said.

But significant skepticism confronts the initiative. Under a proposal circulating Saturday, the
Treasury could spend as much as $700 billion to buy mortgage-linked investments, then sell what it
can as it works out the messy details of the loans. But no one really knows what this cosmically
complex web of finance will be worth, making the final price tag for the taxpayer unknowable. One
may just as well try to predict the weather three years from Tuesday.

Some question the prudence of adding to the nation's overall debt at a time when the Treasury
relies on the largess of foreigners to cover the bills. Most broadly, what are the longer-term costs of
the government stepping in to restore order after so many wealthy financiers have become so much
wealthier through what now seem like reckless bets on real estate - bets now covered with public
dollars?

Also, what message does that send to the next investment bank caught up in the next speculative
bubble and contemplating the risks of jumping in while wondering who is ultimately on the hook if
things go awry?
Many economists say such questions are beside the point. The United States is gripped by the
worst financial crisis since the Great Depression.

Before Thursday night, when the Treasury secretary, the Federal Reserve chairman and leaders on
Capitol Hill proclaimed their intentions to take over bad debts, the prognosis for the American
financial system was sliding from grim toward potentially apocalyptic.

"It looked like we might be falling into the abyss," Blinder said.

As the details of the government's plans are hashed out, no hallelujah chorus is wafting across
Washington, down Wall Street or through the glistening condos of the United States. Too many
households are having trouble paying their mortgages. Too many people are out of work. Too many
banks are bloodied.

Still, the prospect that the government is preparing to wade in deep - perhaps sparing families from
foreclosure and banks from insolvency - has muted talk of the most dire possibilities: a severe
shortage of credit that would crimp the availability of finance for many years, effectively halting
economic growth, both in the United States and around the globe.

"The risk of ending up like Japan, with 10 years of stagnation, is now much lessened," said Nouriel
Roubini, an economist at the Stern School of Business at New York University. "The recession train
has left the station, but it's going to be 18 months instead of five years."

If the plan works, it will attack the central cause of American economic distress - the continued
plunge in housing prices. If banks resumed lending more liberally, mortgages would become more
readily available. That would give more people the wherewithal to buy homes, lifting housing prices
or at least preventing them from falling further. This would prevent more mortgage-linked
investments from going bad, further easing the strain on banks. As a result, the current downward
spiral would end and start heading up.

"It's easy to forget amid all the fancy stuff - credit derivatives, swaps - that the root cause of all this
is declining house prices," Blinder said. "If you can reverse that, then people start coming out of
their foxholes and start putting their money in places they have been too afraid to put it."

For many Americans, the events that have transfixed and horrified Wall Street in recent days - the
disintegration of supposedly impregnable institutions, government bailouts with 11-figure price tags
- have been less stunning than inscrutable. The headlines proclaim that the taxpayer now owns the
mortgage finance giants Fannie Mae and Freddie Mac, along with the liabilities of a mysterious
colossus called the American Insurance Group, which, as it happens, insures against corporate
defaults. Much like the human appendix, these were organs whose existence was only dimly
evident to many until the pain began.

And yet these institutions are deeply intertwined with the American economy. When the financial
system is in danger, it stops investing and lending, depriving ordinary people of financing for
homes, cars and education. Businesses cannot borrow to start and expand.

"Wall Street isn't this island to itself," said Jared Bernstein, senior economist at the labor-oriented
Economic Policy Institute. "Even people with good credit histories are having a very hard time
getting loans at terms that make sense. If that gets worse, we're going to be stuck in the doldrums
for a very long time, because that directly blocks healthy economic activity."

Giant Investment Banks Grasp for Government Safety Net

Monday, September 22, 2008
The Federal Reserve approved the conversion last night of the two remaining investment titans on Wall
Street, Goldman Sachs and Morgan Stanley, into bank holding companies, offering them broader
government protection in exchange for tighter regulation and constraints on their once fabulously
profitable business.

With the federal government continuing its rapid and radical reshaping of the U.S. financial system, the
two investment banks agreed to transform themselves in an effort to escape the financial turmoil that last
week put their existence in jeopardy.

The move, approved by the Fed with unusual haste, gives Goldman Sachs and Morgan Stanley greater
latitude to borrow from the Fed and access to stable sources of funding -- namely, deposits from ordinary
people and businesses. But the firms are also accepting regulation by the Fed that will make it far more
expensive for them to borrow huge sums of money -- long an essential ingredient in their investment
strategy -- and restrict what sorts of business activities they can engage in.

This development completes a sweeping transformation of Wall Street. Now extinct are the specialized
trading houses that broke off from larger financial companies during the Great Depression, enterprises
that once prized their independence of regulation and exploited their agility to make fortunes. Over the
past 30 years, these firms even surpassed commercial banks as the prime funding source for corporate
America.

The conversion of investment banks into the kind of banking companies that once were their rivals will
have profound and long-lasting implications for the economy.

Seven months ago, there were five major independent investment banks, selling stocks and bonds,
advising companies on mergers and engaging in ever more arcane financial engineering. Since then,
Bear Stearns was bought in a fire sale by commercial bank J.P. Morgan Chase, Lehman Brothers went
bankrupt, and Merrill Lynch agreed to be bought by Bank of America.

Now, the two biggest, strongest and most prestigious of those firms will become traditional commercial
banks, too. The firms concluded that it was worth it to accept the safety net of government protection,
even though it will probably lead to much more scrutiny by Fed regulators into what businesses they can
engage in.

The change is likely to make easier, and could intensify, both companies' efforts to link up with
commercial banks. Now that Goldman Sachs and Morgan Stanley have committed to using deposits to
fund their operations, they have a tremendous incentive to gain access to the largest possible networks
of bank branches.

In trying to save themselves, Goldman Sachs and Morgan Stanley are agreeing to surrender some of the
activities that drove their profitability over the past decade. The two companies made massive bets while
putting little money on the table. And they invested vast sums in a wide range of commercial enterprises.

As bank holding companies, Goldman and Morgan will be forced to put more money on the table when
they make investment bets. Goldman Sachs, for example, currently holds about $1 for every $22 in
investments. Morgan Stanley's ratio is even more dramatic. By contrast, Bank of America, which will soon
be the nation's largest bank holding company, holds about $1 for every $11 in investments. And Goldman
and Morgan will be sharply limited in their ability to make equity investments in non-financial companies.

"The marketplace won't give them leverage, the regulators won't give them leverage and so now we have
formal confirmation that the model of freestanding investment banks is kaput," said Ed Yingling, president
of the American Bankers Association.

Currently, the Fed has about a half-dozen examiners in Goldman and Morgan combined. By contrast,
major bank holding companies host dozens of examiners, who monitor and restrict the firms' activities.
It's too early to tell what restrictions the Fed will put in place. The Fed must now send in its examiners
and assess the companies' businesses, which are in flux.

Conventional banks, such as Bank of America and J.P. Morgan, have weathered the financial crisis much
better than investment firms, despite incurring vast losses of their own. One key is that their deposits offer
a steady source of funding, unlike the short-term debt that investment banks have relied on. That left
them susceptible to runs, as Bear Stearns and then Lehman Brothers experienced.

It is in many ways a move to the business model used by banks in Europe, where large firms engage in
both investment banking and commercial banking.

Also yesterday, the Treasury Department issued a major caveat to its Friday announcement that it would
guarantee investments in money-market mutual funds, emulating the long-standing federal guarantee of
deposits in bank accounts. The Treasury said yesterday that it would only guarantee existing investments
in money-market funds.

The caveat came after loud pressure from the banking industry, which worried that a guarantee on new
investments would encourage customers to pull money from bank accounts because money-market
funds, which pay higher interest rates, would now be seen as equally safe. Both banks and banking
regulators were concerned about how an exodus of deposits could impact already-struggling banks.

As banks fall, a bid to curb short sellers

Traders who have sought to profit from the financial crisis by betting against bank stocks were
attacked on two continents Thursday.

The U.S. Securities and Exchange Commission is considering a temporary ban on short sales of
some or all shares and an announcement could be made as early as Friday morning. Earlier
Thursday, the commission scrambled to put together an emergency rule to force major investors to
disclose their short sales daily. In Britain, regulators announced new rules to bar short selling.

Short selling ( a bet that a stock price will decline) is the practice of selling stock without owning it,
hoping to buy it later at a lower price, and thus make a profit. It has often been blamed for forcing
prices down in times of market stress, but the level of anger has intensified as the U.S. government
has been forced to bail out major financial institutions and the leaders of some investment banks
have asked for action to protect their shares. Both the commission and the New York State attorney
general promised to intensify investigations into short selling abuses.

"They are like looters after a hurricane," said Andrew Cuomo, the New York State attorney general.
"If you pass a rumor in a normal marketplace, people are calm, they check it out, they do their due
diligence. When you get the market in this frenzied state and they are on pins and needles, any
false information is much more impactful."

Senator John McCain, the Republican presidential candidate, said the commission had "kept in
place trading rules that let speculators and hedge funds turn our markets into a casino" and the
commission's chairman, Christopher Cox, had "betrayed the public's trust." Speaking at a rally in
Cedar Rapids, Iowa, McCain said, "If I were president today, I would fire him."

The White House immediately said it supported Cox, who has said he would resign at the end of
the Bush administration. Cox said he had moved against short sellers and was doing all he could to
stem the financial crisis. "Now is not the time for those of us in the trenches to be distracted by the
ebb and flow of the current election campaign," Cox said in a statement released by the
commission. "It is precisely the wrong moment for a change in leadership that inevitably would
disrupt the work of the SEC at just the wrong time."
Cox is a former White House aide to President Ronald Reagan and a former Republican
congressman from California. Some conservative columnists and commentators supported him as
a running mate for McCain. Writing in The American Spectator magazine earlier this year, Quin
Hillyer said that conservatives would rally to a Cox selection and called him "the best choice, bar
none."

In recent weeks, Cox has also stepped up his criticism of short sellers, particularly those who
engage in "naked" short selling. While short sellers are supposed to borrow shares before selling
them, naked shorts do not borrow. That saves the cost of borrowing, though the trader is still
vulnerable to losses if the share price rises.

Opponents of short selling say that it can force share prices down and destroy confidence in a
company that might otherwise survive. Regulators have long thought that the practice was crucial
for efficient markets to function, but earlier this year the SEC imposed temporary limits on short
selling of some financial stocks. Financial share prices rallied when those limits were announced
but fell during the period in which the rule was in effect.

Share prices for many financial companies shot up Thursday after plunging the day before in the
wake of the government decision to take control of the American International Group, a large
insurance company, to prevent it from collapsing. Financial shares were especially hard hit
Wednesday, with Morgan Stanley plunging 24 percent, to $21.75, and its chief executive, John
Mack, blaming false rumors spread by short sellers. On Thursday, Morgan Stanley regained part of
that loss, rising 3.7 percent to close at $22.55.

The latest moves against short sellers began Wednesday. In the morning, Cox announced new
rules to prevent brokerage firms from selling a stock short if they previously had sold the stock short
without having borrowed it. That night, he said that he would propose more rules, to force large
short sellers to disclose their positions.

The rules were needed, he said, "to ensure that hidden manipulation, illegal naked short selling or
illegitimate trading tactics do not drive market behavior and undermine confidence."

Details of the possible new disclosure rule were not released, and it is not clear how much authority
the SEC has over hedge funds, which have successfully sued to prevent the commission from
forcing them to even register with it. Institutional investors, including some hedge funds, provide
details of stocks they own every three months but do not disclose short positions. Cox said he
wanted daily disclosure of short positions, which he said would be made public, though he did not
say how quickly.

By late Thursday, the commission was considering a temporary ban of some or all short selling.
Cox told reporters in Washington late Thursday that he had discussed the ban with other senior
administration officials but no decision had been made yet. Richard Baker, the president of the
Managed Funds Association, a hedge fund trade group, said the funds would comply with any rules
but said that disclosure of their trading positions should not be made so quickly that it would harm
them in the market. Cox also said the commission would intensify its investigations of short selling
by hedge funds and would demand their records on trading in certain securities.

In Britain, the Financial Services Authority said that beginning Friday it would bar traders from
taking new short positions in listed stocks of financial companies, and that starting next week,
investors would have to disclose their short positions if they were at least 0.25 percent of a
company's outstanding shares.

This week, the British bank Lloyds TSB took over HBOS, a mortgage lender, after HBOS's stock
tumbled. That fall was widely blamed on short sellers, and Prime Minister Gordon Brown of Britain
vowed to clean up the financial system.
To obtain shares to sell short, traders often borrow them from institutional investors, who receive
small fees for the loans. But public pension funds in New York and California said Thursday that
they would stop lending shares of some financial companies.
The New York State comptroller said the state's Common Retirement Fund would temporarily stop
lending the shares of 19 banks and brokerage firms to short sellers. "This speculative selling has
put downward pressure on the entire stock market and threatens to drive our national economy
deeper into decline," Thomas DiNapoli, the comptroller, said in a statement.

"My action is intended to bring stability and rationality back to our equity markets."
The suspension removes 105 million shares from the fund's securities lending program. It will last
until market conditions stabilize, a spokesman said.

New York City's comptroller announced the same move, as did California officials.
"We're pulling them back because of the unfortunate predators that are out there right now, trying to
be greedy," said Patricia Macht, an official of Calpers, the California Public Employees' Retirement
System.

The California State Teachers' Retirement System took a similar step. "We were just trying to stem
the bleeding," said Ricardo Durán, a spokesman for that fund.

More regulators move to curb short-selling

More financial regulators across the globe are following the lead of the United States and Britain to
curb the short sales of financial stocks in a move aimed at returning stability to financial markets.
On Sunday, the Australian Securities and Investments Commission said in a statement that it had
expanded a curb announced Friday, which had outlawed "naked" short sales, to include a ban on
the more traditional form of "covered" short-selling of all traded stocks.

Also Sunday, the Financial Supervisory Commission of Taiwan placed a ban on the short-selling of
150 stocks for two weeks starting Sept. 22. Supervisors from Germany, France and Belgium curbed
short sales of financial companies late Friday to defend banks from trading that has been blamed
for pushing down share prices and worsening the market crisis.

Short-selling is a tactic designed to profit from falling share prices. It has been favored in particular
by hedge funds and has been blamed for some of the huge gyrations in world stock markets in
recent sessions.

Short-sellers borrow shares of the stock and sell them. If the price drops, they buy shares at the
lower price to cover the borrowed ones, pocketing the difference. So-called naked short-selling
occurs when sellers do not even borrow the shares before selling them and then look to cover
positions immediately after the sale.
Analysts were not convinced that curbing short sales would necessarily help stabilize the shares of
financial companies.

"It should give the market some breathing room, but is not the answer to reopening the money
markets long-term," RBC Capital Markets said in a research note published Friday. "Paradoxically,
weak financial institutions that benefited from increased financial market volatility could now see a
temporary reduction in revenues."

The chairman of the U.S. Securities and Exchange Commission, Christopher Cox, on Friday
announced a list of 799 financial stocks on which short-selling was banned until Oct. 2.

The Financial Services Agency in Britain also banned investors last week from taking new short
positions in financial shares or adding to existing ones. The ban will remain in force until Jan. 16
and will be reviewed after an initial period of 30 days, the agency said.
The German financial regulator BaFin said late Friday that it had suspended short-selling of shares
in 11 financial companies - including Deutsche Bank, the insurer Allianz and the exchange operator
Deutsche Börse - to try to protect them from speculators until the end of the year.

The French and Belgian regulators barred most investors from overnight short positions in banks
and insurers to "avoid all abusive arbitrage," according to coordinated statements. The measures
are effective Monday and will be in place for three months. Market makers, liquidity providers and
block sales are exempt.
Similar steps were taken last week in Ireland, Canada, Switzerland and Portugal. Consob, the
Italian stock market regulator, said it would increase scrutiny of short-selling and might tighten the
rules on such sales.

U.S. weighs bailout of foreign banks, too

Monday, September 22, 2008

The financial crisis that began in the United States spread to many corners of the globe. Now, the
U.S. bailout looks as if it is going global, too, a move that could raise its cost and intensify scrutiny
by Congress and critics.

Foreign banks, which were initially excluded from the plan, lobbied successfully over the weekend
to be able to sell the toxic U.S. mortgage debt owned by their American units to the Treasury,
getting the same treatment as United States banks.

On Sunday, the Treasury secretary, Henry Paulson Jr., indicated in a series of appearances on
morning talk shows that an original proposal introduced on Saturday had been widened. "It's a
distinction without a difference whether it's a foreign or a U.S. one," he said in an interview with Fox
News.
The prospect of being locked out of the bailout set off alarm bells among chief executives of
overseas banks whose American affiliates also hold distressed mortgage-related assets, like
Barclays and UBS. The original text provided access to the $700 billion bailout for any financial
institution based in the United States.

As the day wore on, some raised their concerns with the Treasury Department, arguing that foreign
institutions were both big employers and major players in the American capital markets. By
Saturday evening, the language had been changed to allow any financial institution "having
significant operations" in the United States.

While Paulson has agreed with that argument, the Bush administration is also leaning on foreign
governments to pitch in with bailout programs of their own as needed. "We have a global financial
system and we are talking very aggressively with other countries around the world, and
encouraging them to do similar things, and I believe a number of them will," Paulson said on
Sunday.
The request is expected to be discussed during a conference call among Group of 7 finance
ministries scheduled for Sunday evening, a European official said.

Allowing foreign banks to participate in the federal rescue package has not yet drawn widespread
scrutiny in Congress, where a number of lawmakers, including Senator Christopher Dodd,
Democrat of Connecticut, have acknowledged that millions of U.S. citizens do business with UBS,
the Royal Bank of Scotland, and many other foreign-based banks in the United States.
But a number of lawmakers are wary that such an extension may worsen what could ultimately turn
out to be a trillion-dollar bailout for Wall Street.

"I'm skeptical of the bailout, the whole bill is only a couple of pages long," said Representative Scott
Garrett, Republican of New Jersey, who is a member of the House Financial Services Committee.
As for the participation of foreign banks, Garrett said: "I have a concern with it, they probably should
be treated differently, but Congress is really not getting any say."
Christopher Whalen, a managing partner at Institutional Risk Analytics, said that Paulson needed to
justify why a wider bailout was in the national interest.

"Can you imagine the Congress floating a bailout for Deutsche Bank or UBS? It is the responsibility
of the German or Swiss government," he said. "We shouldn't be bailing them out."
While politicians in the United States may emphasize the benefits for banks based overseas, the
definition of what is a European or U.S. bank has blurred in recent years with the growth of global
giants like HSBC, Barclays and Deutsche Bank.

Deutsche Bank, for example, became a major player in the United States with its acquisition of
Bankers Trust in 2001. It has written down more than $11 billion in investments linked to the
subprime crisis.
Barclays, meanwhile, is on course to buy a significant portion of the North American operations of
Lehman Brothers, the 158-year-old firm that filed for bankruptcy protection last week, helping to set
off the global financial panic that forced Washington to act.

Gaining access to the relief was a top priority for European foreign financial institutions with banking
operations in the United States, according to officials in industry and government.
They argued that the reputation of Wall Street and the U.S. government would suffer immensely if
properly licensed foreign banks in the United States were shut out of the system.
"Who would open a bank again in the United States?" asked one executive of a major European
bank who has been following the discussions.

At the same time, it was unclear how much European governments would bow to the Treasury
Department's encouragement to set up national programs to deal with their own vast mortgage
problems. Real estate markets in Britain, Spain and Ireland have been particularly hard-hit as their
own housing market bubbles — which grew in tandem with America's — have collapsed.

Other governments have struggled to get budget deficits under control in the last few years. The
German government, for example, has discouraged talk of a stimulus package, and British officials
said Sunday that they were not working on a plan like that of the United States.

Robert Kelly, at the Bank of New York Mellon, said every European central bank would probably be
scrutinizing the American bailout proposal. "I would expect every finance minister is looking closely
at what is happening in the United States, trying to hypothesize what the impact will be, and is
thinking about the tools the Fed and Treasury have used," he said. "I would not be surprised, and
probably expect, some of those tools to be used in Europe as well."

If the plan is approved in Congress and is signed into law, the benefits would be large for European
banks with licensed operations in the United States, which incurred major losses from mortgage-
linked securities.
UBS, the Swiss giant, has been among the hardest-hit institutions in the world; both its chairman
and chief executive left amid more than $40 billion in write-downs. Even so, it still retains roughly
$20 billion more in potential exposure to the troubled U.S. housing market.

If a battle does develop in Congress over foreign participation, UBS, among others, is poised to
make just these arguments. Officials at the Zurich-based giant point out the bank employs more
than 30,000 Americans, is listed on the New York Stock Exchange, and owns two broker-dealers
registered under United States laws, UBS Securities and UBS Financial Services, better known to
Americans as the former Paine Webber unit.

"These are Americans who work in New York," said one executive who requested anonymity
because the U.S. plan was still in development. "And they are working for a bank that was
incorporated in the United States." One senior Wall Street executive said he believed that the
proposal would apply to other institutions with regulated U.S. entities. Credit Suisse, for example,
includes the old First Boston Corporation, though that name was dropped years ago. He said the
biggest issue being debated was what securities would be included in the proposal, and how the
actual mechanism to buy them would work.
In Asia, the plan to purchase distressed assets drew little reaction over the weekend. Asian banks
generally have not invested significant assets in U.S. mortgage-backed securities.

The bigger question in Asia, bankers said, lies in how the American legislation will affect HSBC, the
large British-based bank with significant operations in Asia. The bank's U.S. subsidiary was a large
buyer of mortgages over the last decade, and kept many of these mortgages on its books instead of
trying to repackage and resell them as mortgage-backed securities.

Richard Lindsay, a spokesman for HSBC, said that senior management was still evaluating the
situation and said it was a "positive step forward but it won't solve the problems of an overleveraged
industry."

Three views of a financial rescue plan

Monday, September 22, 2008

The Bush administration is working with Congress to fill in the details of its plan to take the bad
mortgage-related debt off the books of banks and financial institutions and stabilize the financial
markets.

With Congress scheduled to begin its election-year recess at the end of this week, the
administration has little time to pull the plan together. While the negotiations are going on, The New
York Times asked three economists to offer their thoughts about the administration's actions.

Steven Schwarcz, professor of law and business, Duke University School of Law:

"The proposal by the Treasury to use government money to purchase mortgage-backed securities
held by financial institutions should defuse the financial crisis, but at a cost to taxpayers that
unfortunately will be much higher than if the government had acted when markets first began to
collapse. It is, however, along with Treasury's Sept. 7 announcement that it will purchase securities
issued by Fannie Mae and Freddie Mac, the first serious attempt by government to cure the
underlying financial disease and not merely treat its symptoms.

"To cure the disease, government must focus on treating the loss of confidence in the financial
markets. The American International Group, Bear Stearns, Lehman and potentially other financial
institutions are in trouble, not because of problems with economic fundamentals, but because of
falling prices of mortgage-backed and other securities, requiring these institutions to mark their
securities down to the collapsed market prices or triggering insurance obligations on these
securities. That, in turn, has created a downward death spiral of collapsing prices.

"A market liquidity provider of last resort is needed to correct these market failures by investing
directly in securities of panicked financial markets, thereby stabilizing prices and dampening the
downward death spiral that can lead to market collapse. This type of targeted market investment
should generate minimal costs, and certainly lower costs than those of a lender of last resort to
financial institutions — the Fed's traditional role.

"Whatever entity the Treasury is contemplating to purchase mortgage-backed securities held by

financial institutions, the fact that it will directly purchase securities will set an important precedent
for creation of a market liquidity provider that can act proactively, not merely reactively, after the
damage is done.
"By acting at the outset of a market panic, a market liquidity provider can profitably invest in
securities at a deep discount from the market price and still provide a "floor" to how low the market
will drop. Had a market liquidity provider been in existence when the subprime crisis started, the
resulting collapse of the credit markets would almost certainly have been restricted in scope and
lessened in impact, and we would not now be facing the need to try to save AIG and other
institutions."

Douglas Elmendorf, senior fellow at the Brookings Institution in Washington:

"The Treasury's new plan for stabilizing the financial system has already made a sharp impression
on financial markets and the public consciousness. Yet little has been revealed about how the plan
will work.

"The Resolution Trust Corporation of the early 1990s provides scant guidance on how to proceed.
That company was designed to sell assets the government had acquired by honoring deposit
insurance at savings and loans. But the objective now is to buy assets. The challenge is picking the
best means of doing so. What should the government buy, from whom, in what quantity and at what
price?

"The Treasury plans to purchase mortgage-related debt, which lies at the heart of the crisis. Yet this
approach has significant disadvantages.

"First, mortgage-backed securities and derivatives of these securities are not all alike. Reverse
auctions within broad debt classes would be risky, because current holders would try to unload the
lowest-quality securities within each class. Relying on the judgment of hired investment firms to pick
prices and quantities has the potential for inefficiency, unfairness and abuse.

"Second, buying troubled debt provides the most help to firms that made the worst investments.
Banks that stayed clear of bad debt or cut their losses early would receive little or no gain, while
banks with the weakest balance sheets would reap the biggest rewards. Not only is this unfair, it
would dampen the impetus for restructuring the financial sector to give a smaller role to institutions
and business models that have failed.

"Third, taxpayers would take on significant risk but see limited potential gain — in contrast with the
rescues of Fannie Mae, Freddie Mac and AIG, where taxpayers got large equity stakes.

"An alternative approach is to make equity investments in a wide range of financial institutions. If
the government offered each bank an investment equal to a given percent of its market value in
exchange for a corresponding equity stake, the problems I listed above would be avoided. And
because the government would be a minority shareholder, it would not directly manage or control
these banks. This approach raises its own concerns that would need to be addressed, but it is a
more promising starting point."

Vincent Reinhart, resident scholar at the American Enterprise Institute:

"Political leaders recognize that more than improvisation is needed to cope with the collapse of the
housing market and the financial market crisis in its wake. Before they turn to the details of draft
legislation, however, they had better settle on what they are trying to accomplish.

"Helping households in distress is a retail business, requiring decisions on a mortgage-by-mortgage

basis. Similarly, negotiating with individual financial firms about their mortgage holdings takes time
and infrastructure. Such negotiations put the government at a decided disadvantage because the
other side in the transactions has more information about each asset.
"In both cases, politicians will have trouble establishing boundaries for assistance. While about one
in 15 households with mortgages is now late in making payments, many more have suffered wealth
losses. Builders, too, are in distress. And there are tens of thousands of financial institutions in the
country, almost all of which have some impaired loans on their books.

"The unpleasant reality is that time is short, resources are stretched and many of the nation's urgent
needs are unmet. Because government funds are not unlimited, legislation should focus on the
immediate problem of the strains in financial markets.

"Providing aid to large financial firms is distasteful, especially when remembering their excesses
and the time when their managers were considered masters of the universe. But those firms hold
the larger economy hostage. As long as they are unwilling to support market functioning and make
new loans, spending will sag and asset prices will slide.

"The Congress should authorize the Treasury to purchase asset-backed securities in the secondary
market and mortgages through auctions. For assets where it might not have all the information it
needs, the Treasury could demand a slice of equity in the selling firm as well. As has been the case
since its inception, the Federal Reserve can act as fiscal agent, making some of the purchases
directly and supervising outside managers where special expertise is needed.

"The election calendar narrows the window of action and provides reason to keep the draft
legislation simple. The assets acquired this year will certainly not be sold before a new
administration and Congress are in power. Thus, it is neither necessary nor appropriate to make
decisions on what to do with those mortgage assets."

A Prescription for Recovery

By Robert H. Dugger, September 22, 2008;

This week, Congress is expected to commit hundreds of billions of taxpayer funds to a revitalization
program to halt our financial hemorrhaging. Twenty years ago, in the midst of another financial
crisis, I was part of a banking industry effort to solve the savings and loan problem. The result of
that effort was the Resolution Trust Corporation, which, under Bill Seidman's masterful leadership,
cleaned up the S&L mess in 48 months.

The situation then was very different. The S&L problem involved only one sector of the economy
and was just 3 percent of gross domestic product. We were not so dependent on foreign savings, and
the crushing pressure on our federal budget from tax policies and entitlements was far off. This crisis
is many times larger than that created by the S&Ls. We are deeply dependent on savings from other
countries, and our fiscal resources are limited and shrinking.

One lesson is clear: If Congress commits money without firm principles to guide its use, the cost to
taxpayers will be far higher and the economy will remain weaker longer. Before the 1989 legislation,
efforts to stem losses growing inside the S&L industry lacked firm principles; as a result, they did
not remove the swelling tumor of losses and in some instances actually helped it grow.

Here are five principles Congress needs to impose now:

· Put individual taxpayers first. The program needs to focus on keeping taxpayers in their homes,
strengthening their local economies and protecting their savings. It has to help Americans broadly,
not just a few, and certainly not the managers who got us into this mess.
· Minimize taxpayer costs over the long term. Short-term thinking created this crisis. Only long-
term efforts will end it. The S&L crisis was limited to the financial sector. It was best addressed on
an aggressive basis, bank by bank. This meant that least-cost resolutions were the way to go and that
the RTC should buy and sell assets quickly, which it did. But the current situation is systemic. It
involves our entire economy. This means the revitalization program should buy distressed assets
early and plan to hold them for a long time. The goal is to make the economic adjustment as shallow
as possible, to limit the injury to families, jobs, homes and savings.

· Avoid creating an interim program. This program must not be like the S&L "rescues" of the mid-
1980s, which merely enabled the problems to grow. The program needs to have the capacity,
flexibility and scope to address the vast size of the current crisis. Congress should put no dollar or
time limit on our national commitment. Yes, markets will want dollar figures. If numbers must be
given, let them be in statements about the program -- and let them be big. Do not shy away from
saying that the United States is prepared to commit a trillion dollars over the next 10 years to halt
this meltdown here and now.

· Remember global investors, whose confidence we must regain. This crisis is an economic heart
attack, but not a fatal one. We must assure global investors that we are fully prepared to cover
American losses. No one suggests that this will be easy. The budget choices being forced on us will
be profoundly difficult. But we have the strongest democracy and the most durable legal and
financial systems in the world. We have the capacity to absorb losses and the ability to reshape our
economy. Foreign investors need evidence that we are committed to the changes necessary for
recovery. When they see that, they will buy our private assets again.

· Do not hesitate. Bill Seidman's greatest lesson was action. It is far better to deal with a few assets,
even without knowing quite what to do, than to do nothing while trying to work out the details.
Whoever is in charge of the revitalization program must not hesitate to buy the assets that
institutions offer -- these will be what is burdening the institutions and clogging our credit system the
most. There are many strategies for buying assets and infusing capital that can protect the program
from paying too much and ensure that taxpayers benefit from price increases as recovery occurs. The
key is to get the assets in-house quickly and learn how to manage them effectively.

The writer is a managing partner of a global hedge fund and chairman of the Partnership for
America's Economic Success. As policy director of the American Bankers Association, he led a panel
of bankers in developing a plan that became the RTC

The shadow banking system is unraveling

Last week saw the demise of the shadow banking system that has been created over the past 20
years. Because of a greater regulation of banks, most financial intermediation in the past two
decades has grown within this shadow system whose members are broker-dealers, hedge funds,
private equity groups, structured investment vehicles and conduits, money market funds and non-
bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more
highly leveraged than banks (the exception being money market funds) and lend and invest into
more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but
liquid institution may be subject to a self-fulfilling and destructive run on its -liquid liabilities.
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central
banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to
these firewalls that -prevent runs.

A generalized run on these shadow banks started when the deleveraging after the asset bubble
bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the
entire SIVs/conduits system once investors realized the toxicity of its investments and its very short-
term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days.
The Federal Reserve then extended its lender-of-last-resort support to systemically important
broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns
about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the
same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both
would be well advised to merge – like Merrill – with a large bank that has a stable base of insured
deposits.

The third stage was the collapse of other leveraged institutions that were both illiquid and most
likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300
mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets
and, in order to provide higher returns to attract investors, some of them invested in illiquid
instruments. Once these investments went bust, panic ensued among investors, leading to a
massive run on such funds. This would have been disastrous; so, in another radical departure, the
US extended deposit insurance to the funds.

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up
period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like
run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken
excessive risks with high leverage and are poorly managed may collapse. A massive shakeout of
the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The
private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run
on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include
traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash
interest payments and accrue more debt, but these only delay the eventual refinancing crisis and
will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and
Chrysler, are now at risk.

We are observing an accelerated run on the shadow banking system that is leading to its
unraveling. If lender-of-last-resort support and deposit insurance are extended to more of its
members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course
this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will
have to close.

The real economic side of this financial crisis will be a severe US recession. Financial contagion,
the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a
hawkish European Central Bank will lead to a recession in the Euro zone, the UK and most
advanced economies.

European financial institutions are at risk of sharp losses because of the toxic US securitized
products sold to them; the massive increase in leverage following aggressive risk-taking and
domestic securitization; a severe liquidity crunch exacerbated by a dollar shortage and a credit
crunch; the bursting of domestic housing bubbles; household and corporate defaults in the
recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian
banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed
in foreign currency are leading to hard landings.

Thus the financial crisis of the century will also envelop European financial institutions.

In Bailout, Seeing a Need for a Penalty

As economists puzzle over the proposed details of what may be the biggest financial bailout in
American history, the initial skepticism that greeted its unveiling has only deepened.

Some are horrified at the prospect of putting $700 billion in public money on the line. Others are
outraged that Wall Street, home of the eight-figure salary, may get rescued from the consequences
of its real estate bender, even as working families give up their houses to foreclosure.

Most economists accept that the nation’s financial crisis — the worst since the Great Depression —
has reached such perilous proportions that an expensive intervention is required. But considerable
disagreement centers on how to go about it. The Treasury’s proposal for a bailout, now being
negotiated with Congress, is being challenged as fundamentally deficient.

“At first it was, ‘thank goodness the cavalry is coming,’ but what exactly is the cavalry going to do?”
asked Douglas W. Elmendorf, a former Treasury and Federal Reserve Board economist, and now a
fellow at the Brookings Institution in Washington. “What I worry about is that the Treasury has acted
very quickly, without having the time to solicit enough opinions.”

The common denominator to many reactions is a visceral discomfort with giving Treasury Secretary
Henry Paulson Jr. — himself a product of Wall Street — carte blanche to relieve major financial
institutions of bad loans choking their balance sheets, all on the taxpayer’s bill.

There are substantive reasons for this discomfort, not least concerns that Mr. Paulson will pay too
much, thus subsidizing giant financial institutions. Many economists argue that taxpayers ought to
get more than avoidance of the apocalypse for their dollars: they ought to get an ownership stake in
the companies on the receiving end.

But an underlying source of doubt about the bailout stems from who is asking for it. The rescue is
being sold as a must-have emergency measure by an administration with a controversial record
when it comes to asking Congress for special authority in time of duress.

“This administration is asking for a $700 billion blank check to be put in the hands of Henry
Paulson, a guy who totally missed this, and has been wrong about almost everything,” said Dean
Baker, co-director of the liberal Center for Economic and Policy Research in Washington. “It’s
almost amazing they can do this with a straight face. There is clearly skepticism and anger at the
idea that we’d give this money to these guys, no questions asked.”

Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at
the door: a potentially swift shredding of the American financial system. That would be catastrophic
for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances
to buy homes and cars, and to pay for college.

Some are suspicious of Mr. Paulson’s characterizations, finding in his warnings and demands for
extraordinary powers a parallel with the way the Bush administration gained authority for the war in
Iraq. Then, the White House suggested that mushroom clouds could accompany Congress’s failure
to act. This time, it is financial Armageddon supposedly on the doorstep.
“This is scare tactics to try to do something that’s in the private but not the public interest,” said
Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at
the Carnegie Mellon Tepper School of Business. “It’s terrible.”

In part, Mr. Paulson’s credibility has been dented by his pronouncements in previous weeks that the
crisis was already contained. Some suggest this was a well-intentioned effort to stem panic. But the
aftermath complicates his quest for the bailout.

“If you view your public statements as an instrument of policy, people don’t believe you anymore,”
said Vincent R. Reinhart, a former Federal Reserve economist and now a scholar at the
conservative American Enterprise Institute.

The biggest point of contention is over whether and how taxpayers would benefit if the bailout
succeeded in righting the financial system, sending banking stocks upward.

In Mr. Paulson’s plan, the Treasury would have the right to buy as much as $700 billion worth of
troubled investments, with the taxpayer recouping the proceeds when those investments were sold
over coming years. But many economists — Mr. Elmendorf among them — argue that taxpayers
should get more out of the deal, securing stock in the banks that make use of the bailout. The
government could then sell off that stock at a profit when conditions improve. A similar approach
was used successfully in Sweden in the early 1990s when its financial system melted down.

Others argue that any bailout must pinch the people who have run the companies now needing
rescue, along with their shareholders, addressing the unseemly reality that executives have
amassed beach houses and fat bank accounts while taxpayers are now stuck with the bill for their
reckless ways.

“It absolutely has to be punitive,” Mr. Baker said. “If they sell us the junk, then we own the company.
This isn’t a way to make these companies and their executives rich. This should be about keeping
them in business so the financial system doesn’t collapse.”

Other questions center on how to value what the Treasury aims to purchase — an issue that goes
to the heart of the crisis itself.

The financial system got to its dangerous perch by betting extravagantly on real estate. When
housing prices began plummeting and borrowers stopped making payments, financial institutions
found themselves with huge inventories of bad loans. Not simple loans, but complex investments
created by pooling millions of mortgages together and then slicing them into pieces. These were the
investments that Wall Street bought, sold and borrowed against in cooking up the money it poured
into housing.

The trouble is that these investments are so intertwined and complex that no one seems able to
figure out what they are worth. So no one has been willing to buy them. This is why banks have
been in lockdown mode: with mystery enshrouding both the value of their assets and their future
losses, banks have held tight to their remaining dollars, depriving the economy of capital.

Now, the Treasury aims to clear the fog by buying up these investments. But their value is as
mysterious as ever.

“There’s a tendency for people to think these are stocks and bonds and you know what the price is,”
said Bruce Bartlett, a former White House economist under President Reagan. “The problem is
people are operating in a world in which nobody knows what the hell is going on. There’s some
naïve assumptions about how this would function.”
If Mr. Paulson pays the market rate — whatever that is — that presumably would not be enough to
persuade banks to sell. Otherwise, they would have sold already. For the plan to work, Treasury
has to pay a premium.

“It’s a straight subsidy to financial institutions,” said Martin Baily, a former chairman of the Council of
Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings
Institution. “You’re essentially giving them money.”

Mr. Baily favors the basics of the Paulson plan, albeit with some mechanism that would give the
government a slice of any resulting profits. And yet he remains troubled by the dearth of information
combined with the abundance of zeroes in the bailout request.

“I’d like a clearer statement of what we were afraid was going to happen that requires $700 billion,”
Mr. Baily said. “Maybe they don’t want to talk about it because it would scare everybody, but it’s a
bit much to ask.”

A Fine Mess
By WILLIAM KRISTOL
Published: September 21, 2008

A friend serving in the Bush administration called Sunday to try to talk me out of my doubts about
the $700 billion financial bailout the administration was asking Congress to approve. I picked up the
phone, and made the mistake of good-naturedly remarking, in my best imitation of Oliver Hardy,
“Well, this is a fine mess you’ve gotten us into.”

People who’ve been working 18-hour days trying to avert a meltdown are entitled to bristle at
jocular comments from those of us not in public office. So he bristled. He then tried to persuade me
that the only responsible course of action was to support the administration’s request.

I’m not convinced.

It’s not that I don’t believe the situation is dire. It’s not that I want to insist on some sort of
ideological purity or free-market fastidiousness. I will stipulate that this is an emergency, and is a
time for pragmatic problem-solving, perhaps even for violating some cherished economic or political
principles. (What are cherished principles for but to be violated in emergencies?)

And I acknowledge that there are serious people who think the situation too urgent and the day too
late to allow for a real public and Congressional debate on what should be done. But — based on
conversations with economists, Wall Street types, businessmen and public officials — I’m doubtful
that the only thing standing between us and a financial panic is for Congress to sign this week, on
behalf of the American taxpayer, a $700 billion check over to the Treasury.

A huge speculative housing bubble has collapsed. We’re going to have a recession. Unemployment
will go up. Credit is going to be tighter. The challenge is to contain the damage to a “normal”
recession — and to prevent a devastating series of bank runs, a collapse of the credit markets and
a full-bore depression.

Everyone seems to agree on the need for a big and comprehensive plan, and that the markets have
to have some confidence that help is on the way. Funds need to be supplied, trading markets need
to be stabilized, solvent institutions needs to be protected, and insolvent institutions need to be put
on the path to a deliberate liquidation or reorganization.

But is the administration’s proposal the right way to do this? It would enable the Treasury, without
Congressionally approved guidelines as to pricing or procedure, to purchase hundreds of billions of
dollars of financial assets, and hire private firms to manage and sell them, presumably at their
discretion There are no provisions for — or even promises of — disclosure, accountability or
transparency. Surely Congress can at least ask some hard questions about such an open-ended
commitment.

And I’ve been shocked by the number of (mostly conservative) experts I’ve spoken with who aren’t
at all confident that the Bush administration has even the basics right — or who think that the plan,
though it looks simple on paper, will prove to be a nightmare in practice.

But will political leaders dare oppose it? Barack Obama called Sunday for more accountability, and I
imagine he’ll support the efforts of the Democratic Congressional leadership to try to add to the
legislation a host of liberal spending provisions. He probably won’t want to run the risk of actually
opposing it, or even of raising big questions and causing significant delay — lest he be attacked for
risking the possible meltdown of the global financial system.

What about John McCain? He could play it safe, going along with whatever the Bush administration
and the Congress are able to negotiate.

If he wants to be critical, but concludes that Congress has to pass something quickly lest the
markets fall apart again, and that he can’t reasonably insist that Congress come up with something
fundamentally better, he could propose various amendments insisting on much more accountability
and transparency in how Treasury handles this amazing grant of power.

Comments by McCain on Sunday suggest he might propose an amendment along the lines of one I
received in an e-mail message from a fellow semi-populist conservative: “Any institution selling
securities under this legislation to the Treasury Department shall not be allowed to compensate any
officer or employee with a higher salary next year than that paid the president of the United States.”
This would punish overpaid Wall Streeters and, more important, limit participation in the bailout to
institutions really in trouble.

Or McCain — more of a gambler than Obama — could take a big risk. While assuring the public
and the financial markets that his administration will act forcefully and swiftly to deal with the crisis,
he could decide that he must oppose the bailout as the panicked product of a discredited
administration, an irresponsible Congress, and a feckless financial establishment, all of which got
us into this fine mess.

Critics would charge that in opposing the bailout, in standing against an apparent bipartisan
consensus, McCain was being irresponsible.

Or would this be an act of responsibility and courage?

How the Fannie and Freddie Created the Financial Crisis: Kevin Hassett

The financial crisis of the past year has provided a number of surprising twists and turns, and from
Bear Stearns Cos. to American International Group Inc., ambiguity has been a big part of the story.

Why did Bear Stearns fail, and how does that relate to AIG? It all seems so complex.

But really, it isn't. Enough cards on this table have been turned over that the story is now clear. The
economic history books will describe this episode in simple and understandable terms: Fannie Mae
and Freddie Mac exploded, and many bystanders were injured in the blast, some fatally.

Fannie and Freddie did this by becoming a key enabler of the mortgage crisis. They fueled Wall
Street's efforts to securitize subprime loans by becoming the primary customer of all AAA-rated
subprime-mortgage pools. In addition, they held an enormous portfolio of these toxic mortgages
themselves.
In the times that Fannie and Freddie couldn't make the market, they became the market. Over the
years, it added up to an enormous obligation. As of last June, Fannie alone owned or guaranteed
more than $388 billion in high-risk mortgage investments. Their large presence created an
environment within which even mortgage-backed securities assembled by others could find a ready
home.

The problem was that the trillions of dollars in play were only low-risk investments if real estate
prices continued to rise. Once they began to fall, the entire house of cards came down with them.

Turning Point

Take away Fannie and Freddie, or regulate them more wisely, and it's hard to imagine how these
highly liquid markets would ever have emerged. This whole mess would never have happened.

It is easy to identify the historical turning point that marked the beginning of the end.

Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They
were enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late
2004, the chief accountant of the SEC told disgraced Fannie Mae chief Franklin Raines that Fannie's
position on the relevant accounting issue was not even ``on the page'' of allowable interpretations.

Then legislative momentum emerged for an attempt to create a ``world-class regulator'' that would
oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks.
Politicians who previously had associated themselves proudly with the two accounting miscreants
were less eager to be associated with them. The time was ripe.

Greenspan's Warning

The clear gravity of the situation pushed the legislation forward. Some might say the current mess
couldn't be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the
clearest possible terms: If Fannie and Freddie ``continue to grow, continue to have the low capital
that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do
for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the
road,'' he said. ``We are placing the total financial system of the future at a substantial risk.''

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie
reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack
down, and would have required the companies to eliminate their investments in risky assets.

Different World

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a
blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of
our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and
buying up excess supply, this Ponzi scheme of a ‘market’ would likely have not existed.

But the bill didn't become law, for a simple reason: It died in committee due to partisan politics and
an unbridled lobbying effort on behalf of the two institutions. It was rightly observed at the time that
this: ``Is a classic case of socializing the risk while privatizing the profit.''

Mounds of Materials
Now that the collapse has occurred, the roadblock built by the incompetent politicians who once
again succumbed to the influence of industry lobbyists is unforgivable. Many who opposed the bill
doubtlessly did so for honorable reasons. Fannie and Freddie provided mounds of materials
defending their practices. Perhaps some found their propaganda convincing.

(This article cut off here as it deteriorated into a ‘blame game’ piece trying to pin it all on the
Democrats who supposedly were the only ones who accepted lobbyists’ money to stop
legislation against Fannie & Freddie))

Op-ed in the Financial Times September 24, 2008

The Price of Salvation

The government plans to bail out the banking sector by buying up to $700bn (for now) of
"impaired assets" … but at what price? Pay too little, and the banks will not have sufficient
capital to remain solvent; pay too much, and the wealth of the American taxpayer will be
unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury
secretary, said the government would pay "fair market value", which, many pointed out,
would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the
current market with a "fire sale" and proposed paying "hold–to–maturity" prices. But what
does this mean?

There are five different prices that the government theoretically might pay for a mortgage-
backed security (MBS):

P1. The par value of the security (largely irrelevant at this point).

P2. The current book value on the holder's balance sheet: because of the accounting rules
for banks, and because banks today have a strong incentive to overvalue these assets,
these book values may be artificially high.

P3. Fair market value (FMV) in a market free of government intervention: Until September
17, this was set by actual transactions between buyers and sellers, such as Merrill Lynch's
sale in July at 22 cents on the dollar. However, for most securities it was impossible to
determine the FMV, because there were few comparable transactions.

P4. FMV with government intervention: Since the bailout was announced, the prices of
MBS have drifted upward, on the assumption that the government has an incentive to pay
artificially high prices (the point of the bailout being to pay prices high enough to ensure
banks' solvency).

P5. Model value: The people who buy MBS on behalf of the government will use their own
models of long–term cash flows to estimate their value.

The banks would like to get P2, since that would leave their capital levels where they are,
but this amounts to paying whatever price the banks have decided their assets are worth,
which is obviously foolish.

An ordinary fund manager would pay P3, but if that were the entire transaction, it would
defeat the purpose of the bailout; banks could sell at P3 today, but cannot absorb the
collateral damage to their balance sheets. As Bernanke acknowledged in Tuesday's
Congressional testimony, the plan is to pay more than current market prices, which is
another way of saying that Treasury will be overpaying to save the banks.

Bernanke's comments can be interpreted in two ways. He could be saying the

government's liquidity and capacity to bear risk will create a new market equilibrium, and
that Treasury will pay the new market price (P4). Alternatively, his "hold–to–maturity" price
could be the output of a long–term cash flow model (P5). The two are not necessarily
exclusive.

But either possibility raises problems. First, the valuation models that produce hold–to–
maturity prices are highly sensitive to their assumptions, and can be used to justify virtually
any price, removing any constraints on overpayment. Second, in either case it will be
impossible to determine P3, the price absent government intervention, and hence the real
amount of overpayment – making it impossible to know how much wealth has been
transferred from taxpayers to banks. Third, what if neither P4 nor P5 is high enough to
ensure bank solvency? In that case the bailout would fail to accomplish its most important
task: to recapitalize the banks.

But there is another solution. Given the need to (a) take these "toxic" assets off the hands
of the banks and (b) make sure that they get more money than they would get on the open
market, the answer is to separate the two parts of the transaction. In the first step, Treasury
would pay FMV for the securities; in the second step, after assessing the bank's resulting
condition, Treasury would do a capital injection by buying newly issued preferred shares.

In order to determine FMV in the first step for a given tranche of securities, a portion of the
debt could be auctioned to the private sector. Any debt bought by the private sector will
have no further recourse to the government, i.e., it is "bailout free". Properly designed, this
auction will indicate P3, the fair market value in a free market. The government would then
acquire the securities not bought by the private sector, at the price established in the
auction. With their MBS gone, it will be easier to assess banks' solvency and determine the
appropriate terms for a government recapitalization.

By explicitly identifying the FMV of the assets and distinguishing the asset purchase from
the capital injection, this mechanism provides transparency to the operations of the
proposed fund and limits the risk of overpayment. More fundamentally, it provides the
much–needed assurance that the overall plan is fair to the American taxpayer and not
simply a handout to the banking sector.

OFF THE CHARTS

Out of the Shadows and Into the Harsh Light
By FLOYD NORRIS
September 27, 2008
THE credit default swaps market — a market that for years was kept out of view and away from any
regulation — has suddenly turned into a political hot potato in Washington.
The chairman of the Securities and Exchange Commission said this week that regulation was
needed immediately, while the secretary of the Treasury said efforts were already under way to get
things under control, and urged caution.
Such swaps, which enable lenders to a company to purchase what amounts to insurance that will
protect them if the company defaults on its debts, have grown exponentially in recent years, with
the nominal amount of debt guaranteed rising to more than $62 trillion at the end of last year from
$631 billion in mid-2001.
The sudden interest in the market stems from two separate but related developments. The collapse
of a major firm in the market could set off a chain of problems, a fact that has scared the Treasury
Department this year.
In addition, speculators who think a financial firm will fail can buy credit-default swaps. They will
profit if they are right. But even if the firm is not in trouble, an increase in the price of those swaps
may scare other investors, and send the company’s stock down. That prospect has alarmed the
S.E.C. As the political debate was growing, the International Swaps and Derivatives Association, a
trade group, reported that the amount of outstanding credit-default swaps declined in the first half of
2008, something that had never happened before.
The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of
debt that can be insured. The huge total reflects the way the market is structured, as well as the fact
that someone does not need to actually be owed money by a company to be able to buy a credit-
default swap. In that case, the buyer is betting that the company will go broke.
Within that huge market, many contracts offset one another — assuming that all parties honor their
commitments. But if one major firm goes broke, the effect could snowball as others are unable to
meet their commitments.
In regulated futures markets, contracts are centrally cleared. If you buy an oil futures contract on
Monday, and sell it on Wednesday, you have made your profit (or taken your loss) and you no
longer have any stake in whether oil prices rise or fall. But if you buy a credit-default swap on
Monday from one firm, and sell an identical swap on Wednesday to another firm, you still face the
potential of risk if the party that sold the swap to you is unable to pay when a default occurs,
perhaps years later.
“One of the major reasons that the government helped out in the Bear Stearns situation,” Treasury
Secretary Henry M. Paulson Jr. testified at a Senate hearing this week, “was to avoid throwing it
into bankruptcy with all the credit-default swaps.”
Mr. Paulson said the Federal Reserve Bank of New York was working to develop protocols for that
market to deal with a failure of a big player, and indicated that he did not see a need for legislation.
But Christopher Cox, the S.E.C. chairman, said Congress should act. “Neither the S.E.C. nor any
regulator has authority over the C.D.S. market, even to require minimum disclosure to the market,”
he testified. “The market is ripe for fraud and manipulation,” he added.
The S.E.C. is investigating possible fraud, although no charges have been brought, and is looking
for cases where someone may have purchased credit-default swaps to drive up their price and
persuade others that a company was in trouble.
The swaps market has been exempt from regulation since it began to grow, thanks to legislation the
industry sought. The industry argued that regulation would drive business overseas, and that no
regulation was needed because ordinary investors did not trade in the market.
In announcing the decline in the amount of swaps outstanding, Robert Pickel, the chief executive of
the trade group, said it reflected industry efforts “to reduce risk by tearing up economically offsetting
transactions, and demonstrates the industry’s ongoing commitment to reduce risk and enhance
operational efficiency.”
The accompanying charts show the growth of the amount of credit-default swaps outstanding, and
show how those totals compare with the total amount of outstanding loans from banks and others to
corporations and foreign governments. Even with the decline, the swaps volume is more than three
times the debt total.

Cash for Trash (excellent commentary)

By PAUL KRUGMAN

Some skeptics are calling Henry Paulson’s $700 billion rescue plan for the U.S. financial system
“cash for trash.” Others are calling the proposed legislation the Authorization for Use of Financial
Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush
administration the green light to invade Iraq.

There’s justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson
is demanding extraordinary power for himself — and for his successor — to deploy taxpayers’
money on behalf of a plan that, as far as I can see, doesn’t make sense.

Some are saying that we should simply trust Mr. Paulson, because he’s a smart guy who knows
what he’s doing. But that’s only half true: he is a smart guy, but what, exactly, in the experience of
the past year and a half — a period during which Mr. Paulson repeatedly declared the financial
crisis “contained,” and then offered a series of unsuccessful fixes — justifies the belief that he
knows what he’s doing? He’s making it up as he goes along, just like the rest of us.

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn
has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately
comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets
compared with their debt. This problem is especially severe because everyone took on so much
debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or
willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those
mortgage-backed securities, but this drives asset prices down and makes their financial position
even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets,
mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description.
Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are
under pressure. And even if the vicious circle is limited, the financial system will still be crippled by
inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays
for the assets it buys, giving financial firms — and their stockholders and executives — a giant
windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial
system needs more capital. And if the government is going to provide capital to financial firms, it
should get what people who provide capital are entitled to — a share in ownership, so that all the
gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad
banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way,
that rescue has done what it was supposed to. Mortgage interest rates have come down sharply
since the federal takeover.)

But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-
financed bailout with no strings attached — no quid pro quo on the part of those being bailed out.
Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial
authority, plus immunity from review “by any court of law or any administrative agency,” and this
adds up to an unacceptable proposal.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few
days, with at most a few modifications that make it slightly less bad. Basically, after having spent a
year and a half telling everyone that things were under control, the Bush administration says that
the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the
structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be
railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the
not-too-distant future.

Can the U.S. learn any lessons from Sweden's banking bailout?
Monday, September 22, 2008

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs.
A market-oriented government struggling to stem the panic. Sound familiar?

It does to Sweden, which was so far in the hole in 1992 - after years of imprudent regulation,
shortsighted macroeconomic policy and the end of its property boom - that its banking system was,
for all practical purposes, insolvent.

But unlike the United States, whose Treasury has made a proposal to deal with a similar situation;
Sweden did not just bail out its financial institutions by having the government take over the bad
debts. It also clawed its way back by pugnaciously extracting equity from bank shareholders before
the state started writing checks.

That strategy kept banks on the hook while returning profits to taxpayers from the sale of distressed
assets by granting warrants that turned the government into an owner. Even the chairman of
Sweden's largest bank got a stern answer to the question of whether the state would really
nationalize his bank: Yes, we will.

"If I go into a bank," Bo Lundgren, Sweden's finance minister at the time, said, "I'd rather get equity
so that there is some upside for the taxpayer."

The tumultuous events of the last few weeks have produced a lot of tight-lipped nods in Stockholm.
And for all the differences between Sweden and the United States, Swedish officials say there are
lessons to be learned from their own nightmare that Washington may be missing. Lundgren even
made the rounds in New York in early September, explaining what the country did in the early
1990s.

A few American commentators have proposed that the U.S. government extract equity from banks
as a price for the bailout they are likely to receive, as Sweden did. But it does not seem to be under
serious consideration yet in the Bush administration or in Congress.

That's despite the fact that the U.S. government has already swapped its sovereign guarantee for
equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and American
International Group, the insurance giant.

Putting taxpayers on the hook without offering anything in return could be a mistake, said Urban
Backstrom, a senior Swedish Finance Ministry official at the time. "The public will not support a
plan," he said, "if you leave the former shareholders with anything."

The Swedish crisis had strikingly similar origins to the American one. Norway and Finland went
through related experiences, and they also turned to a government bailout to escape the morass
that bad policy had created.

Financial deregulation in the 1980s fed a frenzy of real estate lending by Swedish banks, which
spent too little time worrying whether the value of collateral might evaporate in tougher times.
Property prices exploded.
The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden's currency, the krona,
resulted in an incredible spike in overnight interest rates at one point to 500 percent. The Swedish
economy contracted for two years straight after a long expansion, and unemployment, at 3 percent
in 1990, quadrupled in three years.

After a series of bank failures led to ad hoc solutions, the moment of truth arrived in September
1992, when the government of Prime Minister Carl Bildt opted for a clear-the-decks solution.

With the full support of the opposition center-left, Bildt's conservative government announced that
the Swedish state would guarantee all bank deposits and creditors of the nation's 114 banks.
Sweden formed an agency to supervise institutions that needed recapitalization, and another that
sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for
recapitalization. In a similar situation later in the decade, Japan made the mistake of dragging the
process out, officials in Sweden and elsewhere note, delaying a solution for years.

Then came the imperative to bleed shareholders first.

Lundgren, the former finance minister, recalls a conversation with Peter Wallenberg, at the time
chairman of SEB, Sweden's largest bank. Wallenberg, the scion of the country's most famous family
and steward of large chunks of its economy, heard from the finance minister that there would be no
sacred cows.

The Wallenbergs turned around and arranged a private recapitalization, obviating the need for a
bailout at all. SEB turned a profit the next year, 1993.

"For every krona we put into the bank, we wanted the same influence," Lundgren said. "That
ensured that we did not have to go into certain banks at all."

By the end of the crisis, the Swedish government had seized vast swaths of the banking sector, and
the agency had mostly fulfilled its tough mandate to drain share capital before injecting cash. When
markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

Indeed, more money may come into official coffers. The government still owns 19.9 percent of
Nordea, a Stockholm bank that was fully nationalized and is now a highly regarded giant in
Scandinavia and the Baltic Sea region.

The politics of Sweden's crisis management were similarly tough-minded, though much quieter.

Soon after the plan was announced, the Swedish government found that international confidence
returned more quickly than expected, easing pressure on its currency and bringing money back into
the country. A serious credit crunch was avoided. So the center-left opposition, though wary that the
government might yet let the banks off the hook, made its points about penalizing shareholders
privately.

"The only thing that held back an avalanche was the hope that the system was holding," said Leif
Pagrotzky, a senior member of the opposition at the time. "In public we stuck together 100 percent
but we fought behind the scenes."

Sweden eventually shelled out 4 percent of its gross domestic product, 65 billion krona, or $10
billion, to rescue ailing banks. That is slightly less, in terms of the national economy, than the
minimum of $700 billion, or about 5 percent of GDP, that the Bush administration estimates a
similar move would cost in the United States.
But enough was recouped through sales of distressed assets and bank shares that were sold later,
that the cost ended up being less than 2 percent of GDP. Some officials believe it was closer to
zero, depending on how certain rates of return are calculated.

Looking back, Swedish official say the tough approach toward the banks paved the way for
success. It eliminated "moral hazard," the problem of relieving investors of bad decisions. And,
much as it might be a shock in the United States, the demise of shareholders also underpinned the
political consensus that help restore stability to financial markets even before the bailout was truly
under way.

While government ownership of banks goes against the American grain, Lundgren worries that if
the U.S. bailout rests on a thin reed, politically speaking, then it could fail.

The U.S. Treasury is now planning to purchase the distressed assets outright, without demanding
equity. If it wants to restore the banking system's creditworthiness, it would have to err on the side
of paying too much money to the banks that caused the crisis, Lundgren said.

"If the valuation is bad, from the taxpayer's point of view, you lose," he said. "And that decreases
the legitimacy of the plan."

Improving Paulson's Cure

September 23, 2008

Liberal Democrats are in agony over bailing out Wall Street. Conservative Republicans are in agony
over massive government intervention in what they like to call the free market. Yet neither side
wants to be blamed if the financial system implodes.

It gets more complicated: An administration whose critics believe it abused the power it grabbed
during a different kind of national emergency, after the Sept. 11 attacks, is asking for unprecedented
authority over the financial system. Yet the man leading the charge this time, Treasury Secretary
Henry Paulson, is one of the few administration officials trusted by Democrats.

All this is happening suddenly, and just six weeks before Election Day. Both presidential candidates
are wary of getting on the wrong side of the public's justified populist fury or its desire for prudence
in the face of potential catastrophe.

The broad outcome is already in view: Unless something very strange happens, Congress will pass a
massive bailout of the financial system by week's end simply because every other option is worse.

Rep. Barney Frank, a Democrat who chairs the House Financial Services Committee, captured the
prevailing mood in an interview Sunday night during a break in the negotiations. "What's the
alternative?" he asked.

But the content of the bailout package matters enormously. To get what it needs, the administration
will have to give taxpayers more protection and more accountability.

One core doubt about this bailout is whether taxpayers will be left holding a bag of dreadful
investments that reckless financial mavens get to unload without having to part with their houses in
the Hamptons. This isn't just rhetorical populism: There is a moral problem for capitalism itself if
taxpayers take on a burden created by the foolishness of the privileged and get little compensation in
return.
A related problem is how much new spending should be piled onto a federal budget that is already in
the red.

Yes, a bailout is necessary, but several steps could limit the risks. Sen. Jack Reed (D-R.I.) has
proposed granting the federal government warrants to acquire stock in financial firms that profit
from the bailout. This way, taxpayers would share in the gain if the industry recovered -- which, of
course, is the whole point of this exercise.

Socialism, you say? We're already into that. The administration's plan amounts to socialism for the
rich only. And as Reed explained in an interview, his proposal is actually more in keeping with
capitalism than a pure bailout. "If taxpayers take risks, they should be able to reap some of the
rewards," he said. Frank is trying to get this provision into the final bill.

Moreover, as Reed notes, giving the government an option to have a share in companies if they
succeed will protect taxpayers if the feds pay too much for a company's bad debt. If a company
prospers because it receives more than what turns out to be a reasonable market price for its debt --
and the debt we're talking about will be very hard to price -- taxpayers get at least some of the money
back when the company's stock goes up.

The bottom line should be: no potential upside for the taxpayers, no bailout.

Another question: Why bail out Wall Street and not help those who are losing their homes in the
subprime mortgage fiasco? Frank believes that if the government comes to hold bad mortgages
under the bailout plan, it will be able to halt foreclosures. Sen. Charles Schumer (D-N.Y.) wants to
give bankruptcy courts the power to change mortgage provisions to keep people in their homes.

Almost everyone in both parties, including Barack Obama and John McCain, agrees that the final
bailout bill should place real checks on the power of the Treasury secretary. Such accountability
provisions were a key element in a proposal offered yesterday by Senate Banking Committee
Chairman Chris Dodd (D-Conn.). Even if Paulson proves to be a sainted and savvy steward, what
about the next secretary?

And if Congress can appropriate $700 billion for Wall Street, where is the help for everyone else
hurting in this economy? Isn't it strange that an administration that could not come up with a
comparatively modest sum to increase the number of children with health insurance could suddenly
find all this cash for the financial industry?

Sadly, this bailout is inevitable. But it should be done right. Congress shouldn't be bullied into
passing a flawed plan that will leave the next president in an even deeper hole.

A Lesson the Markets Ignored

By Richard Cohen
September 23, 2008;

Of all the self-proclaimed experts I wanted to hear from about the financial crisis, the one I looked
forward to the most was Nick Leeson, late of Britain's Barings Bank. In 1995, he bet hugely on
Nikkei futures (whatever they are) and lost something like $1.4 billion. Leeson was 28 years old and
often drunk, Barings was 233 years old and in fiduciary senility. Leeson went to prison, Barings
went bust and Wall Street, without so much as a pause, went on its merry way.
Sadly, Leeson did not have much to say about the current financial crisis. Writing last week in the
Guardian, he instead expressed bitterness that the former owners of Barings went on with their lives
while he spent 4 1/2 years in prison. What he did not say, to the regret of us all, is how once again
the kids were allowed to play with huge amounts of money without any adult supervision.

"I was astonished that nobody stopped me," he wrote in his book "Rogue Trader." "People in
London should have known." Indeed.

The theme in the current financial crisis is not, as John McCain would have it, greed, since that, like
lust, will be with us forever. Instead, it is transparency. Leeson, you may recall, was dealing from
Singapore in exotic derivatives that his bosses in London little understood. All they knew was that
Leeson was putting huge profits on the books, not that those books had anything to do with reality.

Somewhat the same thing happened on Wall Street. The complicated, exotic and downright erotic
financial instruments cooked up at the investment houses were, in fact, little understood not only by
the buyers but also by the sellers. You can see that from what they said and from what they did:
Lehman Brothers, Bear Stearns, AIG and others all held on to financial instruments that were worth
less than they once thought. This was truly a case of the blind leading the blind.

"The problem is that nobody knows what any institution owns and what the terms of the securities
they own are and what they're worth," New York Mayor Michael Bloomberg said Sunday on "Meet
the Press." He's saying what others on the Street having been saying for some time: Nobody knows
what these things -- securitized mortgages, etc. -- are worth. And, just to darken the mystery (and
maybe your mood), no one knows the value of the underlying real estate, either.

I started with Leeson for a reason. He is the personification of a generational gap in the finance
industry. He was young and computer-savvy, and his bosses in London were neither. That was true
on Wall Street, too. The very top guys really had little idea of what was going on below. Everything
was going right. They were making lots of money, which they deserved -- in their wonderful circular
reasoning -- because they were making it. This, I tell you, is the true magic of the vaunted market: It
justifies both stupidity and greed.

Now the government is proposing another pig in a poke. The huge federal bailout is necessary, but
Democrats are right to insist on detail and oversight. For too long, the financial markets have
operated without much of either. Now the Bush administration is asking Congress for a blank check,
what New Jersey Gov. Jon Corzine calls the "moral equivalent" of the congressional resolution that
wound up authorizing the Iraq war. Corzine, a former Goldman Sachs chairman (not to mention U.S.
senator), is a voice worth heeding nowadays. When I talked to him, he had just gotten hold of the
two-page administration program. Two pages! This is another exotic financial instrument.

The wise words of William Goldman, the screenwriter, should echo in Congress's ears. He not only
coined the phrase "follow the money" for "All the President's Men," but he expressed the sum total
of knowledge about the making of movies with: "Nobody knows anything." The same has been true
about opaque financial instruments. It's up to Congress to fix that.

The lesson of Leeson has yet to be learned. Financial markets have moved well beyond the trading
of things that could be seen or measured or weighed. On Wall Street, older men employed the lingo
of younger men to pretend they knew what was happening -- but they didn't. Now, Congress is being
asked to do something similar. That won't do. Bear down. Ask questions. Don't be afraid to regulate.
Act as if you're the government, for crying out loud. Because if you don't do this right, you soon
won't be.
 Countdown to a Meltdown
Congress has to act quickly but carefully to get financial rescue legislation right.

September 23, 2008

LAST THURSDAY, the top economic policymakers in the United States told congressional leaders
that the financial system was only days away from a catastrophic failure -- and that the only hope
was an immediate, massive government bailout. Congress agreed in principle, buoying financial
markets. But five days later, the specifics of the rescue legislation remain undecided. Two of
yesterday's market events -- a 372-point drop in the Dow Jones industrial average and a $16-per-
barrel jump in the price of oil -- show just how rapidly the clock is ticking.

Congress and the Bush administration generally agree that the government should buy up the toxic
mortgage-backed securities that are spreading losses and destroying the confidence essential for
debtors and creditors to function. This taxpayer-funded bailout is not necessarily the only
conceivable approach or even the most efficient one. Quite possibly, it would have been wiser
instead to inject government capital directly into banks so they would be better able to work out
problem assets on their own. But for better or worse, that option is off the table, and the question is
how Uncle Sam can most effectively take on as much as $700 billion worth of bad debt. The basic
tradeoff here is between speed and flexibility on one hand and oversight and accountability on the
other.

Treasury Secretary Henry M. Paulson Jr. clearly believes that the way to get the maximum number
of financial institutions to unload as much distressed paper as possible, as quickly as possible, is to
keep it simple: announce that the U.S. Treasury is open for business and let the fire sale begin. That
is essentially what he advocated when he asked Congress for the power to purchase troubled
mortgage-backed assets from financial institutions at whatever price he and hired experts saw fit,
with only minimal congressional supervision and complete immunity from lawsuits.

The problem, of course, is that this raises the risk that the government will get fleeced by the debt-
sellers, raising the ultimate cost to taxpayers. It was also politically unrealistic, in that members of
Congress were quite properly concerned that financial institutions accept limits on executive
compensation in return for their federal lifeline. There was no provision in Mr. Paulson's proposal
for taxpayers to enjoy any of the profits that financial institutions may enjoy once they have been
restored to health.

A new proposal by Senate Democrats seeks to correct this by requiring would-be asset-dumpers to
give the government equity if Uncle Sam winds up having to sell the paper at a loss. Of course, at
the margin, the proposal could deter some firms from ridding themselves of the bad loans in the first
place. And that would slow the process. Democrats are also insisting on various forms of mortgage
relief for the homeowners who are about to find themselves in debt to Uncle Sam. Mortgage relief
might help stabilize home prices, but since the government would now own so many mortgages,
taxpayers (most of whose mortgages are not in trouble) would have to foot the bill once again.

A little delay was both inevitable and desirable. Congress cannot write a $700 billion check with no
questions asked. But speed and focus are still of the essence, and leaders in both parties must not use
this crisis as an opportunity to refight all the political battles of the past year. They should treat it as
what it is: a chance, possibly the last chance, to keep the U.S. financial system from collapsing.
 Bailout's Tricky Balancing Act: How Much Is Too Much?
Architects of Government Plan Face Dilemma in Deciding How to Price .
Wall Street's Shaky Mortgage-Related Assets

Tuesday, September 23, 2008; A08

As the government weighs how to bail out the financial sector, the plan's engineers face a dilemma.

The higher the prices the government pays for troubled mortgage securities held by banks, the more
the rescue will bolster those banks and sustain the lending that is vital to the broader economy. But
higher prices would also mean a worse deal for taxpayers.

In other words, the more effective the plan, the more expensive it will ultimately be.

Under both the Bush administration's proposal and many of the variations finding favor among
Democrats, the government would buy up to $700 billion in shaky assets now on the books of
financial companies. As the government does so, it will be forced to grapple with the same question
that has vexed the brightest minds on Wall Street for more than a year: What are the darn things
worth?

The very reason for the financial crisis of the past 14 months is that no one knows for sure. Wall
Street created securities so complex that their value can swing wildly depending on what happens to
the overall housing market. For example, a particular type of mortgage-backed security might offer a
giant payout if home prices drop 10 percent but be worthless if they drop another 15 percent.

The outlook for the broader economy and housing market is so uncertain that investors have been
unwilling to buy these exotic securities at any price. With these impossible-to-value investments
clogging their books, banks haven't been able to make loans to people and businesses, a major
reason for the nation's economic distress.

If the government buys the assets at relatively high prices, this would fortify the banks and help
lending return to normal. Even banks that do not sell their securities to the government could be
forced under accounting rules to assign the government sale price to assets on their books, giving
them some clarity about their financial outlook.

"Psychologically, it's very, very important," said Thomas A. Renyi, former chairman of Bank of
New York Mellon, referring to the price the government pays. "It provides the underpinning beneath
what is a very, very uncertain market. It provides a stable environment for the proper valuation of
assets in the marketplace."

If the government pays relatively low prices, it would protect taxpayers more, even giving them the
potential of profiting on the deal when the Treasury ultimately sells them in the future.

But if the government sets prices below those that banks have placed on their own holdings, these
financial firms could be forced to take the difference as a loss. Indeed, the prices could be set by the
banks most desperate to sell, artificially depressing the value of similar assets on the books of
healthy banks. As a result, some of those banks may become less healthy, requiring them to raise
more money to cover their expected losses.
"What it could show is the depressing news that even greater infusions of capital are needed across
the banking system than previously thought," CreditSights analysts wrote in a note to clients
yesterday.

The plan also could hurt banks that have set relatively high values for their holdings. Until now,
there has been no way to prove those banks have inaccurately priced their assets. But the
government plan could force a massive repricing. In a research note to clients yesterday, a Merrill
Lynch analyst warned that regional banks were particularly vulnerable because many of them have
been slower than large banks to write down the values of mortgage loans on their books.

Under the current proposal, private companies will be hired as asset managers to help figure out
which assets to buy, how to buy them and ultimately when to sell them off.

The Treasury Department has provided only broad outlines of how it intends to set prices, saying in
a fact sheet that it will use "market mechanisms where possible, such as reverse auctions." In a
reverse auction, the government could agree to purchase a specific amount of assets and buy those
that are offered at the lowest price.

But that may be harder than it sounds, economists said.

The problem is that there are thousands of kinds of mortgage-related securities. If the Treasury just
opens the door for banks to sell those securities to the government, firms will offer up the very worst
ones, possibly leading to huge losses for taxpayers. But if the government specifies exactly which
securities it will accept, the Treasury secretary will have unusually broad authority to decide which
banks get bailed out and which don't.

Imagine that the market for used cars had fallen apart and the government decided to restore order
by buying up thousands of vehicles. If the winning price in a reverse auction was $3,000, owners of
lower-priced Ford Pintos would trade their cars in to the government, while owners of higher-priced
BMWs would hold on to theirs. When the government went to sell the Pintos, it could not recoup its
investment and would lose money.

In an alternate scenario, the government could have separate auctions for Pintos and BMWs. But in
choosing how many of each to buy, the government would be deciding which kinds of car owners to
bail out and which to let suffer.

"Which assets do you buy and how much of each?" asked Douglas Elmendorf, a senior fellow at the
Brookings Institution. "That determines who you end up helping. If it's at the discretion of
investment managers, I assume we'll hire good smart ones, but that discretion when applied to $700
billion seems like a lot of discretion, and has a lot of potential for unfair outcomes and abuse."

Elmendorf suggests that a way around that problem would be for the government to make
investments in financial companies, proportional to the firms' market value. That way, the
companies would have extra cash and then could sell the troubled assets on private markets for a loss
while continuing to make loans and operate normally.

That approach could have its own drawbacks, though, including making the government a major
shareholder of large financial companies, which to some critics smacks of socialism.

The very structure of the auctions will go a long way to determining the outcome. The people who
design how the auction works can set the rules such that almost any outcome is likely.
"Just because it's called a reverse auction doesn't mean it results in lower prices automatically," said
Bob Emiliani, a Central Connecticut State University professor who studies reverse auctions. He
said that in some cases, reverse auctions are set up so the buyer accepts the highest price submitted
by any of the sellers and then pays that price across the board -- even to sellers who were willing to
accept lower prices.

A Bailout or a Bonanza?

Tuesday, September
23, 2008

The uber-capitalists of Wall Street are all socialists now. Free- market ideology, it turns out, doesn't
pay the mortgage. That appears to be a job for, ahem, Big Government.

Let's be clear about why we're facing a crisis that could pull down the global financial system. The
irresponsibility of individuals who bought houses they couldn't quite afford pales in comparison with
the irresponsibility of the financial wizards who built on those shaky mortgages a towering edifice of
irrational faith. Someone in the government should have looked at all those trillions of dollars' worth
of mortgage-backed securities and collateralized debt obligations and credit default swaps and
demanded that Wall Street prove that all, or even most, of this purported money was real. But we're
in the eighth year of the Bush administration; adult supervision left the building long ago.

Now that the whole highly leveraged structure is threatening to fall, some kind of government
bailout is necessary and inevitable. But Congress shouldn't approve Treasury Secretary Henry
Paulson's $700 billion rescue plan without insisting on some measure of equity and accountability.

See, neglecting such details as equity -- in both senses of the word -- and accountability is what got
us here in the first place.

Congress should have learned by now what happens when this administration is given a blank check.
Unlike the run-up to the Iraq war, at least this time there's a genuine emergency -- we came within a
whisker of a financial meltdown last week, and we're still way deep in the woods. No one thinks that
delay is an option.

Not Barack Obama, who introduced legislation in 2006 to address lax mortgage lending and in
March proposed a new regulatory framework for the financial markets. Not John McCain, who has
been all over the map. Within one week, McCain has gone from saying the "fundamentals of the
economy are strong" to declaring that "we are in the most serious crisis since World War II."

But first we need to be convinced that Paulson's proposal -- have the government purchase the bad
debt -- is the best thing to do. Not all economists believe it is, although it's true that if you put six
economists in a room, they'll come up with seven sharply differing, strongly held points of view
about the time of day. Assuming that Paulson's plan is deemed workable, the "details" yet to be
worked out involve staggering amounts of money. Hedge funds apparently don't qualify for relief,
but what about insurance companies that branched out into exotic mortgage-backed investments?
What about foreign banks with big U.S. operations?

Clearly there has to be some definition of just who is covered, and there has to be some oversight.
And now that the government has nationalized Fannie Mae and Freddie Mac, who's going to run
those still-vital institutions? Who's going to run the giant insurance company AIG, which was
effectively nationalized last week?
Maybe Congress can insert a provision that broadly insists on the principle of oversight and leaves
the particulars to be worked out later. But it would be unconscionable for Congress to absolve a
bunch of wealthy financiers of the consequences of their bad decisions and not do the same for
homeowners who showed similarly poor judgment. Paulson has indicated his awareness that this is,
indeed, an election year -- and that members of Congress are not eager to go home to their districts
and explain why Wall Street's pooh-bahs get to keep their mansions and their yachts while working-
class families lose their modest homes.

The more contentious issue is the idea, supported thus far mostly by Democrats on Capitol Hill, that
there should be salary caps for executives of companies that take advantage of the government
bailout. Paulson complains that this will provide a disincentive for companies to participate in the
program -- whatever the program turns out to be -- but it seems to me to be a reasonable idea, and a
winner politically.

Why shouldn't the executives who put their companies at risk by making unwise investments pay a
price for their lack of prudence?

We can't just let the system collapse -- nobody wins in that event. But I thought one of the
fundamental tenets of capitalism was a direct relationship between risk and reward. The Masters of
the Universe who created this mess ought to share the pain of cleaning it up.

A Hedge Fund Like No Other

A Key Task for Congress: Matching Managers' and Taxpayers' Interests

By Simon Johnson and James Kwak

Tuesday, September 23, 2008;

Given the panic in Washington over the financial markets, it is virtually certain that Congress will
soon pass some form of the bailout plan the Treasury put forward last week. This is not an ideal
proposal, particularly since it does not address the underlying problem with mortgages and negative
housing equity. No troubled mortgage holders would benefit directly, and key commercial banks
might still end up undercapitalized.

However, no legislator wants to risk allowing the economy to collapse on his or her watch, and,
according to Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, that is what's at
stake.

Within these political realities, there is a key issue on which lawmakers should focus, quickly, in
designing this legislation: governance.

The draft proposal authorizes the Treasury to "purchase . . . on such terms and conditions as
determined by the secretary, mortgage-related assets from any financial institution having its
headquarters in the United States." In effect, this would invest $700 billion (for starters) of taxpayer
money in a hedge fund controlled by a single person, the Treasury secretary. Given the urgency of
the effort and the complex nature of the securities involved, this de facto fund would be government-
run but overseen largely by Wall Street veterans; any actual management would probably be
outsourced to existing fund management companies.

Ordinarily, the interests of hedge fund managers and investors are at least somewhat aligned by the
fee structure of hedge funds, in which managers are paid 2 percent of assets under management plus
a share of the returns over a certain threshold (commonly 20 percent). In addition, competition in the
industry dictates that fund managers with below-market returns are less likely to be able to raise new
funds. But neither of these incentives exists in this case.

Management fees cannot be tied to fund returns in the usual manner because the fund is highly likely
-- some would say designed -- to lose money. To restore our nation's banks to health, the fund must
pay above-market prices for mortgage-backed securities; if it paid market prices (about 22 cents on
the dollar, based on the largest known recent transaction), that would simply trigger the massive
write-downs that everyone fears. Because there is no competition for this fund, and no one involved
is planning to raise another, the second incentive doesn't apply. Worse, the Treasury-appointed fund
managers negotiating with banks to buy their mortgage-backed securities not only come from those
banks but will almost certainly be looking for jobs at those banks once the need for the fund has
passed, creating enormous potential conflicts of interest.

While the usual mechanisms for aligning incentives are unavailable, the stakes are unprecedented.
Every dollar that the fund loses is a dollar handed from taxpayers to the banks and their
shareholders. While previous bailouts, including that of AIG, have been designed to give the
government at least some of the potential upside, the only upside here is that these securities may
turn out to be worth more in the long term than the market thinks they are worth today. Despite this
possibility, paying more for something than anyone else is willing to pay is, simply put, a sucker's
bet. It is most likely that "governance" over the fund will be provided by periodic hearings of the
relevant Senate and House committees during which the Treasury secretary and the fund managers
will be asked why they overpaid for banks' securities and will answer that there was no choice if the
financial system was to be saved.

While there is still time, Congress should consider alternative means of aligning incentives. For
example, lawmakers could set a target for what return the fund is expected to get, and managers'
compensation could be tied to their actual return relative to that target. Would-be fund managers
should bid in an open process what target return they are willing to base their compensation on -- the
management company that is willing to accept the highest (or least negative) target for a set of assets
would get the contract for those assets.

In any case, the fund should provide full disclosure of the securities it buys, its valuation of them and
the price paid, which would help ensure that the fund is managed in the country's best interests. Its
leaders should be open about overpaying relative to market price, and on that basis, the fund should
receive preferred stock in any participating bank. This would, among other things, give taxpayers
some much deserved and long overdue potential upside.

Are short-sellers really to blame?

September 23, 2008

The world may soon find out if short-sellers really are the scoundrels they have been made out to be.

In the past few days, regulators in the United States, Britain, Canada and Germany have imposed
unprecedented temporary bans on the short-selling of financial shares as they seek to head off what
is threatening to be the worst financial turmoil since the Great Depression.

The regulators blamed short-sellers for the rapid decline last week in the share prices of major banks
like Morgan Stanley. For financial markets already reeling from the collapse of Bear Stearns and
Lehman Brothers, the declines led to questions about whether more big banks would falter and
worsen a credit markets freeze that threatens the broader economy.
At first, the short-selling crackdown helped stocks.

But after rising more than a combined 700 points on Thursday and Friday, the Dow Jones industrial
average fell 372.75 points, or 3.3 percent, on Monday. Banking stocks, supposedly protected from
short-selling, were hit hard, with Bank of America down almost 9 percent and JPMorgan Chase
losing more than 13 percent.

Although far from conclusive, the drop illustrates that there can be very bearish days without short-
selling being allowed across a big part of the market.

The ban "will result in exactly the opposite in what they want to achieve," said Doug Kass, a short-
seller who is founder and president of Seabreeze Partners Management, a hedge fund. "It will scare
the longs into selling, exacerbating stock price declines."

Short-sellers have been blamed for nearly every financial meltdown since the 1929 crash, but it has
often been debated whether this is because they were either smart or lucky enough to profit while
others struggled, or because they spread malicious rumors and provoked bear raids on quality
companies.

Now, the short-sellers are being singled out again. The emergency order in the United States that
halted short-selling in nearly 800 financial stocks was issued early Friday and effective immediately.
The order runs through Oct. 2 and may be extended by the agency if needed. The order can last a
total of 30 calendar days.

And since the SEC issued the order, nearly 100 companies, including General Electric, have been
added to the ban. But there are concerns that regulators do not fully understand the forces they have
unleashed with the ban.

Critics say they are interfering with the basic functioning of the markets, including taking away
liquidity provided by the short-sellers, at a time when things are already enormously shaky.

"My concern is that a total ban really does not comport with free market principles," said Harvey
Pitt, who was the chairman of the SEC when U.S. markets fell after the Sept. 11, 2001, terrorist
attacks.

In addition, the ban may cause "dislocations in our markets that don't need to have been created this
way," Pitt said. "There are a lot of people who are engaging in entirely appropriate short-selling
activities."

The potential harm, short-selling experts say, comes from discouraging any short-selling. Because
short-sellers borrow shares and have to buy them back later, they represent forced buying in the
market, purchasing shares when no one else will.

"We are very concerned that these emergency orders will not enhance long-term market integrity,
nor will they address the fundamental economic issues that have been afflicting our financial sector,"
said James Chanos, a prominent short-seller and president of the hedge fund Kynikos Associates.
"Simply put, short-selling is a vital investment strategy that responds to market fundamentals and
contributes to the integrity of stock prices."

Chanos was one of the first to point out concerns about the accounting at Enron, the energy-trading
company that collapsed in 2001.
In sophisticated markets like the United States, there rarely have been restrictions on short-sellers
like the ones made last week.

Christopher Cox, chairman of the SEC, justified its drastic action by saying the ban would restore
equilibrium to markets.

The commission said: "Under normal market conditions, short-selling contributes to price efficiency
and adds liquidity to the markets. At present, it appears that unbridled short-selling is contributing to
the recent, sudden price declines in the securities of financial institutions unrelated to true price
valuation."

Bailout is financial equivalent of the Patriot Act

September 23, 2008

The passage is stunning:

"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed
to agency discretion, and may not be reviewed by any court of law or any administrative agency,"
the original draft of the proposed bill says.

And with those words, the Treasury secretary - whoever that may be in a few months - would be
vested with perhaps the most incredible powers ever bestowed on one person over the economic
and financial life of the United States. It is the financial equivalent of the Patriot Act, after 9/11.

Treasury Secretary Henry Paulson Jr.'s $700 billion proposal to bail out Wall Street is both the
biggest rescue and the most amazing power grab in the history of the American economy.

In many ways, it is classic Wall Street: a big, bold roll of the dice that one trade can save the day.
But at the same time, the hypocrisy is thick. The lack of transparency and oversight that got our
financial system in trouble in the first place seems written directly into the proposed bill, known as
TARP, or the Troubled Asset Relief Program.

Just take a look at the original draft: "The Secretary is authorized to take such actions as the
Secretary deems necessary to carry out the authorities in this act," the proposed bill read when it
was first presented to Congress, "without regard to any other provision of law regarding public
contracts."

It goes on to say, "Any funds expended for actions authorized by this Act, including the payment of
administrative expenses, shall be deemed appropriated at the time of such expenditure."

Slowly but surely, as new versions of the bill are making the rounds in Washington, some legislators
are pressing to include new language to give them at least a modicum of oversight. Democrats
have complained that the bill gives the Treasury Department "a blank check" - and they're right.

But given the rush to push the bill through, even if Congress cobbles together some oversight
language, it will almost surely be inadequate.

Joshua Rosner, a managing director at Graham Fisher, says TARP should stand for "Total
Abdication of Responsibility to the Public." He calls it "a clear abdication of all congressional
oversight and fiscal authorities to a secretary of Treasury that has bungled this crisis from the
beginning."
He argues that the bill grants "greater powers to the secretary of the Treasury than even the
president enjoys."

The bigger issue is that the bill effectively creates protections not just for the Treasury, but for the
executives on Wall Street who created this near Armageddon. Rosner says the draft bill "prevents
judicial review that could allow the protection of decisions that create false marks, hide prior marks,
or could be used to prevent civil or criminal prosecution in situations where a management
knowingly provided false marks that aided the growth of this crisis of confidence."

False marks - using mark-to-market accounting to hide the true value of security, rather than
disclose it honestly - has a lot to do with why Jeffrey Skilling, the former Enron chief executive, is in
jail.

It is absolutely true, of course, that Paulson needed to do something. By Thursday afternoon, less
than 48 hours after the bailout of American International Group, the financial system was near
meltdown. The mere rumor that Paulson and the Federal Reserve chairman, Ben Bernanke, were
devising a big bailout fund cause the stock market to soar.

In truth, I'm not sure I agree with Rosner's assessment of Paulson's job performance. I think he is
one of the most competent Treasury secretaries we've ever had, and it is hard to imagine anyone
else handling this crisis any better. His predecessors, who lacked his grounding in the world of high
finance, would most likely have been like deer in headlights.

And when Paulson says, as he did on all the television talk shows Sunday, "I hate the fact that we
have to do it, but it's better than the alternative," I believe him. (It would have looked better, of
course, if he had come up with this plan before it looked as if his former firm, Goldman Sachs, was
in jeopardy.)

But the question on the table now is whether the government's latest response to this crisis - the
way it has been constructed, and frankly, the way it is being crammed down everyone's throat at the
eleventh hour - is the right approach. Already the market has its doubts; just look at its performance
Monday.

Let put aside the bill's most offensive aspect - the raw power it gives the Treasury Department, and
the lack of oversight it provides - and take a closer look at the practicalities. First off, there is
nothing in the bill that will prevent these problems from happening again.

The bill doesn't address adding greater transparency in investments in subprime loans and
securities and credit derivatives, which led directly to the debacles at Lehman and AIG. The bill
does nothing to rein in the credit-default swap market, which has turned out to be the weapon of
financial mass destruction that Warren Buffett always said it was.

Nor are the Democrats going to help matters with their own changes.

It is all well and good that they hope to use the bill to restrain executive compensation, and add
stipulations to help people in danger of losing their homes. But nothing the Democrats have
suggested so far tackles the core issues of oversight, transparency or regulation.

Of course, the sickest part is that Wall Street is lining up at the trough for a piece of the action,
lobbying to run some of the $700 billion fund - and take huge fees - for their own mess.

However the bailout is structured, no matter what safeguards are put in place, it is likely to be a
conflicted mess. How can we possibly trust that the price the government agrees to buy the
securities will be fair?
And then there is the jockeying among the banks so they can sell their absolute worst stuff to the
government - even loans that have nothing to do with mortgages - and change the rules in the
process.

The Financial Services Roundtable, which represents big financial services companies, wrote an e-
mail message to members Sunday suggesting, laughably, that "the government bid for the assets
should not count as a mark-to-market value for accounting purposes."

In other words, if the government drives a hard bargain - as it should - the banks don't have to take
write-downs based on the price the feds pay to take junk off their balance sheets.

Watching Wall Street double-dip makes even some in the industry's top tier cringe.

"Maybe I should move to Russia," one titan of finance said to me. "It's obscene, the whole thing. I'm
embarrassed for myself."

Actually, I've got a better suggestion: Venezuela.

On Friday last week, Hugo Chávez, the Socialist president of Venezuela, gave a speech in Caracas
where, according to Reuters, he said, "The United States has spent $900 billion, four times what
Venezuela produces in a year, to try to boost the troubled finance system and housing market."

Gloating, he added: "They have criticized me, especially in the United States, for nationalizing a
great company, Cantv, that didn't even cost $1.5 billion."

U.S. rescue for mortgage industry, but not for homeowners

September 23, 2008

Even if the U.S. Treasury Department reaches agreement with Democratic leaders in Congress on its
$700 billion proposal to rescue the mortgage industry, housing experts warned Monday that the plan
might do little to help troubled borrowers stay in their homes.

As lawmakers in the House of Representatives and Senate struggled to reach a deal with the
administration of President George W. Bush, one of the most vexing battles was how much the plan
should balance a rescue of financial institutions with a rescue of homeowners facing foreclosure.

Henry Paulson Jr., the Treasury secretary, has placed top priority on bailing out financial institutions
by buying soured mortgages and mortgage-backed securities, so banks and other lenders can clean
up their balance sheets and get back to normal lending.

But Democrats insist that the Treasury also help restructure many of those loans, by lowering the
interest rate or the loan amount, to make the mortgages affordable and reduce the number of people
who lose their homes through foreclosure. The Bush administration has been lukewarm to that idea,
but many housing and mortgage experts say the government would have a difficult time modifying
mortgages even if it were eager to do so.

The vast majority of subprime mortgages - 90 percent or more, by some estimates - are inside giant
pools, or trusts, which have in turn sold bonds with different levels of seniority to institutional
investors around the world.
Even if the government acquired hundreds of billions of dollars worth of mortgage-backed
securities, finance experts said, the Treasury would be unlikely to acquire all the bonds tied to a
particular mortgage pool. And if the government did not own all those bonds, it might not have the
power to demand changes in the underlying mortgages.

"We are literally spending hundreds of billions of dollars on subsidies for financial institutions," said
Christopher Mayer, a professor of real estate finance and vice dean at the Columbia Business
School. "This won't do anything to help the housing market. This plan is about buying mortgage-
backed securities, not mortgages, and there is a big difference."

Amanda Darwin, a partner at the law firm of Nixon Peabody who specializes in both bankruptcy and
securities law, said that the Treasury was likely to become bogged down in legal problems if it tried
any relief more radical than the cautious framework adopted earlier this year by the American
Securitization Forum, an industry group.

"In order to modify loans beyond that framework, you have to have the consent of 100 percent of the
holders of the affected securities," Darwin said. And some of those investors, especially those
holding senior securities that are shielded from many of the losses, may not want to sell out or make
concessions.

Because of that problem, congressional Democrats are also demanding that the final bill change the
bankruptcy law to give troubled homeowners more bargaining power with their lenders.

Proposals put forward by Representative Barney Frank, the Democrat who is chairman of the House
Financial Services Committee, and Senator Christopher Dodd, the Democrat who is chairman of the
Senate Banking Committee, would allow bankruptcy judges to reduce a person's loan amount or
interest rate in much the way that bankruptcy judges decide how much money most other creditors
receive.

Bankruptcy courts have long been prohibited from modifying the terms of mortgages on a person's
primary residence. Community advocates and consumer groups have argued for months that
changing the law would cut through the tangle of legal conflicts involving most mortgages and give
borrowers a big increase in their bargaining power with lenders.

"That is by orders of magnitude the best thing that can be done to keep people in their homes," said
Eric Stein, senior vice president of the Center for Responsible Lending, a nonprofit group based in
North Carolina.

On Monday, 30 community and consumer groups from around the country sent an open letter to
lawmakers to press their case.

"It is an illusion to assume that bailing out financial institutions is the same thing as providing relief
to foreclosure-plagued American homeowners," said the groups, which included the Consumers
Union, the National Council of La Raza and the Leadership Conference on Civil Rights.

But Paulson and the Bush administration remain firmly opposed to the proposal, known informally
as a cram-down, saying it would frighten even more investors away from the mortgage market.

The banking and securities industries, meanwhile, are fighting the change with all their might, as
they did when it came up with the housing bill that was adopted in July.
"Authorizing write-downs of mortgages by bankruptcy judges will increase the risks of mortgage
lending at a time when the market is already struggling, and this will harm consumers," Floyd
Stoner, a top lobbyist for the American Banking Association, wrote in a statement on Monday.

Economists see need for a penalty in bailout package

September 23, 2008

As economists puzzle over the proposed details of what may be the biggest financial bailout in U.S.
history, the initial skepticism that greeted its unveiling has only deepened.

Some are horrified at the prospect of putting $700 billion in public money on the line. Others are
outraged that Wall Street, home of the eight-figure salary, may get rescued from the consequences
of its real estate bender, even as working families give up their houses to foreclosure.

Most economists accept that the U.S. financial crisis — the worst since the Great Depression —
has reached such perilous proportions that an expensive intervention is required. But considerable
disagreement centers on how to go about it. The Treasury's proposal for a bailout, now being
negotiated with Congress, is being challenged as fundamentally deficient.

"At first it was, 'thank goodness the cavalry is coming,' but what exactly is the cavalry going to do?"
asked Douglas Elmendorf, a former Treasury and Federal Reserve Board economist, and now a
fellow at the Brookings Institution in Washington. "What I worry about is that the Treasury has acted
very quickly, without having the time to solicit enough opinions."

The common denominator to many reactions is a visceral discomfort with giving Treasury Secretary
Henry Paulson Jr. — himself a product of Wall Street — carte blanche to relieve major financial
institutions of bad loans choking their balance sheets, all on the taxpayer's bill.

There are substantive reasons for this discomfort, not least concerns that Paulson will pay too
much, thus subsidizing giant financial institutions. Many economists argue that taxpayers ought to
get more than avoidance of the apocalypse for their dollars: they ought to get an ownership stake in
the companies on the receiving end.

But an underlying source of doubt about the bailout stems from who is asking for it. The rescue is
being sold as a must-have emergency measure by an administration with a controversial record
when it comes to asking Congress for special authority in time of duress.

"This administration is asking for a $700 billion blank check to be put in the hands of Henry
Paulson, a guy who totally missed this, and has been wrong about almost everything," said Dean
Baker, co-director of the liberal Center for Economic and Policy Research in Washington. "It's
almost amazing they can do this with a straight face. There is clearly skepticism and anger at the
idea that we'd give this money to these guys, no questions asked."

Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the
door: a potentially swift shredding of the American financial system. That would be catastrophic for
everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to
buy homes and cars, and to pay for college.

Some are suspicious of Paulson's characterizations, finding in his warnings and demands for
extraordinary powers a parallel with the way the Bush administration gained authority for the war in
Iraq. Then, the White House suggested that mushroom clouds could accompany Congress's failure
to act. This time, it is financial Armageddon supposedly on the doorstep.

"This is scare tactics to try to do something that's in the private but not the public interest," said
Allan Meltzer, a former economic adviser to President Ronald Reagan, and an expert on monetary
policy at the Carnegie Mellon Tepper School of Business. "It's terrible."

In part, Paulson's credibility has been dented by his pronouncements in previous weeks that the
crisis was already contained. Some suggest this was a well-intentioned effort to stem panic. But the
aftermath complicates his quest for the bailout.

"If you view your public statements as an instrument of policy, people don't believe you anymore,"
said Vincent Reinhart, a former Federal Reserve economist and now a scholar at the conservative
American Enterprise Institute.

The biggest point of contention is over whether and how taxpayers would benefit if the bailout
succeeded in righting the financial system, sending banking stocks upward.

In Paulson's plan, the Treasury would have the right to buy as much as $700 billion worth of
troubled investments, with the taxpayer recouping the proceeds when those investments were sold
over coming years. But many economists — Elmendorf among them — argue that taxpayers should
get more out of the deal, securing stock in the banks that make use of the bailout. The government
could then sell off that stock at a profit when conditions improve. A similar approach was used
successfully in Sweden in the early 1990s when its financial system melted down.

Others argue that any bailout must pinch the people who have run the companies now needing
rescue, along with their shareholders, addressing the unseemly reality that executives have
amassed beach houses and fat bank accounts while taxpayers are now stuck with the bill for their
reckless ways.

"It absolutely has to be punitive," Baker said. "If they sell us the junk, then we own the company.
This isn't a way to make these companies and their executives rich. This should be about keeping
them in business so the financial system doesn't collapse."

Other questions center on how to value what the Treasury aims to purchase — an issue that goes
to the heart of the crisis itself.

The financial system got to its dangerous perch by betting extravagantly on real estate. When
housing prices began plummeting and borrowers stopped making payments, financial institutions
found themselves with huge inventories of bad loans. Not simple loans, but complex investments
created by pooling millions of mortgages together and then slicing them into pieces. These were the
investments that Wall Street bought, sold and borrowed against in cooking up the money it poured
into housing.

The trouble is that these investments are so intertwined and complex that no one seems able to
figure out what they are worth. So no one has been willing to buy them. This is why banks have
been in lockdown mode: with mystery enshrouding both the value of their assets and their future
losses, banks have held tight to their remaining dollars, depriving the economy of capital.

Now, the Treasury aims to clear the fog by buying up these investments. But their value is as
mysterious as ever.

"There's a tendency for people to think these are stocks and bonds and you know what the price is,"
said Bruce Bartlett, a former White House economist under Reagan. "The problem is people are
operating in a world in which nobody knows what the hell is going on. There are some naïve
assumptions about how this would function."

If Paulson pays the market rate — whatever that is — that presumably would not be enough to
persuade banks to sell. Otherwise, they would have sold already. For the plan to work, Treasury
has to pay a premium.

"It's a straight subsidy to financial institutions," said Martin Baily, a former chairman of the Council of
Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings
Institution. "You're essentially giving them money."

Baily favors the basics of the Paulson plan, albeit with some mechanism that would give the
government a slice of any resulting profits. And yet he remains troubled by the dearth of information
combined with the abundance of zeroes in the bailout request.

"I'd like a clearer statement of what we were afraid was going to happen that requires $700 billion,"
Baily said. "Maybe they don't want to talk about it because it would scare everybody, but it's a bit
much to ask."

Congress grills Paulson and Bernanke on bailout

Sept.24th

The Treasury secretary, Henry Paulson Jr., faced a deeply skeptical audience Tuesday when he
appeared before the Senate Banking Committee to defend the $700 billion plan to rescue the battered
U.S. financial system.

"This is not something I ever wanted to ask for, but it is much better than the alternative," Paulson
said.

Appearing alongside the chairman of the Federal Reserve, Ben Bernanke, and other senior officials,
he urged lawmakers "to enact this bill quickly and cleanly, and avoid slowing it down with other
provisions that are unrelated or don't have broad support."

Both men warned that without a drastic government intervention, the financial markets would be
paralyzed, further hobbling the economy, costing jobs, and impeding hopes of a recovery.

"This is a precondition for a good, healthy recovery of our economy," Bernanke said. "We need to
act to stabilize the situation, which is continuing to be very unpredictable and worrisome."

But one after another, senators from both parties said that, while they were prepared to move fast,
they were far from ready to give the administration of President George W. Bush everything it
wanted in its proposed $700 billion plan to buy and hopefully resell troubled mortgage-backed
securities.

Senator Christopher Dodd, Democrat of Connecticut and chairman of the Banking Committee,
called the Treasury proposal "stunning and unprecedented in its scope and lack of detail."

Asserting that the plan would allow Paulson to act with "absolute impunity," Dodd said, "After
reading this proposal, I can only conclude that it is not only our economy that is at risk, Mr.
Secretary, but our Constitution, as well."

Another expression of disgust came from Senator Jim Bunning, Republican of Kentucky, who said
the plan would "take Wall Street's pain and spread it to the taxpayers." He added, "It's financial
socialism, and it's un-American."

Investors were also taking a wait-and-see attitude to the package. After a steep slide on Monday,
European markets closed down again Tuesday, while afternoon trading was moderately lower on
Wall Street. Oil and gold prices also retreated. (Page 20)
In Washington, Dodd called the crisis "entirely foreseeable and preventable, not an act of God," and
said that it angered him to think about "the authors of this calamity" walking away with the
proverbial golden parachutes while taxpayers bore the cost.

"There is no second act on this," Dodd said, acknowledging that speed was important. But it is more
important, he said, "to get it right."

Paulson said in response to questions that he shared the senators' exasperation.

"I'm not only concerned, I'm angry" over the events that led to the problem, Paulson said. He blamed
an outdated regulatory system for the turmoil and, in an attempt to counter any impression that the
proposed rescue plan was for the benefit of fat-cats on Wall Street, said: "This is all about the
taxpayers. That is all we are about."

Paulson said that "this troubled-asset purchase program is the single most effective thing we can do
to help homeowners, the American people, and stimulate our economy."

He and Bernanke said that the problems in the housing industry were the core of the crisis but that
the problems would continue to spread far outside the housing sector if the problems in the mortgage
markets were not addressed, and soon.

Bush, speaking in New York before the markets opened, expressed confidence that Congress would
agree on a financial rescue plan and left open the possibility of accepting amendments being
proposed by Democrats.

"Now there's a natural give and take when it comes to the legislative process," Bush said. "There are
good ideas that need to be listened to in order to get a good bill that will address the situation."

In a statement released earlier in the day, Bush said he had reassured worried world leaders that the
United States had the "right plan" to deal with the crisis.

Vice President Dick Cheney was at the Capitol on Tuesday morning, trying to round up support for
the administration's package. But the senators on the banking panel were unanimous in calling for
ways to protect taxpayers' investments - which, at $700 billion, would amount to $2,300 for every
U.S. citizen, said Senator Mike Enzi, Republican of Wyoming.

Democrats and Republicans are eager to include legislation that would protect mortgage holders, cut
the salaries of executives at Wall Street firms and prevent a breakdown of the financial system.

Senator Richard Shelby of Alabama, the ranking Republican on the banking panel, expressed disdain
for regulators "who sat on the sidelines" as the crisis was building. He recalled, too, that Alan
Greenspan, the former Federal Reserve chairman, once told him that the rate of borrowing in the
U.S. economy and the high percentage of their incomes that many people were spending on their
homes posed "a rather small risk to the mortgage market."

Shelby complained that the emerging program seemed to be "a series of ad hoc measures," rather
than the kind of comprehensive approach that was needed.

The back-and-forth came as the Bush administration and congressional leaders moved closer to
some kind of agreement on the bailout, including tight oversight of the program and new efforts to
help homeowners at risk of foreclosure.
But Congress and the administration remained at odds over the demands of some lawmakers,
including limits on the compensation of top executives, and new authority to allow bankruptcy
judges to reduce mortgage payments for borrowers facing foreclosure.

Congressional leaders and Treasury officials also said they were close to an agreement over a
proposal by some Democrats in which taxpayers could receive an ownership stake, in the form of
warrants to buy stock, from companies seeking to sell distressed debt to the government.

Bernanke's testimony was exceptionally brief, considering the enormous stakes involved, a mere
nine paragraphs, much of it devoted to a recapitulation of the growing crisis and how it took shape.

It seemed to reflect the way Paulson and the administration have presented the legislation, in bare-
bones fashion, but with a clear tone of urgency.

The White House has begun intensive lobbying to persuade nervous lawmakers to support the plan.
Joshua Bolten, the White House chief of staff, and Keith Hennessy, the chairman of Bush's National
Economics Council, were also scheduled at the Capitol on Tuesday.

Tony Fratto, the White House deputy press secretary, told reporters there was a "great sense of
urgency" to get the legislation passed this week.

Lawmakers challenge the proposed bailout plan

September 24, 2008

The White House waged a multi-front campaign Tuesday to persuade Congress to accept its vast
bailout plan, with President George W. Bush telling world leaders that the United States had taken
"bold steps" to stanch the financial crisis while Vice President Dick Cheney and other top officials
went to Capitol Hill to try to persuade reluctant lawmakers.

Treasury Secretary Henry Paulson Jr. and the chairman of the Federal Reserve Board, Ben
Bernanke, faced five hours of grilling by skeptical, angry members of the Senate Banking
Committee.
In blunt terms, Bernanke warned the senators that if they failed to pass the $700 billion plan, they
risked causing a recession, increasing joblessness and pushing more homes into foreclosure.

"This will be a major drag on the U.S. economy and greatly impede the ability of the economy to
recover," Bernanke said.

The lawmakers objected strenuously to the broad authority Paulson was requesting, the lack of
additional steps to help homeowners avoid foreclosure and the absence of any demands for
ownership stakes in the banks that are helped.

But with Congress and the administration negotiating intensely behind the scenes to resolve these
and other major sticking points in the plan, some of the drama was intended for hometown
audiences, six weeks before lawmakers face an election.
Even Senator Richard Shelby of Alabama, the senior Republican on the banking committee and
one of the most vocal critics of the proposal, said he expected Congress and the White House
eventually to reach a deal.

"I think Congress will react positively at the end of the day," he said. "But in what form, we're not
sure yet."
House Speaker Nancy Pelosi; the Senate majority leader, Harry Reid of Nevada; and other
Democratic leaders met Tuesday afternoon to form a strategy for bringing the bailout legislation to
the floors of both chambers later this week.
But there was no clear road map by the end of Tuesday. House Republicans seemed the least
receptive of all. Cheney led a delegation from the White House to meet with House Republicans on
Tuesday morning, including the chief of staff, Joshua Bolten, and the budget director Jim Nussle.
But the visit did little to quiet a rising chorus of doubts.

"My sense is that the meeting did not abate the growing discontent," said Representative Mike
Pence, Republican of Indiana, who opposes the plan. Representative John Boehner of Ohio, the
Republican leader, said that there seemed to be little appetite for the bailout among his conference.
Still, he said that swift action was needed and he remained committed to a deal.

To help win some votes, Paulson agreed to speak to House Republicans on Wednesday morning,
after which he and Bernanke must give a repeat performance before the House Financial Services
Committee, an audience that could prove even more hostile than the Senate banking panel.

On Tuesday, Paulson rushed from the banking committee hearing to meet with Republicans at their
weekly lunch. He faced tough questioning but many lawmakers emerged from the meeting
expressing support.
"We're anxious to act, and to act quickly, to restore confidence in the markets and in our country,"
Senator Mitch McConnell of Kentucky, the Republican leader, said after the meeting. Democrats,
however, grew concerned that a lack of Republican support, particularly in the House, could leave
them in an undesired alliance with the Bush administration.

Reid, at a news conference, said Democrats were waiting for Republicans to signal that they had
enough votes to support the bailout. "We have all heard what went on over in the House today,"
Reid said. "It was a scene of disarray. So we need the Republicans to start producing some votes
for us."

Before that happens, however, lawmakers were waiting to see a final version of the plan.
Democrats were pushing hardest for provisions that would require the Treasury to obtain warrants
that would convert into equity in the companies helped and limits on the salaries of executives
whose firms participate in the bailout. Both presidential candidates, Senator Barack Obama and
Senator John McCain, have called for such limits, as has Shelby, making it more likely that
Treasury will have to find some form of compromise on this issue.\"The party is over for this
compensation for CEO's who take golden parachutes as they drive their companies into the
ground," Pelosi said.

The White House is eager for a deal on the plan, recognizing that markets around the world are
fluctuating daily, depending on how investors assess the United States' response to the crisis.
In his speech to the United Nations, Bush said, "I can assure you that my administration and our
Congress are working together to quickly pass legislation approving this strategy." He added, "And
I'm confident we will act in the urgent time frame required."
Along with Cheney, and Bolten, Bush dispatched Keith Hennessey, the director of Bush's National
Economic Council, to Capitol Hill. Tony Fratto, Bush's deputy press secretary, told reporters that it
was imperative that Congress pass a bill this week. Asked what would happen if Congress fails to
act this week, he said, "You should think of that as unthinkable."

Reflecting their frustration, and perhaps the narrowness of their options, the lawmakers peppered
Paulson and Bernanke with questions ranging from whether the rescue would work to whether it
would end up bailing out Wall Street on the backs of taxpayers. "I get some sense that we're flying
by the seat of our pants," said Senator Robert Menendez, Democrat of New Jersey. "You want to
come in strong and have the cavalry be there, but you're not quite sure what the cavalry does once
it arrives. And that's part of my concern."
Senator Charles Schumer, Democrat of New York, proposed limiting financing to $150 billion, and
budgeting more in three months, after its progress could be assessed. Several senators said they
thought the best way to protect taxpayers was by requiring the Treasury Department to take
warrants, which are instruments that are convertible into shares, as it did in its rescue of Fannie
Mae, Freddie Mac and the American International Group. But Paulson said that could limit
participation in the program, especially if companies decided to hold onto their troubled assets
rather than cede some control to the Treasury Department. If that happened, Paulson said, the
program would not do enough to get the market moving again.

But he and Bernanke did not do much to clear up confusion about how the bailout plan would work
in practice. Bernanke, an economist, gave a tutorial on valuation of assets, distinguishing between
those sold at fire-sale prices — what a portfolio of mortgages would sell for if the cash were needed
immediately — and those at hold-to-maturity prices, or what the same portfolio would fetch on the
assumption that the underlying debt would be repaid. To unclog the market, he said, the
government would have to determine the hold-to-maturity price for assets with no other buyers.
"Just as you sell a painting at Sotheby's, until you sell it, nobody knows what it is worth," Bernanke
said.

He described a system of reverse auctions, in which the Treasury would name a price it was willing
to pay, and the banks would decide whether to sell. Paulson said the government would also use
other methods, depending on the assets involved, and was open to experimentation. Both officials
pleaded with Congress not to tie the government's hands by writing any particular sales method into
the bailout legislation.
House Democrats were also reviving their push to grant bankruptcy judges the authority to modify
the terms of mortgages on a primary residence, to lower payments for strapped borrowers.

Several senators challenged Paulson on why the Treasury should help foreign banks with
operations in the United States. He said he was "leaning on" countries to devise their own
programs, but that this plan needed to be open to any banks active in the United States.

"The American public, when they're dealing with the financial system, doesn't know who owns that
bank," he said. None of the senators who listened to Paulson and Bernanke disputed the grim
possibilities if Congress should do nothing, but it was clear they were hearing from angry
constituents.
On perhaps the day's most pressing question — will the plan work? — Paulson and Bernanke could
offer only hope.

"I do believe it is our best shot," Bernanke said.

Paulson quickly added, "It's not only our best shot; we're going to make it work."

Hard landing / the real crisis may not have hit yet
(from Haaretz-Jerusalem 9/24)

At the height of the subprime crisis but still before the great crash, a certain kind of derivative was
still circulating in the international markets, a securitized certificate called a "CDO squared."

These were collateralized debt obligations (CDOs) comprised of other CDOs whose underlying
collateral included residential mortgage backed securities. Alternatively, they were bonds based on
chunks of mortgage loans being sold for the third time.

How on earth do you do that? You bundle together a huge package of subprime mortgage loans and
divide it into 16 unequal chunks. At one end you have the chunk of loans that will almost certainly
be repaid, and at the other end the shakiest loans. You sell each chunk onward through bonds whose
ratings range from AAA (blue-chip) to BBB (doghouse).
But it doesn't end there. Now, you repackage all those BBB chunks together into a huge pile, divide
it into 16 unequal chunks and sell it again as separate bonds. And, believe it or not, the credit rating
agencies gave the most superior part of this dodgy stuff an AAA rating, while the most inferior got
BBB.

But even that that isn't where it ends. Now, you bundle all those inferior BBB chunks together into a
huge pile, repackage and split it again and sell it again. You guessed it: the credit rating agencies
gave the most superior part of this icky stuff a senior AAA rating.

And that, dear reader, is a CDO squared. The most inferior stuff was sold again and again in two
rounds of securitization and were rated at levels reserved for U.S. government debt.

The rules of economics are that demand creates supply. The fact that there were investment banks
and commercial banks that carried out the financial engineering, and sold squared garbage at an
AAA rating, is structural. Banks have no sentiments. If you'll buy it, they'll sell it.

The less understandable aspect of all this is, who on earth was buying this toxic stuff? Who agreed to
spend hard-earned money on rubbish squared?

You were, that's who. Not directly, perhaps - you didn't waltz into your back begging to buy stinking
fish. Happily, Israel's capital market is an immature thing, so these financial finagles didn't cross the
ocean. But the widows and orphans of America bought these hybrids through their provident and
mutual fund and hedge fund holdings.

Ah, you sigh, why should you care? That's their problem. But you're wrong. The mechanism by
which America's fund managers bought the alchemical sludge without asking silly questions is the
same mechanism that our provident and mutual funds use in Israel. It's the same mechanism driving
our bankers and brokers, who by a miracle were spared the hideous wrath of the markets.

The mechanism is humanity. Banks such as UBS bought billions of dollars worth of the engineered
sludge because they're staffed by humans. They may be highly educated and clever humans with
degrees in economics and statistics (which should have taught them about the fallacy of
alchemistry), but they're just humans with that basic human craving: to make a buck.

The root of the problem is basic. What motivated the finance sector employees? Was it the greater
good of their customers - the investors, the shareholders? No, it wasn't. The brokers and their
customers were at odds, and that was the root of all evil.

Savers and shareholders want to earn money over years, at a reasonable level of risk. The finance
sector employees wanted to earn as much money as possible as quickly as possible, and let long-
term profit go hang.

And thus the demand for the CDO squared was born. It was demand created by people driven by one
thing only: achieving the highest possible returns in the shortest possible time and to hell with the
risk. Interest rates around the world were very low: It was hard to make a killing through more
ordinary avenues. Also, the investment banks were in a cutthroat contest over who could make the
highest returns, resulting in the fattest bonuses.

No wonder Wall Street shut its eyes and gorged on these mutated derivatives.
Make no mistake, much the same happened in Israel too, but luckily for us the derivatives were a lot
less dangerous. Here too the contest to achieve the highest returns led to obliviousness to risk.
Institutional investors gorged on corporate bonds. Provident funds today have put as much as half
their managed assets into corporate debt, instead of into safer Israeli government debt, just because
the companies were offering slightly higher interest rates.

Institutional investors are believed to have bought NIS 11 billion worth of ungraded (read, high-risk)
debt in the last few years. If it was a corporate bond and it twitched, somebody would swallow it, no
matter how inferior its flavor. And we will be paying the price of this gluttony for years to come as
the companies default on debt.

Why did this happen? Because the competition between the investment banks focused on the wrong
thing, from our perspective. All they cared about was achieving the highest profit in a given year.
But all we savers care about is achieving the highest profit over time. The gap between the two is all
about risk. To achieve fast gains means to take high risks and to lock in gains over the long-term is
to settle for lower risk.

One lesson is that the way a financial firm's results is measured must change, to factor in risk
criteria. Profit must be measured not in net terms, but adjusted for risk. Also, the way the bankers
and brokers running our money are remunerated must also change. They cannot be allowed to earn
millions plus options plus golden parachutes if they fail us, the long-term savers. A paycheck of
millions in a country with social gaps like Israel's is not merely immoral; it causes actual economic
damage. Pay incentives at the banks and brokerages must be linked to long-term achievement, to
link between their aspirations and ours.

Hard landing / a cry for common sense

What asset is safer for investment: illiquid bonds issued by a foreign country, or bonds backed by
American subprime mortgages?

That might have been a tough one once upon a time but today, every Tom, Dick and Yossi would
answer without even thinking about it, bonds issued by a foreign country, even if they're illiquid
(which means, you can't just up and sell them).

In fact, in a world where structured financial instruments managed to destroy the entire industry of
investment banking as well as the biggest insurance company in the world - blind instinct would
counsel that almost anything is better than derivatives on debt.

The thing is, the person who manages your pension find may not see things that way. Nor is it his
fault, poor thing. The rules governing risk among Israel's institutional investors state that when it
comes to liquidity risk (meaning, you may get stuck with the merchandise), illiquid government
bonds are as hazardous as weird derivatives.

Now, when it comes to rating the liquidity of bonds issued by foreign companies - never mind
whether they're the biggest, most blue-chip companies in the world - the rule for institutionals is that
they are inferior in grade to bonds issued by Israeli companies with bottom-crawling ratings of BBB.

If you're hopelessly lost in the intricacies of risk rating and its ramifications, it isn't your fault, poor
thing. Risk rating rules were written in a way that only experts could possibly understand. If pressed
to the wall, they don't understand them either. The subprime morass exposed the bitter truth: the
people who are supposed to have the greatest understanding hadn't understood anything at all.
Some even claim that the present mess was born of sheer embarrassment - the embarrassment of
directors unable to admit they were baffled by the convoluted derivatives their young employees
were pushing.

No executive can admit that he's less clever than some junior staffer and can't understand the
statistical models underlying the kid's product. Thus directors and executives allowed junior
employees to get into activities they couldn't comprehend and therefore couldn't possibly supervise.

So the next time you read a report by the manager of some structured note you were persuaded to
buy, saying something like "As stated in the pricing statements of the respective series of notes,
Lehman Bros is the guarantor under the swap accord which the issuer had entered into with Lehman
Cousins Special Shoelaces. The issuer entered into the swap pact to enable it to meet its payment and
other duties under such notes. Under the swap agreement the fact that Lehman Bros Holdings has
filed for bankruptcy protection gives the issuer the right to decide to terminate the swap transactions
which will in turn trigger early redemption of the notes" and it's Greek to you - don't be embarrassed.

No: Feel angry. Feel very angry at the regulators whose ass-covering mechanism called "proper
disclosure" enables companies to issue gibberish as statements to investors that nobody could
possibly understand.

The fact that you can't understand the announcements that companies issue to the stock exchange,
and that you can't really understand the risk level at which your pension money is being managed,
says nothing bad about you. It does say a lot of bad things about the supervision of the capital
market.

Your inability to understand the jargon being spouted enabled market players to play you.

It enabled them to sell you bad assets at bad prices without you understanding. But you weren't the
only victim. The incomprehension and obtuseness rose to the highest levels of Wall Street and
ultimately brought down the monsters that created it: the investment banks, the commercial banks
and the hedge funds.

At the end of the day it was the sheer inability to understand that brought down Wall Street, and that
has almost brought down the entire global economy.

The pride and inability of managers to admit that they simply couldn't understand, mushroomed
from a human frailty into a macroeconomic hurricane that required the intervention of global
authorities.

Ascertain that the people responsible for pricing assets use good judgment and don't rely solely on
technical means to evaluate the assets, counsels the Institute of International Finance, which is the
umbrella organization of the world's banks, discussing the roots of the present crisis.

In July the IIF issued a document that relates to the human element behind the crisis. The roots of
evil were opacity and poor understanding, it concluded. Everybody relied on mathematical models to
price risk instead of using common sense when evaluating the assets. The result was that the global
capital markets turned into a sort of pyramid scheme: Everybody passed on high-risk assets that
nobody thoroughly, fundamentally understood and finally, everybody fell down together.

Following that train of thought, the IIF decided that it should be the responsibility of mortgage
lenders to apply the same credit checks on borrowers, whether the lender kept the loan or sold it
onward through securitization. One cause of the crisis was that this very basic rule was not followed.

In the same spirit, the IIF ruled that institutional investors around the world had relied too much on
the risk ratings of assets. They bought and sold assets relying solely on assessments of credit rating
agencies, without checking the merits of the assets themselves. The IIF therefore recommends that
institutional investors actually study assets they're thinking of buying, and develop their own risk
evaluation models.

Nor does the IIF spare its contempt from the capital market supervisors, who handed down rules and
standards that also relied on risk ratings from credit rating agencies, which induced institutional
investors to do the same - to rely on the credit rating agencies - without actually analyzing the
securities themselves. The IIF recommends that supervisory regulations no longer rely solely on
credit ratings.

To sum up, the IIF is saying that risk models shouldn't only be based on statistical models. They
should factor in actual underlying risk, the risk of the borrower, on which all these structured notes
were based.

And finally, the IIF acknowledges that to restore investor faith in the market, transparency has to
return. The public must know what it's buying and why. To achieve that, the IIF suggests improving
proper disclosure. That doesn't mean requiring more reports - too much information can be
confusing, the IIF says. The whole point is for reports to be relevant and useful, it points out,
providing clear qualitative and quantitative information about a company's risk.

It all sounds quite trite, yet it took the umbrella organization of the world's banks and the worst
capital market crash in 80 years to remind us that common sense and simple understanding are the
only way to run a business properly.
Financial Fallout—Q&A

News reports about the upheaval in the world of finance have been full of esoteric terms like
“mortgage-backed securities” and “credit-default swaps,” but the crisis has resonated for people
who know little about Wall Street and who did not think they would ever have to know. Here are
several questions and answers of concern to Main Street Americans:

Q. The bailout program being negotiated by the Bush administration and Congressional leaders
calls for the government to spend up to $700 billion to buy distressed mortgages. How did the
politicians come up with that number, and could it go higher?

A. The recovery package cannot go higher than $700 billion without additional legislation. As for
that figure, it lies between the optimistic estimate of $500 billion and the pessimistic guess of $1
trillion about the cost of fixing the financial mess. But the $700 billion is in addition to an $85 billion
agreement on a bailout of the insurance giant American International Group, plus $29 billion in
support that the government pledged in the marriage of Bear Stearns and JPMorgan Chase. On top
of all that, the Congressional Budget Office says the federal bailout of the mortgage finance
companies Fannie Mae and Freddie Mac could cost $25 billion.

Q. Who, really, is going to come up with the $700 billion?

A. American taxpayers will come up with the money, although if you are bullish on America in the
long run, there is reason to hope that the tab will be less than $700 billion. After the Treasury buys
up those troubled mortgages, it will try to resell them to investors. The Treasury’s involvement in the
crisis and the speed with which Congress is responding could generate long-range optimism and
raise the value of those mortgages, although it is impossible to say by how much.

So it would not be correct to think of the federal government as simply writing a check for $700
billion. It is just committing itself to spend that much, if necessary. But the bottom line is, yes, this
bailout could cost American taxpayers a lot of money.

Q. So is it fair to say that Americans who are neither rich nor reckless are being asked to rescue
people who are? What is in this package for responsible homeowners of modest means who might
be forced out of their homes, perhaps for reasons beyond their control?

A. Yes, you could argue that people who cannot tell soybean futures from puts, calls and options
are being asked to clean up the costly mess left by Wall Street. To make the bailout palatable to the
public, it is being described as far better than inaction, which administration officials and members
of Congress say could imperil the retirement savings and other investments of Americans who are
anything but rich.

But it is a good bet that the negotiations between the administration and Capitol Hill will include
ideas about ways to help middle-class homeowners avoid foreclosure and perhaps some limits on
pay for executives. And it should be noted that neither party is solely responsible for whatever
neglect led the country to the brink of disaster.

Q. How is it that the administration and Congress, which have not tried to find huge amounts of
money to, say, improve the nation’s health insurance system or repair bridges and tunnels, can now
be ready to come up with $700 billion to rescue the financial system? And is it realistic to think that
the parties can reach agreement and get legislation passed in a hurry?

A. The first question will surely come up again, involving as it does not just issues of spending
policy but also more profound questions about national aspirations. As for rescuing the financial
system, elected officials in both parties became convinced that, while a couple of venerable
investment banks could fade into oblivion or be absorbed by mergers, the entire financial system
could not be allowed to collapse.

And, yes, the parties are likely to reach an accord. Many members of Congress are eager to leave
Washington to go home and campaign for the November elections, and no one wants to face the
voters without having done something to protect modest savings portfolios as well as giant
investors.

THE FOLLOWING 6 ARTICLES FROM BUSINESSWEEK

Strong Push for an RTC-Type Solution to the Crisis

The U.S. once purged bad S&Ls for $85 billion. How much would it cost to clean up a much bigger
financial crisis? No one seems to know

As Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke met on the
evening of Sept. 18 with congressional leaders, momentum was building for a new Resolution Trust
Corp.-style entity. The vehicle would be set up to stem the slide in the markets and halt the erosion
of the financial sector.
Just two days earlier, Treasury officials had said no broader entity was needed. But rather than
easing market woes, the $85 billion federal bailout of insurer American International Group (AIG)
sent new waves of fear through the market, as investors tried to assess what other corporations
might suddenly turn up insolvent. With the markets down through midday Sept. 18, and lending
among institutions all but grinding to a halt, regulators and lawmakers decided a more systematic
approach was needed to keep more institutions from buckling under the strain.

At the hastily called Capitol Hill meeting, Paulson and Bernanke met with House and Senate
Republicans and Democrats to discuss current market conditions. Paulson and Bernanke "began a
discussion with them on a comprehensive approach to address the illiquid assets on bank balance
sheets that are the underlying source of the current stresses in our financial institutions and
financial markets," said Treasury spokeswoman Brookly McLaughlin in a statement. "They are
exploring all options, legislative and administrative, and expect to work through the weekend with
congressional leaders to finalize a way forward."

A CHORUS OF DEMANDS

With the policy measures taken by Washington so far unable to stop the slide, there had been
growing calls in recent days for a more systematic approach modeled on the RTC, which was set
up in the late 1980s to restructure the underwater mortgages held by nearly 750 insolvent savings
and loan institutions. "Lesson No. 1 from that era is: Move quickly. Troubled assets don't become
more valuable over time; they become less valuable," said Richard Breeden, the RTC's architect
and a former Securities & Exchange Commission chairman.

The idea has drawn powerful supporters: ex-Treasury Secretary Lawrence Summers and former
Federal Reserve chairmen Alan Greenspan and Paul Volcker have recently backed it, while
lawmakers ranging from Representative Barney Frank (D-Mass.), the influential head of the House
Financial Services Committee, to Senator Richard Shelby (R-Ala.), the top Republican on the
Senate Banking Committee, said early in the week that a new RTC should be considered.

Both Presidential contenders have also said such an approach was needed. "I am calling for the
creation of the Mortgage & Financial Institutions Trust—the MFI," Senator John McCain (R-Ariz.)
said Sept. 18. "The priorities of this trust will be to work with the private sector and regulators to
identify institutions that are weak and take remedies to strengthen them before they become
insolvent. For troubled institutions, this will provide an orderly process through which to identify bad
loans and eventually sell them." Senator Barack Obama's (D-Ill.) rhetoric was similar: "I'll call for the
passage of a Homeowner & Financial Support Act that would establish a more stable and
permanent solution than the daily improvisations that have characterized policymaking over the last
year."

How would an RTC-like entity help? The original RTC sold off the restructured loans as the market
improved, rather than in a quick-fire sale, thus lessening the cost of the savings and loan crisis to
the economy and to taxpayers.

AN UNDERCAPITALIZED SYSTEM?

One key difference between the 1980s S&L affair and today's financial crisis is that the government
had already taken over the insolvent banks by the time it created the RTC. In effect, Uncle Sam
already owned the assets and set the agency up to facilitate a smooth liquidation. That's not the
case today: The goal now would be to buy up bad mortgage-related assets from banks and other
institutions to prevent a further wave of insolvencies.

But the basic idea remains the same. The deepening housing crisis has forced banks and other
institutions to write down repeatedly the value of the mortgage-related assets they hold, be they
mortgage-backed securities or more complicated derivatives. The markdowns have eroded capital,
pushing many toward insolvency. And as those firms try to get rid of their toxic assets, the fire sales
put further downward pressure on prices, weakening their capital further—and forcing more sales.
With no end to that vicious spiral in sight, private buyers are scarce, as Lehman Brothers and AIG
discovered. "The worry is that the system as a whole may be undercapitalized," says Brad Setser, a
former Treasury official now with the Council on Foreign Relations. "There may not be enough
capital to absorb the losses caused by the ferocity of the downward spiral."

That's where a new entity would come in. The government fund would serve as a buyer of last
resort. It could acquire the bad mortgages or related debt from the banks directly, at a heavily
discounted price or in exchange for equity. That would shift some of the bad assets off the
institutions' balance sheets, stop the downward price spiral, and help the banks remain solvent. Or,
if troubled institutions were too far gone to save, the government might allow them to get bought up
or go bust, and then step in to manage the liquidation of those assets in a more orderly fashion.

BREEDEN: NEW RTC MAY BE UNNECESSARY

Like the old RTC, the new entity would not face a short-term need to sell. "Rather than seeing
forced sales to vulture investors for 10¢ on the dollar, the government could take its time and get,
say, 40¢ on the dollar," says Lawrence J. White, an economics professor at New York University.

As of the night of Sept. 18, it was unclear exactly what form the new entity might take. Breeden
noted that the federal government may already have the tools it needs to buy problem assets out of
the marketplace. By taking over Fannie Mae (FNM) and Freddie Mac (FRE), the government took
control of their massive portfolios of mortgage securities. The Administration also won approval
from Congress to buy more such securities from other holders. "That may be your RTC," Breeden
said. "You don't need to go out and create something new; Treasury probably already has the
structure that will work fine."
Indeed, at the same time it put the government-sponsored enterprises into conservatorship,
Treasury announced it would wade into the market to buy mortgage-backed securities. At the time,
government officials said Treasury had no target amount it planned to purchase, but would start
with a $5 billion purchase soon after the takeover.

TAKE YOUR MORTGAGE TO COURT?

Others would go even further. On the afternoon of Sept. 18, Senator Chuck Schumer (D-N.Y.),
chairman of the Joint Economic Committee, proposed another variation: He argued that the RTC
model, by taking distressed assets off the books of troubled institutions, would shift the risks and
costs of the bad assets to Uncle Sam while doing little to address the underlying problems of
homeowners struggling under mortgages they can no longer afford.

Schumer contends that, in addition to providing capital to troubled financial institutions in exchange
for equity, further measures must be included to help homeowners. He recommended allowing
homeowners to renegotiate their mortgages in bankruptcy court. Such proposals have been before
Congress for months, but banks and other financial institutions have fought hard against them.
Schumer argues that this additional step would spur far greater efforts to modify loans, helping to
avoid the defaults and foreclosures that have been at the root of the crisis. "If the federal
government is going to continue to support the economy, its new formal lending program with the
banks must address both the need for restoring stability and confidence in the U.S. financial system
and the need to set a floor in our plummeting housing markets," Schumer said.

Whatever form it takes, however, a move to shift bad mortgage assets from the balance sheets of
private institutions and onto that of Uncle Sam raises plenty of questions—not least, how much
such a bailout would cost. The original RTC took on some $225 billion in junky S&L assets and
eventually sold them for $140 billion, so the hit to taxpayers was $85 billion. No one knows how
much bad debt a new RTC would have to take on, or what the burden might ultimately be worth, but
the price tag could be far higher.
Restructuring the complex mortgage-backed securities and derivatives at the heart of the crisis will
also be much tougher than what the RTC faced in restructuring portfolios of mostly plain-vanilla
home loans. "Doing this would be an admission we are in deep, deep trouble," says Setser. But, he
adds, "if the situation doesn't stabilize, we have relatively few policy options left."

The ‘Compromises’ in the Bailout Bill

The House has circulated a new draft of the troubled asset relief program, otherwise known as
T.A.R.P. The bill — which was a slim three pages when Treasury Secretary Henry Paulson first
pitched the idea — is now at 110 pages, and it even has a name: The “Emergency Economic
Stabilization Act of 2008.”
In the end, the bill is largely what Mr. Paulson wanted, with some interesting side bars. The House
put in some oversight, but judicial review of the Treasury secretary’s actions is still subject to an
“arbitrary and capricious” standard. Moreover, the executive compensation and the equity purchase
provisions are so watered down that they are not likely to be implemented with respect to any
participating company.
Meanwhile, the most interesting new provision is one allowing the Securities and Exchange
Commission to suspend mark-to-market accounting. As you may have heard, the mark-to-market
requirements have been cited as one of the causes of the current financial-institution liquidity crisis.

The working provisions in the bill are the two that define what the troubled assets are that can be
bought, and from whom they can be bough. The bill provides that “troubled assets” means:
(A) residential or commercial mortgages and any securities, obligations, or other instruments that
are based on or related to such mortgages, that in each case was originated or issued on or before
March 14, 2008, the purchase of which the Secretary determines promotes financial market
stability; and
(B) any other financial instrument that the Secretary, after consultation with the Chairman of the
Board of Governors of the Federal Reserve System, determines the purchase of which is necessary
to promote financial market stability.

So, troubled assets are essentially any financial securities the Treasury secretary deems
appropriate. Mr. Paulson originally asked only for authority to purchase mortgage-related assets.
So, the House has actually expanded Paulson’s authority from what he originally requested,
providing him the authority to extend this program for the entire financial system. Here, the
extension is implemented by another provision, which defines the institutions who can take
advantage of this program. The institutions that can so participate are defined as: any institution,
including, but not limited to, any bank, savings association, credit union, security broker or dealer,
or insurance company, established and regulated under the laws of the United States or any State

So financial institution is defined as any “institution,” and the “including, but not limited to” part just
provides examples. So, Mr. Paulson can buy securities from any institution in the United States.
This could be the dry cleaner down the block, credit card receivables, student loans and those
pesky, bailout-prone automakers. This is an incredible amount of bailout creep in only two short
weeks.
The bill provides for two alternatives to implement this plan. The first is Mr. Paulson’s original
proposal for the Treasury to purchase these troubled assets. The second is the program demanded
by House Republicans, which requires Treasury to offer insurance for these troubled assets.

The first program, the purchase program, provides that: The Secretary is authorized to establish a
troubled asset relief program (or “TARP”) to purchase, and to make and fund commitments to
purchase, troubled assets from any financial institution, on such terms and conditions as are
determined by the Secretary, and in accordance with this Act and the policies and procedures
developed and published by the Secretary.
Again, the issue is this: What price is the government going to pay? Here, the bill states that the
Treasury will disclose policies and procedures for it to make these purchases. So we’ll know shortly
after the bill is enacted. As for overpaying — the bill’s only substantive language on this states:
PREVENTING UNJUST ENRICHMENT. In making purchases under the authority of this Act, the
Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial
institutions participating in a program established under this section, including by preventing the
sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the
asset.

The doctrine of unjust enrichment is defined as when a person receives money or other property
through no effort of his own. But the modifier here would seem to imply that purchasing assets at
above their current value would be acceptable — the government is only talking about the purchase
of assets above the price paid. Given the bare level of review here, this will likely be a weak
constraint on the government’s actions. Ultimately, this means that Mr. Paulson has kept the
authority in his original proposal to set the manner of purchase of these assets and the price.

The second program is for the Treasury secretary to provide a guarantee program for troubled
assets if he sets up the first program. The bill states that “[s]uch guarantee may be on such terms
and conditions as are determined by the Secretary, provided that such terms and conditions are
consistent with the purposes of this Act.” However, the bill requires that the Treasury charge
premiums for this guarantee and that “[t]he premiums . . . . shall be set by the Secretary at a level
necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis,
and to ensure that taxpayers are fully protected.”
So, the second program is required to be offered, but since the insurance premiums required to be
charged will be market rates, they are unlikely to be taken up, because the premiums will be so high
that most companies cannot afford them. This is because these mortgage-related assets are
decidedly risky at this point. The House Republicans ultimately win nothing but being able to say
that the provision is in the bill.
The bill has a provision that the Treasury Department will set compensation and corporate
governance standards, but they are applicable only if the Treasury purchases troubled assets
“where no bidding process or market prices are available,” and the government takes a
“meaningful” equity interest. These requirements are not triggered in the event a financial institution
obtains a guarantee through the second program. Moreover, the compensation standards apply
only if the government makes non-market purchases. In any event, the compensation provisions do
contain a claw back but any standards apply only to the top five compensated officers at the
company.

If the Treasury makes the purchases pursuant to an auction rather than a direct purchase, then the
Treasury is only required to prohibit golden parachute payments for such officers in the “event of an
involuntary termination, bankruptcy filing, insolvency, or receivership.”
The bill does provide for Treasury to take warrants in publicly traded corporations participating in
the program “to provide for reasonable participation by the Secretary, for the benefit of taxpayers, in
equity appreciation in the case of a warrant”. It also provides for the government to make
modifications on mortgage loans it controls.

Ultimately, the bill gives Mr. Paulson discretion on taking equity, and executive compensation
standards will only be implemented if there are direct purchases. This makes some sense, since if
there is an auction or a market purchase, there is no ostensible benefit given to the corporation.
However, neither a market purchase nor a reverse auction in this market is really efficient. So,
perhaps this implies that Mr. Paulson will be doing this pursuant to one of these two means.
Ultimately, these limitations likely mean that no corporation will be subject to these standards and
the Democrats significantly retreated from their initial proposal.

As for oversight, there is lots of talk about guidelines and otherwise in the bill, but ultimately these
are largely phrased so broadly that the Treasury secretary has maximum latitude. There is, though,
an oversight board headed by (1) the Chairman of the Board of Governors of the Federal Reserve
System; (2) the Secretary of the Treasury; (3) the Director of the Federal Home Finance Agency;
(4) the Chairman of the Securities Exchange Commission; and (5) the Secretary of Housing and
Urban Development. The board has only review and reporting authority.

The Treasury secretary initially has authority to purchase $250 billion in troubled assets outstanding
at any one time. The next $100 billion comes upon certification of the Treasury secretary, while the
last $350 billion can be drawn with Congress having the right to veto if it passes a resolution. The
carrying cost of these assets for purposes of these limits is still determined under the Federal Credit
Protection Act, although now the government can adjust the discount rate for market risk. This will
mean that the discount rate will go higher, reducing the value of the assets and meaning Treasury
can buy more of these (spending much more than the $700 billion if it wants).
For more on these last two points see my post “How Much Will it Really Cost?”

Ultimately, this bill grants a terrific amount of authority to Mr. Paulson to implement this bailout on
the terms he deems appropriate. There is a lot of talk about oversight and authority, but ultimately
none of it is mandatory and the judicial review is a high standard. The standard is:
Actions by the Secretary pursuant to the authority of this Act shall be subject to chapter 7 of title 5,
United States Code [that’s the Administrative Procedures Act], including that such actions shall be
held unlawful and set aside if found to be arbitrary, capricious, an abuse of discretion, or not in
accordance with law. [But] No injunction or other form of equitable relief shall be issued against the
Secretary for actions pursuant to section 101 … other than to remedy a violation of the Constitution.

To quote David Zaring at the Conglomerate blog, “You tell me, dear reader, whether the Secretary’s
run-of-the-mill decisions will or will not be subject to arbitrary and capricious judicial review under
the statute.”
If the bill is passed in this form, the Democrats will claim a victory through these executive and
corporate governance provisions as well as the warrant provisions. But Mr. Paulson can decide how
much of these warrants to take, and the executive compensation and corporate governance
provisions are unlikely to be implemented for any companies. The bill is not much different than the
original proposal — just 107 pages longer. Ultimately, the credit markets are frozen and we need
this plan, but the authority provide the Treasury secretary and the potential scope of this program is
troubling.
Expect things to keep moving and changing today, as the Congress officially takes up this bill.
Comments:
1. September 29th,
I know there are allot of added things that have been put in to this bill that don’t
really have to do with the bailout. Why can’t the gov. officials just say it how it is
(short and sweet) not 110 pages. So it’s to the point and there can’t be any vagueness.
Executives should not be allowed compensation if their businesses need gov help.
Their should be no lessening of bankruptcy laws, maybe they should be even stricter.
The gov should not get involved with money market funds and insure them, banks
will even have a harder time finding deposits and thus extend credit. Please really
think this out and I would say PRAY about it, God still watches over us. — Posted
by Mark Truman
2. September 29th
While your analysis is usually spot-on, I don’t think you interpreted the definition
of “institution” correctly. While it is true that the “including but not limited to”
merely provides examples, the phrase “established and regulated under the laws of
the United States” can only be read to modify “institution.” So I don’t think Hank
will be helping out the local dry cleaners. — Posted by Reader1
3. September 29th,
The numerous references in the articles and commentary which have been written
about the bailout bill always refer to the role of Mr. Paulson. It seems more than
likely that Mr. Paulson will no longer be in office beginning in January 2009 and his
 successor could be the appointee of a president of another party . This likelihood
seems not to receive much consideration by the press. — Posted by S.
4. September 29th,
Who could believe that amidst all of the bluster and buffoonery in Congress about
transparency, review, oversight and lax regulation over the past ten days, that that
august body would even condescend to consider allowing the ‘mark to market rules’
being waived? Lots of people find it wonderfully convenient not to acknowledge that
the “Emperor has no clothes”, but Regulators should not be among them. One of the
intrinsic strengths and appeal of the American investment market around the world
is the confidence that investors have in American accounting procedures. This rule
cannot be applied on a case by case basis. If it is applied, investing in American listed
shares becomes a case of blind man’s bluff. — Posted by doubting Thomas
5. September 29th,
I don’t think the mark to market requirement is the reason for all this financial
turmoil. The root of the problem was greed. — Posted by paul
6. September 29th,
In reference to the comment from Reader 1 above, I think it could easily be
interpreted that the local dry cleaners is “established and regulated under the laws of
the United States”. Agencies that come to mind that might regulate such a business
(well, practically every business) include the EPA and the IRS. — Posted by W
7. September 29th,
To No. 2, The definition also includes any “State”. However, I grant you that the
term institution itself could be read to have a narrower reading than corporation. In
addition, the definition states that a financial institution is any institution,
including, but not limited to, any bank, savings association, credit union, security
broker or dealer, or insurance company, established and regulated under the laws of
the United States or any State, territory, or possession of the United States . . . . So
you could argue that an institution can only be a regulated entity under the above
definition, but if you slot the regulated into the part about including we are still
defining any “financial institution” to be an institution. Pretty vague to me still, but
you may have a point that it is more limited than I posit. — Posted by Steven M.
Davidoff
8. September 29th,
Mr Davidoff: Apparently the conclusion is the country will be run by Mr Paulson,
who will make the decisions, rather than the politicians. Somebody who knows
something about finance, rather than someone who pretends to know something
about finance. — Posted by Garrett Skelly
9. September 29th,
Once again, the Bush Administration tells us the sky is falling. Once again, they
urge our Senators and Representatives to take drastic measures in order to prop it
back up, quickly now, before it’s too late! (Doesn’t this sound familiar?) What
should we do? Quick, fork over 700 billion dollars to a financial industry insider,
and give him complete authority to remove those burdensome mortgage-backed
securities from the ledgers of all the banks run by his old buddies. Nobody seems to
know how much they’re worth, but we will encourage our insider not to overpay. Let
him allow his favorite banks to subvert the rules of accounting and keep their losses
off the books. What, the taxpayers want regulation? Fine, our insider will be
supervised by one committee of presidential appointees, and another committee
with a few appointed Democrats. That should satisfy them. This bill transfers
enormous wealth from the taxpayer into the arms of a man partially responsible for
the fix we’re in. Since when do we solve problems by further enriching the
perpetrators of this robbery of the American people? While adding additional
 oversight was a good idea in principle, the weak language of these regulations
ensures that it is nothing better than — wait for it — lipstick on a pig. The Secretary
of the Treasury and his banker friends will laugh all the way to the bank, giggling
with anticipation for the next time they will take my hard-earned tax dollars with
permission of Congress. Is this the best we can do? I am very disappointed in this
bill. — Posted by Sarah
10. September 29th,
An “arbitrary and capricious” standard of review in effect is no standard of review
since courts rarely if ever find that a government official or any defendant has acted
“arbitrarily” and/or “capriciously.” This is THE lowest standard of review possible
which as a practical matter gives Paulsen unfettered discretion. I know this from my
40 years of being an attorney and my several decades as a law professor studying
such matters. It certainly is not what the Democrats in either house or the Senate
Republicans meant by judicial oversight, let alone Congressional oversight. —
Posted by Barbara Brudno, Esq.
11. September 29th,
As proposed, the non-judicial oversight is by a board comprised solely by
appointees of the Bush administration whose failure to regulate is a major source of
the problem. This is not bipartisan oversight and thus raises serious concerns. [add
to previous comment] — Posted by Barbara Brudno, Esq.
12. September 29th,
The bailout bill purports to give Congress the authority to stop disbursement of
the second $350 billion by resolution, but such a legislative veto would likely be
found unconstitutional as a violation of separation of powers. US v Chadha, 462 U.S.
919 (1983). — Posted by John Adams
13. September 29th,
So, they EXPANDED Paulson’s authority with regard to the bad assets he could
buy with public money to include, let’s see, ANYTHING. And EXPANDED the
definition of financial institution to include…wait for it…ANYBODY Paulson wants to
bail out. This includes, presumably, foreign banks, private equity firms and hedge
funds. Astounding. The executive pay provision was written un such a way that it
is virtually un-enforceable, and the oversight provision is toothless. Nicely done,
Rep. Frank and Sen. Dodd. Nicely done. Schmucks. — Posted by Joe
14. September 29th,
Somebody has to do something, and it’s just incredibly pathetic that it has to be us.
— Posted by mbi
15. September 29th,
To say that Wall Street (itself not quite a monolithic entity as it is made out to be)
is greedy is to miss the point. There is no industry in the entire world that doesn’t
have its share of greedy people. At the same time, every industry also has its
conservative stalwarts, those companies and individuals who shun taking larger
risks. The only thing separating Wall Street from other industries is its centrality to
other industries. The connection between a pizzeria in Peoria is likely minimal to a
tailor in Boston, but that’s not the case with Wall Street. It is for that reason that
Wall Street subjects itself to much greater regulation than your average business
does (even in this time of relatively light regulatory oversight over the
industry). Politicians calling Wall Street greedy are simply using populist tactics
and class warfare to get ahead in the political rat race. Bashing the rich is not only
silly, but it’s counterproductive. Somehow, a belief that a person sitting at a desk, not
sweating, and “not making anything” does not deserve wealth is about as antiquated
a notion as a monarchy. It exists, but we’ve found superior alternatives. But there
will always be monarchists. Rather, I would ask people to consider why people who
 sit in front of a computer all day at work and don’t really make anything get paid as
much as they do. It is not because what they offer has no value. Such
products/services go out of fashion quite quickly, but that has not been the case of
the white collar worker, or even more specifically the financial type on Wall Street.
Rather, we find that white collar jobs are a growing portion of our economy and blue
collar jobs are going elsewhere. We’re an economy of service providers, and someone
who can provide services to thousands of people by his or her lonesome (such as a
hedge fund) can rightfully ask to be compensated in such a fashion. Yes, I
understand the rules of our economy have skewed a bit towards the wealthy (let’s not
forget that they still pay the bulk of the taxes in this country), but this has become a
nation where people are unwilling to look into the mirror and recognize that their
value has not gone up nearly as much as that of others’. What matters now is that we
are competitive on a global scale. If you find yourself suddenly charging more than a
Chinese laborer or an Indian call center worker, you have to wonder where you can
provide more bang for your buck. You are now, for all intents and purposes, a
business of one, competing in this global economy. Forget greed and blaming others.
There will always be others to blame, but it’s time that we started to assess our
offering (as capitalism demands) and improve upon it to keep our value higher than
that for the average Chinese or Indian worker. It’s tough, but it’s this sense of
continuous improvement that’s allowed our businesses to be the best in the world.
It’s this sense of continuous improvement that can make our workers the best in the
world. Competition, don’t forget, forces companies and individuals to push
themselves beyond limits they never imagined. It’s not fun, but it is progress. That’s
nothing to turn your nose up at. — Posted by AJ
16. September 29th,
Essentially, Congress jumped through hoops to make it look like they were adding
important language to the bill. At the end of the day, Paulson gets exactly what he
wants. When the whole thing collapses after the horrible January retail numbers
come in, then it might be time for plan B. What’s plan B? Simple. Canned goods and
shotgun shells. — Posted by Juan
17. September 29th,
You are correct regarding the definition of “financial institution”. This is clever
drafting, which is controlled only by the interpretation of what is covered by
“established and regulated under the laws of the US”. Would this extend to hedge
funds? And don’t forget about Sec. 112, which extends the right of the Sec. to
purchase troubled assets held by “foreign financial authorities and central bank”. So
don’t be surprised to see the Sec. Treasury buying “troubled assets” from the Bank of
China or the Saudi Central Bank - this is permitted under the Bill. As to the
restrictions on comp, your initial analysis is only partially correct. While there are
more restrictions in the event of Direct Purchases, the tax provisions that prohibit
companies from deduction executive compensation > $500K are written such that
companies that participate in Direct Purchases are effectively excluded from the tax
provisions. So what the bill took away, the tax provisions gaveth back - clever
drafting. Frankly, the compensation provisions are basically meaningless as they are
so vague as to be completely ineffective.

Finally, Sec. 119 (a)(2) is the most disturbing. Essentially Paulson was in fact given a
judicial blank check - that is, there is no judicial relief available, “other than to
remedy a violation of the Constitution” - so Paulson can cut any deal he wants with
Goldman or the Bank of China or the Saudi’s and there is nothing anybody can do!
No wonder the pols were congratulating themselves in front of the cameras - a very
effective way of diverting attention from what really happened - they got some
 reporting and $50million for an inspector general but Paulson and Bush otherwise
got the blank check they asked for plus, more. The key point, that I have been waiting
for the press to report, is that Paulson can expand the bailout to cover credit cards,
and auto loans, and RV loans and every other form of securitized debt that has been
packaged over the last decade - and so when that occurs, $700 billion is going to
seem like a drop in the bucket. Better hold on tight…….. — Posted by Frank
18. September 29th,
The term “mortgage related” is even too broad. It should be “mortgage backed” as
“related” is open to interpretation. Bank of America is already taken — should this
be the Paulson Federal Bank? — Posted by ken
19. September 29th,
no wonder the thing did not pass. Better luck next time. Hope the markets hold
together that long. Election is five weeks from tomorrow. . . . — Posted by Dave

The Big Bailout: Measuring the Aftershocks

While the government's plan lets Wall Street relax for the time being, huge questions about
potential side effects of the strategy remain

Capping possibly the wildest week in U.S. financial history, the markets breathed a sigh of relief on
Friday, Sept. 19, at the U.S. government's multipronged plan to fight the financial crisis
(BusinessWeek.com, 9/19/08), including a bailout fund par excellence to be created by the
Treasury Dept. that will buy up bad debt and cleanse financial institutions' balance sheets of the
toxic credit derivative products they have been holding. The details of the fund—how much bad
stuff it will be authorized to buy and how those assets will be valued, to take two examples—are still
to be worked out, and therein lies a host of questions about what negative side effects there
potentially will be as a result.

In addition to the bailout fund, which could cost taxpayers up to half a trillion dollars, the
government's overhauled playbook includes the Federal Reserve's unprecedented $85 billion
bailout of privately owned insurance giant American International Group (AIG), Treasury's $2 trillion
backstop of U.S. money market funds, and the U.S. Securities & Exchange Commission's
temporary ban on short-selling on nearly 800 U.S. financial stocks.

To borrow the medical metaphor that's been cited all week, with priority given to restarting the
patient's heart, less attention has been paid to the possible collateral damage the stress may cause
his other vital functions. While survival of the financial system has been at the forefront of people's
mind, there are a host of questions that remain to be answered in the weeks and months ahead,
from details about how some of the government programs will work to possible unintended effects
the cure may have on the way the markets function and how the economy performs over the longer
term. BusinessWeek takes a look at some of the potential aftershocks.

Foremost will be how actually to value the assets to be bought by the superfund, a task likely to be
neither simple nor quick, given the difficulty the market has had up until now in valuing them amid
widespread unwillingness to buy them, says Hank Herrmann, chief executive of Waddell & Reed
(WDR) in Overland Park, Kan. "A great deal of consideration has been given to how to value
[collateralized debt obligations]" to no avail, he says. "And who's going to value them? Outside
professionals?"

WORTH THE NEGATIVES?

Herrmann also wonders what impact those valuations will have on homeowners across the country
when their neighbors' foreclosed houses start being appraised differently and how fair that is to
people who have kept up with their mortgage payments. "It's a lot better than the vicious cycle of
spiraling down we've been having, so I think you're going to have to put up with some of this stuff,"
he concludes.

A related question is who exactly will U.S. taxpayers be bailing out? Should the commercial banks
struggling with mortgage loans that have gone into default be treated the same way as the broker-
dealers who are responsible for helping to create the crisis in the first place, asks David Joy, chief
market strategist at RiverSource Investments in Minneapolis.
"It's the banking system you want to help out here. You want to free up credit so lending takes
place. I'm not sure that's helped by including the [large financial] institutions in this," says Joy.

Another matter to be clarified: Will the government be buying bad mortgage-backed securities
bought by foreign central banks and other overseas investors?

Although the credit crisis has been addressed, the reality of how all these extraordinary measures
taken by the government over the past two weeks will play out in the economy is still very fuzzy,
says Herrmann at Waddell. A major uncertainty is what impact it will have on the creditworthiness of
the U.S. government itself and whether or not that is reflected in the value of the dollar, he says.
That's hard to gauge since the number of other countries with possibly more complicated problems
may leave foreign investors no better alternative for where to stow their money, he adds.

AN IFFY SUPPLY INCREASE

With the national deficit expected to double next year to $800 billion as a result of the bailouts, a
hike in inflation is very likely, say investment strategists. The extent to which the money supply
expands will depend on how much money the Fed decides to create, vs. swaps and transfers says
Herrmann. If the Fed decides to sell more Treasury bonds to help finance the programs, and the
public gives cash to the Fed in exchange, does that really increase the money supply? he wonders.
And how might the bond market react to a big expansion in Treasury debt? Treasury yields plunged
this week in reaction to an enormous flight to quality into government bonds.

"The Fed can attempt to sterilize some of this by selling Treasuries and taking some money out of
the system, but I'm not sure they have the latitude to do that," says Joy at RiverSource. The central
bank's balance sheet has gone from 80% Treasuries to 50% since the crisis began, he says.
Herrmann also allows for the possibility of deflation as a result if the government moves lead to
more risk-averse behavior from the banks and credit remains hard to come by. That would translate
to less economic expansion and probably reduced concerns about inflation, he says.

The SEC's sudden ban on short-selling on 799 financial stocks—perhaps the most controversial
move—has already had an unintended disruptive impact on the options market, where market
makers rely on being able to short underlying stocks in order to hedge their risk.

ANOTHER CRISIS?

By implementing the new rule on options expiration Friday, the busiest day of the month for the
options market, without consulting the exchanges or firms that make a market in options, the SEC
caused liquidity to freeze up and the bid-ask spread on options to widen on Sept. 19, says Joe
Kusick, senior market analyst at OptionsXpress (OXPS) in Chicago.

"Depending on what the SEC does right now, we have an extreme problem on our hands come
Monday [the day the ban takes effect]. The exemption has not been made for market makers," he
says. "This is adding another potential crisis. The options exchanges with the short-stop rule cannot
provide the liquidity necessary to stay open."
He says the SEC needs to make a definitive statement about the impact that the rule, which lasts
until Oct. 2 but could be extended for up to 30 days, will have not only on retail customers but on
the exchanges and how they provide that liquidity.
As for whether the government's new rule book has overturned long-standing assumptions of how
free markets are supposed to operate, Alec Young, equity strategist at Standard & Poor's Equity
Research, thinks it's too soon to tell. "It's dangerous to make heavy-duty judgments when you're still
sort of in the eye of the storm," he says. "This has been a fairly run-of-the-mill bear market if you
see the percent decline. It will reinforce the fact that equities tend to outperform other assets like
Treasuries over time because you take on more risk."

He doubts that many investors will turn away from stocks in the long run because of the extra
volatility. Most people, he believes, own stocks for retirement purposes in tax-deferred accounts
and don't rely on them for short-term gains.

Joseph Biondo Sr., senior portfolio manager at Biondo Investment Advisors in Milford, Pa., says
he's not worried about a challenge to the free market philosophy but warns that the regulation likely
to be imposed could become too confining. Ironically, the comprehensive bailout plan could turn out
to be the ultimate moral hazard, encouraging more reckless risk-taking behavior in the future.
There's certainly potential that by providing a backstop for money market funds, the government
might exacerbate the temptation of overly reckless behavior, unless it puts regulations in place to
prevent inappropriate practices, says Herrmann. Those regulations would add an extra layer of
expense on those running the money funds, however, he adds.

Wall Street Bailout: Now, the Lawsuits

Angry investors are suing the Reserve Fund for "breaking the buck," AIG for pension losses, Merrill
Lynch for its Bank of America deal—but the bar is high

Consider the developments of the past 10 days: collapsing share prices, huge investor losses,
allegations of financial obfuscation and mismanagement. It would seem a likely setup for a new
wave of litigation and a boon for the plaintiffs' bar. The reality, however, is far more muted. Legal
rulings have made it significantly harder to press shareholder claims. And since the victims of the
current financial carnage include some of the primary defendants themselves, investors may find
themselves reaching into empty pockets for redress.

Yes, lawsuits stemming directly from the turmoil of recent days have been filed. On Sept. 19, for
example, an investment firm sued the Reserve Fund, a money-market fund that serves institutions,
for "breaking the buck" and causing a flood of investors to cash out at less than $1 per share. A
former employee sued American International Group (AIG) for losses in AIG's pension resulting
from the collapse of the insurer's stock. And a Merrill Lynch (MER) shareholder sued the investment
firm, claiming the terms of its proposed acquisition by Bank of America (BAC) are unfair.

Reserve Fund representatives could not be reached over the weekend for comment. An AIG
spokesman says the company does not discuss pending litigation, and Bank of America said it has
no comment. Merrill Lynch did not immediately respond to requests for comment.

TOUGH SLOG FOR PLAINTIFFS

The fact is, though, many of the nation's major financial-service firms were sued months ago for
losses stemming from the subprime mortgage crisis. Plaintiffs already faced tough slogging in those
cases due to U.S. Supreme Court decisions in recent years that raised the bar for investor claims.
To avoid having their cases dismissed, for instance, investors must now come forth with very
specific allegations about what defendant companies did to knowingly deceive the market—a high
hurdle. And a ruling in January of this year made it virtually impossible to try to hold corporate
advisers, such as accountants and lawyers, responsible for a stock issuers' securities fraud, putting
any insurance they have beyond reach.
Recent events raise additional obstacles. With Lehman Brothers (LEH) in bankruptcy, all lawsuits
against the firm are frozen and funds to pay out on any claims will be severely limited. Squeezing
money out of institutions that have been effectively nationalized, such as AIG, Fannie Mae (FNM),
and Freddie Mac (FRE), will also be no easy task. "It's going to make it more challenging for
investors to recover assets that have basically gone into thin air," says Gerald H. Silk, an attorney
with Bernstein Litowitz Berger & Grossmann, the New York firm that filed suit against the Reserve
Fund. As for losses incurred in recent days, defendants may assert they were due not to any
misleading statements or mismanagement on their part but by the calamitous state of the markets.
Courts don't award damages for market-related price drops.

NEXT TARGET: RATING AGENCIES?

Plaintiffs' attorneys vow to press forward, including with new cases. Rating agencies may once
again come within their sites, says John P. "Sean" Coffey, another Bernstein Litowitz lawyer. They
"are very complicit in this disaster," he maintains. "They were putting the Good Housekeeping seal
of approval on crap." Courts have rejected past efforts to hold bond raters liable, in part based on
the notion that ratings are expressions of opinion protected as free speech. Fitch Ratings said it had
no comment; Moody's Investors Services (MCO) did not respond to a request for comment;
Standard & Poor's, which, like BusinessWeek, is a division of The McGraw-Hill Companies (MHP),
declined to comment.

The phenomenon of investors losing money in supposedly highly secure money-market funds may
also prompt additional litigation. Says Darren J. Robbins, an attorney at Coughlin Stoia Geller
Rudman & Robbins in San Diego: "You cannot overstate the concern that our pension fund clients
have concerning those investment vehicles marketed as conservative" turning out to hold
"substantial amounts of high-risk, mortgage-backed products."

The Bailout: Public Anger, Private Talks

Congress is wary of angry voters, but behind the scenes a compromise is forming. Executive pay
restrictions may be near

With public sentiment casting the Bush Administration's plan to resolve the financial crisis as a
bailout for the firms that caused it, Senate Banking Committee members took turns grilling Treasury
Secretary Henry Paulson and Federal Reserve Board Chairman Ben Bernanke at a hearing on
Sept. 23. Behind the scenes, however, many expected nuts-and-bolts negotiation to yield a
compromise bill, perhaps over the weekend if not by Friday's scheduled adjournment. Agreement
was already coalescing to require some restrictions on executive pay at companies that sell toxic
assets to the Treasury, one financial-industry official said.

The theater playing out on Capitol Hill on Tuesday reflected deeply held positions on the role of
government and the economy, but with an eye toward how events would play out politically. Polls
failed to give a clear picture of just how much support there is for Congress to act: Support ranged
from 25% to 56% in different polls.

Lawmakers worry that failing to back the bailout could hurt them, particularly in light of the
Administration's warnings of the dire consequences of inaction and the reality of a tumbling stock
market (BusinessWeek.com, 9/23/08). At the same time, fears grew that a protracted debate could
undermine support altogether as more questions are raised about the plan's costs and
effectiveness.

SOME HOMEOWNER HELP

Political analysts predicted both sides would give way at least partially on various fronts. Indeed, the
Administration has already indicated it would accept at least some provisions aiding homeowners
struggling to pay their mortgages, and the House was said to be cooling to a proposal, popular
among many Democrats, to allow judges to modify mortgages in bankruptcy court. Congressional
aides conceded the measure faced too much opposition from the financial-services industry, which
has focused its most intense lobbying efforts on killing the provision.
Senator Christopher Dodd (D-Conn.), chairman of the Senate Banking Committee, said he would
work with Representative Barney Frank (D-Mass.), chairman of the House Financial Services
Committee, to combine draft legislation each chamber had circulated.

Many of the Democrats' demands could ultimately prove to be part of a strategy to "ask for five in
the hopes of getting three," says Daniel Clifton, a political analyst for investment adviser Strategas
Research. And the political calculus has many twists: Democrats, for example, could suffer if they
are seen as impeding a much needed rescue, or might set themselves up for a public-relations
victory if the Administration succeeds in blocking executive-pay restrictions (BusinessWeek.com,
9/22/08) or measures to help homeowners that prove popular. That would be a win-win either way:
Six weeks before the election, they could tell the folks back home they won such concessions from
the Administration, or they could campaign on the fact that Republicans blocked them.

However, one financial industry official said that Republicans have read the populist writing on the
wall. "Senate Republicans have now endorsed putting limits on executive comp, so that will stay in
the bill," said Scott E. Talbott, senior vice president of government affairs for the Financial Services
Roundtable, which represents the country's largest financial services companies. "That's why
Republicans endorsed the exec compensation bit—so they can go home and look their constituents
in the eye and say, 'yes, it cost $700 billion in the end, but we also cut their pay.' After today's
testimony, enough members heard the doom and gloom."

DIRE WARNINGS FROM THE ADMINISTRATION

During Tuesday's steady-rolling, five-hour hearing, the main battle lines were clear: Bernanke,
Paulson, and other Administration officials urged quick passage of a stripped-down bill to let the
Treasury use up to $700 billion to buy complex mortgage-related securities from financial
institutions. That would push many decisions—about oversight, disclosure, the prices the
government would pay to take toxic assets off corporate balance sheets—into the future, leaving
most such calls up to the Treasury, in this Presidential Administration and the next.

Bush Administration officials warned of dire consequences should Congress delay or impose too
many limits on Treasury's authority. Paulson said he believed the stock market's recovery late last
week stemmed from the belief that Congress would act. "I feel great urgency, and I believe it's got
to be done this week or before you leave," Paulson said. Stocks opened ahead early Tuesday, but
sank as the hearing progressed. The Standard & Poor's 500-stock index closed down 18.87, or
1.56%, to 1,188.22. The Dow Jones industrial average was off 161.52, or 1.47%, to 10,854.17.
Including Monday's 370-point drop, the Dow was down 534 points, or 4.69%, so far for the week.

The response from lawmakers to the bailout plan was generally chilly. Most indicated that they
agreed some action was necessary soon. But many took the Bush Administration to task for initially
proposing to give itself nearly complete discretion, with no oversight and no judicial review.
Administration officials have since indicated that they would accept some measure of oversight,
though details remain unclear. Congressional proposals include an inspector-general's office,
regular audits, and weekly public disclosures, among other measures.

TAKING WALL STREET TO TASK

Senators of both parties demanded more oversight and transparency, questioned the
Administration's decision not to give taxpayers a stake in companies benefiting from the Treasury
program, and above all insisted that the final measure should clearly and in many cases directly
assist homeowners struggling to pay their mortgages. Many Democrats called for restrictions on
executive compensation, and several held out hope that the final measure would allow judges to
modify the terms of mortgages in bankruptcy court, much as other loans can be modified.

Throughout, the senators took Wall Street and the financial sector vigorously to task. Some
Senators expressed skepticism that the multibillion-dollar bailout would resolve the economic threat.
"Wall Street bet that the government would rescue them if they got into trouble; it appears that bet
may be the one that pays off," said Senator Richard Shelby (R-Ala.). "I do not believe, however, that
we can solve this crisis by spending a massive amount of money on bad securities."

Congressional staff and political analysts say that, while many lawmakers have been impressed by
Bernanke and Paulson with the need to move swiftly, they also have constituents to satisfy. And
those constituents appear to be taking a dim view of the Treasury's proposal. Some of those
insiders predicted that a compromise would likely be reached by week's end, and said much of the
bickering over specific provisions would fall by the wayside—with each side getting a few key
concessions—as a kind of posturing aimed at placating constituents. "The phones are burning up
with angry constituents," says Howard Glaser, a former Clinton housing official and mortgage-
industry consultant. "Congress is looking for something to say, 'Here's help for households.'"

CALLS FOR DUE DILIGENCE

Indeed, calls for "foreclosure assistance" peppered the hearing. Dodd complained at the outset that
Treasury's proposal "would do nothing, in my opinion, to save a single home, at least up front."

Lawmakers have been reluctant to embrace Paulson and Bernanke's argument that helping the
financial markets will help Main Street to prevent foreclosures. "The very best thing we can do is
make sure the capital markets are open and that lenders are continuing to lend," Paulson said.
Instead, draft legislation circulated for discussion in both the House and Senate this week have
included provisions designed to help homeowners stave off foreclosure directly.

In the hearing, lawmakers also took issue with the Administration's request for access to $700
billion, and by the hearing's end, several seemed to be mulling the possibility of handing over only a
portion of the $700 billion the Administration has requested and doling out more as results warrant.
"None of the thousands of money managers would invest that sum without the appropriate due
diligence," said Senator Charles Schumer (D-N.Y.) "This hearing today and the discussions that will
follow are our due diligence."

PROFIT NOT LIKELY

Paulson stressed that the loans and mortgage-related securities Treasury acquired would
eventually be sold to recoup some of the outlay, and acknowledged that the agency wasn't likely to
use the full amount quickly. But he said the Treasury needed access to the full amount from the
beginning. "The best way to protect the taxpayer…is to do something that has the maximum chance
of working," he said. "We need market confidence and we need the tools to work with."

A few lawmakers suggested that the rescue program, run judiciously, might break even or turn a
small profit. Paulson and Bernanke made clear that they didn't consider a profit likely.

Paulson and Bernanke took perhaps greatest issue with suggestions that the government should
receive stakes in companies that seek federal aid, and that the companies should also accept limits
on executive compensation. Paulson noted that the government has acquired stakes in companies
it has saved from insolvency, including a 79.9% stake in insurer American International Group
(AIG). But he stressed that the plan for systematically buying up troubled securities depends on a
broad spectrum of companies participating. Layering conditions on the program would dissuade
them. "If we have to have companies grant equity stakes, grant options, that would render this
ineffective," Paulson said. Compensation reforms, meantime, can wait for more deliberate
regulation in the near future, he said.

Thomas Friedman: No laughing matter

Sunday, September 21, 2008

Of all the points raised by different analysts about the economy last week, surely the best was
Representative Barney Frank's reminder that Ronald Reagan's favorite laugh line was telling
audiences that: "The nine most terrifying words in the English language are: 'I'm from the
government, and I'm here to help."'

Hah, hah, hah.

Are you still laughing? If it weren't for the government bailing out Fannie Mae, Freddie Mac and
AIG, and rescuing people from Hurricane Ike and pumping tons of liquidity into the banking system,
our economy would be a shambles. How would you like to hear the line today: "I'm from the
government, and I can't do a darn thing for you."

In this age of globalization, government matters more than ever.

Smart, fiscally strong governments are the ones best able to empower their people to compete and
win. I was just in Michigan to give a talk on energy. I can't tell you how many business cards I
collected from innovators who had either started renewable-energy companies or were working for
big firms, like the Dow Chemical Co., on clean energy solutions.

It just reminded me how much innovative prowess and entrepreneurial energy is exploding from
below in this country. If it were channeled and enhanced by better leadership in Washington, no one
could touch us.

If I were to draw a picture of America today, it would be of the space shuttle taking off. There is all
this thrust coming from below.

But the booster rocket - Washington - is cracked and leaking energy, and the pilots in the cockpit are
fighting over the flight plan. So we can't achieve escape velocity to enter the next orbit - the next
great industrial revolution, which is going to be ET, energy technology.

In many ways, this election is about how we get our groove back as a country. We have been living
on borrowed time and borrowed dimes.

President Bush has nothing to offer anymore. So that leaves us with Barack Obama and John
McCain. Neither has wowed me with his reaction to the market turmoil. In fairness, though, neither
man has any levers of power to pull. But what could they say that would give you confidence that
they could lead us out of this rut? My test is simple: Which guy can tell people what they don't want
to hear - especially his own base.

Think how much better off McCain would be today had he nominated Michael Bloomberg as his
vice president rather than Sarah Palin.

McCain could have said, "I'm not an expert on markets, but I've got one of the best on my team."
Instead of a VP to re-energize America, McCain went for a VP to re-energize the Republican base.

So what would get my attention from McCain? If he said the following: "My fellow Americans, I've
decided for now not to continue the Bush tax cuts, because the most important thing for our country
today is to get the government's balance sheet in order. We can't go on cutting taxes and not cutting
spending. For too long my party has indulged that nonsense. Second, I intend to have most U.S.
troops out of Iraq in 24 months. We have done all we can to midwife democracy there. Iraqis need to
take it from here. We need every dollar now for nation-building in America. We will do everything
we can to wind down our presence and facilitate the Iraqi elections, but we're not going to baby-sit
Iraqi politicians who don't have the will or the courage to reconcile their differences - unless they
want to pay us for that. In America, baby sitters get paid."

What would impress me from Obama? How about this: "The Big Three automakers and the United
Auto Workers union want a Washington bailout. The only way they will get a dime out of my
administration is if the automakers and unions come up with a joint plan to retool their fleets to get
an average of 40 miles per gallon by 2015 - instead of the 35 mpg by 2020 that they've reluctantly
accepted. I am not going to bail out Detroit with taxpayer money, but I will invest in Detroit's
transformation with taxpayer money, provided the management and unions agree to radical change.
At the same time, while I will go along with the bailout of the banking system, it will only be on the
condition that the institutions that got us into this mess accept sweeping reforms - in terms of
transparency and limits on the leverage they can amass - so we don't go through something like this
again. To help me figure this out, I'm going to keep Treasury Secretary Hank Paulson on the job for
a while. I am impressed with his handling of this crisis."

Those are the kind of words that would get my attention. The last president who challenged his base
was Bill Clinton, when he reformed welfare and created a budget surplus with a fair and equitable
tax program. George W. Bush never once - not one time - challenged Americans to do anything
hard, let alone great. The next president is not going to have that luxury. He will have to ask
everyone to do something hard - and I want to know now who is up to that task.

Wall Street Bailout Could Cut CEO Pay

Democrats want to rein in rich exit packages and reclaim millions paid to bosses who piled
up toxic mortgage assets. But it won't be easy.

As Congress and the Bush Administration negotiate over the terms of a financial rescue bill,
Democrats on Capitol Hill are drafting language designed to rein in executive compensation, in
particular controversial severance packages at foundering companies. And for politicians concerned
about the growing backlash on Main Street over what many see as a bailout of Wall Street fat cats,
executive pay is a ripe target. After all, average total pay for a CEO at one of the 500 biggest
companies last year was $12.8 million, double what it was a decade ago.

But compensation attorneys and experts say many of the restrictions could prove tough to enforce.

Executive pay was shaping up as one of a few remaining sticking points as Congress and the
Republican Administration hurried to put a deal together amid further stock market declines on
Sept. 22. In several areas the players were nearing accord, with Administration officials reportedly
accepting some congressional oversight and relief for homeowners struggling to pay their
mortgages -- key provisions for Democrats.

Legislative language circulating on Capitol Hill on Monday afternoon also included mechanisms that
would give the government ownership stakes in companies benefiting from the bailout, to make up
for losses the government might incur. Senate Democrats revived a provision that would allow
judges to modify the terms of mortgages in bankruptcy proceedings, much as other debts can be
adjusted. But the financial-services industry is strongly opposed to the provision and some
predicted it would not garner sufficient support in the House.

Vaguely Worded Provisions

Treasury Secretary Henry Paulson was scheduled to appear before the Senate Banking Committee
on Tuesday, Sept. 23, with Federal Reserve Chairman Ben Bernanke and Christopher Cox,
chairman of the Securities & Exchange Commission. Lawmakers have said they hope to craft a
deal by the end of the week, when Congress is slated to adjourn.

Although executive-pay restrictions received considerable attention publicly and in negotiations on

the Hill, the draft bills themselves included only short, vaguely worded sections that would require
Treasury to limit pay and severance for executives at companies from which it buys troubled assets,
while giving the agency wide discretion over the details. Treasury Secretary Paulson,
acknowledging that "there have been excesses" in executive pay that should be addressed, has
argued that the government's first priority should be stabilizing the financial markets, with
compensation curbs and other reforms to come later.

A Senate discussion draft would require the government to ban incentive payments that the agency
considers "inappropriate or excessive;" require executives to return incentives "based on earnings,
gains, or other criteria that are later proven to be inaccurate;" and limit severance as "appropriate to
the public interest" and the assistance the company receives.

Severance Pay Ban

Language in a draft House bill was similar, applying the restrictions for two years following Treasury
assistance. But it also imposed additional restrictions on at least some companies, banning
severance pay for top executives and requiring the companies to make it easier for substantial
shareholders to nominate and elect board members and for shareholders generally to hold advisory
votes on executive compensation.

Capitol Hill staffers acknowledged that the measures were worded broadly and said lawmakers
want to give Treasury authority it can actually use. "The goal is something that sends a clear
message of intention but is not necessarily binding" on Treasury, one senior congressional aide
said.

A variety of obstacles face the Treasury if it ultimately sets out trying to enforce such provisions.

Legal Remedies May Be Required

For one thing, executive compensation is typically governed by multiyear contracts. Forcing
companies to change provisions in those contracts could require them to reopen negotiations with
the executives who stand to lose benefits. Getting those execs to agree without sweetening the
deal in some other way could prove difficult, especially if the executives are on their way out the
door or face being ousted. "If I'm being invited to modify the agreement and then being shown the
door at the same time, I'm probably not going to be too agreeable," says Lewis Wiener, head of the
financial-services litigation practice at Sutherland Asbill & Brennan.

Nor are many executives likely to simply agree to give up pay because of public pressure and
publicity, if recent history is any guide. Most executives who have agreed to surrender
compensation have done so after being sued. Former UnitedHealth Group Chief Executive William
McGuire, for example, agreed earlier this month to repay $30 million and return some 3.7 million
stock options to settle allegations of backdating stock-option awards. (McGuire denied wrongdoing.)

"People settle for all kinds of reasons, but usually it's because there's some kind of potentially valid
legal claim," says Robert Salwen, a compensation consultant in Scarsdale, N.Y. "If that's not the
case, then I wouldn't assume these people would be prepared to relinquish substantial sums of
money, period."

Constitutional Challenge Possible

"Claw-back" provisions requiring executives to give up pay or severance benefits if corporate results
prove to be misstated, for example, might be even trickier. Large companies have increasingly
written claw-backs into executive-pay contracts, with triggers ranging from financial restatements to
fraud. But where such clauses aren't already in place, the government's insistence on adding one
could leave it open to a constitutional challenge under the Fifth Amendment, which bars the
government from taking private property for public use without just compensation.

That's particularly true where the severance had already been earned by the executive or paid out
to him. But even where the change modified existing severance promises by the company,
executives could find plenty of room to sue, says Wiener, defending "takings" litigation in which
plaintiffs argued that the government had taken property in violation of the Fifth Amendment. "I think
there's merit to that case," he says.

In bankruptcy proceedings, creditors in some circumstances can seek to recover compensation

already paid out, particularly if executives maintained the company was still solvent when it wasn't,
says Paul Hodgson, a senior research associate at the Corporate Library, a corporate-governance
research firm. Still, "if the company was solvent when it paid out the compensation, there's no real
legal backing for recouping any of that" in bankruptcy court, Hodgson says.

How Will Banks Fare in the Bailout?

Here are the industry winners and losers that could emerge as the grand plan takes shape

The details still have to be worked out for the $700 billion fund the U.S. government will create to
take distressed mortgage-related assets off banks' hands in hopes of thawing the country's frozen
credit system. The most obvious beneficiaries of the plan will be members of the "shadow banking
system," including such surviving investment banks as Merrill Lynch (MER)— which has agreed to
be acquired by Bank of America (BAC)— and Morgan Stanley (MS), but even more conservative
commercial banks that don't have much to purge from their balance sheets are expected to gain as
the effects of the program spread through the economy.

A major question that will determine how helpful the bailout is: the price the government is willing to
pay, which could turn out to be as low the 22 cents on the dollar that Merrill Lynch got for $30 billion
in assets it sold to private equity firm Lone Star in July.

The financial companies that are holding distressed assets don't even necessarily have to sell them
to the U.S. Treasury in order to benefit from what many are calling the "mother of all bailouts." A
financial company might decide not to sell its distressed assets in the belief that there's more value
in holding onto them until the market recovers somewhat and prices for the assets increase,
predicts Gerard Cassidy, senior equity analyst at RBC Capital Markets (RY) in Portland, Me.

THE BUYER OF LAST RESORT

As Merrill Lynch's transaction with Lone Star showed, the discount on these assets has two
components: credit risk, which is based on the likelihood of defaults on the underlying mortgages,
and lack of liquidity discount, which stems from a dearth of potential buyers, says Cassidy.

By stepping in as the buyer of last resort, the U.S. government will be pumping liquidity into the
banking system, which is expected to boost the value of these securities, he says. As a result, the
liquidity discount in the price of the assets should narrow substantially as market participants
recognize there's a big buyer providing liquidity, which could help attract more buyers, Cassidy
adds.

One group that isn't likely to get any relief from the bailout are hedge funds that hold a large
quantity of the distressed debt products, says Jack Ablin, chief investment officer at Harris Private
Bank (BMO) in Chicago. "Here's a case where hedge funds, as unregulated entities, have no
recourse at the table," unlike the banking lobby and mutual-fund industry group Investment
Company Institute, both of which will likely have some influence over the legislation that ultimately
materializes, he says. He also believes the hedge funds were directly targeted by the Securities &
Exchange Commission's ban on shorting more than 800 financial stocks, which took effect on Sept.
22 and is due to last through Oct. 2.

GM MAY BE A LOSER
Other losers may include companies such as General Motors (GM), whose affiliated financing arm
GMAC likely has exposure to toxic securities but may not qualify for the government bailout
because it's not strictly a financial firm, says Ablin. "You certainly get into odd territory with GMAC,"
he says. "It's almost entirely owned by a private equity fund [Cerberus Capital Management]. So do
you want to bail out [Cerberus chairman] John Snow?"

Commercial banks, most of which have kept their balance sheets free of toxic assets, will probably
benefit indirectly as the increase in market liquidity will help push their borrowing costs lower, says
John Jay, senior analyst at the Aite Group, an independent financial services research firm in
Boston. "If [its funding costs] go low enough, their senior managers will start to look for businesses
to lend money to." In the end, their profit margins are expected to grow as the differential between
their borrowing costs and lending rates widens.

The shares of some financial players have had a strong run in spite of the market's attempts to
paint them with the same brush as the rest of the industry, says Jocelyn Drake, an equity analyst at
Schaeffer's Investment Research in Cleveland. PNC Financial Services (PNC), Wells Fargo (WFC),
and Hudson City Bancorp (HCBK) all steered clear of toxic assets and their shares hit one-year
highs last week before Treasury Secretary Henry Paulson announced the plan on Sept. 18. The
shares posted further gains after the announcement.

SKELETONS IN THE CLOSET

Schaeffer's tends to base its stock picks on technical performance and the degree of pessimism
directed at them. Market pessimism —which is reflected in analysts' ratings, the level of short
interest and the ratio of options betting on lower prices for certain stocks vs. bets on higher prices—
can give you a sense of how much investing money is sitting on the sidelines waiting for the right
signals to come into the market. "There are still some skeletons that could come out of the closet
[for the financial industry] and hinder the group," says Drake. But she's betting that as certain stocks
continue to buck the trend and outperform their peers, sidelined investors will cave in and start to
buy these stocks so as not to miss the boat.
There are also a couple of homebuilder stocks that Drake expects to benefit as liquidity returns to
the housing market and inventory begins to move.

She likes Meritage Homes (MTH) and Toll Brothers (TOL), both of which have been in an uptrend
since the beginning of this year. She takes the drop in mortgage rates after the government bailout
of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) was announced two weeks ago as a
positive sign, which she believes will help stoke demand for houses.

A CONTRARIAN VIEW
She recommends that investors hedge such bets that go contrary to market sentiment by buying
shares of index exchange-traded funds that short the corresponding sectors. For financials, she
uses Financial Select Sector SPDR (XLF and UltraShort Financials ProShares (SKF) to hedge her
bank picks and SPDR S&P Homebuilders (XHB) to protect against the downside in homebuilders.

A U.S. financial rescue plan, with modifications, seen as likely

Wednesday, September 24, 2008

Influential U.S. lawmakers said Wednesday that the proposed $700 billion financial rescue plan was
likely to win approval, but in modified form, as the Federal Reserve chairman, Ben Bernanke,
warned Congress that a weakening economic outlook at home and abroad made it imperative to
take quick action.

"Despite the efforts of the Federal Reserve, the Treasury and other agencies, global financial
markets remain under extraordinary stress," Bernanke told the Joint Economic Committee of
Congress, predicting that the U.S. economy was likely to lose ground even if the plan was
approved. But without it, he warned, the situation would be far worse.

"Action by the Congress is urgently required to stabilize the situation," he said, "and avert what
otherwise could be very serious consequences for our financial markets and our economy."

The committee chairman, Senator Charles Schumer, Democrat of New York, said that all but "a few
outliers" among the lawmakers agreed that some version of the vast plan to rescue the U.S.
financial system must be approved, and soon. But he said it would not be passed without adequate
safeguards that lawmakers intend to add to protect the interests of taxpayers.

Bernanke's testimony, part of an intensive drive at the Capitol for the bailout, came the morning
after Warren Buffett, the most famous American investor and one of the richest men in the world,
disclosed that he would invest $5 billion in Goldman Sachs, the embattled Wall Street titan. That
move, intended to bolster confidence in the financial markets, was greeted by investors with relief
but did little to push up stocks trading Wednesday in Europe and the United States. Credit markets
remained under stress and the cost of borrowing dollars rose on world markets, requiring central
banks to add extra funds to the banking system.

Until now, Buffett, who has navigated the stock market with legendary prowess, had largely
refrained from investing in the stricken financial industry, saying repeatedly that things could get
worse. Thousands of people on and off Wall Street follow Buffett's moves, so his decision to invest
in Goldman suggested to some that a bottom might be nearing in financial stocks.

"Buffett is saying he's confident," said Brad Hintz, an analyst at Sanford C. Bernstein.

Despite the varied efforts to relieve the financial crisis, the bailout continued to face skepticism,
especially in the House of Representatives, which was holding its first day of hearings on the crisis.

As congressional leaders worked anxiously behind the scenes to build support for a vote later this
week, House Republicans complained bitterly at a meeting of their caucus, telling Treasury
Secretary Henry Paulson Jr. that the White House had failed to explain its proposal to the public.

The result, they said, has been a deluge of calls and e-mail messages from constituents
overwhelmingly opposed to taxpayer money bailing out rich Wall Streeters.

In his testimony, Bernanke said that international trade "provided considerable support for the U.S.
economy over the first half of the year," but that this stimulus could not be counted on in the long
run.

"In recent months," he said, "the outlook for foreign economic activity has deteriorated amid
unsettled conditions in financial markets, troubling housing sectors and softening sentiment. As a
consequence, in coming quarters, the contribution of net exports to United States production is not
likely to be as sizable as it was in the first half of the year."

Bernanke's remarks added to the continuing sense of urgency, as he alluded to extraordinarily high
levels of uncertainty and risk, well beyond the sagging housing market whose troubles lie at the
core of the problems.

The session offered a blend of concerns over financial markets, both on Wall Street and abroad,
and intensely political worries for the lawmakers as Election Day draws near.

Schumer said he and other members of Congress were listening to their constituents, who were
reacting with "amazement, astonishment and intense anger" to the original outlines of the $700
billion plan, as laid out by the administration of President George W. Bush, and to the high-risk
behavior that spawned the crisis.

"We were told that markets knew best, and that we were entering a new world of global growth and
prosperity," Schumer said. "We now have to pay for the greed and recklessness of those who
should have known better."

But Schumer suggested that Congress had little choice but to approve some sort of rescue
package.

"With the exception of a few outliers on either side, there is clear recognition among members of
both parties that we must act and act soon," Schumer said. Without adequate safeguards, however,
"we risk the plan failing."

The White House said that Bush would make a prime-time television appearance Wednesday night
to lift support for the program, whose basic premise calls for the Treasury Department to oversee
the purchase of troubled mortgage-backed securities, reselling them later in a bid to recoup at least
some of the taxpayers' money used to buy them.

The chief spokeswoman for Bush, Dana Perino, said Wednesday that the country could face "a
financial calamity" if Congress did not act soon.

Bernanke, who reminded members of Congress on Tuesday that his background is in academe, not
Wall Street, told Schumer's panel that the Fed believed in general that "private-sector
arrangements" were best in straightening out problems in the financial markets.

"Government assistance should be given with the greatest of reluctance and only when the stability
of the financial system and, consequently, the health of the broader economy is at risk," Bernanke
said. And now is such a time, he said.

Buffett's move suggested that a few well-placed investors might also help stabilize the financial
system.

Buffett's conglomerate, Berkshire Hathaway, announced the move Tuesday, two days after
Goldman, long the premier investment house on Wall Street, embarked on a radical plan to
transform itself into a traditional bank to ensure its survival. Goldman, which examined various
options over the past week as its shares tumbled and some clients abandoned it, also said Tuesday
that it would sell at least $2.5 billion of common stock to the public.

Since the credit crisis began flaring more than a year ago, Buffett had stayed his hand even as
other investors, including funds controlled by governments in the Middle East and Asia, poured
money into ailing U.S. financial companies like Citigroup and Merrill Lynch, only to see their
investments plunge in value.

Wariness is a hallmark of Buffett's investing style, and many on Wall Street have wondered when
he might jump in.
Buffett, 78, has learned from past mistakes in the financial sector. For instance, Berkshire's
acquisition in 1998 of General Re, the insurance company, was marred by a portfolio of complex
derivative securities and state and U.S. government investigations into reinsurance policies written
by the company. Another trying experience was with Salomon Brothers, the Wall Street firm that the
government pressed Buffett to take control of in the early 1990s amid a trading scandal.

But Goldman is a classic Buffett play: It is a blue-chip institution, with a premier brand and a long,
successful history, that has been beaten down in the stock market, and one that he is investing in
on very favorable terms. The share price of Goldman has fallen 39 percent this year and reached a
peak of $250.70 less than a year ago.

Some lawmakers pointed to Buffett’s deal as an example the government should follow. Berkshire
will receive perpetual preferred shares that will pay an annual dividend of 10 percent, or $500
million. Those dividends take precedence over other payments to common shareholders. Goldman
has the right to buy back the shares at any time at a premium of 10 percent.

In addition, Berkshire will receive warrants to buy $5 billion in common stock at $115 a share,
exercisable anytime within five years. Those warrants are already in the money: Goldman shares
rose 3.5 percent Tuesday and climbed $6.62, or 5.3 percent, to $131.67 by Wednesday afternoon.

Meanwhile, doubts were raised about the ultimate cost of any government bailout. Until more
details emerge about what the government will buy, and how, the director of the Congressional
Budget Office said it "cannot provide a meaningful estimate of the ultimate cost" to American
taxpayers.

Over time, Peter Orszag of the nonpartisan budget office told the House Budget Committee, the
cost could actually be less than the $700 billion sticker price. The challenge, he said, is for the
Treasury to avoid taking the riskiest assets off Wall Street's hands unless it can get them at fire-sale
prices.

Ben White reported from New York

U.S. home prices tumble

A record decline in U.S. home prices in August attracted more buyers in some areas and led to a
sizable decline in the number of unsold homes on the market, the National Association of Realtors
said Wednesday, The Associated Press reported from Washington.
The median price fell 9.5 percent, to $203,100, the largest price decline in records dating to 1999.
As prices fall, buyers are taking advantage of steep discounts, especially in hard-hit markets like
California, Nevada and Florida.

The inventory of unsold homes fell 7 percent, to 4.3 million, from the record of 4.6 million in July.
That is a 10.4-month supply at the current sales pace. But the decline merits only "a small round of
applause" because around 5 months of inventory is a more typical level, wrote Patrick Newport, an
economist with Global Insight. Lawrence Yun, the trade group's chief economist, said he hoped the
downward trend in inventories continued because "home prices will not stabilize as long as
inventories remain high."

Washington Mutual may be on block

Thursday, September 25, 2008

U.S. government regulators are moving quickly to broker a deal for Washington Mutual as the
savings-and-loan comes under mounting financial pressure, according to people briefed on the talks.

Even as Washington moves to bail out financial institutions, the fortunes of Washington Mutual
have spiraled downward. On Wednesday, Standard & Poor's, a major credit rating agency,
downgraded Washington Mutual's debt further into junk territory, citing the increased chance that
the company might have to be split up to facilitate a sale.

Washington Mutual insists that it is well-capitalized and has adequate access to funding and noted
"the rating actions do not affect the safety of customer deposits, which are insured up to the limits
allowed" by the U.S. government.

Brad Russell, a Washington Mutual spokesman, declined to comment on speculation about a

possible sale. Still, shares fell 94 cents, or 29 percent, to $2.26 a share on Wednesday, leaving them
down 83 percent this year.

The government's entrance suggests the sales process may be entering a new phase after the bank
struggled to find an interested buyer. Washington Mutual had vowed that it could remain
independent, but it quietly hired Goldman Sachs early last week to identify potential bidders.

Among the banks that have expressed interest in buying all or part of Washington Mutual are
Citigroup, JPMorgan Chase, HSBC, Banco Santander, and Wells Fargo. It is unclear what form of
assistance U.S. regulators will now offer.

Analysts suggest that Washington Mutual, which plunged into the subprime mortgage and credit
card business over the last few years, could rack up more losses totaling $30 billion or more.

Credit markets remain tight amid uncertainty

September 25, 2008

A new bout of anxiety gripped the credit markets on Wednesday as banks hoarded cash and
investors once again rushed for the safest of investments, like Treasury bills.

A crucial bank interest rate that determines the cost of money for companies and consumers around
the world spiked to its highest level since January. At the same time, yields on Treasury bills fell
sharply, nearly reaching the lows touched a week earlier, when many feared the nation's financial
system was in jeopardy. Most financial shares declined, even as the broader stock market closed
mixed.

"The credit markets are saying that things are likely to get worse before they get better," said
Michael Darda, chief economist at MKM Partners, an investment and research firm in Greenwich,
Connecticut

"It's harder for companies to get financing, and those conditions make economic weakness worse."

With the structure of the rescue still in doubt, and a protracted political battle brewing over its fate,
worries are building in the credit markets.

Investors took little solace from the news late Tuesday that Warren Buffett, the noted investor, had
agreed to invest $5 billion in the investment bank Goldman Sachs.

Several crucial barometers pointed toward renewed stress in the credit markets. The one-month
London interbank offered rate, or Libor, rose nearly a fifth of a percentage point, to 3.43 percent, its
highest since January.
The difference between Treasury bills and a three-month Libor jumped to nearly 3 percentage
points, from 2.5 on Tuesday, signaling deep unease among investors.

In the stock market, the Standard & Poor's 500-stock index seesawed up and down most of the day
and closed down 2.35 points, to 1,185.87 points. The Dow Jones industrial average fell 29 points, to
10,825.17. The Nasdaq composite index rose 2.35 points, to 2,155.68.

To some investors, the markets' skeptical reaction to the news out of Washington and from Goldman
Sachs appears to be part of a pattern that was set with the near collapse of Bear Stearns. Investors
cheer initially, hoping government intervention will help, but after further thought realize that the
nation's economic and financial troubles will not be resolved easily.

"There are a lot of qualms about it," Martin Fridson, chief executive of Fridson Investment Advisors,
said about the Treasury proposal to buy troubled assets. "The same questions still hang over us,
which is what is this stuff worth?"

A report released on Wednesday showed that the housing market, where many of the financial
problems originated, remains weak. Sales of previously owned homes fell 2.2 percent in August, to a
4.91 million annual rate, down from 5.02 million in July, according to the National Association of
Realtors. But there were a few signs of improvement, the number of homes for sale fell 7 percent, to
4.26 million.

For financial firms it was another tough day. The cost to insure Goldman's corporate debt dropped
immediately after Buffett's announcement, but climbed higher throughout the day, according to
Credit Derivatives Research. By the end of the afternoon, insurance protection on Goldman Sachs
debt was slightly more expensive to buy than it was on Tuesday, a sign that even the aura of Buffett
was not enough to fully placate the fears of investors.

The cost of protecting against a default by Morgan Stanley, the other investment bank that this week
agreed to become a bank holding company, surged toward the record highs of last week.

A big source of stress in the credit market appears to be coming from money market funds, the
traditionally ultra-safe short-term investment vehicles. Over the last week, retail and institutional
investors have been moving hundreds of billions of dollars from prime money market funds to
government funds, because they are worried about potential losses after the net asset value of one
large fund fell below $1 a share.

That has forced many money market fund managers to sell debts issued by corporations, known as
commercial paper, and go into Treasury bills, creating a scramble for government-backed debt and
severely reducing demand for corporate debt.

"When the money markets are attacked as they were, that is to me, and a lot of other people, a sign
that there is a sense of panic out there," said Milton Ezrati, senior economist and market strategist at
Lord Abbett & Co., an investment firm in Jersey City.

At the end of last week, the Federal Reserve and Treasury announced several measures to ease the
strain on money market funds and reassure investors that their money was protected. Those moves
appear to have helped. The outflow of money from prime money market funds has slowed
significantly in recent days, according to iMoneyNet, a research firm. But analysts said that fund
managers are keeping more cash on hand in case redemptions pick up again.
The benchmark 10-year Treasury bill was down 3/32, to 101 17/32. The yield, which moves in the
opposite direction from the price, was 3.81 percent, up from 3.8 percent late Tuesday.

The buck stopped then

September 24, 2008

Critics of the Bush administration's Wall Street bailout condemn the waste of taxpayer dollars. But
the taxpayers aren't the weightiest American financial constituency, even in this election year. The
dollar is the world's currency. And it is on the world's opinion of the dollar that the U.S. Treasury's
plan ultimately hangs.

It hangs by a thread, if the latest steep drop of the greenback against the euro is any indication. We
Americans, constitutionally inattentive to developments in the foreign exchange markets, should be
grateful for what we have. That a piece of paper of no intrinsic value should pass for good money
the world over is nothing less than a secular miracle. We pay our bills with it. And our creditors not
only accept it, they also obligingly invest it in American securities, including our slightly shop-soiled
mortgage-backed securities. Every year but one since 1982, the United States has consumed much
more than it has produced, and it has managed to discharge its debts with the money that it alone
can lawfully print.

No other nation ever had it quite so good. Before the dollar, the pound sterling was the pre-eminent
monetary brand. But when Britannia ruled the waves, the pound was backed by gold. You could
exchange pound notes for gold coin, and vice versa, at the fixed statutory rate.

Today's dollar, in contrast, is faith-based. Since 1971, nothing has stood behind it except the
world's good opinion of the United States. And now, watching the largest American financial
institutions quake, and the administration fly from one emergency stopgap to the next, the world is
changing its mind.

"Not since the Great Depression," news reports keep repeating, has America's banking machinery
been quite so jammed up. The comparison is hardly flattering to this generation of financiers. From
1929 to 1933, the American economy shrank by 46 percent. The wonder is that any bank, any
corporate borrower, any mortgagor could have remained solvent, not that so many defaulted. There
is not the faintest shadow of that kind of hardship today. Even on the question of whether the nation
has entered a recession, the cyclical jury is still out. Yet Wall Street shudders.

The remote cause of its troubles is the paper dollar itself - the dollar and the growth in the immense
piles of debt it has facilitated. The age of paper money brought with it an increasingly uninhibited
style of doing business.

The dollar emerged at the center of the monetary system that took its name from the 1944
convention in Bretton Woods, New Hampshire. The U.S. currency alone was made exchangeable
into gold. The other currencies, when they got their peacetime legs back under them, were made
exchangeable into the dollar.

All was well for a time - indeed, for one of the most prosperous times in modern history. Under the
system of fixed exchange rates and a gold-anchored dollar, world trade boomed (albeit from a low,
war-ravaged base). Employment was strong and inflation dormant. The early 1960s were a kind of
macroeconomic heaven on earth.

However, by the middle of that decade it had come to the attention of America's creditors that the
United States, fighting the war in Vietnam, was emitting a worryingly high volume of dollars into the
world's payment channels. Foreign central banks, nervously eyeing the ratio of dollars outstanding
to gold in the Treasury's vaults, began prudently exchanging greenbacks for bullion at the posted
rate of $35 per ounce.
In 1965, William McChesney Martin, chairman of the Federal Reserve, sought to reassure the dollar
holders. He lectured the House Banking Committee on the importance of maintaining the dollar's
credibility "down to the last bar of gold, if that be necessary."

Necessary, it might have been, but expedient, it was not, and the Nixon administration, on Aug. 15,
1971, decreed that the dollar would henceforth be convertible into nothing except small change.
The age of the pure paper dollar was fairly launched.

In the absence of a golden anchor, the United States produced as many dollars as the world cared
to absorb. And the world's appetite was prodigious. It was the very lack of gold-standard inhibition
that permitted the buildup of titanic dollar balances overseas. At the end of 2007, no less than $9.4
trillion in dollar-denominated securities were sitting in the vaults of foreign investors. Not a few of
these trillions were the property of Asian central banks. So, although the United States has run
heavy and persistent current account deficits - $6.7 trillion in total since 1982 - they have been
"deficits without tears," to quote the French economist Jacques Rueff. The dollars American debtors
sent abroad America's creditors sent right back in the shape of investments in American stocks,
bonds and factories.

Under the Bretton Woods system, worried foreign creditors would long ago have cleaned out Fort
Knox. But, conveniently, the dollar is uncollateralized and unconvertible. America's overseas
creditors hold it for many reasons. But even the governments that scoop up dollars for no better
reason than to manipulate their own currency's value presumably put some store in the integrity of
American finance.

As never before, that trust is being put to the test. In the best of times, the Treasury and the Federal
Reserve pretended as if the dollar were America's currency alone. Now, in some of the worst of
times, Washington is treating its vital overseas dollar constituency as if it weren't even there.

Which failing financial institution will the administration pluck from the flames of crisis? Which will it
let roast? Which market, or investment technique, will the regulators bless? Which - in a capricious
change of the rules - will it condemn or outlaw? Just how shall the Treasury secretary spend the
$700 billion he's begging for? Viewed from Wall Street, the administration's recent actions appear
erratic enough. Seen from the perch of a foreign investor, they must look very much like "political
risk," a phrase we Americans usually associate with so-called emerging markets, not with our own
very developed one.

Where all this might end, nobody can say. But it is unlikely that either the dollar, or the post-Bretton
Woods system of which it is the beating heart, will emerge whole. It behooves Barack Obama and
John McCain to do a little monetary planning. In the absence of faith, what stands behind a faith-
based currency?

Bailout plan's basic mystery: What's this stuff worth?

September 25, 2008
What would you pay, sight unseen, for a house that nobody wants, on a hard-luck street where no
houses are selling?

That question is easy compared to the one confronting the Treasury Department as Washington
works toward a vast bailout of financial institutions. Treasury Secretary Henry Paulson Jr. is
proposing to spend up to $700 billion to buy troubled investments that even Wall Street is struggling
to put a price on.

A big concern in Washington — and among many ordinary Americans — is that the difficulty in
valuing these assets could result in the government's buying them for more than they will ever be
worth, a step that would benefit financial institutions at taxpayers' expense.
Anyone who has tried to buy or sell a house when the market is falling, as it is now in the United
States, knows how difficult it can be to agree on a price. But valuing the securities that the Treasury
aims to buy will be far more difficult. Each one of these investments is tied to thousands of
individual mortgages, and many of those loans are going bad as the housing market worsens.

"The reality is that we are not going to know what the right price is for years," said Andrew Feltus, a
bond portfolio manager at Pioneer Investments, a mutual fund firm based in Boston. "It might be 20
cents on the dollar or 60 cents on the dollar, but we won't know for years."

While prices of most stocks are no mystery — they flicker across computer screens and televisions
all day — the troubled investments are not traded on any exchange. The market for them is opaque:
traders do business over the telephone, and days can go by without a single trade.

Not only that, many of these instruments are extremely complex. Consider the Bear Stearns Alt-A
Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here's how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall
Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans — the kind often referred
to as liar loans, because lenders made them without the usual documentation to verify borrowers'
incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona,
where home prices rose — and subsequently fell — faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for
sale to investment banks, hedge funds and insurance companies.

If any of the mortgages went bad — and, it turned out, many did — the bonds at the bottom of the
pecking order would suffer losses first, followed by the next lowest, and so on up the chain. By one
measure, the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered losses of about 1.6
percent. Of those loans, 778 have been paid off or moved through the foreclosure process.

But by many other measures, it's a toxic portfolio. Of the 2,093 loans that remain, 23 percent are
delinquent or in foreclosure, according to Bloomberg News data. Initially rated triple-A, the most
senior of the securities were downgraded to near junk bond status last week. Valuing mortgage
bonds, even the safest variety, requires guesstimates: How many homeowners will fall behind on
their mortgages? If the bank forecloses, what will the homes sell for? Investments like the Bear
Stearns securities are almost certain to lose value as long as home prices keep falling.

"Under the current circumstances it's likely that you are going to take a loss on these loans," said
Chandrajit Bhattacharya, a mortgage strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the government could buy, and
they are by no means the most complicated of the lot. Wall Street took bonds like those of Bear
Stearns and bundled and rebundled them into even trickier investments known as collateralized debt
obligations.

"No two pieces of paper are the same," said Feltus of Pioneer Investments.

On Wall Street, many of these collateralized debt obligations have been selling for pennies on the
dollar, if they are selling at all. In July, Merrill Lynch, struggling to bolster its finances, sold $31
billion of tricky mortgage-linked investments for 22 cents on the dollar. Last November, Citadel, a
large hedge fund in Chicago, bought $3 billion of mortgage securities and other investments for 27
cents on the dollar.

But Citigroup, the financial giant, values similar investments on its books at 61 cents on the dollar.
Citigroup says its collateralized debt obligations are relatively high quality because they were
created before lending standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy the troubled investments near
the values at which the banks hold them on their books. That would help minimize losses for
financial institutions. Driving a hard bargain, however, would protect taxpayers.

"Many are tempted by a strategy of trying to do both things at once," said Lawrence Summers, a
former Treasury secretary in the Clinton administration. As a hypothetical example, Summers
suggested that an institution could have securities on its books at $60, but the current market price
might only be $30. In that case, the government might be tempted to come in at about $55.

Many financial institutions are so weak that they must sell their troubled assets at prices near the
value on their books, Carlos Mendez, a senior managing director at ICP Capital, an investment firm
that specializes in credit markets. Anything less would eat into their capital.

"Depending on your perspective on the economy, foreclosure rates and home prices, the market may
eventually reflect that price. But most buyers are not willing to make that bet right now," he said.
"And that's why we have these low prices."

Ben Bernanke, the chairman of the Federal Reserve Board, told Congress on Tuesday that the
government should avoid paying a fire-sale price, and pay what he called the "hold-to-maturity
price," or the price that investors would bid if they expected to keep the bond till it was paid off.

The government would buy the troubled investments with the intention of eventually selling them
back to the market when prices recover.

The Treasury has suggested it might conduct reverse auctions to determine the price for securities
that are not trading in the market.

Unlike in a traditional auction in which would-be buyers submit bids to the seller, in a reverse
auction the buyer solicits bids from would-be sellers. Often, the buyer agrees to pay the second-
highest bid submitted to encourage sellers to compete by lowering their bids for all the assets
submitted. The buyer often also sets a reserve price and refuses to pay any more than that price.

But Paulson told Congress on Tuesday that the government would use many other means in addition
to auctions, suggesting that it would exercise wide discretion over the final prices to be paid.

Financial institutions will have an incentive to sell their worst assets to the government, a risk that
the Treasury will have to guard against, said Robert Hansen, senior associate dean at the Tuck
School of Business at Dartmouth College, New Hampshire.

"I am worried that the people who are going to offer the securities to the government will be the ones
that have the absolute worst toxic waste," Hansen said. Even so, he added, the government could
actually make a profit on its purchases provided the Treasury buys at the right prices. Richard
Breeden, a former chairman of the Securities and Exchange Commission, said the auctions could
thaw parts of the markets that have been frozen since late last year.

"One of the problems that many institutions are having is finding any bid for some of these assets,
even though they are not without value," said Breeden, who is chairman and chief executive of
Breeden Capital Management, an investment firm in Greenwich, Connecticut

"What are these assets worth?" asked Breeden. "Sometimes, because of fear or extreme uncertainty
in the markets, you get in a situation in which there are no bids at all, or at least no realistic bids."

A Bailout We Don't Need

September 25, 2008

Now that all five big investment banks -- Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman
Sachs and Morgan Stanley -- have disappeared or morphed into regular banks, a question arises.

Is this bailout still necessary?

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold
assets like that all the time. They're called "loans."

With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit
insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit
insurance and go take inventory? If a bank is solvent, money market funds would flow in,
eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to
take care of that.

Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture --
and as much money into that agency and the FBI as is needed for examiners, auditors and
investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying
preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the
situation in three months, when Congress comes back. Hedge funds should be left on their own. You
can't save everyone, and those investors aren't poor.

With this solution, the systemic financial threat should go away. Does that mean the economy would
quickly recover? No. Sadly, it does not. Two vast economic problems will confront the next
president immediately. First, the underlying housing crisis: There are too many houses out there, too
many vacant or unsold, too many homeowners underwater. Credit will not start to flow, as some
suggest, simply because the crisis is contained. There have to be borrowers, and there has to be
collateral. There won't be enough.

In Texas, recovery from the 1980s oil bust took seven years and the pull of strong national economic
growth. The present slump is national, and it can't be cured that way. But it could be resolved in
three years, rather than 10, by a new Home Owners Loan Corp., which would rewrite mortgages,
manage rental conversions and decide when vacant, degraded properties should be
demolished. Set it up like a draft board in each community, under federal guidelines, and get
to work.

The second great crisis is in state and local government. Just Tuesday, New York Mayor Michael
Bloomberg announced $1.5 billion in public spending cuts. The scenario is playing out everywhere:
Schools, fire departments, police stations, parks, libraries and water projects are getting the ax, while
essential maintenance gets deferred and important capital projects don't get built. This is pernicious
when unemployment is rising and when we have all the real resources we need to preserve services
and expand public investment. It's also unnecessary.

What to do? Reenact Richard Nixon's great idea: federal revenue sharing. States and localities
should get the funds to plug their revenue gaps and maintain real public spending, per capita, for the
next three to five years. Also, enact the National Infrastructure Bank, making bond revenue available
in a revolving fund for capital improvements. There is work to do. There are people to do it. Bring
them together. What could be easier or more sensible?

Here's another problem: the wealth loss to near-retirees and the elderly from a declining stock
market as things shake out. How about taking care of this, with rough justice, through a supplement
to Social Security? If you need a revenue source, impose a turnover tax on stocks.

Next, let's think about what the next upswing should try to achieve and how it should be powered. If
the 1960s were about raising baby boomers and the '90s about technology, what should the '10s and
'20s be about? It's obvious: energy and climate change. That's where the present great unmet needs
are.

So, let's use the next few years to plan, mapping out a program of energy conservation,
reconstruction and renewable power. Let's get the public sector and the universities working on it.
And let's prepare the private sector so that when the credit crunch finally ends, we'll have the firms,
the labs, the standards and the talent in place, ready to go.

Some will ask if we can afford it. To see the answer, don't look at budget projections. Just look at
interest rates. Last week, in the panic, the federal government could fund itself, short term, for free.
It could have raised money for 30 years and paid less than 4 percent. That's far less than it cost back
in 2000.

No country in this situation is broke, or insolvent, or even in much trouble. For once, Wall Street's
own markets speak the truth. The financially challenged customer isn't Uncle Sam. He's up on Wall
Street, where deregulation, greed and fraud ran wild.
The crisis last time
September 25, 2008

The Federal Reserve chairman and senior economic officials of the Bush administration solemnly
filed into the large conference room of the Treasury Department. There was a sense of urgency, an
understanding that drastic action - restructuring the financial landscape of corporate America - was
desperately needed.

Last week? This past Wednesday night, as the president and his advisers prepared for his address
to the nation? Hardly. It was Feb. 22, 2002. The officials were President Bush's original economic
team, including the Securities and Exchange Commission's chairman, Harvey Pitt; Glenn Hubbard,
the chairman of the Council of Economic Advisers; and the senior White House economic adviser,
Lawrence Lindsey. The Federal Reserve chairman, of course, was Alan Greenspan.

The crisis of that moment was the implosion of Enron, Global Crossing and other companies. Along
with conflicts of interest and criminally creative bookkeeping, the culprit was often a combination of
financial complexity and insanely expensive compensation packages.

Enron is long gone, but this episode - as much a warning for our financial security as the 1993
World Trade Center bombing was to the threat of wider terrorism - carries some telling lessons as
our best minds struggle now to save the economy.
The meeting, recounted to me by Paul O'Neill, Bush's first Treasury secretary, and several other
participants, was something of a showdown. Everyone came armed for battle, none more than
Greenspan and O'Neill, who railed that day like a pair of blue-suited Jeremiahs.

Their colloquy on economic policy and corporate practice, which began when they were senior
officials in the Ford administration, had evolved over three decades.

To the surprise of many younger men in the room, the duo opened by reminiscing about a bygone
era when the value of a company's stock was assessed by how strong a dividend was paid. It was a
standard that demanded tough, tangible choices. Everything, of course, came out of the same pot
of cash, from executive compensation and capital improvements to the dividend - which could be
spent by a shareholder or reinvested in more stock as a show of support.

In contrast to dividends, Greenspan intoned, "Earnings are a very dubious measure" of corporate
health. "Asset values are, after all, just based on a forecast," he said, and a chief executive can
"craft" an earnings statement in misleading ways.

Speaking with a hard-edged frankness rarely heard in public - and seeing that those assembled
were not sharing his outrage - Greenspan slapped the table. "There's been too much gaming of the
system," he thundered. "Capitalism is not working! There's been a corrupting of the system of
capitalism."

O'Neill, for his part, pushed to alter the threshold for action against chief executives from
"recklessness" - where a difficult finding of willful malfeasance would be necessary for action
against a corporate chief - to negligence. That is, if a company went south, the boss could face a
hard-eyed appraisal from government auditors and be subject to heavy fines and other penalties.
By matching upside rewards with downside consequences - a bracing idea for the corner office -
O'Neill and Greenspan hoped fear would compel the titans of business to enforce financial
discipline, full public disclosure and probity down the corporate ranks.

But they were in the minority. Pitt, the SEC chairman, voiced concern that creation of a new entity
to assess negligence by corporate honchos might draw power away from his agency. Lawrence
Lindsey said, "There's always the option of doing nothing," that the markets are "already
discounting the stocks in companies that show accounting irregularities."

An article about the meeting appeared a few days later in The Wall Street Journal. The next day,
O'Neill was in Florida addressing chief executives of America's top 20 financial services companies.
They piled on. One told the Treasury secretary that he'd "rather resign" than be held accountable
for "what's going on in my company." A phalanx of outraged financial industry chiefs, many of them
large Republican contributors, called the White House. Real reform was a political dead letter.

A presidential speech that followed was toothless, mostly recommending that chief executives
personally certify their companies' financial statements. Earnings per share remained the gold
standard.

The Sarbanes-Oxley bill, signed into law a few months later, largely focused on the auditors, and
actually increased the complexity of reporting practices. As for lawsuits? Not to worry. No significant
rise.

At issue, of course, were those twins, transparency and accountability. The years since have shown
that the first one is meaningless without the second. With a world financial crisis upon us, the
president and his economic team are forced again to talk about accountability. Let's hope this time
they mean it.

Ron Suskind is the author of "The Price of Loyalty: George W. Bush, the White House and the
Education of Paul O'Neill" and "The Way of the World: A Story of Truth and Hope in an Age of
Extremism."
 An inadequate case for the bailout plan
IHT Editorial--September 25, 2008

Under skeptical questioning in the Senate Banking Committee on Tuesday, Treasury Secretary
Henry Paulson and Federal Reserve Chairman Ben Bernanke gave no ground in defense of their
$700 billion proposal to bail out the financial system.

They also gave little reason to believe that their proposal would protect taxpayers from huge losses.
Instead, they said that any eventual loss would be less than the losses that Americans would
endure if lending froze up, as it did briefly last week in the panicked aftermath of the failure of
Lehman Brothers and the near-death of the American International Group.

The candor is appreciated, but it is not a good enough answer for Congress or the American
people. Rather than rushing to approve the $700 billion bailout, lawmakers need to examine
alternatives. They should look for one that ideally would let taxpayers share in the gains from any
post-bailout revival, along with the bankers and private investors who will make money if the bailout
succeeds. Several ideas have been advanced that Congress should examine.

Prominent among them is a plan to make a direct investment of taxpayer dollars into financial firms,
rather than buying up their bad assets. With that money, the firms could absorb the losses that they
are bound to take as their investments go sour. Once the firms begin to recover, taxpayers would
earn a return.

Such equity investments are risky, and careful analysis is needed to show if they would be riskier
than what the administration has proposed.

Another proposal, advanced by Senator Christopher Dodd, would buy up bad assets, as proposed
by the administration, but would give the government the option to acquire stock in the firms
receiving help. The danger is that private investors, fearful of seeing their ownership stakes diluted
if the government becomes a shareholder, might be reluctant to invest money. That would deprive
the firms of investments they need to recover.

There is time to clarify that sort of uncertainty. The system is vulnerable to more severe problems,
but the credit squeeze has eased a bit since the administration's bailout was proposed.

That's partly because of the expectation of a bailout, so Congress should be clear that it is working
on a plan with appropriate speed.

One thing is certain. If taxpayers do not share in the potential profits from a bailout, someone else
will. On Tuesday, the Federal Reserve announced that it was relaxing rules that require investors
who take large stakes in banks to submit to longstanding regulations on transparency and
managerial control. Private equity firms have pushed for the changes because they would like to
become big investors in beaten-down banks but do not want to be regulated.

Relaxing the rules invites more of the same type of opacity and risk-taking into banking that caused
many of today's financial problems. Politically, the Fed's timing could not have been worse.

Taxpayers are being asked to buy up banks' junky assets, with little expectation of return. At the
same time, private equity firms are being invited to make what are likely to be highly profitable
investments in the same banks. That's not a plan that lawmakers and voters can support. Congress
has more work to do.

America's bail-out plan

I want your money

 Sep 25th 2008
From The Economist print edition
No government bail-out of the banking system was ever going to be pretty.
This one deserves support

SAVING the world is a thankless task. The only thing beyond dispute in the $700 billion plan of
Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, to
stem the financial crisis is that everyone can find something in it to dislike. The left accuses it of
ripping off taxpayers to save Wall Street, the right damns it as socialism; economists disparage its
technicalities, political scientists its sweeping powers. The administration gave ground to Congress,
George Bush delivered a televised appeal and Barack Obama and John McCain suspended the
presidential campaign. Even so, as The Economist went to press, the differences remained. There
was a chance that Congress would say no.

Spending a sum of money that could buy you a war in Iraq should not come easily; and the notion
of any bail-out is deeply troubling to any self-respecting capitalist. Against that stand two overriding
arguments. First this is a plan that could work. And, second, the potential costs of producing
nothing, or too little too slowly, include a financial collapse and a deep recession spilling across the
world: those far outweigh any plausible estimate of the bail-out’s cost.

Mr Market goes to Congress

America’s financial system has two ailments: it owns a huge amount of toxic securities linked to
falling house prices. And it is burdened by losses that leave it short of capital (although the world
has capital, not enough has been available to the banks). For over a year, since August 2007,
central bankers, principally Mr Bernanke, have been trying to make this toxic debt liquid. But by
September 17th, following the bankruptcy of Lehman Brothers and the nationalization of American
International Group earlier that week, the problem started to become one of the system’s solvency
too. The market lost faith in a strategy that saved finance one institution at a time. The economy is
not healing itself. If credit markets stay blocked, consumers and firms will enter a vicious spiral.

Mr Paulson’s plan relies on buying vast amounts of toxic securities. The theory is that in any auction
a huge buyer like the federal government would end up paying more than today’s prices,
temporarily depressed by the scarcity of buyers, and still buy the loans cheaply enough to reflect
the high chance of a default. That would help recapitalize some banks—which could also set less
capital aside against a cleaner balance sheet. And by creating credible, transparent prices, it would
at last encourage investors to come in and repair the financial system: this week Warren Buffett and
Japan’s Mitsubishi-UFJ agreed to buy stakes in Goldman Sachs and Morgan Stanley. Some banks
would still not have enough capital, but under Mr Paulson’s original plan, the state could put equity
in them, or, if they become insolvent, take them over and run them down.

The economics behind this is sound. Government support to the banking system can break the
cycle of panic and pessimism that threatens to suck the economy into deep recession. Intervention
may help taxpayers, because they are also employees and consumers. Although $700 billion is a
lot—about 6% of GDP—some of it will be earned back and it is small compared with the 16% of
GDP that banking crises typically swallow and trivial compared with the Depression, when
unemployment surged above 20% (compared with 6% now). Messrs Bernanke and Paulson also
have done well by acting quickly: it took seven years for Japan’s regulators to set up a mechanism
to take over large broke banks in the 1990s.

Could the plan be better structured? Some economists want the state to focus on putting equity into
the banks—arguing that it is the best way to address their lack of solvency. In theory you would
need to spend less, because a dollar of new equity would support $10 in assets. Yet the banks
might not take part until they were on the ropes and, if house prices later fell dramatically more, the
value of the banks’ shares would collapse. The threat of the government taking stakes would scare
off some private investors. And in the charged atmosphere after this bail-out meddling politicians,
as part-owners, would have a tempting lever over the banks.

Mr Paulson’s plan also has its shortcomings. He will find it hard to stop sellers from rigging
auctions, if only because no two lots of dodgy securities are exactly the same. Taxpayers may thus
pay over the odds and banks may be rewarded for their stupidity. Yet these costs seem small
against the benefit of putting a floor under the markets. And fine calculations about moral hazard
are less pressing when investors are fleeing risk.

If the economics of Mr Paulson’s plan are broadly correct, the politics are fiendish. You are
lavishing money on the people who got you into this mess. Sensible intervention cannot even buy
long-term relief: the plan cannot stop house prices falling and the bloated financial sector shrinking.
Although the economic risk is that the plan fails, the political risk is that the plan succeeds. Voters
will scarcely notice a depression that never happened. But even as they lose their houses and their
jobs, they will see Wall Street once again making millions.

Buckle a little, but do it briefly

In retrospect, Mr Paulson made his job harder by misreading the politics. His original plan contained
no help for homeowners. And he assumed sweeping powers to spend the cash quickly. He was
right to want flexibility to buy a range of assets. But flexibility does not exclude accountability. As
complaints mounted, Mr Paulson and Mr Bernanke buckled—agreeing, for instance, to more
oversight. Now that Messrs McCain and Obama have returned to Congress to forge a deal, more
buckling may be necessary. Ideally, concessions should not outlast the crisis: temporary help for
people able to stay in their houses, a brief ban on dividends in financial firms, even another fiscal
package. They should not be permanent or so onerous that the program fails for want of
participants—which is why proposed limits on pay are a mistake.

Mr Paulson’s plan is not perfect. But it is good enough and it is the plan on offer. The prospect of its
failure sent credit markets once again veering towards the abyss. Congress should pass it—and
soon.

America’s bail-out plan

The doctors' bill

Sep 25th 2008 | WASHINGTON, DC
From The Economist print edition

The chairman of the Federal Reserve and the treasury secretary give Congress
a gloomy prognosis for the economy, and propose a drastic remedy

AMERICAN congressmen are used to hyperbole, but they were left speechless by the dire scenario
Ben Bernanke, the chairman of the Federal Reserve, painted for them on the night of September
18th. He “told us that our American economy’s arteries, our financial system, is clogged, and if we
don’t act, the patient will surely suffer a heart attack, maybe next week, maybe in six months, but it
will happen,” according to Charles Schumer, a Democratic senator from New York. Mr Schumer’s
interpretation: failure to act would cause “a depression”.

Mr Bernanke and Hank Paulson, the treasury secretary, had met congressional leaders to argue
that ad hoc responses to the continuing financial crisis like that week’s bail-out of American
International Group (AIG), a huge insurer, were no longer sufficient. By the weekend Mr Paulson
had asked for authority to own up to $700 billion in mortgage-related assets. By the time The
Economist went to press, Congress and Mr Paulson appeared to have agreed on the broad outlines
of what is being called the Troubled Asset Relief Program, or TARP.
However, passage was not assured as rank-and-file congressmen, in particular Republicans,
balked. Uncertainty over the outcome rattled credit markets: three-month interbank rates jumped
and Treasury yields fell on September 24th. In a prime-time address that evening to rally support,
George Bush warned of bank failures, plummeting house values and millions of lost jobs if
Congress did not act.

Both the crisis and the authorities’ response

have been called the most sweeping since the
Depression. Yet the differences from that era are
more notable than the similarities to it. From the
stockmarket crash of 1929 to the federally
declared bank holiday that marked its bottom,
three and a half years elapsed, and
unemployment reached 25%. This crisis has been
under way for a little over a year and
unemployment is just over 6%, lower even
than in the wake of the last, mild
recession. More than 4% of mortgages are now
seriously delinquent (see chart 1), but the
figure topped 40% in 1934.

The scale of the American authorities’ response

reflects both the violence with which this crisis has
spread, and the determination of the American
authorities, most importantly Mr Bernanke, to learn from the mistakes that made the Depression so
deep and long.

In responding with such speed and vigor, they run several risks. One is that they overdo it, paying
far too much for assets, sending the deficit into the stratosphere and triggering a run on the dollar.
The risk of underdoing it may be even greater. Politicians, determined not to be seen as doing
favors for Wall Street, might blunt the program’s effect in the name of protecting the taxpayer. Then
there’s the logistical nightmare of fixing a market whose very complexity is central to the crisis.

Experience, at home and abroad, is a poor guide. In past episodes authorities have typically not
committed public money to their financial systems until bank failures and insolvency have become
widespread. The first wave of savings-and-loan failures came in the early 1980s; the Resolution
Trust Corporation was not created to dispose of their assets until 1989. Japan’s banks began to fail
in 1991, but a mechanism for taking over large, insolvent banks was not set up until 1998. Mr
Paulson and Mr Bernanke are attempting to prevent the crisis from reaching that stage. “The firms
we’re dealing with now are not necessarily failing, but they are contracting, they are deleveraging,”
Mr Bernanke told Congress. They are unable to raise capital and are refusing to lend, and that, he
said, is squeezing the economy.

One risk with such a pre-emptive bail-out is that to congressmen the benefits are hypothetical
whereas the fiscal and political costs, five weeks before an election, are all too real. In polls voters
waver between opposition and support depending on how the question is asked.

In spite of these risks, the odds seem to be in favor of both political passage and success. America
has owned up to its mistakes with exceptional speed, and pulled out the stops to correct them.

After the crisis first broke in August last year, the Fed pursued a two-pronged strategy. The first
element was to lower interest rates to cushion the economy. The second was to use its balance
sheet to help commercial and investment banks finance their holdings of hard-to-value securities
and avoid fire-sales of assets. Behind this approach lay the belief that the economy and the
financial system were basically solid. Yes, too many houses had been built and prices were too
high, but a return to more normal levels would be manageable if stretched over a few years. And
banks in aggregate had entered the crisis in good shape, with much more capital this June than in
1990. The Fed saw their problem essentially as illiquidity, not insolvency. The Bush administration
broadly shared this diagnosis—and an aversion to using public money to help overextended
borrowers.

The intensification of the crisis came not from the banks but the “shadow banking system”: the
finance companies, investment banks, off-balance-sheet vehicles, government-sponsored
enterprises and hedge funds that fuelled the credit boom, aided by less regulation and more
leverage than commercial banks. As home prices fell and loan losses mounted, more of the shadow
system became insolvent.

Insolvency cannot be cured with more loans, no matter how easy the terms. It requires more
capital, which in deep crises only the government can provide. Mr Bernanke’s groundbreaking
paper on the Depression, published in 1983, noted that recovery began in 1933 with large infusions
of federal cash into institutions, through the Reconstruction Finance Corporation, and households,
through the Home Owners’ Loan Corporation. They were, he wrote, “the only major New Deal
program which successfully promoted economic recovery.”

A month ago Mr Bernanke and his closest aides began to think something similar might now be
needed. The Fed and the Treasury had already drawn up contingency plans, thinking it would be
months before a need arose. Then the financial hurricane blew up over the weekend of September
13th and 14th. That is when Mr Paulson, Mr Bernanke and Tim Geithner, president of the Federal
Reserve Bank of New York, decided not to commit any public money to a bail-out of Lehman
Brothers. They reasoned, wrongly, that the financial system was adequately prepared. The
company’s failure, coupled with the near-bankruptcy of AIG, threw the safety of all financial
institutions into doubt, causing their stocks to plunge and borrowing costs to soar.

Several money-market funds that held Lehman debt reported negative returns, sparking a flight of
cash to the safety of Treasury bills that briefly pushed their yields close to zero. On September 18th
companies could no longer issue commercial paper. Banks, anticipating huge demands from
companies seeking funds, began hoarding cash, sending the federal funds rate as high as 6%. That
week, no investment-grade bonds were issued, for the first time (holidays aside) since 1981.

Conceivably, the Fed could have contained the damage

by supplying lots of cash. But that would have meant
ever greater and more creative use of its balance
sheet. By September 17th it had grown to $1 trillion, up
by 10% in a fortnight, with most of it tied up in loans to
banks, investment banks, foreign central banks, AIG
and Bear Stearns (see chart 2). It was becoming
the lender of first resort, not last.

Such steps were also courting political risk. After the

rescue of AIG, Nancy Pelosi, speaker of the House of
Representatives, demanded, “Why does one person
have the right to grant $85 billion in a bail- out [to AIG]
without the scrutiny and transparency the American
people deserve?” Mr Bernanke later acknowledged that the Fed wanted to get out of crisis
management, for which it lacked authority and broad support. “We prefer to get back to monetary
policy, which is our function, our key mission,” he told Congress this week.

The Fed chairman told Mr Paulson on September 17th that the time had come to call for a big
injection of public money. By the next day Mr Paulson was in agreement and the two men, after
getting Mr Bush’s approval, approached Capitol Hill.

Mr Paulson’s first proposal left Democrats cold: it would give the Treasury virtually unchecked
authority for two years to spend up to $700 billion on mortgage assets or anything else necessary to
stabilize the system. It looked like a power-grab. Democrats countered with several conditions:
troubled mortgages would be modified where possible to keep homeowners in their homes; an
oversight board would watch over the program; taxpayers would share any gains for participating
companies via shares or warrants; and executives’ compensation would be capped. By September
24th, Mr Paulson seemed to be bending to all these conditions. For its part, the finance industry is
ready to yield to all of these conditions in order to get something done. “It was a gargantuan abyss
that we faced last week,” says Steve Bartlett, chairman of the Financial Services Roundtable, which
represents about 100 big financial firms.

Assuming it comes into existence, there are still numerous risks surrounding the TARP. The first is
that it does too much. At $700 billion, the amount allocated to it easily exceeds the Federal Deposit
Insurance Corporation’s (FDIC) estimate of roughly $500 billion of residential mortgages seriously
delinquent in June, out of a total of $10.6 trillion, though that figure will rise. The Treasury has
sought broad authority to buy not just mortgage securities but anything related to them, such as
credit derivatives, and if necessary equity in companies weakened by their bad loans.

The arithmetic of crisis

When the loans to AIG and Bear Stearns assets are added in, the gross public backing so far
approaches 6% of GDP, well above the 3.7% of the savings-and-loan bail-out in the late 1980s and
early 1990s (see chart 3). That would still be much less than the average cost of resolving banking
crises around the world in the past three decades, which a study by Luc Laeven and Fabian
Valencia, of the IMF, puts at 16%. One reason why bail-outs, especially in emerging markets, have
been so costly is inadequate safeguards against abuse, says Gerard Caprio, an economist at
Williams College. “There was a lot of outright looting going on.”

The Congressional Budget Office had pegged

next year’s federal budget deficit at more than
$400 billion, or 3% of GDP. Private estimates
top $600 billion. Tack on $700 billion and various
other crisis-related outlays and the total could
reach 10% of GDP, notes JPMorgan Chase, a
level last seen in the Second World War. On
September 22nd the euro made its largest-ever
advance against the dollar on worries that America
might one day inflate its way out of those debts.
Such fears are compounded by the expansion of
the Fed’s balance sheet. Some even think that the
burden of repairing a broken financial system
could place the dollar’s status as the world’s
leading reserve currency in jeopardy.

The consequences will probably not be so far-

reaching. The true cost to taxpayers is unlikely to
be anywhere near $700 billion, because many of the acquired mortgages will be repaid. The
expansion of the Fed’s balance sheet reflects a fear-induced demand for cash, which drove the
federal funds rate above the 2% target.

It is more likely that the program will not go far enough. Conscious of the public’s deep antipathy to
anything that smacks of favors for Wall Street, politicians from both parties have insisted that the
protection of the taxpayer be paramount. Yet the point of bail-outs is to socialize losses that are
clogging the financial system. If taxpayers are completely insulated from losses, the bail-out will
probably be ineffective. “The ultimate taxpayer protection will be the market stability provided,” Mr
Paulson argues.
This is especially critical in deciding how the government will set the price for the assets it
purchases. An impaired mortgage security might yield 65 cents on the dollar if held to maturity. But
because the market is so illiquid and suspicion about mortgage values so high, it might fetch just 35
cents in the market today. Recapitalizing banks would mean paying as close to 65 cents as
possible. Those that valued them at less on their books could mark them up, boosting their capital.
On the other hand, minimizing taxpayer losses would dictate that the government seek to pay only
35 cents. But this would provide little benefit to the selling banks, and those that carried them at
higher values on their books could see their capital further impaired.

To some, that would be fine. “If they choose to fail rather than sell their debt at its real market value
and record the loss on the books, they should be free to take that option,” said Michael Enzi, a
Republican senator from Wyoming. The failure of smaller regional banks may be tolerable. The
FDIC offers a proven system for coping with failed entities (although it too may need a loan from the
taxpayer) and other banks are keen to snap up their deposits. But the final result of big-bank
failures would be a deeper crisis and a bigger cost in lost economic output.

Similarly, requiring participating banks to give the government warrants or cap their executives’
salaries might make them less willing to take part. Veterans of the emerging-markets crises of the
1990s say their effectiveness would have been crippled had their ability instantly to deploy cash as
they saw fit been compromised. “There is far more risk that the authorities will have too little
flexibility…than there is risk that they will have too much authority,” says Lawrence Summers, a
former treasury secretary.

A more serious criticism is that buying assets is an inefficient way to recapitalize the banking
system. Better, many argue, to inject cash directly into weakened banks. A dollar of new equity
could support $10 in assets, reducing the pressure to deleverage. Moreover, since the price of
banks’ shares are less arbitrary and more homogeneous than those of illiquid mortgage securities,
the process would be far more transparent, says Doug Elmendorf of the Brookings Institution. But
banks might not volunteer to sell equity to the government before they reach death’s door; and the
prospect of share dilution could discourage private investors. In any event, the Treasury plan could
be flexible enough to permit such capital injections.

But will it work?

Reuters
Time to mend the market

There have been several false dawns since the crisis began in August of last year. This could be
another. The TARP may address the root cause, namely house prices and mortgage defaults, but
the crisis has long since mutated. “The same underlying phenomenon that we saw in housing we’re
seeing in auto loans, in credit-card loans and student loans,” says Eric Mindich, head of Eton Park
Capital Management, a hedge fund. The crisis could claim another institution before the TARP’s
effect is felt.

The TARP could conceivably slow the resolution of the crisis by stopping property prices and home
ownership falling to sustainable levels. Some homeowners who are up-to-date with payments but
whose home is worth less than their mortgage may stop paying, betting the federal government will
be a more forgiving creditor. The Treasury is considering using the TARP to write down mortgages
to levels that squeezed homeowners can afford. But in the meantime, buyers might be reluctant to
step in while a big inventory of government-owned property hangs over the market. That’s one
reason Japan’s many efforts to bail out its banks failed to revitalize its economy: the institutions that
took over the loans were hesitant to dispose of them for fear of pushing insolvent borrowers into
bankruptcy, says Takeo Hoshi of the University of California at San Diego.

All the same, the TARP is likely to mark a turning-point. “It promises to break the vicious circle of
deleveraging in the mortgage market,” predicts Jan Hatzius, an economist at Goldman Sachs. This
does not mean the economy will soon rebound, but it does suggest the worst scenarios will be
averted. If the TARP helps banks and investors establish reliable prices for mortgage securities, it
could restart lending and help bring the housing crisis to an end.

This will not come without a price. The unprecedented intrusion of the federal government into the
capital markets seems certain to be accompanied by a heavier regulatory hand, something on
which both Barack Obama and John McCain now agree.

Even without new rules, more of the system will be regulated because so much of it has been
absorbed by banks, which are closely overseen. Sheila Bair, chairman of the FDIC, thinks this is a
good thing. Banks were relative pillars of stability because of their insured deposits and the
regulation that accompanied it. Although some banks have failed, she notes that other banks, not
taxpayers, will pay the clean-up costs. Now that institutions like money-market funds are caught by
the federal safety net even though that was never intended, they can expect to pay for it.

Yet predictions of a sea change towards more invasive government are premature. The Depression
witnessed a pervasive expansion of the federal government into numerous walks of life, from
trucking and railways to farming, out of a broadly shared belief that capitalism had failed utterly. If
Mr Paulson and Mr Bernanke have prevented a Depression-like collapse in economic output with
their actions these past two weeks, then they may also have prevented a Depression-like backlash
against the free market.

And then there were none….

What the death of the investment bank means for Wall Street

THE radical overhaul of the City of London in 1986 was dubbed the Big Bang. The brutal reshaping
of Wall Street might be better described as the Big Implosion. The “bulge-bracket” brokerage
model—the envy of moneymen everywhere before the crunch—has collapsed in on itself. Even
more humiliating for the Green Berets of the markets, the new force in finance is the government.

The last remaining investment banks, Goldman Sachs and Morgan Stanley, sought safety by
becoming bank holding companies after last week’s run on the industry, which sent Wall Street
scrambling for loans from the central bank (see chart). After Lehman Brothers collapsed, the
markets could no longer stomach their mix of illiquid assets and unstable wholesale liabilities. Both
will now start gathering deposits, a more stable form of funding. Signing up strong partners should
also help. Mitsubishi UFJ Financial Group (MUFG), a giant Japanese bank, will buy up to 20% of
Morgan. Goldman has gone one better, coaxing $5 billion from Warren Buffett.

Mr Buffett, no idle flatterer, describes Goldman as “exceptional”. But some doubt that it will be able
to adapt and thrive. As a bank, it faces more supervision from the Federal Reserve, tougher capital
requirements and restrictions on investing. Universal banks, such as Citigroup and Bank of
America, long dismissed as stodgy, argue that their vast balance sheets and wide range of
businesses, from credit cards to capital markets, give them an edge in trying times. The head of
one bank suggests that the golden years of risk-taking enjoyed by investment banks in 2003-06
were an “aberration”, fuelled by the global liquidity glut.

Private-equity firms and hedge funds spy opportunity, too. Blackstone’s Stephen Schwarzman is
keen to take advantage of Wall Street’s disarray. Kohlberg Kravis Roberts, a rival, has ambitions to
create a financial “ecosystem”. The buy-out barons got good news this week, when the Fed relaxed
its rules on their ownership of banks. One of them, Christopher Flowers, bought a small lender in
Missouri, which he may use to hoover up other troubled financial firms. Citadel, a hedge-fund group
that is already an options marketmaker, is reportedly mulling a move into the advisory business.
Hedge funds have stepped up their financing of mid-tier firms that cannot get loans from Wall
Street.

These investors are also going after the “talent” in investment banks. Morale there is not high. One
executive admits that becoming a bank “does little for our cachet”. Hedge funds will be particularly
keen to get their hands on cutting-edge risk-takers, particularly the Goldman crowd who used to
thrive on leverage.

Power may shift in two other directions: abroad and, to a lesser extent, to boutique investment
banks. MUFG will be joined by others. After a brief wrangle in the bankruptcy courts, Britain’s
Barclays has taken over Lehman’s American operations and quickly put its logo on the fallen firm’s
headquarters. “Global financial power is becoming more diffuse,” says Andrew Schwedel of Bain &
Company, a consultancy. Merger boutiques, such as Lazard and Greenhill, will emphasize their
stability to pick up business. Their shares have done relatively well this year.

But all is not lost for the former investment banks. For one thing, they may not have to cut leverage
by as much as feared. Though their overall leverage ratios are high, their risk-adjusted capital ratios
under the Basel 2 rules are stronger than those of most commercial banks. They acknowledge,
however, that they may have to raise these even higher for a while to assuage market concerns
about hard-to-sell assets.

Brad Hintz of Sanford Bernstein, an asset manager and research firm, reckons regulatory shackles
will cut Goldman’s return on equity by four percentage points over the cycle. The bank disputes this.
Either way, even if it is forced to tone down its in-house proprietary trading it can make up for this
by, for instance, launching more hedge funds. And it faces no immediate pressure to sell its large
private-equity or commodities holdings. It will continue to co-invest in projects alongside clients, a
key Goldman strategy.

Moreover, there are some advantages to becoming a bank. Goldman and Morgan should be able to
amass deposits cheaply and easily, because dozens of regional lenders are expected to fail. Almost
one-fifth have less capital than regulators consider a safe minimum. However, the new banks will
be under scrutiny to ensure they do not put those deposits at great risk.

As sharp distressed-debt investors, they will also be looking to buy assets from the government’s
giant loan-buying entity when it gets going. This is likely to be more helpful to them than to
commercial banks, which have marked down their mortgage assets less and will not benefit as
much when clearing prices are set.

Given the acute stress that remains in money markets, however, the accent for the time being is still
on survival. Morgan Stanley’s debt with a maturity of four months was trading to yield as much as
37.5%. Maybe it should consider using credit cards instead.

Financial firms fear further fallout from the recent, potentially catastrophic run on money-market
funds, after several of the supposedly ultra-safe vehicles saw their net asset values slip below the
sacrosanct $1 level at which investors break even. Only when the government stepped in to
guarantee that no more funds would “break the buck” did a semblance of calm return. But “prime”
money funds, which are big buyers of corporate debt, are still pulling away from anything deemed
risky. This is a big problem for banks, since some $1.3 trillion of their short-term debt is held by
such funds, and they may have to turn to longer-term (and dearer) sources.

You might just miss us

Once markets stabilize, Wall Street will start to wonder if it is better or worse off without its stand-
alone investment banks. Some think they were no more worth saving than Detroit, another once-
iconic industry caught up in its own battle for a public rescue. Perhaps even less so: the securities
Wall Street packaged were the financial equivalent of slick-looking cars with no brakes. But they
may leave a hole. As broker-dealers, regulated more lightly by the Securities and Exchange
Commission, they were free to put large dollops of capital to work, providing liquidity, making
markets and assuming risk. As banks, they may find the Fed takes a more restrictive view.

It seems implausible that the investment bank will make a comeback, given the speed with which it
has unraveled. Yet, 75 years after the legal separation of commercial and investment banking,
America has made a full return to the one-stop-shop model practiced by John Pierpont Morgan.
Another black swan in 2083, and who knows?

WaMu is largest U.S. bank failure

September 25, 2008
Washington Mutual Inc was closed by the U.S. government in by far the largest failure of a U.S.
bank, and its banking assets were sold to JPMorgan Chase & Co for $1.9 billion.

Thursday's seizure and sale is the latest historic step in U.S. government attempts to clean up a
banking industry littered with toxic mortgage debt. Negotiations over a $700 billion bailout of the
entire financial system stalled in Washington on Thursday.

Washington Mutual, the largest U.S. savings and loan, has been one of the lenders hardest hit by
the nation's housing bust and credit crisis, and had already suffered from soaring mortgage losses.

Washington Mutual was shut by the federal Office of Thrift Supervision, and the Federal Deposit
Insurance Corp was named receiver. This followed $16.7 billion of deposit outflows at the Seattle-
based thrift since Sept 15, the OTS said.

"With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to
transact business," the OTS said.

Customers should expect business as usual on Friday, and all depositors are fully protected, the
FDIC said.

FDIC Chairman Sheila Bair said the bailout happened on Thursday night because of media leaks,
and to calm customers. Usually, the FDIC takes control of failed institutions on Friday nights, giving
it the weekend to go through the books and enable them to reopen smoothly the following Monday.

Washington Mutual has about $307 billion of assets and $188 billion of deposits, regulators said.
The largest previous U.S. banking failure was Continental Illinois National Bank & Trust, which had
$40 billion of assets when it collapsed in 1984.

JPMorgan said the transaction means it will now have 5,410 branches in 23 U.S. states from coast
to coast, as well as the largest U.S. credit card business.

It vaults JPMorgan past Bank of America Corp to become the nation's second-largest bank, with
$2.04 trillion of assets, just behind Citigroup Inc. Bank of America will go to No. 1 once it completes
its planned purchase of Merrill Lynch & Co.

The bailout also fulfills JPMorgan Chief Executive Jamie Dimon's long-held goal of becoming a
retail bank force in the western United States. It comes four months after JPMorgan acquired the
failing investment bank Bear Stearns Cos at a fire-sale price through a government-financed
transaction.

On a conference call, Dimon said the "risk here obviously is the asset values."

He added: "That's what created this opportunity."

JPMorgan expects to incur $1.5 billion of pre-tax costs, but realize an equal amount of annual
savings, mostly by the end of 2010. It expects the transaction to add to earnings immediately, and
increase earnings 70 cents per share by 2011.

It also plans to sell $8 billion of stock, and take a $31 billion write-down for the loans it bought,
representing estimated future credit losses.

The FDIC said the acquisition does not cover claims of Washington Mutual equity, senior debt and
subordinated debt holders. It also said the transaction will not affect its roughly $45.2 billion deposit
insurance fund.

"Jamie Dimon is clearly feeling that he has an opportunity to grab market share, and get it at fire-
sale prices," said Matt McCormick, a portfolio manager at Bahl & Gaynor Investment Counsel in
Cincinnati. "He's becoming an acquisition machine."

BAILOUT UNCERTAINTY

The transaction came as Washington wrangles over the fate of a $700 billion bailout of the financial
services industry, which has been battered by mortgage defaults and tight credit conditions, and
evaporating investor confidence.

"It removes an uncertainty from the market," said Shane Oliver, head of investment strategy at AMP
Capital in Sydney. "The problem is that markets are in a jittery stage. Washington Mutual provides
another reminder how tenuous things are."

Washington Mutual's collapse is the latest of a series of takeovers and outright failures that have
transformed the American financial landscape and wiped out hundreds of billions of dollars of
shareholder wealth.

These include the disappearance of Bear, government takeovers of mortgage companies Fannie
Mae and Freddie Mac and the insurer American International Group Inc, the bankruptcy of Lehman
Brothers Holdings Inc, and Bank of America's purchase of Merrill.

JPMorgan, based in New York, ended June with $1.78 trillion of assets, $722.9 billion of deposits
and 3,157 branches. Washington Mutual then had 2,239 branches and 43,198 employees. It is
unclear how many people will lose their jobs.

Shares of Washington Mutual plunged $1.24 to 45 cents in after-hours trading after news of a
JPMorgan transaction surfaced. JPMorgan shares rose $1.04 to $44.50 after hours, but before the
stock offering was announced.

119-YEAR HISTORY

The transaction ends exactly 119 years of independence for Washington Mutual, whose
predecessor was incorporated on September 25, 1889, "to offer its stockholders a safe and
profitable vehicle for investing and lending," according to the thrift's website. This helped Seattle
residents rebuild after a fire torched the city's downtown.

It also follows more than a week of sale talks in which Washington Mutual attracted interest from
several suitors.

These included Banco Santander SA, Citigroup Inc, HSBC Holdings Plc, Toronto-Dominion Bank
and Wells Fargo & Co, as well as private equity firms Blackstone Group LP and Carlyle Group,
people familiar with the situation said.

Less than three weeks ago, Washington Mutual ousted Chief Executive Kerry Killinger, who drove
the thrift's growth as well as its expansion in subprime and other risky mortgages. It replaced him
with Alan Fishman, the former chief executive of Brooklyn, New York's Independence Community
Bank Corp.

WaMu's board was surprised at the seizure, and had been working on alternatives, people familiar
with the matter said.

More than half of Washington Mutual's roughly $227 billion book of real estate loans was in home
equity loans, and in adjustable-rate mortgages and subprime mortgages that are now considered
risky.

The transaction wipes out a $1.35 billion investment by David Bonderman's private equity firm TPG
Inc, the lead investor in a $7 billion capital raising by the thrift in April.

A TPG spokesman said the firm is "dissatisfied with the loss," but that the investment "represented
a very small portion of our assets."

DIMON POUNCES

The deal is the latest ambitious move by Dimon.

Once a golden child at Citigroup before his mentor Sanford "Sandy" Weill engineered his ouster in
1998, Dimon has carved for himself something of a role as a Wall Street savior.

Dimon joined JPMorgan in 2004 after selling his Bank One Corp to the bank for $56.9 billion, and
became chief executive at the end of 2005.

Some historians see parallels between him and the legendary financier John Pierpont Morgan, who
ran J.P. Morgan & Co and was credited with intervening to end a banking panic in 1907.

JPMorgan has suffered less than many rivals from the credit crisis, but has been hurt. It said on
Thursday it has already taken $3 billion to $3.5 billion of write-downs this quarter on mortgages and
leveraged loans.

Washington Mutual has a major presence in California and Florida, two of the states hardest hit by
the housing crisis. It also has a big presence in the New York City area. The thrift lost $6.3 billion in
the nine months ended June 30.

"It is surprising that it has hung on for as long as it has," said Nancy Bush, an analyst at NAB
Research LLC.

Amid GOP revolt, bailout deal breaks down

September 25,2008

A Republican rebellion stalled government efforts Thursday to avoid economic meltdown, a chaotic
turnaround that disrupted the choreography of an extraordinary White House meeting meant to
show joint resolve from the president, the political parties and the presidential candidates. Instead,
the summit broke up so bitterly that Treasury Secretary Henry Paulson got on one knee before
Democratic leaders in a theatrical attempt to salvage talks.

After six days of bare-knuckled negotiations on the $700 billion financial industry bailout proposed
by the Bush administration, with Wall Street tottering and presidential politics intruding six weeks
before the election, there was far more confusion than clarity.
An apparent breakthrough was announced with fanfare at midday by key members of Congress
from both parties — but not top leaders. Wall Street cautiously showed its pleasure, with the Dow
Jones industrials closing 196 points higher.

But the good news and the market close were followed by a rash of less-positive developments.

Washington Mutual Inc. was seized by the Federal Deposit Insurance Corp. in the largest failure
ever of a U.S. bank, after which JPMorgan Chase & Co. Inc. came to its rescue by buying the thrift's
banking assets.

And the late-afternoon White House gathering of President Bush, presidential contenders John
McCain and Barack Obama, and top congressional leaders turned into what one person in the room
described as "a full-throated discussion" and McCain's campaign called "a contentious shouting
match."

Conservatives were in revolt over the astonishing price tag of the proposal and the hand of
government that it would place on private markets.

Sen. Richard Shelby of Alabama, the top Republican on the Senate Banking Committee, emerged
from the White House meeting to say the announced agreement "is, obviously, no agreement."
McCain's campaign issued a statement saying, "the plan that has been put forth by the
administration does not enjoy the confidence of the American people as it will not protect the
taxpayers and will sacrifice Main Street in favor of Wall Street." The White House, too,
acknowledged there was no deal, only progress.

Meanwhile a group of House GOP lawmakers circulated an alternative that would put much less
focus on a government takeover of failing institutions' sour assets. This proposal would have the
government provide insurance to companies that agree to hold frozen assets, rather than have the
U.S. purchase the assets.

Inside the White House session, House Republican leader John Boehner announced his concerns
about the emerging plan and asked that the conservatives' alternative be considered, said people
from both parties who were briefed on the exchange.

Financial Services Chairman Barney Frank, the feisty Democrat who has been leading negotiations
with Paulson, reacted angrily, saying Republicans had waited until the last moment to present their
proposal.

McCain, who dramatically announced Wednesday that he was suspending his campaign to deal
with the economic crisis, stayed silent for most of the session and spoke only briefly to voice
general principles for a rescue plan.

After the session, Paulson, hoping to prevent any chance for agreement from being torpedoed,
pleaded with Democratic leaders not to publicly disclose how poorly the session had gone, said
three people familiar with the episode. Frank and House Speaker Nancy Pelosi responded angrily,
and Paulson, in an attempt to lighten the mood, got down on one knee, said the sources who spoke
on condition of anonymity, like the others, because the conversations were private.

Weary congressional negotiators then resumed working with Paulson into the night in an effort to
revive or rework the proposal that Bush said must be quickly approved by Congress to stave off "a
long and painful recession." They gave up after 10 p.m. EDT, more than an hour after the lone
House Republican involved, Rep. Spencer Bachus of Alabama, left the room.

Talks were to resume Friday morning on the effort to bail out failing financial institutions and restart
the flow of credit that has begun to starve the national economy.
The Bush administration plan's centerpiece remained for the government to buy the toxic,
mortgage-based assets of shaky financial institutions in a bid to keep them from going under and
setting off a cascade of ruinous events, including wiped-out retirement savings, rising home
foreclosures, closed businesses and lost jobs.

The earlier bipartisan accord establishing principles and important details would have given the
Bush administration just a fraction of the money it wanted up front, subjecting half the $700 billion
total to a congressional veto. The treasury secretary would get $250 billion immediately and could
have an additional $100 billion if he certified it was needed, an approach designed to give
lawmakers a stronger hand in controlling the unprecedented rescue.

The Bush administration had already agreed to several concessions based on demands from the
right and left, including that the government take equity in companies helped by the bailout and put
rules in place to limit excessive compensation of their executives, according to a draft of the outline
obtained by The Associated Press.

Democrat Obama and Republican McCain, who have both sought to distance themselves from the
unpopular Bush, sat down with the president at the White House for the hour-long afternoon
session that was striking in this brutally partisan season. By also including Congress' Democratic
and Republican leaders, the meeting gathered nearly all Washington's political power structure at
one long table in a small West Wing room.

"All of us around the table ... know we've got to get something done as quickly as possible," Bush
declared optimistically at the start of the meeting. Obama and McCain were at distant ends of the
oval table, not even in each other's sight lines. Bush, playing host in the middle, was flanked by
Congress' two Democratic leaders, Pelosi and Senate Majority Leader Harry Reid.

But neither Bush, McCain nor Obama have been deeply involved so far in this week's scramble to
hammer out a package. The meeting was intended more to provide bipartisan political cover for
lawmakers to support a plan in the face of an angry public and their own re-election bids in six
weeks.

At day's end, Frank said he told Paulson "this whole thing is at risk if the president can't get
members of his own party to participate."

Layered over the White House meeting was a complicated web of potential political benefits and
consequences for both presidential candidates.

McCain hoped voters would believe that he rose above politics to wade into nitty-gritty and
ultimately successful deal making at a time of urgent crisis, but he risked being seen instead as
either overly impulsive or politically craven, or both. Obama saw a chance to appear presidential
and fit for duty but was also caught off guard strategically by McCain's surprising campaign gamble.

U.S. bailout plan stalls after day of talks

September 26, 2008

The day began with an agreement that U.S. government hoped would end the financial crisis that
has gripped the United States. It dissolved into a verbal brawl in the Cabinet Room of the White
House, warnings from an angry president and pleas from a Treasury secretary who knelt before the
House speaker and appealed for her support.

"If money isn't loosened up, this sucker could go down," President George W. Bush declared
Thursday as he watched the $700 billion bailout package fall apart before his eyes, according to
one person in the room.

It was an implosion that spilled out from behind closed doors into public view in a way rarely seen in
Washington. Left uncertain was the fate of the bailout, which the White House says is urgently
needed to fix broken financial and credit markets, as well as whether the first presidential debate
would go forward as planned Friday night in Mississippi.

When congressional leaders and Senators John McCain and Barack Obama, the two major party
presidential candidates, trooped to the White House on Thursday, all signs pointed toward a
bipartisan agreement on a grand compromise that could be accepted by all sides and signed into
law by the weekend. It was to have pumped billions of dollars into the financial system and
transformed the way Wall Street is regulated.

"We're in a serious economic crisis," Bush told reporters as the meeting began shortly before 4 p.m.
in the Cabinet Room, adding, "My hope is we can reach an agreement very shortly."

But once the doors closed, the House Republican leader, John Boehner of Ohio, surprised many in
the room by declaring that his caucus could not support the plan to allow the government to buy
distressed mortgage assets from ailing financial companies.

Boehner pressed an alternative that involved a smaller role for the government, and McCain, whose
support of the deal is critical if fellow Republicans are to sign on, declined to take a stand.

The talks broke up in angry recriminations, according to accounts provided by a participant and
others who were briefed on the session, and were followed by dueling news conferences and
interviews rife with partisan finger pointing.

In the Roosevelt Room of the White House after the session, Treasury Secretary Henry Paulson Jr.
literally bent down on one knee as he pleaded with Nancy Pelosi, the House speaker, not to
withdraw her party's support for the package over what Pelosi derided as a Republican betrayal.

It was the very outcome the White House had said it intended to avoid, with presidential politics
appearing to trample what had been exceedingly delicate congressional negotiations.

Senator Christopher Dodd, Democrat of Connecticut and chairman of the Senate banking
committee, denounced the session as "a rescue plan for John McCain" in an interview on CNN, and
proclaimed it a waste of precious hours that could have been spent negotiating.

But a top aide to Boehner said it was Democrats who had done the political posturing. The aide,
Kevin Smith, said Republicans revolted, in part, because they were chafing at what they saw as an
attempt by Democrats to jam through an agreement on the bailout early Thursday and deny McCain
an opportunity to participate in the agreement.

The day seemed to hold promise as it began. On Wednesday night, Bush had delivered a prime-
time televised address to the nation, warning that "our country could experience a long and painful
recession" if lawmakers did not act quickly to pass a massive Wall Street bailout plan.

After spending Thursday morning behind closed doors, senior lawmakers from both parties
emerged at noon in the ornate painted corridors on the first floor of the Capitol to herald their
agreement on the broad outlines of a deal.

They said the legislation, which would authorize unprecedented government intervention to buy
distressed debt from private firms, would include limits on pay packages for executives of some
firms that seek assistance and a mechanism for the government to take an equity stake in some of
the firms, so taxpayers have a chance to profit if the bailout plan works.

"I now expect we will indeed have a plan that can pass the House, pass the Senate, be signed by
the president, and bring a sense of certainty to this crisis that is still roiling in the markets," said
Senator Robert Bennett, Republican of Utah, a senior member of the banking committee. "That is
our primary responsibility and I think we are now prepared to meet it."
Bennett made a point of describing that meeting as free of political maneuvering. "We focused on
solving the problem, rather than posturing politically, and it was one of the most productive sessions
in that regard that I have participated in since I have been in the Senate," Bennett said.

But a few blocks away, a senior House Republican lawmaker was at a luncheon with reporters,
saying his caucus would never go along with the deal. This Republican said Representative Eric
Cantor of Virginia, the chief deputy whip, was circulating an alternative proposal that would rely on
government-backed insurance, rather than taxpayer-financed purchase of mortgage assets.

He said the recalcitrant Republicans were calculating that Pelosi, Democrat of California, would not
want to leave her caucus politically exposed in an election season by passing a bailout bill without
rank-and-file Republican support.

"You can have all the meetings you want," this Republican said, referring to the White House
session with Bush, the presidential candidates and congressional leaders, still hours away. "It
comes to the floor and the votes aren't there. It won't pass."

House Republicans have spent days expressing their deep unease about such a huge government
intervention, which they regard as a step down the path to socialism.

Smith, the aide to Boehner, said the leader had directed a group of Republicans a few days ago to
see if they could come up with alternatives that relied less on tax funds in providing the rescue
package; that led to Cantor's mortgage-insurance approach.

Smith said Boehner was supportive of Cantor's idea, and believed the concepts should be
considered as part of the solution.

But the new initiative shocked Democrats; the Senate majority leader, Harry Reid of Nevada, said
later that he was under the impression that Boehner had been a strong advocate for moving
forward with the Paulson plan.

Representative Barney Frank, the Massachusetts Democrat, who attended the White House
meeting, was shocked as well. "We were ready to make a deal," Frank said later.

At 4 p.m., Bush convened his meeting at the White House; McCain had already met with House
Republicans to hear their concerns. He later said on ABC that he had known going into the White
House that "there never was a deal," but he kept that sentiment to himself.

The meeting opened with Paulson, the chief architect of the bailout plan, "giving a status report on
the condition of the market," Tony Fratto, Bush's deputy press secretary, said. Fratto said Paulson
warned in particular of the tightening of credit markets overnight, adding, "that is something very
much on his mind."

McCain was at one end of the long conference table, Obama at the other, with the president and
senior congressional leaders between them. Participants said Obama peppered Paulson with
questions, while McCain said little. Outside the West Wing, a huge crowd of reporters gathered in
the driveway, anxiously awaiting an appearance by either presidential candidate, with expectations
running high.

Instead, the first politician to emerge was Senator Richard Shelby of Alabama, the senior
Republican on the banking committee, waving a sheet of paper that he said detailed his own
concerns. "The agreement," Shelby declared, "is obviously no agreement."

At 8 p.m., an exasperated Frank, the lead Democratic negotiator, walked back to the ornate Rules
Committee room on the second floor of the Senate side of the Capitol, with a pack of reporters on
his heels.

He was headed for another late-night meeting with Paulson and many other lawmakers to see if
they could restart the negotiations — and ward off a Monday morning bloodbath in the markets.

Bailout talks in disarray

High stakes talks over $700 billion rescue end in chaos, one day after President Bush warns
'entire economy at risk.'

One day after President Bush said the nation's economy is at grave risk, the high-stakes
negotiations over the proposed $700 billion bailout of the financial system ended in chaos on
Thursday.

Lawmakers bickered over competing counterproposals and hours of meetings between key
lawmakers broke down without any progress late into the evening.

A meeting at the White House between President Bush, congressional leaders and the presidential
candidates was meant to speed approval of an agreement. Instead, the session revealed deep
divisions between Democrats and House Republicans.

As a result, House and Senate leaders and Treasury Secretary Henry Paulson rushed to Capitol
Hill at 8 p.m. to try to hash out a deal.

But shortly after 10 p.m., Rep. Barney Frank, D-Mass., the lead House Democrat on the issue who
had been in close talks with Paulson for days, accused Republicans of refusing to negotiate.

"At this point, we have absolutely no participation or cooperation from House Republicans," Frank
said.

The next step was not clear late Thursday night. One thing seems certain: Lawmakers won't recess
for the year on Friday, as originally planned. Instead, if they can't reach a deal in the next 24 hours,
they're likely to work through the weekend.

The page many thought they were on

Leading Democrats said they were presented for the first time with the House Republican principles
at the White House meeting.

Senate Banking Committee Chairman Christopher Dodd, D-Conn., said the White House meeting
was thrown off course when participants were blindsided by a new "core agreement" that emerged
in the meeting that not many had seen before.

Earlier in the day, congressional negotiators said they had agreed to a set of principles on revisions
to the rescue plan, which calls for the Treasury Department to buy up bad mortgage securities from
banks in an effort to get them to lend again.

The proposal, as amended by leaders in both chambers, will help homeowners, curb executive pay
packages at participating firms and provide oversight of Treasury's actions, Dodd said in a
lunchtime address.

"We've reached a fundamental agreement on a set of principles, one, for taxpayers, which is
tremendously important," he said. "We're very confident we can act expeditiously."

Details on the plans

The principles the Democrats said had been agreed upon call for Congress to make $250 billion
available immediately with $100 billion available, if needed, without requiring additional
congressional approval, said two senior Democratic aides familiar with the negotiations. The
second half of $350 billion would then become available by a special approval of Congress.
On executive compensation, the draft would require limits on compensation for executives of any
company participating in the bailout. These caps would apply for as long as the company is in the
program. This would include some language to limit excess "golden parachutes."

Treasury will also get an equity stake in the companies being helped by the bailout, though what
type remains to be worked out.

Still to be worked out is whether to allow bankruptcy judges to modify mortgage terms, a provision
backed by many Democrats and community activists but opposed by Republicans and the banking
industry.

What House Republicans want:

The bankruptcy provision is not the only sticking point, however. House Republicans are not on
board, according to Minority Leader Rep. John Boehner, R-Ohio.

"House Republicans have not agreed to any plan at this point," Boehner said.

Instead, they issued a statement of economic rescue principles that calls for Wall Street to fund the
recovery by injecting private capital - not taxpayer dollars - into the financial markets. Easing tax
laws would prompt investors to put in their own dollars, they said.

The plan also calls for: participating firms to disclose the value of the mortgage assets on their
books, ending Fannie Mae and Freddie Mac's securitization of "unsound mortgages," reviewing the
performance of the credit rating agencies and having the Securities and Exchange Commission
audit failed companies to ensure their financial standing was accurately portrayed.

House Republicans also want to create a panel to make recommendations for reforming the
financial industry by year's end.

Meanwhile, the ranking Republican on the Senate Banking Committee has another idea. Sen.
Richard Shelby, R-Ala., said he doesn't support the Treasury plan until there is serious
consideration of alternatives. He proposed Thursday adding funds to the Federal Reserve and
Treasury to allow them to lend more to financial institutions.

Bush still hopeful

Before the afternoon meeting, Bush said he expects a deal "very shortly."

After, a counselor to the president said "we're getting closer. There's some more that has to be
done. It's going to be a consensus plan at the end of the day."

"Both sides are going to have to work hard to get to an agreement," presidential counselor Ed
Gillespie said on CNN.

Administration officials have spent countless hours this week behind closed doors with and in public
hearings before Congress. Lawmakers were hoping to have a deal agreeable to both parties
hammered out before Thursday's meeting at the White House.

On Wednesday night, Bush took the nation's airwaves in a prime-time address in which he laid out
a looming economic disaster.

"The government's top economic experts warn that, without immediate action by Congress, America
could slip into a financial panic and a distressing scenario would unfold," Bush said. "More banks
could fail, including some in your community. The stock market would drop even more, which would
reduce the value of your retirement account. The value of your home could plummet. Foreclosures
would rise dramatically."
 Buffett's deal versus Paulson's
September 25, 2008
Maybe the American taxpayers should be asking Warren Buffett to be negotiating on their behalf.

Treasury Secretary Henry Paulson Jr. spent a good part of two days on Capitol Hill arguing that the
federal government should not demand a stake in any Wall Street concerns it bails out. Demanding
such a stake, Paulson said, could scare away many of those companies from participating in the
bailout, leaving the credit markets as hobbled as they are now.

And then Buffett swooped in and announced that his company, Berkshire Hathaway, was investing
$5 billion in Goldman Sachs, which made far fewer bad investments than most of Wall Street.
Buffett's money will help Goldman shore up its balance sheet. What will he receive in exchange?
Something like a 7 percent stake.

Paulson, of course, has a different objective than Buffett. The Treasury secretary is trying to
resuscitate the U.S. financial system and keep the economy from falling into a deep recession. If he
drives too hard a bargain, he won't solve the problem. Buffet is merely trying to make money.

But to the many critics of the Paulson plan, the juxtaposition of the Goldman deal crystallizes the
problems. The critics are worried that the government is taking on too much risk with too little
upside. And they can't help but notice that other governments that faced similar crises in recent
decades - in Japan and Sweden - struck deals that looked more like Buffett's than Paulson's.

On Wednesday, several members of Congress wistfully mentioned the Goldman deal. "When
Warren Buffett invests $5 billion, he gets preferred stock in Goldman Sachs," Senator Jeff
Bingaman, Democrat of New Mexico, said to Ben Bernanke, the Federal Reserve chairman. "We're
being asked to endorse a bailout where we basically take the assets that these companies - these
firms - can't otherwise dispose of at a reasonable price and take them off their hands."

Buffett appears to have gotten a very good deal, one that may not have been available to anybody
whose name carries less prestige - which is to say, just about anybody else. (He will receive
dividends that will effectively pay him a 10 percent annual return on his investment, as well as the
right to buy a sizable stake in Goldman at a price below the current market price.) Goldman
partners surely figured that his investment would allow them to turn around and raise yet more
capital from other investors. Sure enough, they announced Wednesday that they were doing so.

A company that accepted money from the Treasury Department would get none of this halo effect.
If anything, investors might view a company desperate enough to approach the Treasury as an
endangered species unworthy of further investment.

But as imperfect as the Buffett analogy may be, it still raises a real question: Is the government
getting a raw deal? The inability of Paulson and Bernanke - as well as President George W. Bush -
to make people comfortable with the answer is the main reason that the bailout has encountered so
much hostility.

Economists overwhelmingly agree that the economy faces risk that is serious enough to need
quick, bold action. Yet they're deeply skeptical that Paulson's plan is the right one. Buffett's deal
nicely highlights their two main worries.

The first is that the Paulson plan may not have the best chance of success. Buffett's deal with
Goldman injects $5 billion in cash into the company, and those dollars strengthens Goldman's
balance sheet. Goldman will then presumably become more willing to lend money, and the credit
crisis will be one small step closer to lifting.

The Japanese government, after years of missteps, followed a strategy much like that one in 1998,
putting capital directly into its banks. The move helped end a long downturn.
Paulson, on the other hand, has asked for a $700 billion credit line to buy distressed assets from
financial concerns. It is the equivalent of trying to cut a tumor out of the financial system. But there
is a potential downside.

The Treasury would not be giving money to the companies. It would be buying an asset of some
value (albeit much less value than a year ago). As a result, the transaction might not do enough to
bolster the companies' balance sheets.

The second worry is that even if the Paulson plan works, it may end up being needlessly expensive.
There is huge uncertainty about the true value of those distressed assets. If the government ends
up overpaying for them, it won't have any way to recoup the money.

Without an ownership stake - like the one Buffett got or the one the Swedish government got when
it bailed out its banks in the 1990s - taxpayers wouldn't really be able to share in the bounty of a
Wall Street recovery.

What would Buffett have said if Goldman asked for his money and wouldn't let him share in the
upside? "He would have said 'no deal!"' Daniel Alpert of Westwood Capital, an investment firm,
said. "And that is what Congress must say as well in defense of the American people."

On Capitol Hill, Bernanke and Paulson answered their critics by returning to the same point they
have made before. If companies must hand over an ownership stake, only the sickest may come
forward. Others may wait out the crisis, confident they can survive. But the credit markets would
meanwhile remain paralyzed, as a Treasury official argued to me, and the economy could
deteriorate.

But the Goldman deal, in which a company that didn't seem near extinction agreed to give up a fat
equity stake in exchange for cash, puts the onus on Bernanke and Paulson to make a better case
than they have so far.

Bernanke pointed out Wednesday that Buffett had urged Congress to pass the current bailout plan.
I'd point out that Buffett drove a harder bargain when his own money was on the line.

Big bailout is unlikely to work

September 25, 2008
The U.S. "hold-to-maturity" bailout plan is really just the new "mark-to-myth," and even its heroic
proportions are not likely to paper over solvency problems in the banking system.

Ben Bernanke, the chairman of the U.S. Federal Reserve, told lawmakers that the plan to spend
$700 billion to buy up bad assets would allow banks to avoid unloading loans at fire-sale prices.

"Auctions and other mechanisms could be devised that will give the market good information on
what the hold-to-maturity price is for a large class of mortgage-related assets," he said, trying to
persuade a skeptical Congress that the plan he and Treasury Secretary Henry Paulson Jr. have
been pushing will give value for taxpayers' money.

Banks are forced to mark their assets to market, a process that has become increasingly painful
and is likely to lead to bank failures as a shortage of investors and the swiftly declining performance
of the underlying collateral have driven prices lower. Since many securities are so complex that
they seldom trade, banks sometimes must mark the assets according to modeled prices, a process
sometimes referred to as "marking to myth" by doubters.

What "is a 'held-to-maturity' price, and how in the world can an auction or 'other mechanism' be
devised that gives the market a good idea of 'hold-to-maturity' prices - since there is no such thing?"
the economist Thomas Lawler, a former Fannie Mae manager now with Lawler Economic &
Housing Consulting, wrote in a note to clients. "Of course, everyone knew what he meant: 'held-to-
maturity' means 'above market."'

The hope, presumably, is that the subsidy given by buying debt for more than it will fetch on the
open market will be enough to prop up banks and attract new investors.

If it is a subsidy, why not call it one?

And though $700 billion is a lot, it is not enough to wipe the slate clean and leave banks with
workable balance sheets; the plan will only work if that $700 billion, which amounts to far less in
terms of capital relief, is leveraged by new money from outsiders now sitting on the sidelines.

But I find it hard to believe that the sovereign wealth funds of the world, already burned by banking
investments, will be attracted by a price arrived at through what promises to be an opaque process.

One possibility being discussed is a reverse auction, where banks will compete to sell bonds to the
government. Given that private label securities are often unique, that may be difficult to carry out in
a competitive and transparent way.

And since part of the purpose of the exercise is to establish a mark for banks to use on their
portfolios, there is scope for collusion.

If banks do compete and bid down the prices of debt instruments, the authorities may be faced with
another round of failures, as ailing banks are forced to use new marks and find their capital deficient
in the new light.

Alternatively, the government, which has bottomless pockets and no liquidity risk, may simply arrive
at a price based on what it, or its advisers - and one wonders who they could be and if they saw this
disaster coming - think is a fair bet on what repayment flows will be.

There is also the issue of protecting the taxpayers, who may justifiably argue that they should share
in the benefit of any subsidy offered to the industry in return for footing the bill. But taking equity
stakes in banks in exchange for below-market funding or asset sales probably would choke off any
hope of new equity infusions from actual investors seeking profits.

It's easy to understand why the United States is considering an apparently indiscriminate reward for
those who took too much risk. The stakes are very high, and a disorderly deleveraging would be
worse than an orderly one, even if the orderly one isn't perfect.

The debate about whether or not the United States will need a huge intervention of public capital
into its banking system and wider economy is over. The crisis requires a huge outlay of public
funds, both to clean up after the many banks that will fail and to soften the blow to homeowners and
consumers.

Banking is a confidence game, even if done soberly and responsibly. But this plan, because it fails
to meet the issue of insolvent and failing institutions head on, is not likely to work.

What About the Rest of Us?

September 26, 2008
Lawmakers were still wrangling Thursday night about the Bush administration’s $700 billion bailout
of the financial system. Political theater was mainly responsible for the delay, but it will be worth the
wait if lawmakers take the time to make sure that the plan includes real relief for homeowners and
not only for Wall Street.

The problems in the financial system have their roots in the housing bust, as do the problems of
America’s homeowners. Millions face foreclosure, and millions more are watching their equity being
wiped out as foreclosures provoke price declines.
The problems became even more evident Thursday night with the federal seizure and sale of
Washington Mutual to JPMorgan Chase.

It’s unacceptable that lawmakers have yet to come out squarely in favor of bold homeowner relief in
the bailout bill. Treasury Secretary Henry Paulson, the biggest advocate of bailing out Wall Street,
is also a big roadblock to helping hard-pressed borrowers. He wants to keep relying on the
mortgage industry to voluntarily rework troubled loans, even though that approach has failed to
stem the foreclosure tide — and does a disservice to the taxpayers whose money he would put at
risk in the bailout.

Many of the assets that Mr. Paulson wants to buy with the $700 billion have gone sour because
they are tied to mortgages that have defaulted or are at risk of default. Unless homeowners get
some help — and its a pittance compared to what Mr. Paulson wants to give to bankers — the
downward spiral of defaults, foreclosures and tumbling home prices will continue, which could push
down the value of those assets even further.

We could make a strong moral argument that the government has a greater responsibility to help
homeowners than it does to bail out Wall Street. But we don’t have to. Basic economics argues for
a robust plan to stanch foreclosures and thereby protect the taxpayers’ $700 billion investment.
Mr. Paulson has long opposed what is probably the best way to help Americans stay in their homes:
allowing a bankruptcy court to reduce the size of bankrupt borrowers’ mortgages. Unfortunately, but
predictably, drafts of the bailout plan circulated late Thursday do not mention that relief.

It is simply outrageous that every type of secured debt — except the mortgage on a primary home
— can be reworked in bankruptcy court. The law was designed to protect lenders, who have
obviously and disastrously abused that protection. There would be no favors dispensed in
bankruptcy proceedings. Lenders would have to accept less of a payback and borrowers would
have to submit to the oversight of the bankruptcy court for years.

But the bankruptcy process would mean many fewer foreclosures. And that would halt the
downward slide in home prices, reduce the number of vacant homes — and the blight that comes
with them — and help preserve equity for all homeowners. It would cost the taxpayer nothing.
Arguments against bankruptcy relief for mortgages have all been raised and refuted in
Congressional hearings and debates over the past year.
There should be no more balking. Any bailout bill must allow struggling homeowners to modify their
mortgages in bankruptcy court. Mr. Paulson should drop his opposition now. If he won’t, Congress
should insist on the bailout for homeowners. Americans’ $700 billion investment needs to be
protected.

Timeline: Crisis on Wall Street

Sept. 27, 2008
The credit crisis shaking the global economy is forcing a dramatic reconfiguration of Wall Street.
Here is a day-by-day look at the impact of the crisis on the markets and Wall Street and the steps
legislators and government officials are taking to avert a meltdown in the global financial markets.

Sept. 26
The Dow opens down triple digits, but recovers most of its losses during morning trading.
President Bush delivers a brief address on national television saying that key negotiators would
pass a bailout bill.
John McCain says he will join Barack Obama for their debate in Mississippi.
Democrats say they are 'back on track' after hitting yesterday's roadblock, but no agreement on the
$700 billion plan has been reached.
Dow Jones Industrial Average: +121.07

Sept. 25
Negotiators from the Republican and Democratic parties say they have reached agreement on
basic principles governing the massive financial bailout, but later in the day top Republicans deny
reports of an agreement.
Federal regulators seize troubled mortgage lender Washington Mutual in the largest bank failure
in U.S. history, then immediately sell much of the company to J.P. Morgan Chase for $1.9 billion in
a deal that will create the largest bank in the country.
Despite weak economic data, stocks soar as hopeful investors are buoyed by news reports that the
financial rescue plan was making its way through Congress.
James B. Lockhart III, the chairman of the Federal Housing Finance Agency tells the House
Financial Services Committee that the new chiefs of Fannie Mae and Freddie Mac will receive
salaries of $900,000.

Dow Jones Industrial Average: +196.89

Sept. 24
President Bush delivers a nationally televised address, asking the nation to support the financial
bailout plan. Sen. John McCain suspends his presidential campaign to focus on crafting the bailout
package and asks Sen. Barack Obama to delay a debate scheduled for Friday, Sept. 26. Obama
says it is more important than ever to have the debate.
During his second day of testimony on Capitol Hill, Federal Reserve chairman Ben Bernanke tells
lawmakers the U.S. economy is faltering.
Peter R. Orszag, the director of the Congressional Budget Office tells the House Budget
Committee that the proposed Wall Street bailout could actually worsen the current financial crisis.
The Dow takes a breather, moving little amid light trading.
Standard & Poors cuts the credit rating of troubled bank Washington Mutual from BB- to CCC.

Dow Jones Industrial Average: -28.28 | Graphic Analysis

Sept. 23

Lawmakers from both parties question policymakers in the first day of Capitol Hill hearings.
Federal Housing Finance Agency official, James B. Lockhart III, says Fannie Mae and Freddie
Mac could not continue to cover mortgage losses without government support.
The FBI launches an investigation into whether fraud played a role in the collapse of finance giants
Fannie Mae, Freddie Mac, Lehman Brothers and AIG, bringing to 26 the number of bureau
investigations tied to the crisis.
Major Japanese banks continue to snap up Wall Street holdings.
Despite pressure from Vice President Dick Cheney and Chief of Staff Joshua Bolten, House
Republicans are reluctant to approve massive rescue plan.
The Dow falls in late trading.
Billionaire investor Warren Buffet's company Berkshire Hathaway invests $5 billion in Goldman
Sachs.

Dow Jones Industrial Average: -161.52

Sept. 22

Democrats call for the bailout plan to include caps on executive compensation and aid for struggling
homeowners.
Those engineering the bailout plan struggle with how to value the troubled securities that would be
purchased and with how to auction them.
Goldman Sachs and Morgan Stanley are converted into bank holding companies, offering them
broader government protection in exchange for tighter regulation.
Asian banks invest in Morgan Stanley and gobble up the remains of Lehman Brothers.
The SEC expands its temporary ban on short selling of financial stocks to 100 additional
companies.
Fearing massive transfers from bank accounts to money market funds, the Treasury Dept. says it
will only guarantee existing investments in money market funds.
Inflation fears spark the steepest one-day drop in the dollar in years. Gold prices soar.
Oil prices spike more than $16 a barrel, the biggest one-day price jump ever.

Dow Jones Industrial Average: -372.75 | Graphic Analysis

Sept. 19
President Bush announces plan to buy troubled assets from financial firms.
Treasury Dept. offers to protect investments in money market funds.
Fannie Mae and Freddie Mac will increase their purchases of mortgage-backed securities,
Treasury Dept. says.
SEC temporarily bans short selling in shares of nearly 800 financial institutions and expands its
investigations into credit default swaps.
Stock markets soar as details of the multi-billion dollar financial rescue plan emerge.

Dow Jones Industrial Average: +360.93 | Graphic Analysis

Sept. 18
Global Lenders

The Fed and central banks in Europe, Japan and Canada team up
to inject as much as $180 billion into global markets to ease the
cash crunch, while investors withdraw $80 billion from money
market funds.
The Bush administration urgently prepares a massive rescue
plan to revive the U.S. financial system by buying up bad debts
choking the books of financial institutions.
Stocks whipsaw, ending on a high note as word spreads of a possible U.S. plan to address the
crisis.
Putnam Investments closes a $12.3 billion money-market fund to limit losses to its investors.
Dow Jones Industrial Average: +410.68

Sept. 17
London interbank offered rate (LIBOR)

As banks abruptly stop lending to each other, cash

becomes scarce, driving up the cost of capital.
Washington Mutual puts itself up for sale.
Morgan Stanley and Goldman Sachs shares drop 24 and 14 percent respectively.
Morgan Stanley and Wachovia enter merger talks.
The price of gold soars more than 8 percent.
Markets sustain heavy losses as AIG takeover unnerves
investors.
The SEC adopts new rules prohibiting abusive "naked
short-selling."

Dow Jones Industrial Average: -446.92

Sept. 16
AIG stock price, daily close

The Fed lends insurance giant American International Group (AIG) $85 billion in exchange for
nearly 80 percent of its stock.
Lawmakers clamor for government action and contemplate other dramatic interventions.
Lehman Brothers heads to bankruptcy court and seeks to sell parts of its business to ease the
bankruptcy process.
Oil prices drop almost $4.56 a barrel, continuing a two-month decline from all-time highs.
The Dow Jones industrial average rebounds on the news that the Fed has agreed to help AIG.

Dow Jones Industrial Average: +153.40

Sept. 15

Lehman Brothers files for bankruptcy protection.

Bank of America agrees to buy Merrill Lynch.
The Federal Reserve elects not to raise interest rates, despite
pleas from Wall Street.
Global stocks plunge on Wall Street worries.
Oil drops below $100 a barrel.
New York state allows insurance giant AIG to use $20 billion
from its own insurance subsidiaries to ease a financial crunch.

Dow Jones Industrial Average: -498.86

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Lawmakers Get Down to Details of Drafting Bill

September 27, 2008

Talks over the Bush administration's plan to stabilize the U.S. financial system lurched forward
yesterday, as rebellious Republicans returned to the negotiating table and congressional aides
began the tortuous work of drafting a bill to execute one of the biggest interventions into the private
market in modern history.

One day after they nearly derailed the plan, House Republicans agreed to send their second-
ranking leader to negotiate with Democrats and Senate Republicans.

Lawmakers canceled plans to adjourn yesterday for the November election and instead prepared to
work through the weekend on the proposal, which would authorize the Treasury Department to
spend up to $700 billion to take bad assets off the books of faltering financial institutions.
Democrats said they hoped to announce an agreement late Sunday before Asian financial markets
open, with a House vote on the measure possible by Monday. A Senate vote would follow later in
the week.

"Great progress is being made. We will not leave until legislation is passed that will be signed by the
president," said House Speaker Nancy Pelosi (D-Calif.).

Added Rep. Barney Frank (D-Mass.), an architect of the legislation: "I am convinced that by Sunday
we will have an agreement people will understand."

With global markets hanging on every twist of the debate in Washington, White House officials
swarmed Capitol Hill in an attempt to salvage a deal, while President Bush issued another call for
action during a brief appearance outside the Oval Office.

"There are disagreements over aspects of the rescue plan, but there is no disagreement that
something substantial must be done," Bush said yesterday morning. "The legislative process is
sometimes not very pretty, but we are going to get a package passed. We will rise to the occasion."

Bush followed his remarks with calls to House Republican leaders, who have balked at approving a
massive bailout for Wall Street dealmakers and are pushing an alternative plan to create a
government insurance program for home mortgages. Republicans say that plan would blunt the
impact of record foreclosures, which have paralyzed institutions that hold mortgage-related assets.
But critics say it would do nothing to inject needed cash into banks and other institutions.

Treasury Secretary Henry M. Paulson Jr. presented lawmakers with a three-page plan for salvaging
the country's financial system one week ago. By yesterday, following discussions with Democratic
leaders, the draft proposal had grown to more than 100 pages, with hours of negotiation to come.

Under a tentative agreement among lawmakers and administration officials, the measure would
grant the Treasury sweeping power to buy up bad mortgage-related assets through Dec. 31, 2009,
but it also would create an independent inspector general to oversee that program. As the new
owner of billions of dollars worth of mortgage-backed assets, Treasury would be required to reduce
the number of foreclosures by modifying the terms of the loans that underlie those assets.

Frank said Treasury also has agreed to accept other changes to its original plan, though aides were
still haggling over details. Among the changes:

· A proposal to dole out the money in segments, with Paulson getting $250 billion immediately,
another $100 billion later and the final $350 billion after giving Congress 30 days to object.

· A plan to help taxpayers recover their investment by granting them equity in companies that
participate in the bailout and return to profitability.

· A provision that would require the Treasury to ban "excessive and inappropriate" compensation for
top executives at participating firms. Democrats are also seeking to eliminate a tax deduction
companies take for executive compensation if a senior manager is paid more than $400,000 a year.

Republican negotiators, meanwhile, appeared to be most concerned yesterday about a Democratic

proposal to dedicate a portion of any profits from the eventual sale of the assets to an affordable
housing fund. Republicans argue that the fund would benefit social service organizations with
strong ties to the Democratic party.

Lawmakers from both parties reached an agreement in principle on the bailout plan around
lunchtime Thursday. But that deal was imperiled hours later, after a White House summit that
included Bush and both presidential candidates turned into a shouting match. House Minority
Leader John A. Boehner (R-Ohio) angered Democrats by floating the insurance idea, then refusing
to participate in a late-night negotiating session with Paulson.

Yesterday got off to a much better start, as House Minority Whip Roy Blunt (R-Mo.) announced that
he would join the negotiations. A member of GOP leadership for six years, Blunt enjoys a
comfortable relationship with some Democrats and played the lead role in several recent bipartisan
negotiations, including a compromise on foreign intelligence surveillance legislation.

Meanwhile, Rep. Eric Cantor (R-Va.), a key figure in a band of Republicans that had adamantly
opposed the bailout plan, softened his opposition. Cantor acknowledged that, in dealing with the
most troubled mortgage securities, the insurance model preferred by many Republicans would not
be sufficient because the securities already had minimal value. "So you've got to go with Paulson's
model," Cantor said.

Including an option for mortgage insurance might persuade more Republicans to support the bailout
plan, Cantor said. Boehner concurred, saying the entire deal could collapse unless the idea were
given serious consideration.

Without it, "a large majority of Republicans cannot -- and will not -- support Secretary Paulson's
plan," Boehner wrote in a letter to Pelosi yesterday.

Democrats said they don't think insuring mortgages would solve the credit crisis, because the
Republican plan proposes to charge premiums to the very banks that are struggling to stay afloat.
They sad the idea also would make the government the insurer of last resort, exposing it to losses
that could exceed the price of the Bush proposal.

But Frank said he was willing to add an insurance option if it secured Republican votes. With less
than six weeks until the November election, Pelosi, Frank and other Democrats have demanded
that a large number of Republicans join them in approving the controversial legislation.

"It's no problem to add something that's not going to do much," Frank said.

Democrats have accused the GOP presidential candidate, Sen. John McCain (R-Ariz.), of
engineering Thursday's breakdown in hopes of garnering attention for his campaign. Republicans
yesterday defended McCain but acknowledged that his intervention had created a stir that
threatened the bailout.
With McCain and his Democratic opponent, Sen. Barack Obama (D-Ill.), both back on the campaign
trail, the talks are "back on track," said Sen. Lamar Alexander (R-Tenn.). Alexander said he expects
more than 40 Republicans in the Senate to support the final legislation if it is endorsed by their lead
negotiator, Sen. Judd Gregg (R-N.H.).

"He'll have overwhelming support for it," Alexander said.

In Full Stride as Others Fall

During Crisis, Dimon Bolsters J.P. Morgan Chase's Position
September 27, 2008\

Jamie Dimon steered his bank away from the bad mortgage bets and risky financing methods that
have damaged much of his competition. But the J.P. Morgan Chase chief executive finds himself
playing a major role in the credit crisis anyway.

From a dashing rescue of Bear Stearns in March to this week's winning bid in an emergency
auction of savings and loan Washington Mutual, Dimon has helped federal officials avoid potential
messes stemming from the turmoil in the financial markets.

"It's very fortunate that he's in the position to appear as a white knight, but make no mistake: J.P.
Morgan and Jamie Dimon are in this thing to make money for their shareholders," said Tom
Kersting, a banking analyst at Edward Jones.

J.P. Morgan shares jumped 11 percent to $48.24 on Friday as investors applauded Dimon's $1.9
billion acquisition of Washington Mutual's banking operations.

Dimon has been instrumental in turning J.P. Morgan into a banking giant. He came to the firm from
Bank One, itself the product of mergers, after J.P. Morgan bought it in 2004. With the latest
acquisition, he now heads a U.S. banking empire of 5,400 locations in 23 states whose only peer is
Bank of America.

The son and grandson of stockbrokers who for many years worked alongside former Citigroup
chairman Sanford Weill, Dimon has never shared the appetite for risk and disdain for plain-vanilla
lending that have defined much of Wall Street in recent years.

"Jamie has always been focused on deposits and on creating what he calls a 'fortress balance
sheet,' which among other things means carrying a stable supply of cash that doesn't run out the
door at the first sign of crisis," said former J.P. Morgan investment banker David Stowell, now a
professor at Northwestern University's Kellogg School of Management.

That fortress mentality has raised Dimon's already considerable profile as competitors, investors
and federal officials scramble to unfreeze credit markets and restore faith in the American banking
system.

Dimon, 52, said that he and his top lieutenants don't consider themselves "go-to guys" for the
federal government.

Although he conceded to showing some degree of flexibility when he was asked by top regulators
to buy Bear Stearns and stave off the fallout from a failure of a major securities firm, he suggested
that anyone in his position would have responded similarly.

"We went out of our way to accommodate what we thought could have been a devastating
situation," Dimon told reporters Friday on a conference call. "Personally, I think that should be the
attitude of everybody."
Earlier this month, J.P. Morgan joined Goldman Sachs in trying to arrange a $75 billion loan for
ailing insurance giant American International Group, also at the government's behest. But the firms
could not raise the financing in the two-day time frame that AIG needed to meet its obligations, and
the government stepped in with a loan.

Dimon appeared on the scene again Thursday, picking up Washington Mutual's banking operations
for far less than what he was rumored to be interested in paying earlier this year when he was
mulling a takeover of the company. But this time, Dimon's bid was not solicited by the government.

"This was an arm's length transaction," he said. "There may have been other people willing to do it,"
he said, but not at the price J.P. Morgan had offered.

Unlike the Bear Stearns transaction, the Washington Mutual acquisition comes with no guarantees
from the Federal Reserve, which put up $29 billion to help J.P. Morgan absorb potential losses from
Bear Stearns's assets.

The Washington Mutual purchase, executed late Thursday evening, should generate profit quickly,
adding an estimated 50 cents to per-share earnings for 2009, the company said. And crucially, J.P.
Morgan sold $10 billion of common stock Friday to ensure that it could absorb any potential losses
on Washington Mutual's mortgage-laden books.

Costs related to the merger are expected to total $1.5 billion, the company said.

The acquisition quickly expands J.P. Morgan Chase's retail banking business in California, Florida
and Washington State, and strengthens its presence in key markets including New York and Texas.

Michael Moskow, president of the Chicago Fed, described the New York native as a "personable,
but no-nonsense" executive who "speaks about a thousand words a minute," is widely known for his
attention to detail.

"He's willing to go into the weeds," similar to his mentor, said Stowell, of Northwestern. "Sandy Weill
was another extreme detail guy who understood the plumbing of an organization. That was, I'm
sure, a very big influence on him. But above and beyond that, he's just a very tenacious guy. And
he sees things that a lot of people don't see."

J.P. Morgan hasn't been completely shielded from the mortgage crisis that has infiltrated Wall
Street. But its write-downs have been relatively small, and investors have maintained confidence in
Dimon's ability to keep the bank healthy.

"He's been preparing for this moment for years," said Jason Polun, a banking analyst at T. Rowe
Price. "It's not luck. He's very, very smart. And his discipline, while others were jumping into growth
opportunities with great risk, kept the balance sheet in great position to take advantage of the
situation at Bear Stearns and at Washington Mutual."

That doesn't mean J.P. Morgan won't have to worry about the backdrop to the ongoing credit crisis:
a slowing economy and a more cautious consumer. But Dimon doesn't expect economic tides to
throw his growing company too far off course.

"We've never said we're immune to that," Dimon said in the conference call with reporters. "We're
just prepared for it."
What $700B won't buy: a quick fix for the economy
Sat Sep 27, 2:45 PM ET

Not even $700 billion will be enough to spare the United States from more economic anguish if the
government's proposed banking bailout pans out like similar desperation moves during the past two
decades.

It usually takes years to recover from a financial crisis severe enough for politicians to ride to the
rescue with truckloads of taxpayer money.

Take, for example, the U.S. government's August 1989 bailout of the savings-and-loan industry.
The stock market fell by 12 percent within the first 14 months of the rescue plan while the economy
slipped into an eight-month recession that began in July 1990. Housing prices that had just begun
to erode continued to fall for another three years.

There's little reason to believe it will be dramatically different this time around, particularly since this
bailout involves harder-to-value assets and comes with the U.S. economy already on the edge of a
recession, if one hasn't begun already.

"This is going to take years to work out and it will be incredibly complicated," predicted banking
consultant Bert Ely, who has extensively studied the U.S. government's 1989 bailout.

Although lawmakers are still sparring over the precise details, the proposed bailout would authorize
the government to borrow up to $700 billion to buy the toxic assets poisoning banks. Most of these
holdings are tied to mortgages made to borrowers who either can't afford to make their monthly
payments or have simply chosen to default because they owe far more than their homes are worth.
No one seems quite certain how much these assets are worth, but the government is betting that —
with time — it can get a handle on it and eventually profit.

Even as the government tries to clean up the mess left by reckless home lenders, borrowers and
investors, more problems are likely to stack up.

The trouble could include longer unemployment lines as struggling companies faced with declining
sales and limited access to credit trim their payrolls. That could lead to even more bank failures, as
cash-strapped borrowers don't repay loans. And most experts think there's still a good chance the
downturn in the housing and stock markets will deepen to further spook already frightened
consumers.

The government is hoping its intervention will unclog the lending pipeline, but that isn't a certainty
either, said Sung Won Sohn, an economics professor at California State University, Channel
Islands.

"If I am a medium-sized bank on Main Street, simply because the government is bringing a bailout
package to Wall Street doesn't mean I am suddenly going to change my mind and start lending
money again," Sohn said.

That suggests the economic statistics won't even capture some of the collateral damage — all the
lost lending opportunities that occur as banks try to bolster their rickety balance sheets. Many banks
have curtailed their lending because they are already swimming in losses and don't want to risk
drowning by taking chances on more borrowers.

"The real tragedy is we will never know how many businesses would have been started or how
many businesses might have expanded if all this hadn't happened," said Jonathan Macey, deputy
dean of Yale Law School, who wrote a book about a government bailout in Sweden during the early
1990s.

In a best case scenario, Macey said the United States will bounce back within two years, like
Sweden did after the government spent billions of dollars to salvage the country's troubled banks
and prop up a slumping housing market.
Before the medicine took effect, Sweden suffered through a 20-month recession that saw nearly
60,000 companies go bankrupt, housing prices fall by 19 percent and the country's bellwether stock
market index plunge 45 percent from its peak. Once the hangover ended, the good times resumed;
Sweden's economic growth has averaged 3.2 percent since 1994.

Sweden spent 65 billion kronor (about $10 billion at the time), but made most of the money back
because it bought a stake in some of the troubled banks. The government still owns nearly 20
percent in one bank — a stake that is now up for sale. U.S. lawmakers also have been debating
whether it makes sense to acquire stock in some of the banks that the government intends to help
out.

In a more sobering situation, the payoff from the U.S. bailout might take much longer. That's what
happened in Japan after its government finally intervened in a real estate and banking crisis that
began in the early 1990s.

By the time the government acted in 1997, the economic hole was so deep that it took another
seven or eight years to climb out. The net public outlay to clean up mess was 18 trillion yen ($168
billion), according to the Financial Services Agency.

The abysmal times in Japan during the 1990s are now known as the "lost decade." Even though the
economy is better now, the Japan's stock market still hasn't returned to its peak before the bubble
burst. And Japan still has about $9 billion worth of property held as collateral that needs to be sold.

It seems unlikely that the United States will have to wait as long for a recovery because the
government is wading into the financial muck much more quickly than Japan did.

In contrast, the United States is promising to bail out its banks 18 months after mortgage lender
New Century Financial Corp. filed for bankruptcy — a move that set off alarms about the rot ruining
home loan portfolios.

"Some resolution measures are more effective than others in restoring the banking system to health
and containing the fallout on the real economy," the International Monetary Fund concluded in a
study of 124 financial crises since 1970. "Above all, speed appears to be of the essence."

Even if the U.S. government is moving in time to make a difference, success is likely to hinge on the
ability to figure out the right price to pay for an exotic mix of mortgage-backed investments and
other serpentine securities that aren't easily appraised. And then the government must hope the
housing market eventually rebounds to lift the value of the acquired assets.

If those pieces fall into place, the United States could profit or at least minimize its losses. On the
flip side, the losses could be huge if the government misjudges the value of the problem assets or
the housing market remains in a funk. "The best we can hope for is that this (bailout) buys us time,"
said Edward Yardeni, who runs his own economic research firm.

The United States moved a little quicker to address the mortgage crisis than it did in the savings-
and-loan debacle of the 1980s. Although warning signs of an industry breakdown started to flash in
the mid-1980s, the government waited until August 1989 to create the Resolution Trust Corp. to
dispose of the repossessed homes, offices, cars, planes and even artwork held by failed S&Ls.

During the next six years, the RTC sold nearly $400 billion in assets on the books of more than 700
failed thrifts. Taxpayers ended up sustaining a loss of $125 billion to $150 billion on the fire sale —
about 2 percent of the country's gross domestic product by the time the bailout was completed in
1995. Entering the S&L bailout, the government had projected a taxpayer loss of $40 billion to $50
billion.
If the ratio of losses to assets inherited in the latest $700 billion bailout is similar to what occurred in
the S&L crisis, the taxpayers will be saddled with a bill of more than $250 billion, which also
translates into about 2 percent of the nation's current GDP.

Data from the IMF's study suggest the losses could run even higher. The monetary fund calculated
governments typically recover about 18 cents on every dollar spent in bailouts — a rate that would
translate into a loss of more than $500 billion. The United States seems unlikely to sustain a loss
that large since it presumably will be buying the banking assets at a sharp discount — leaving
plenty of room for an upside.

Although the S&L bailout was the biggest in U.S. history before this one, the challenges facing the
government are radically different.

In 1989-95, the government and an army of contractors disposed of assets that were dumped into
their laps as S&Ls collapsed. And it wasn't too difficult to figure what those assets were worth
because their value could be easily measured against similar property. That's not the case this time.
Part of the reason so many banks are imperiled is that no one is sure what their investments are
worth.

Most economists agree absorbing the bailout's costs are preferable to running the risk of the entire
U.S. financial system unraveling — a calamity that would probably trigger a global depression. But
knowing things could be even worse probably won't make it easier to stomach the turmoil still to
come.

"Unwinding asset and credit bubbles is a long and arduous task even with aggressive government
involvement," Merrill Lynch economist David Rosenberg wrote in a report titled "Capitalism takes a
sabbatical."

$700B rescue plan finalized; House to vote Monday

September 28,2008

Congressional leaders and the White House agreed Sunday to a $700 billion rescue of the ailing
financial industry after lawmakers insisted on sharing spending controls with the Bush
administration. The biggest U.S. bailout in history won the tentative support of both presidential
candidates and goes to the House for a vote Monday.

The plan, bollixed up for days by election-year politics, would give the administration broad power to
use taxpayers' money to purchase billions upon billions of home mortgage-related assets held by
cash-starved financial firms.

President Bush called the vote a difficult one for lawmakers but said he is confident Congress will
pass it. "Without this rescue plan, the costs to the American economy could be disastrous," Bush
said in a written statement released by the White House.

Flexing its political muscle, Congress insisted on a stronger hand in controlling the money than the
White House had wanted. Lawmakers had to navigate between angry voters with little regard for
Wall Street and administration officials who warned that inaction would cause the economy to seize
up and spiral into recession.

A deal in hand, Capitol Hill leaders scrambled to sell it to colleagues in both parties and
acknowledged they were not certain it would pass. "Now we have to get the votes," said Sen. Harry
Reid, D-Nev., the majority leader.

The final legislation was released Sunday evening. House Republicans and Democrats met
privately to review it and decide how they would vote. "This isn't about a bailout of Wall Street, it's a
buy-in, so that we can turn our economy around," said House Speaker Nancy Pelosi, D-Calif.

The largest government intervention in financial markets since the Great Depression casts
Washington's long shadow over Wall Street. The government would take over huge amounts of
devalued assets from beleaguered financial companies in hopes of unlocking frozen credit.

"I don't know of anyone here who wants the center of the economic universe to be Washington,"
said a top negotiator, Sen. Chris Dodd, chairman of the Senate Banking, Housing and Urban Affairs
Committee. But, he added, "The center of gravity is here temporarily. ... God forbid it's here any
longer than it takes to get credit moving again."

The plan would let Congress block half the money and force the president to jump through some
hoops before using it all. The government could get at $250 billion immediately, $100 billion more if
the president certified it was necessary, and the last $350 billion with a separate certification — and
subject to a congressional resolution of disapproval.

Still, the president, meaning it would take extra-large congressional majorities to stop it, could veto
the resolution.

Lawmakers who struck a post-midnight deal on the plan with Treasury Secretary Henry Paulson
predicted final congressional action might not come until Wednesday.

The proposal is designed to end a vicious downward spiral that has battered all levels of the
economy. Hundreds of billions of dollars in investments based on mortgages have soured and
cramped banks' willingness to lend.

"This is the bottom line: If we do not do this, the trauma, the chaos and the disruption to everyday
Americans' lives will be overwhelming, and that's a price we can't afford to risk paying," Sen. Judd
Gregg, the chief Senate Republican in the talks, told The Associated Press. "I do think we'll be able
to pass it, and it will be a bipartisan vote."

A breakthrough came when Democrats agreed to incorporate a GOP demand — letting the
government insure some bad home loans rather than buy them. That would limit the amount of
federal money used in the rescue.

Another important bargain, vital to attracting support from centrist Democrats, would require that the
government, after five years, submit a plan to Congress on how to recoup any losses from the
companies that got help.

"This is something that all of us will swallow hard and go forward with," said Republican presidential
nominee John McCain. "The option of doing nothing is simply not an acceptable option."

His Democratic rival Barack Obama sought credit for taxpayer safeguards added to the initial
proposal from the Bush administration. "I was pushing very hard and involved in shaping those
provisions," he said.

Later, at a rally in Detroit, Obama said, "it looks like we will pass that plan very soon."

House Republicans said they were reviewing the plan.

As late as Sunday afternoon, Republicans regarded the deal as "a proposal that is promising in
principle, but that is still not final," said Antonia Ferrier, a spokeswoman for Missouri Rep. Roy
Blunt, the top House GOP negotiator.
Executives whose companies benefit from the rescue could not get "golden parachutes" and would
see their pay packages limited. Firms that got the most help through the program — $300 million or
more — would face steep taxes on any compensation for their top people over $500,000.

The government would receive stock warrants in return for the bailout relief, giving taxpayers a
chance to share in financial companies' future profits.

To help struggling homeowners, the plan would require the government to try renegotiating the bad
mortgages it acquires with the aim of lowering borrowers' monthly payments so they can keep their
homes.

But Democrats surrendered other cherished goals: letting judges rewrite bankrupt homeowners'
mortgages and steering any profits gained toward an affordable housing fund.

It was Obama who first signaled Democrats were willing to give up some of their favorite proposals.
He told reporters Wednesday that the bankruptcy measure was a priority, but that it "probably
something that we shouldn't try to do in this piece of legislation."

"It's not a bill that any one of us would have written. It's a much better bill than we got. It's not as
good as it should be," said Democratic Rep. Barney Frank of Massachusetts, the House Financial
Services Committee chairman. He predicted it would pass, though not by a large majority.

Frank negotiated much of the compromise in a marathon series of up-and-down meetings and
phone calls with Paulson, Dodd, D-Conn., and key Republicans including Gregg and Blunt.

Pelosi shepherded the discussions at key points, and cut a central deal Saturday night — on
companies paying back taxpayers for any losses — that gave momentum to the final accord.

An extraordinary week of talks unfolded after Paulson and Ben Bernanke, the Federal Reserve
chairman, went to Congress 10 days ago with ominous warnings about a full-blown economic
meltdown if lawmakers did not act quickly to infuse huge amounts of government money into a
financial sector buckling under the weight of toxic debt.

The negotiations were shaped by the political pressures of an intense campaign season in which
voters' economic concerns figure prominently. They brought McCain and Obama to Washington for
a White House meeting that yielded more discord and behind-the-scenes theatrics than progress,
but increased the pressure on both sides to strike a bargain.

Lawmakers in both parties who are facing re-election are loath to embrace a costly plan proposed
by a deeply unpopular president that would benefit perhaps the most publicly detested of all:
companies that got rich off bad bets that have caused economic pain for ordinary people.

But many of them say the plan is vital to ensure their constituents don't pay for Wall Street's
mistakes, in the form of unaffordable credit and major hits to investments they count on, like their
pensions.

Some proponents even said taxpayers could come out as financial winners.

Gregg, R-N.H., said: "I don't think we're going to lose money, myself. We may — it's possible — but
I doubt it in the long run."

Who wins, who loses under proposed bailout plan?

Sun Sep 28, 4:16 PM ET
The proposal to bail out U.S. financial markets to the tune of up to $700 billion creates a lot of
potential short-term winners, as well as some losers.

Wall Street and the banking industry are perhaps the biggest winners. Scores of banks and other
financial institutions faced with going under stand to gain a lifeline that should allow them to start
making loans again.

Under the plan that congressional aide sought to put into final form Sunday, the Treasury
Department can start buying up troubled mortgage-related securities now held by these institutions.

These securities are clogging balance sheets, leaving banks without the required capital to make
new loans and putting the banks dangerously close to insolvency.

Banks not only have slowed lending to individuals and businesses, they have stopped making loans
to each other. The rescue plan should help restore confidence to financial markets.

There are other winners, too, if the bailout works as intended: anyone soon trying to borrow money
— for cars, student loans, even to open new credit card accounts.

Top executives at troubled financial institutions, on the other hand, are in the losing column
because the proposal would limit their compensation and rules out "golden parachutes."

Of course, these executives may take solace in knowing their jobs still exist.

Investors, including the millions of people who hold stock in their 401(k) and pension plans, should
benefit. Failure to reach a deal over the weekend could have sent stock markets around the world
tumbling on Monday.

Homeowners faced with foreclosure or those who have lost their homes get little help from the
agreement. Nor will it help people whose houses are worth less than what they owe get refinancing
or take out equity loans.

It would do little to halt the slide in home values that are one of the root causes of the current
economic slowdown.

"It doesn't deal with the fundamental problems that gave rise to the problem — or alleviate the credit
crisis," said Peter Morici, an economist and business professor at the University of Maryland

Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are potential winners. In just a
few months, they have remade Wall Street. If the plan helps to get the economy moving again, they
may be remembered for having kept the financial crisis from spreading throughout the economy.

"When I see Hank Paulson and Ben Bernanke on TV, I see fear in their eyes. Like on a battlefield
when people are shooting at you. I think they are afraid to say how serious the problem is for fear of
making it worse," said Bruce Bartlett, an economist who was a Treasury official under the first
President Bush.

Bartlett said the plan is flawed, yet the alternative of doing nothing could be catastrophic.

After the heavy dose of new regulation in the agreement, New York will have a hard time claiming it
is the center of the financial universe. That title may have shifted to Washington.

If the plan stays together, Congress — with approval ratings even lower than those of President
Bush — may be seen as having acted decisively at a time of national emergency.

Congressional leaders added new protections to the administration's original proposal. That was
only three pages long and bestowed on the treasury secretary almost unfettered powers.
Instead, the agreement would divide the $700 billion up into as many as three installments, creates
an oversight board to monitor the treasury secretary's actions and set up several major protections
for taxpayers, including a provision putting taxpayers first in line to recover assets if a participating
company fails.

The president, on the other hand, probably would get little credit for the deal. He allowed Paulson
and Bernanke to do the heavy lifting. The only time he called all the players to the White House —
late Thursday afternoon — the wheels almost came off the process entirely.

It's hard to tell which presidential candidate benefits the most from an agreement they tentatively
endorsed Sunday, a little more than five weeks before the Nov. 4 election. Democrat Barack
Obama and Republican John McCain each sought to claim some credit for the deal, even though
they played active roles only over the past few days.

Hard economic times traditionally work against the party that holds the White House, and in recent
polls Obama has inched ahead of McCain. Furthermore, there is widespread consumer resentment
over being asked to bail out Wall Street and lawmakers have learned the proposal has not been
popular with their constituents.

That may help Democrats in general. The strongest opposition to the original bailout plan came
from House Republicans.

Lawmakers and presidential candidates alike are "trying to orchestrate everybody jumping off the
cliff together," said Robert Shapiro, a consultant who was an economic adviser to President Clinton.
"I think we'd have a different plan if we weren't five weeks out from the election."

And ordinary taxpayers?

Nothing that potentially adds $700 billion to the national debt — already surging toward the $10
trillion mark — can be considered a winner for those who foot the bills. But lawmakers did put in
taxpayer protections, including one to require that taxpayers be repaid in full for loans that go bad.

The package could even end up making money for taxpayers, supporters claimed. But only if the
loans and interest on them are repaid in full. Few expect that provision to be a winning proposition,
however.

Investors give $700B rescue plan ho-hum reception

Sun Sep 28, 7:52 PM ET

Financial markets were subdued in early trading Sunday night after congressional leaders said they
are poised to pass a $700 billion rescue plan for banks, brokerages, credit unions, thrifts and
insurance companies.

Failure to reach an agreement would have led to severe market disruptions, analysts said. But even
if investors did dodge a bullet and credit markets start to stabilize, the realities of a weak economy
are likely to weigh on markets, they said.

"When you start thinking of the broader issues, a lot of this is very troubling," said Joseph
Battipaglia, chief investment officer at Ryan Beck & Co. "We have in front of us a recession in the
general economy, the consumer is dramatically retrenching their habits by cutting spending, and
our financial system has sputtered. This isn't necessarily a confidence builder because now
everybody knows how precarious the financial system really is."

In electronic trading Sunday night, futures on the Dow Jones industrial average, Standard & Poor's
500 index and the Nasdaq 100 all rose about 0.1 percent. The dollar recovered moderately against
currencies such as the pound, euro and yen. The yield on three-month Treasuries fell slightly to
0.81 percent in Sunday night trading, an indication that flight-to-quality fears remain high.

The plan would allow the government to buy toxic mortgage-backed assets from embattled financial
institutions, giving them fresh cash to bolster lending. It would permit the Treasury to immediately
spend $250 billion to buy banks' risky assets, provide another $100 billion at the discretion of the
president, and a final $350 billion unless Congress has a change of heart and the president decides
not to veto the decision.

Even if the bailout is passed — the House votes on Monday, and the Senate later this week — the
economy remains balanced on the edge of a recession. Unemployment has been rising; it's now at
a five-year high of 6.1 percent and is expected to rise as high as 7.5 percent by late 2009.

With worries running high about recessions around the world, global stock market volatility should
remain elevated. And while anxiety about the financial institutions could keep boosting demand for
Treasury bills, pushing short-term rates down for U.S. government debt, a glut of new issues with
longer maturities that must be sold to finance the rescue plan could weaken the dollar over time.

In early trading Sunday night, the euro fell to $1.4545, the pound fell to $1.8336, while the dollar
rose to 106.28 yen.

There are also plenty of banks still in trouble, and it may take time before the plan helps them.

Banks and brokerages wrote down about $400 billion worth of toxic mortgage investments since
last year. Analysts believe write-downs could reach $1 trillion as rising home foreclosures further
erode the values of mortgage-backed securities.

In the second quarter, the Federal Deposit Insurance Corp. estimated there were 117 banks and
thrifts in trouble, the highest level since 2003. This past week Washington Mutual Inc. became the
largest bank to fail in U.S. history, and investors are concerned there might be more failures to
come.

In Europe, the beleaguered Dutch-Belgian banking and insurance giant Fortis NV is being partially
nationalized due to the market dislocation. Troubled British mortgage lender Bradford & Bingley will
also be nationalized and sold off in parts, British media reported Sunday.

The threat of more banks failing in the U.S. and abroad forced the government to act swiftly.

"Without this rescue plan, the costs to the American economy could be disastrous," President Bush
said in a statement late Sunday after the legislation was finalized.

Stocks have been volatile and the credit markets have been tight for over a year. The turbulence
escalated to unprecedented levels a few weeks ago.

T-bill yields fell to zero for the first time since 1940 as investors pulled their money out of money-
market funds and turned to the safest assets out there even if they offered no returns. The
difference between those T-bill yields and bank-to-bank lending rates — a key measure of banks'
willingness to lend — rose to the highest levels since 1982. And the Dow Jones industrial average
swung violently, dropping to its lowest point since November 2005.

The proposed $700 billion bailout is aimed at reviving a market for mortgage-backed securities that
has all but disappeared as credit has tightened.

"This gives us a much stronger background to work in compared to the past three weeks," said Ned
Riley, chief investment officer of Boston-based Riley Asset Management. He added, however, that
"we're still not out of the woods relative to all the other problems facing the economy, and there will
be doomsayers who predict this package won't work."

The plan gave no details about how the government will buy banks' troubled assets, leaving it up to
the U.S. Treasury Department to come up with the fine points. The government could price the
assets very conservatively, which will mean further losses for institutions with souring debt on their
books. Pricing the assets too high might leave taxpayers on the hook.

While those details have yet to be worked out, the market's biggest worry is that the rescue
package may trigger inflation, said Quincy Krosby, chief investment strategist for The Hartford. She
said "the government might have to print money to pay for the bailout" by issuing large amounts of
Treasury debt.

"If the market believes this is going to be inflationary, you'll see mortgage rates go up and money go
into commodities," Krosby said.

That would deliver another blow to already struggling consumers. Banks have tightened up their
lending practices, making it more difficult to get everything from home loans to credit cards. And
surging energy prices and an uncertain job market have caused Americans to pare spending.

After the events of the past few weeks, analysts believe Americans are even angrier and more
distrustful of the U.S. financial system. Many have watched their stock portfolios and nest eggs
plummet in the past few weeks, and are going to be more unwilling to take risks.

"Who is going to want to borrow to buy a new home in this environment?" Battipaglia said.

Broad Authority, Lots of Money And Uncertainty

September 29, 2008

Congress is on the verge of granting Treasury Secretary Henry M. Paulson Jr. sweeping powers to
stabilize the nation's financial system. He would stand largely unfettered by traditional rules, largely
unrestricted in his ability to spend $700 billion of federal money.

The Treasury Department would decide what kind of assets to buy, and which financial firms could
sell them. It would decide how much to pay. And it would hire firms to manage its acquisitions,
without having to obey the normal rules for hiring contractors. These decisions would take several
weeks, Paulson said.

The results will determine whether $700 billion is enough to end the financial crisis.

"This is really an unusual situation, a highly unusual situation. And we need flexibility, we need a
variety of tools, we need to figure out how to get out there in weeks," Paulson said in an interview
last night.

It is not clear how patiently investors and depositors in troubled institutions will wait. Nor is it clear
whether, in the meantime, the banking system itself will begin to recover from the uncertainty that is
freezing the flow of loans to major corporations, small businesses and individuals.

Two European banks moved toward failure over the weekend: Bradford & Bingley, a British
mortgage lender, and Fortis, a giant banking and insurance company based in Belgium. Several
American institutions continue to teeter.

The legislation, which the House is expected to vote on today, is the latest in a series of
government efforts to stem the wave of financial failures, which started with large numbers of
Americans losing their homes to foreclosure. The bill allows the Treasury Department to buy
mortgage-related securities devalued by those foreclosures in hopes of leaving troubled financial
institutions with fewer problems and more cash.

With the political process nearly complete, the work of helping the financial markets has only just
begun. The most critical decision facing the Treasury is how to go about buying troubled assets.
Officials say the department may well use different approaches for different kinds of assets, rather
than pursuing a uniform strategy.

The goal is not to vacuum all the industry's troubled assets into a federal holding tank. Rather, the
government wants to determine credible prices for the assets held by banks, through the
mechanism of buying some of those assets. If the plan succeeds, the prices paid by the
government will become a new market standard, bridging the current gap between the higher prices
sought by banks and the lower prices offered by investors.

"We need confidence, and this is about confidence," Paulson said.

In a practical sense, the government is trying to revive the markets because buying up all the
troubled assets would require far more than $700 billion.

Twenty of the nation's largest financial institutions owned a combined total of $2.3 trillion in
mortgages as of June 30. They owned another $1.2 trillion of mortgage-backed securities. And they
reported selling another $1.2 trillion in mortgage-related investments on which they retained
hundreds of billions of dollars in potential liability, according to filings the firms made with regulatory
agencies. The numbers do not include investments derived from mortgages in more complicated
ways, such as collateralized debt obligations.

Experts say the Treasury plan could do more harm than good.

If the Treasury pushes to buy troubled assets at bargain-basement prices, many banks that hold
similar assets would be forced to mark down their holdings. Such losses could push some
institutions over the edge.

If the Treasury overpays, taxpayers could lose massive sums.

"There are more questions of doing this and the consequence of doing it poorly than anything else,"
said Richard H. Baker, a former Congressman and the chief executive of the Managed Funds
Association, which lobbies for hedge funds.

Baker recalled during the savings and loan crisis of the late 1980s and early 1990s, the government
set up the Resolution Trust Corp. to buy real estate and other assets of banks that went into
bankruptcy. The RTC eventually sold some of these properties at such severe discounts in Baker's
home state of Louisiana that real estate values around the region became depressed.

The Treasury faces few boundaries on how it can proceed, and many of those can be waived at the
department's discretion.

The program is focused on mortgages and related securities -- unless the Treasury deems it
important to buy other kinds of assets, such as car or student loans. The Treasury plans to focus on
mortgage-backed securities in the first round of purchases.

It is focused on buying from banks, insurance companies and other financial firms with substantial
U.S. operations -- unless the Treasury decides it's important to buy from any foreign institution that
holds mortgage assets.

The Treasury plans to hire private companies to manage what it buys, and the bill gives the
department the power to waive the rules that govern the use of contractors.

"The Secretary of the Treasury still has huge latitude," said Douglas Elmendorf, a senior fellow at
the Brookings Institution. "Now we have to wait to see how he chooses to proceed."

Treasury officials said the broad discretion is important to the success of the program and the
health of the financial system. Including foreign firms, for example, is intended to encourage those
institutions to continue lending to domestic banks, which often offer mortgage securities as
collateral.

The bill also requires the Treasury to establish an insurance program in which private firms would
pay premiums to the government for a guarantee of their assets. But the department can shape
how this program would be implemented. The difference between the premiums that the firms pay
and the value of the assets would count against the $700 billion cap on the total federal effort.

And Treasury has the authority to decide what restrictions should be imposed on companies that
seek government help, including limits on executive compensation, and what kind of stake the
government should take in companies, so that taxpayers benefit if the companies return to
profitability.

In practice, that is likely to mean companies will pay different costs for participation.
Representatives of financial companies say the details of the plan will determine whether and how
much they participate.

Treasury officials said that flexibility was important to ensure that companies are willing to
participate. There is concern that some companies might refrain, either as a demonstration of
financial strength or to avoid restrictions.

When the Federal Reserve made loans available to investment banks earlier this year, for example,
some companies stayed away, fearful that borrowing would be interpreted by investors as a sign of
weakness.

Scott Talbott, a lobbyist for the Financial Services Roundtable, said he thought the program would
attract wide participation, but that some of the strongest financial institutions might well refrain.

"If you're in a position of strength, you don't need the program," he said. "And if you're in a position
of weakness, you'll do it regardless of the restrictions."

In structuring the program, the Treasury will rely on outside experts. The government already has
tapped Edward Forst, Harvard University's executive vice president, to work on the legislation and
oversee the launch of the program. But Forst is planning to return within two months to Harvard,
where he started as an executive vice president on Sept. 1.

Paulson said he will find longer-term help. "We'll have an organization in place and hire a really
strong person to run this," he said. "We're going to get someone who understands markets and we'll
find someone who's a real professional to come to Treasury and run it."

The bill also forces a re-evaluation of "mark to market" accounting rules, under which banks and
other financial institutions must adjust the value of their assets to reflect current market prices, even
if they intend to hold the assets for the long term. Bank executives have blamed these rules in part
for their troubles, saying that distressed sellers have pushed market prices below actual values,
forcing unreasonable write-downs.

The Securities and Exchange Commission already has the power to overrule the board that sets
those accounting rules, the Financial Accounting Standards Board, but the bill restates that the SEC
had authority to change mark-to-market rules. It also orders a study be conducted on the role mark-
to-market rules played in the current crisis.

Lynn E. Turner, a former chief accountant at the SEC, criticized the provision, which he said was
designed to help bend the commission to the banks' will.

"What they've done here is say let's study whether banks should be allowed to lie," he said.
"Regardless of whether you had mark-to-market accounting, you would have this problem, which is
banks running out of cash. And they're running out of cash because they made loans to people who
aren't paying them back."

Sweeping Bailout Bill Unveiled

House Set to Vote Today, Senate to Follow
September 29, 2008

After a week of political tumult and deepening economic anxiety, congressional leaders yesterday
rallied support for an historic proposal that would grant the government vast new powers over Wall
Street and offer fresh help to homeowners at risk of foreclosure.

The proposed legislation, which is scheduled for a vote today in the House, would authorize
Treasury Secretary Henry M. Paulson Jr. to initiate what is likely to become the biggest government
bailout in U.S. history, allowing him to spend up to $700 billion to relieve faltering banks and other
firms of bad assets backed by home mortgages, which are falling into foreclosure at record rates.

The plan would give Paulson broad latitude to purchase any assets from any firms at any price and
to assemble a team of individuals and institutions to manage them. In wielding those powers,
Paulson and others hope to contain a crisis that already has caused the failure or forced the rescue
of a half-dozen major Wall Street firms and unnerved markets around the world.

The measure was forged during a marathon negotiating session between lawmakers from both
parties and Paulson -- who at one point appeared to negotiators to be on the verge of collapse.
Restive Republican lawmakers originally criticized the package as putting taxpayers at risk and
violating free-market principles, but many of them appeared yesterday to be dropping their
opposition.

House Minority Leader John A. Boehner (R-Ohio) emerged last night from a meeting of House
Republicans to say he is "encouraging every member whose conscience will allow them to support
this." Boehner said he and other GOP leaders made the case that negotiators had improved the bill
by gaining a key concession on a plan to limit taxpayer exposure.

A vote in the Senate could take place as soon as Wednesday.

President Bush last night released a statement praising the measure. Although it has been panned
as a massive bailout for Wall Street financiers, Bush argued the bill would have broad benefits for
ordinary families and business owners who need "access to credit" to "make purchases, ship goods
and meet their payrolls."

"This plan sends a strong signal to markets around the world that the United States is serious about
restoring confidence and stability to our financial system," Bush said. "Without this rescue plan, the
costs to the American economy could be disastrous."

Bush has stressed that the ultimate cost of the bailout would be much less than $700 billion
because the government would eventually sell the assets it purchases and recover most, if not all,
of its investment.

Still, he acknowledged yesterday that the measure presents lawmakers with "a difficult vote" barely
a month before the November elections. Polls show the bailout is hugely unpopular, and lawmakers
have been inundated with calls and e-mails from angry constituents. With investors hanging on
every twist of the debate in Washington, leaders in both chambers predicted that the bill would
pass.

"If we do this and it works right, it's most likely that people will never appreciate how close we came
to the brink. So there's not much political upside to this," said Sen. Judd Gregg (R-N.H.), the lead
negotiator for Senate Republicans. But lawmakers are ready to support the bill, Gregg said,
because they know "we are facing a crisis of proportions that are almost incomprehensible."

The scope of the crisis was laid out 11 days ago during a late-night meeting in the Capitol where
Paulson and Federal Reserve Chairman Ben S. Bernanke warned lawmakers that an imminent
meltdown in financial markets threatened to destroy the wealth and jobs of millions of Americans.
Two days later, Paulson presented lawmakers with a three-page economic rescue plan that would
have granted the Treasury nearly unfettered power to shore up the nation's financial system,
unchecked by federal or judicial review.

By yesterday, the measure had grown to 110 pages; many of them devoted to the creation of
myriad oversight agencies, including an independent inspector general. Still, the measure would
give Paulson broad authority to create an Office of Financial Stability within the Treasury, to hire its
staff and to direct their activities. The head of the office would be subject to Senate confirmation
and would be required to quickly publish guidelines for identifying, pricing and purchasing troubled
assets.

Money for the program would be released in segments, with the Treasury secretary receiving $250
billion immediately. Paulson has said he expects to spend about $50 billion a month on the
program.

The Treasury secretary's power to purchase assets would end on Dec. 31, 2009, although the next
administration could seek a one-year extension. The assets could be held indefinitely and sold
when the housing market recovers, theoretically for a profit.

To protect taxpayers, participating firms would be required to give the government warrants to buy
stock so taxpayers could benefit if they return to profitability. If the government does not regain all of
its money after five years, the president would be required to submit a plan for recovering the
money "from entities benefiting from the program." Given those provisions, some firms might be
discouraged from participating, but few have so far indicated their intentions either way.

The measure also would require federal officials to rein in excessive compensation for corporate
executives who participate in the bailout program, a first step toward addressing a longtime
Democratic priority. According to a recent report by the Institute for Policy Studies, the chief
executives of large U.S. companies made an average of $10.5 million last year, 344 times the pay
of the average worker.

The bill also requires Paulson to establish a new federal insurance program, funded by the banks,
that would protect firms against loss from troubled assets. Although Paulson and Bernanke had
concluded that such a program would not be an effective way to pump needed cash into struggling
firms, House Republicans demanded the provision, saying it would offer an alternative method for
shoring up companies at no cost to taxpayers.

After days of at-times grueling negotiations, House Speaker Nancy Pelosi (D-Calif.) said lawmakers
will now be asked to approve the bill without further changes. "The bill is frozen. It's on the Internet,"
she told reporters. "The public is looking at it."

While the bill is likely to have strong support in the Senate, its chances are less clear in the House,
where leaders in both parties said they were still unsure how many votes it would receive.
Democrats and Republicans were summoned into separate private meetings late yesterday where
leaders shared the final details of the bill and urged a vote for its passage.

After stalling negotiations late last week, key Republicans spoke in support of the measure. Rep.
Eric Cantor (R-Va.) who helped draft the insurance provision assured lawmakers that the bill now
contains important safeguards for taxpayers. Rep. Chris Shays (R-Conn.), a moderate who
represents many financial services industry executives, said the meeting took on a solemn tone as
several retiring lawmakers spoke with passion about the historic nature of what will likely be their
last vote.

Meanwhile, Democrats meeting nearby in the basement of the Capitol also heard a rallying cry from
their leaders, who won support from some surprising corners. Rep. Jim Marshall (D-Ga.), who
represents a conservative-leaning district and is a frequent GOP target, told his colleagues that
passing the legislation is more important than winning re-election.

"I am willing to give up my seat over this," Marshall said, according to one attendee.

In both meetings, lawmakers continued to worry aloud about how to protect taxpayers from bearing
the cost of the bailout, an issue that was also one of the most fiercely contested matters in talks
with Paulson early yesterday.

The negotiators gathered just after 3 p.m. Saturday under an ornate painting of Abraham Lincoln in
a large conference room in Pelosi's suite of offices on the second floor of the Capitol. The first few
hours were intense and contentious, participants said, marked by shouting over executive pay and
a last-minute Democratic request for a fee on the financial services industry to cover the cost of the
bailout program.

When details about the fee quickly leaked to reporters in a hallway outside Pelosi's offices, a senior
aide walked around the negotiating table confiscating BlackBerrys, labeled them by name with
Post-It notes and dumped them into a recycling bin.

As negotiations dragged into the night, Paulson -- already drained by weeks of crisis management -
- appeared at one point to be weary and teary-eyed, according to Rep. Rahm Emanuel (D-Ill.),
prompting lawmakers to fear for his health. "Are you okay?" asked Gregg, who suggested calling
the Capitol physician. Paulson waved them off, saying he was just very tired.

Just before midnight, Pelosi called the White House chief of staff, Joshua Bolten, to report an
impasse over executive compensation and the industry fee. With Emanuel on the call, Pelosi
threatened to let lawmakers vote on the two issues, which she thought would pass overwhelmingly.

"You gotta understand, this is politics at this point," Emanuel told Bolten, a friendly rival. The White
House and Paulson soon reached to a compromise.

The meeting finally broke up around 12:30 a.m. Sunday, when Paulson and lawmakers briefly
addressed journalists. After the historic declarations beneath a statue of Will Rogers, Paulson
locked arms with Sen. Charles E. Schumer (D-N.Y.) and leaned heavily on the senator for support
as they walked away.

Dr. Paulson's Tough Medicine, In a Pill the Public Can Swallow

September 29, 2008

After a week of political brinksmanship and 100 pages of concessions to political reality, Treasury
Secretary Hank Paulson seems to have finally won the power and money he asked for to mount an
unprecedented rescue of the financial system.

If approved by a reluctant Congress and signed into law by the president, the Economic
Stabilization Act of 2008 will authorize Paulson to continue in a bigger and systematic way what the
Treasury and Federal Reserve have been doing since March when they committed $29 billion to
facilitate the sale of Bear Stearns to its stronger rival, J.P. Morgan Chase. And although the initial
focus will be on home mortgages and mortgage-backed securities, there remains enough flexibility
in the legislation for Paulson to address similar problems with auto loans, credit card debt and loans
for commercial real estate.

Global investors no doubt will cheer the weekend's political breakthrough, focusing less on the
details than on the perceived commitment by the United States to do whatever is necessary to
prevent a meltdown in global financial markets.

But nobody should view even this effort as sufficient to keep the U.S. economy out of recession,
stabilize housing markets or prevent the failure of additional banks, investment houses, insurers
and hedge funds. Although more than $600 billion in private-sector credit losses have already been
posted, a number of private and public-sector analysts now estimate that won't be even half the
final tab from the bursting of the greatest credit bubble the world has seen.

The normally sure-footed Paulson stumbled badly last weekend when he rushed to the Capitol with
a vague and poorly explained proposal that all but invited politicians and the news media to label it
as a "$700 billion bailout for Wall Street" -- a moniker from which it nearly never recovered.

In fact, even in its original form, the Paulson plan would not have cost taxpayers anywhere near
$700 billion, nor was Wall Street ever to be the primary beneficiary. The aim all along was to restore
the flow of credit to Main Street's homeowners and businesses through banking and credit channels
that have become dangerously constricted in recent months, threatening to choke off capital to the
entire economy.

By acting as a buyer of last resort and allowing financial institutions to compete to sell some of their
depressed mortgage-backed securities, Paulson hoped to jump-start credit markets to the point that
prices for the securities would rise to close to their real economic value, private investors would feel
confident enough to re-enter the market and banks would have the capital to begin lending again.

Paulson also intended to use some of the money to inject fresh capital into banks and financial
institutions whose failure would jeopardize the stability of the financial system, in exchange for
government ownership and control, much as the Treasury and Fed had done with Fannie Mae,
Freddie Mac and insurance giant AIG.

And all along he had made informal promises to congressional leaders that, as the government
gained effective control of millions of troubled mortgages, it would use its newfound position to
prevent unnecessary foreclosures by renegotiating the loans on more favorable terms.

All three elements -- the auctions, the negotiated recapitalizations and the foreclosure mitigation --
survived the week's negotiations and remain the core of the 106-page bill, along with the mandate
to implement the program quickly, to structure it as he sees fit and to alter it as market conditions
require.

What was added over the past week was a panoply of procedural safeguards, taxpayer protection
and structural reforms to provide an acceptable political context for the use of so much public
money and the grant of such extraordinary discretion and power.

Although the Treasury secretary will have a free hand in hiring staff and outside contractors, buying
assets and negotiating the terms of government investment in struggling banks, he will have to
answer to a board consisting of five other top government officials, be required to post the details of
everything he does on the Internet and be subject to constant oversight by two congressional
committees, a battalion of government auditors and a special inspector general.

For the first time, the federal government will limit the compensation of some top corporate
executives to $500,000 annually -- directly in the case of big banks that participate heavily in the
new program and through limits on tax deductions for everyone else. There will be tough
restrictions on golden parachutes and clawback provisions for bonuses based on profits that later
disappear.

And the legislation takes not-too-subtle swipes at nearly all federal regulators of the financial
system, directing the Securities and Exchange Commission to review the wisdom of "mark-to-
market" accounting, chiding the Treasury for unilaterally extending deposit insurance to money-
market funds and requiring the Fed to make a monthly accounting for its bailouts of Bear Stearns
and AIG. A five-member blue ribbon panel of outside experts is to recommend a new regulatory
blueprint for the financial services industry -- including supervision of hedge funds and derivative
trading -- by Inauguration Day in January.

Finally, the legislation contains several mechanisms for the government to recoup all of its money,
and perhaps even turn a profit, by collecting insurance premiums, demanding stock from
participating banks and, should all else fail, slapping a new tax on the financial services industry
beginning in 2014.

Normally, the mere discussion of such measures would have brought on a furious lobbying effort to
kill them. But it is a measure of the industry's newfound impotence in Washington that it was forced
to sit silently on the sidelines over the weekend as Republicans and Democrats, leaders and
backbenchers joined hands in demanding that Wall Street foot the bill for the mess it has created.

Citigroup to buy Wachovia banking operations

Sept. 29th

In the latest byproduct of the widening global financial crisis, Citigroup Inc. will acquire the banking
operations of Wachovia Corp. in a deal facilitated by the Federal Deposit Insurance Corp.

Citigroup will absorb up to $42 billion of losses from Wachovia's $312 billion loan portfolio, with the
FDIC covering any remaining losses, the government agency said Monday. Citigroup also will issue
$12 billion in preferred stock and warrants to the FDIC.

The deal greatly expands Citigroup's retail outlets and secures its place among the U.S. banking
industry's Big Three, along with Bank of America Corp. and J.P. Morgan Chase & Co. But it comes
at a cost — Citigroup said Monday it will seek to sell $10 billion in common stock and slashed its
quarterly dividend in half to 16 cents to shore up its capital position.

The agreement comes after a fevered weekend courtship in which Citigroup and Wells Fargo & Co.
both were reportedly studying the books of Wachovia, which suffers from mounting losses linked to
its ill-timed 2006 acquisition of mortgage lender Golden West Financial Corp.

Wachovia, like Washington Mutual Inc., which was seized by the federal government last week,
was a big originator of option adjustable-rate mortgages, which offer very low introductory payments
and let borrowers defer some interest payments until later years. Delinquencies and defaults on
these types of mortgages have skyrocketed in recent months, causing big losses for the banks.

The FDIC asserted Monday that Wachovia did not fail, and that all depositors are protected and
there will be no cost to the Deposit Insurance Fund. Federal Reserve Chairman Ben Bernanke, in a
statement Monday, said he supports the "timely actions" taken by the FDIC "which demonstrate our
government's unwavering commitment to financial and economic stability."

Treasury Secretary Henry Paulson also welcomed the sale of Wachovia to Citigroup, saying it
would "mitigate potential market disruptions." Paulson said he agreed with the FDIC and the Fed
that a "failure of Wachovia would have posed a systemic risk" to the nation's financial system. "As I
have said before, in this period of market stress, we are committed to taking all actions necessary
to protect our financial system and our economy," Paulson said.

As details of its takeover unfolded, Wachovia shares plunged 91 percent to 94 cents. The stock had
closed Friday at $10, down 74 percent for the year.

Now that a deal for Wachovia is complete, the most troubled of the nation's largest financial
institutions have been dealt with. However, the FDIC estimated there were 117 banks and thrifts in
trouble during the second quarter, the highest level since 2003. And that number is likely to have
increased during the third quarter.

With the acquisition of Wachovia, Citigroup has reclaimed its title as the biggest U.S. bank by total
assets. Including Wachovia, the bank now has assets of $2.91 trillion, as of June 30. That could
change, however, as Citigroup shrinks its balance sheet, a decision Chief Executive Vikram Pandit
made in May to rid the bank's books of risky debt.

In terms of current market capitalization, Bank of America Corp. remains the largest U.S. bank,
followed by JPMorgan Chase & Co. in second and Citigroup in third place.

Just a short time ago, Citigroup was under the scrutiny of investors who worried about the
possibility of its collapse given its massive exposure to mortgage-backed securities. The New York-
based bank has not turned a profit for three straight quarters, and lost a total of $17.4 billion during
that period after writing down its assets by about $46 billion. That's the most write-downs of any
U.S. bank.

But the government's proposed $700 billion bailout plan could prove to be the deal's silver lining.
While the plan broadly aims to prevent banks from profiting on the sale of troubled assets to the
government, there is an exception made for assets acquired in a merger or buyout, or from
companies that have filed for bankruptcy. This detail could allow Citigroup to sell toxic mortgages
and other assets it gained from Wachovia for a higher price than the bank actually paid for them.

The Wachovia deal caps a wave of unprecedented upheaval in the financial sector in the past six
months that has redefined the banking industry, starting with the government-led forced sale of
Bear Stearns Cos. to JPMorgan in March.

The failure of IndyMac Bancorp in July reignited investors' fears about the stability of the financial
sector, which led to the eventual takeover of struggling mortgage lenders Fannie Mae and Freddie
Mac.

Earlier this month, officials seized both Fannie and Freddie, temporarily putting them in a
government conservatorship, replacing their chief executives and taking a financial stake in the
mortgage finance companies.

After U.S. regulators made it clear that they would not bail out struggling investment bank Lehman
Brothers Holdings Inc., rival Merrill Lynch & Co. arranged a hasty deal to be bought by Bank of
America Corp. for $50 billion in stock.

Lehman Brothers was subsequently forced to declare bankruptcy, the largest ever in the United
States. Investor concerns quickly turned to American International Group Inc., the nation's largest
insurer. Staving off a failure that could have sent shock waves throughout the global markets, the
federal government injected an $85 billion emergency loan into the insurer.

Just days later, the government seized Seattle-based Washington Mutual, marking the largest bank
failure in U.S. history. WaMu's deposits and assets were acquired by JPMorgan for $1.9 billion.
These events have now culminated in extraordinary moves by the federal government to try to fix
the financial crisis that began more than a year ago. Lawmakers are to vote Monday on an
unpopular $700 billion plan to rescue troubled financial companies.

Wachovia's problems stem largely from its acquisition of mortgage lender Golden West Financial
Corp. in 2006 for roughly $25 billion at the height of the nation's housing boom. With that purchase,
Wachovia inherited a deteriorating $122 billion portfolio of Pick-A-Payment loans, Golden West's
specialty, which let borrowers skip some payments.

This summer, Wachovia reported a $9.11 billion loss for the second quarter, announced plans to
cut 11,350 jobs — mostly in its mortgage business — and slashed its dividend. Wachovia also
boosted its provision for loan losses to $5.57 billion during the second quarter, up from $179 million
in the year-ago period.

A Bailout Is Just a Start

By Lawrence Summers
September 29, 2008

Congressional negotiators have completed action on a $700 billion authorization for the bailout of
the financial sector. This step was as necessary as the need for it was regrettable. In the coming
weeks, the authorities will need to consider hugely important tactical issues regarding the
deployment of these funds if the chance of containing the damage is to be maximized.

Right now, what must be considered are the conditions necessitating the bailout and its impact on
federal budget policy. The idea seems to have taken hold that the nation will have to scale back its
aspirations in areas such as health care, energy, education and tax relief. This is more wrong than
right. We have here the unusual case where economic analysis suggests that dismal conclusions
are unwarranted and recent events suggest that in the near term, government should do more, not
less.

First, note that there is a major difference between a $700 billion program to support the financial
sector and $700 billion in new outlays. No one is contemplating that $700 billion will simply be given
away. All of its proposed uses involve purchasing assets, buying equity in financial institutions or
making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000
poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700
billion depends on how it is deployed and how the economy performs.

The American experience with financial support programs is somewhat encouraging. The Chrysler
bailout, President Bill Clinton's emergency loans to Mexico and the Depression-era support
programs for the housing and financial sectors all ultimately made profits for taxpayers. While the
savings and loan bailout through the Resolution Trust Corp. was costly, this reflected enormous
losses exceeding the capacity of federal deposit insurance. The head of the FDIC has offered
assurances that nothing similar will be necessary this time.

It is impossible to predict the ultimate cost to the Treasury of the bailout and the other commitments
that financial authorities have made -- this will depend primarily on the economy as well as the
quality of execution and oversight. But it is very unlikely to approach $700 billion and will be spread
over a number of years.

Second, the usual concern about budget deficits is that the need for government bonds to be held
by investors will crowd out other, more productive, investments or force greater dependence on
foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-
backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognized that it is appropriate to allow government deficits to rise as
the economy turns down if there is also a commitment to reduce deficits in good times. After using
the economic expansion of the 1990s to bring down government indebtedness, the United States
made a serious error in allowing deficits to rise over the past eight years. But it would compound
this error to override what economists call "automatic stabilizers" by seeking to reduce deficits in the
near term.

Indeed, in the current circumstances the case for fiscal stimulus -- policy actions that increase
short-term deficits -- is stronger than ever before in my professional lifetime. Unemployment is
almost certain to increase -- probably to the highest levels in a generation. Monetary policy has little
scope to stimulate the economy given how low interest rates already are and the problems in the
financial system. Global experience with economic downturns caused by financial distress suggests
that while they are of uncertain depth, they are almost always of long duration.

The economic point here can be made straightforwardly: The more people who are unemployed,
the more desirable it is that government takes steps to put them back to work by investing in
infrastructure or energy or simply by providing tax cuts that allow families to avoid cutting back on
their spending.

Fourth, it must be emphasized that nothing in the short-run case for fiscal stimulus vitiates the
argument that action is necessary to ensure the United States is financially viable in the long run.
We still must address issues of entitlements and fiscal sustainability.

From this perspective the worst possible actions would be steps that have relatively modest budget
impacts in the short run but that cut taxes or increase spending by growing amounts over time.
Examples would include new entitlement programs or exploding tax measures. The best measures
would be short-run investments that will pay back to the government over time or those that are
packaged with longer-term actions to improve the budget, such as investments in health-care
restructuring or steps to enable states and localities to accelerate, or at least not slow, their
investments.

A time when confidence is lagging in the consumer, financial and business sectors is not a time for
government to step back.

Well-designed policies are essential to support the economy and, given the seriousness of health-
care, energy, education and inequality issues, can make a longer-term contribution as well.

The writer served as Treasury secretary from 1999 to 2001, is a managing director of D.E. Shaw
& Co. He writes a monthly column for the Financial Times, where this article also appears
today.

In Times of Crisis, Trust Capitalism

By Joseph Calhoun September 29, 2008

The US government is executing a coup d’etat of capitalism and I fear that we will pay the price for
many years to come. Hank Paulson, Ben Bernanke and a host of others tell us the credit market is
not working and the only way to get it working again is for the government to intervene. They claim
this intervention is urgently needed and if we don’t act, the consequences are dire. Dire, as in New
Depression dire. Have these supposed experts on capitalism forgotten how it really works?
Last week Goldman Sachs raised $10 billion in new capital in one day. They sold $5 billion in
preferred stock and warrants to Berkshire Hathaway and also completed a secondary offering of
common stock that raised another $5 billion. Friday, JP Morgan raised $10 billion in a secondary
offering to help pay for the Washington Mutual takeunder. Both of these offerings were
oversubscribed, meaning that the companies could have raised more capital if they wanted. There
is not a shortage of capital for well run financial companies.

There is, however, a shortage of capital for companies that have acted irresponsibly with investor
capital in the recent past. For some reason, our political leaders believe this is a failure of the
market, but isn’t this what should be expected from rational investors? Given a choice, why would a
rational investor allocate limited capital to the losers rather than the winners? If capital is really as
scarce as it seems, isn’t it better for our economy if we make sure that it is allocated wisely?

The biggest bank failure in the history of the United States happened last Thursday night and by
Friday morning, it was business as usual. The only difference was the name on the door and the
losses suffered by those unfortunate enough to invest in Washington Mutual bonds or stock. The
taxpayers didn’t lose anything and depositors didn’t lose anything, only investors. That is how
capitalism works in case everyone has forgotten.

The “crisis” we face today is not a creation of the market. Government intervention over many years
(but especially the last year) is what brought us to the point where we’ve placed our hopes for
economic recovery on the good intentions of a Congress facing re-election in a few weeks. There
has been much commentary recently about the role of Fannie Mae and Freddie Mac in the creation
and expansion of the sub-prime mortgage market which many believe to be the cause of this mess.
That criticism is certainly warranted, but little attention has been paid to the real culprit - the Federal
Reserve. Furthermore, what attention there has been is concentrated on the role of Alan
Greenspan rather than Ben Bernanke. While Alan Greenspan deserves his share of the blame,
Bernanke’s contribution to this mess should not be minimized or excused.

Bernanke obviously does not trust the market to sort the winners from the losers. When this erupted
last year, the Fed lowered interest rates, including the discount rate, which is the rate charged by
the Fed to lend directly to banks. There has always been a stigma attached to borrowing directly
from the Fed and for good reason. If a bank can’t get other banks to lend it money, that tells
the market something about the condition of the bank in question. Last August, Bernanke
convinced three large banks to borrow at the discount window in an effort to remove that stigma.
When that didn’t work, he concocted a scheme to allow banks to borrow from the Fed in anonymity
via a mechanism he called the Term Auction Facility. When Bear Stearns blew up, he added the
Term Securities Lending Facility for investment banks. By removing the stigma of borrowing from
the Fed and hiding the identity of the borrowers, Bernanke removed important information from the
market.

Now we face a situation where banks are not willing to lend to each other and have therefore
become dependent on the Fed for daily liquidity. This is a direct result of the Fed’s actions. Banks
will not lend to each other because they don’t know which ones are really in trouble. The rise in
inter-bank lending rates is a rational market response to a lack of information. Furthermore, why
pay those inter-bank rates when the Fed or ECB is offering easier terms?

These opaque lending facilities are just part of the problem created by the Fed and Treasury. The
Bear Stearns intervention started the process by raising expectations that the government would
step in and broker deals that would normally be left to the private sector. By providing favorable
terms to JP Morgan in the deal, private actors came to see an advantage in waiting to see if the Fed
would provide similar terms again. The worry at the time was that a Bear Stearns failure would
cause a collapse of the system, but after watching Lehman Brothers file bankruptcy one has to
wonder if that worry was based on fear or facts. Lehman filed bankruptcy on a Sunday night and the
market opened the next day and functioned as it should. Would a Bear bankruptcy have been
different? We will never know, but I have my doubts.

Now markets are waiting on pins and needles as the politicians haggle over the details of the latest
bailout attempt by the Fed and Treasury. This has introduced another roadblock to the re-
capitalization and reorganization of the financial industry. Companies that are in need of capital are
waiting to see if the plan will bail them out of their difficulties. If Hank Paulson is willing to pay an
above market price for their bad loans, why should they dilute their equity now? Why not wait until
they can offload the bad paper on the taxpayer and raise capital at a better price? Why take Tony
Soprano terms when Uncle Sam is willing to let the taxpayer take the hit for you?
If this bailout goes ahead in its current form and the Treasury pays a high enough price to
recapitalize the troubled banks, what has been accomplished? The plan may be enough to induce
the banking sector to start lending again, although frankly, I don’t know why we would want
institutions that have shown such poor judgment in the past to stay in that business. This plan short-
circuits the capitalist model which would allow the stronger, well-run institutions to gain market
share and/or expand profit margins. The long-term effect will be to lower the overall return on
capital in the financial services industry. The government apparently believes that the key to
economic recovery is to allocate limited resources in an inefficient manner. Does that make sense?

Paulson and Bernanke have testified to Congress that the market for the mortgage paper rotting on
the balance sheets of bad banks is not working. They have not offered an explanation of why that
market is not functioning except to blame the complicated nature of some of the securities. That
explanation begs the question of how exactly the Treasury believes it will be any better at
deciphering the mortgage market. A more logical explanation is not a lack of willing buyers, but a
lack of willing sellers. The Fed has allowed institutions to use collateral of ever falling quality to
secure loans from the Fed. If a bank can finance its activities through the Fed and keep the bad
loans on the balance sheet, what incentive does it have to sell? Selling will reveal the true condition
of the company and will also force other institutions to do the same under mark- to-market
accounting. The Fed is the one keeping the market from functioning. The Treasury does not need to
enter the market for it to start functioning; the Fed needs to leave the market.

Paulson has said that the cause of the current problems is the housing deflation, but that ignores
the elephant in the living room. The housing bubble, which was concentrated in a relatively small
number of states, was caused by the reckless actions of the Greenspan Fed. The consequences of
that bubble have been exacerbated by the Bernanke Fed. The market is functioning as it should. It
is the Fed that is not functioning correctly. There is no reason we had to go through either the
bubble or the aftermath. We got into this mess because we tried to avoid the consequences of the
Internet bubble. We will only make things worse by trying to avoid the consequences of the housing
bubble.

We are not on the verge of a new depression. The housing bubble collapse in California, Florida
and a few other states is not enough to bring down the entire banking system. Investors who made
mistakes in these markets should be held responsible and those who navigated the Fed-distorted
market should be rewarded for their wisdom and prudence. Enacting the Paulson plan will not allow
that to happen and our economy will suffer for it in the long run. The Japanese tried to prop up
failed banks in the aftermath of the bursting of their twin bubbles and the result was 15 years of
stagnation. Why are we emulating a strategy that is a demonstrable failure? A better alternative
would be to allow capitalism to work as it should and stop the interventions of the Fed in the money
market. Trust capitalism. It works.

House defeats $700B financial markets bailout

September 29th—2pm EDT

The House on Monday defeated a $700 billion emergency rescue package, ignoring urgent pleas
from President Bush and bipartisan congressional leaders to quickly bail out the staggering financial
industry.
Stocks plummeted on Wall Street even before the 228-205 vote to reject the bill was announced on
the House floor.

When the critical vote was tallied, too few members of the House were willing to support the
unpopular measure with elections just five weeks away. Ample no votes came from both the
Democratic and Republican sides of the aisle.

Bush and a host of leading congressional figures had implored the lawmakers to pass the
legislation despite howls of protest from their constituents back home.
The overriding question for congressional leaders was what to do next. Congress has been trying to
adjourn so that its members can go out and campaign. And with only five weeks left until Election
Day, there was no clear indication of whether the leadership would keep them in Washington.
Leaders were huddling after the vote to figure out their next steps.

A White House spokesman said that President Bush was "very disappointed."

"There's no question that the country is facing a difficult crisis that needs to be addressed," Tony
Fratto told reporters. He said the president will be meeting with members of his team later in the
day "to determine next steps."

Monday's mind-numbing vote had been preceded by unusually aggressive White House lobbying,
and spokesman Tony Fratto said that Bush had used a "call list" of people he wanted to persuade
to vote yes as late as just a short time before the vote.

Lawmakers shouted news of the plummeting Dow Jones average as lawmakers crowded on the
House floor during the drawn-out and tense call of the roll, which dragged on for roughly 40 minutes
as leaders on both sides scrambled to corral enough of their rank-and-file members to support the
deeply unpopular measure.

They found only two.

Bush and his economic advisers, as well as congressional leaders in both parties had argued the
plan was vital to insulating ordinary Americans from the effects of Wall Street's bad bets. The
version that was up for vote Monday was the product of marathon closed-door negotiations on
Capitol Hill over the weekend.

"We're all worried about losing our jobs," Rep. Paul Ryan, R-Wis., declared in an impassioned
speech in support of the bill before the vote. "Most of us say, 'I want this thing to pass, but I want
you to vote for it — not me.' "

With their dire warnings of impending economic doom and their sweeping request for
unprecedented sums of money and authority to bail out cash-starved financial firms, Bush and his
economic chiefs have focused the attention of world markets on Congress, Ryan added.

"We're in this moment, and if we fail to do the right thing, Heaven help us," he said.

The legislation the administration promoted would have allowed the government to buy bad
mortgages and other rotten assets held by troubled banks and financial institutions. Getting those
debts off their books should bolster those companies' balance sheets, making them more inclined to
lend and easing one of the biggest choke points in the credit crisis. If the plan worked, the thinking
went, it would help lift a major weight off the national economy that is already sputtering.

The fear in the financial markets sent the Dow Jones industrials cascading down by as over 700
points at one juncture. As the vote was shown on TV, stocks plunged and investors fled to the
safety of the credit markets, worrying that the financial system would keep sinking under the weight
of failed mortgage debt.

A White House spokesman said that President Bush was "very disappointed."

"There's no question that the country is facing a difficult crisis that needs to be addressed," Tony
Fratto told reporters. He said the president will be meeting with members of his team later in the
day "to determine next steps."

House defeats $700B financial industry bailout

 Sept. 29,2008
The House on Monday defeated a $700 billion emergency rescue for the nation's financial system,
ignoring urgent warnings from President Bush and congressional leaders of both parties that the
economy could nosedive into recession without it. Stocks plummeted on Wall Street even before
the 228-205 vote to reject the bill was announced on the House floor.

Bush and a host of leading congressional figures had implored the lawmakers to pass the
legislation despite howls of protest from their constituents back home. Despite pressure from
supporters, not enough members were willing to take the political risk just five weeks before an
election.

Ample no votes came from both the Democratic and Republican sides of the aisle. More than two-
thirds of Republicans and 40 percent of Democrats opposed the bill.

The overriding question for congressional leaders was what to do next. Congress has been trying to
adjourn so that its members can go out and campaign. And with only five weeks left until Election
Day, there was no clear indication of whether the leadership would keep them in Washington.
Leaders were huddling after the vote to figure out their next steps.

A White House spokesman said that President Bush was "very disappointed."

"There's no question that the country is facing a difficult crisis that needs to be addressed," Tony
Fratto told reporters. He said the president will be meeting with members of his team later in the
day "to determine next steps."

"Obviously we are very disappointed in this outcome," Fratto said. "There's no question that the
country is facing a difficult crisis that needs to be addressed. The president will be meeting with his
team this afternoon to determine the next steps and will also be in touch with congressional
leaders."

Monday's mind-numbing vote had been preceded by unusually aggressive White House lobbying,
and Fratto said that Bush had used a "call list" of people he wanted to persuade to vote yes as late
as a short time before the vote.

Lawmakers shouted news of the plummeting Dow Jones average as lawmakers crowded on the
House floor during the drawn-out and tense call of the roll, which dragged on for roughly 40 minutes
as leaders on both sides scrambled to corral enough of their rank-and-file members to support the
deeply unpopular measure.

They found only two.

Bush and his economic advisers, as well as congressional leaders in both parties had argued the
plan was vital to insulating ordinary Americans from the effects of Wall Street's bad bets. The
version that was up for vote Monday was the product of marathon closed-door negotiations on
Capitol Hill over the weekend.

"We're all worried about losing our jobs," Rep. Paul Ryan, R-Wis., declared in an impassioned
speech in support of the bill before the vote. "Most of us say, 'I want this thing to pass, but I want
you to vote for it — not me.' "

With their dire warnings of impending economic doom and their sweeping request for
unprecedented sums of money and authority to bail out cash-starved financial firms, Bush and his
economic chiefs have focused the attention of world markets on Congress, Ryan added.

"We're in this moment, and if we fail to do the right thing, Heaven help us," he said.
The legislation the administration promoted would have allowed the government to buy bad
mortgages and other rotten assets held by troubled banks and financial institutions. Getting those
debts off their books should bolster those companies' balance sheets, making them more inclined to
lend and easing one of the biggest choke points in the credit crisis. If the plan worked, the thinking
went, it would help lift a major weight off the national economy that is already sputtering.

The fear in the financial markets sent the Dow Jones industrials cascading down by over 700 points
at one juncture. As the vote was shown on TV, stocks plunged and investors fled to the safety of
the credit markets, worrying that the financial system would keep sinking under the weight of failed
mortgage debt.

"As I said on the floor, this is a bipartisan responsibility and we think (Democrats) met our
responsibility," said House Majority Leader Steny Hoyer, D-Md.

Asked whether majority Democrats would try to reverse the stunning defeat, Hoyer said, "We're
certainly not going to abandon our responsibility. We'll continue to focus on this and see what
actions we can take."

Several Republican aides said House Speaker Nancy Pelosi, D-Calif., had torpedoed any spirit of
bipartisanship that surrounded the bill with her scathing speech near the close of the debate that
blamed Bush's policies for the economic turmoil.

Without mentioning her by name, Rep. Adam Putnam, R-Fla., No. 3 Republican, said: "The partisan
tone at the end of the debate today I think did impact the votes on our side."

Putnam said lawmakers were working "to garner the necessary votes to avoid a financial collapse."

But the defeat was already causing a brutal round of finger-pointing.

"We could have gotten there today had it not been for the partisan speech that the speaker gave on
the floor of the House," House Minority Leader John Boehner said. Pelosi's words, the Ohio
Republican said, "poisoned our conference, caused a number of members that we thought we
could get, to go south."

Rep. Roy Blunt, R-Mo., the whip, estimated that Pelosi's speech changed the minds of a dozen
Republicans who might otherwise have supported the plan.

Rep. Barney Frank, D-Mass., scoffed at the explanation.

"Well if that stopped people from voting, then shame on them," he said. "If people's feelings were
hurt because of a speech and that led them to vote differently than what they thought the national
interest (requires), then they really don't belong here. They're not tough enough."

More than a repudiation of Democrats, Frank said, Republicans' refusal to vote for the bailout was a
rejection of their own president. "The Republicans don't trust the administration," he said. "It's a
Republican revolt against George Bush and John McCain."

In her speech, Pelosi had assailed Bush and his administration for reckless economic policies.

"They claim to be free market advocates when it's really an anything-goes mentality: No regulation,
no supervision, no discipline. And if you fail, you will have a golden parachute and the taxpayer will
bail you out. Those days are over. The party is over," Pelosi said.

"Democrats believe in a free market," she said. "But in this case, in its unbridled form, as
encouraged, supported, by the Republicans — some in the Republican Party, not all — it has
 created not jobs, not capital. It has created chaos."

Bailout, Take II: What the Feds Do Next

Sept. 30, 2008
OK, so that didn't work.

After a bunch of all-nighters in Washington and some premature back-slapping, we're right back where we
were a couple of weeks ago, after Lehman Brothers declared bankruptcy and the government lent AIG $85
billion. There's no one-size-fits-all bailout plan, after all. That $700 billion in taxpayer money remains under
lock and key. Glum investors are now the ones bailing out, fleeing stocks and bonds and seeking safer
ground.
But there are still some levers the government can pull. Working through the mess just won't be as orderly
or predictable as it would if there were a single plan and a big pot of money. Here's what's likely to happen
next:
Another try at a big bailout plan. A lot of those constituents who have been calling Congress to complain
about rescuing fat cats are going to rethink their indignation as they watch the stock markets--and their
own portfolios--sink. Lawmakers who voted against the bailout plan are going to have to explain why
they're letting the markets collapse. The more uncomfortable voters get, the more likely Congress will be to
pass some kind of sweeping relief plan. This is far from over.

More piecemeal bailouts. Before the big $700 billion bailout plan even existed, the Fed and the Treasury
Department were already patching leaks in the financial system--one trouble spot at a time. The idea
behind an umbrella bailout plan was to overhaul the whole system, establishing public standards and
treating every ailing company more or less the same, before a bunch of leaks became a gusher. That
would have eliminated the guesswork over whether a struggling company meets the criteria for a rescue--
like AIG--or falls short, like Lehman Brothers.

Now we're back to guessing. The feds still have the wherewithal to lend money, buy bad assets, or take
other measures to keep ailing companies afloat. What they don't have is a single plan that applies to all
companies and the authority to soak up vast amounts of bad assets. So those weekend meetings at the
New York Fed, with supplicant CEOs pleading for help, are likely to continue.

More failed companies. Duke University finance Prof. Campbell Harvey predicts there could be 750 to
1,000 bank failures over the next six months because of billions in bad assets stemming from the housing
meltdown. Scarce credit also threatens other types of companies that are already struggling and
desperately need capital, such as the Detroit automakers and some of the airlines. The government will be
able to deal with some of those companies one at a time, but without a comprehensive plan, others will fall
through the cracks.

Manic markets. Investors were hoping that a big bailout plan would offer some predictability about how the
government will deal with struggling companies. Their crystal ball is once again very dark. That means wild
swings in stock prices as big investors try to get out of the market ahead of bad news, and get back in if it
looks like the feds will ride to the rescue. One of the most volatile sectors is likely to be regional bank
stocks as investors worry that banks like Sovereign Bancorp and National City might be the next to fail.

Patchwork regulation. There's already a system in place for dealing with failed banks--led by the FDIC--
but that may not be enough to handle the damage that's unfolding. Even without a big bailout bill,
Congress may have to set up a new agency to deal with dozens or hundreds of bank failures, one similar
to the Resolution Trust Corp. formed in the late 1980s. We could see a whole slew of lesser regulations,
too, like restrictions on certain lending practices and higher federal coverage limits on bank deposits.

Continued government intervention. The Federal Reserve continues to pump huge sums of money into
the global banking system in a desperate effort to prompt banks to loosen their grip on loans to companies,
consumers, and one another. For now, that seems to be having little effect as banks absorb the startling
news from Washington and hunker down. That may lead the Fed to pump out even more money and take
other important steps, like cutting interest rates. Sooner or later, that will probably help loosen things up.
Until then, however, it's apparently up to the markets to fix themselves. Plan accordingly.

Recent Blogs by Paul Krugman

Tuesday, September 30, 2008

OK, we are a banana republic
House votes no. Rex Nutting has the best line: House to Wall Street: Drop Dead. He also correctly places
the blame and/or credit with House Republicans. For reasons I’ve already explained, I don’t think the Dem
leadership was in a position to craft a bill that would have achieved overwhelming Democratic support, so
make or break was whether enough GOPers would sign on. They didn’t.

I assume Pelosi calls a new vote; but if it fails, then what? I guess write a bill that is actually, you know, a
good plan, and try to pass it — though politically it might not make sense to try until after the election.

For now, I’m just going to quote myself:

So what we now have is non-functional government in the face of a major crisis, because Congress
includes a quorum of crazies and nobody trusts the White House an inch. As a friend said last
night, we’ve become a banana republic with nukes.

September 29, 2008

Bailout questions answered
I’m being asked two big questions about this thing: (1) Was it really necessary? (2) Shouldn’t Dems have
tossed the whole Paulson approach out the window and done something completely different?

On (1), the answer is yes. It’s true that some parts of the real economy are doing OK even in the face of
financial disruption; big companies can still sell bonds (and have lots of cash on hand), qualifying home
buyers can still get Fannie-Freddie mortgages, and so on. But commercial paper, which is important to a
lot of businesses, is in trouble, and I’m hearing anecdotes about reduced credit lines causing smaller
businesses to pull back. Plus there’s a serious chance of a run on the hedge funds, which could make
things a lot worse. With the economy already looking like it’s headed into a serious recession by any
definition, the risks of doing nothing look too high.

It’s true that we might be able to stagger through with more case-by-case rescues — I think of this as the
“two, three, many AIGs” strategy; in fact, we might not be at this point if Paulson hadn’t decided to make an
example of Lehman. But right now it’s not even clear who to rescue, and the credit markets are freezing up
as you read this (1-month t-bill at 0.04 %, TED spread at 3.5)

On (2), the call is tougher. But putting myself in Barney Frank or Nancy Pelosi’s shoes, I’d look at it this
way: the Democrats could start over, with a bailout plan that is, say, centered on purchases of preferred
stock and takeovers of failing firms — basically, a plan clearly focused on recapitalizing the financial sector,
with nationalization where necessary.
What the plan should have looked like:
The good, the bad, and the ugly
Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; he’s
right. I haven’t been clear enough about this, it seems, but it’s where my basic diagnosis leads: the
problem is insufficient capital, you want to inject capital, but you don’t want it to be a windfall to existing
stockholders — hence, take over and recapitalize the failing firms. By the way, that’s what we did with AIG
10 years days ago.

So that’s the good solution. The Paulson plan, which is some combination of sheer giveaway and mystic
faith that a slap in the market’s face will make everything OK, is a bad solution (and probably no solution at
all.)

But nationalization doesn’t seem like a politically realistic answer now. This leaves the rough question of
whether to hold out for a good solution, which won’t be possible until Jan. 21st, or accept the ugly
compromise that the WH and the Congressional Dems, once again, say they’ve reached. It’s a tough call,
but as I’ve written, I’ll probably hold my nose and say OK — as long as it has broad Republican support.

If not, go back to the good plan.

Maybe such a plan would have passed Congress; and maybe, just maybe Bush would have signed on;
Paulson is certainly desperate for a deal.

But such a plan would have had next to no Republican votes — and the Republicans would have
demagogued against it full tilt. And the Democratic leadership cannot, cannot, be seen to have sole
ownership of this stuff.

So that, I think, is why it had to be done this way. I don’t like it, and I don’t like the plan, but I see the
constraints under which Dodd, Frank, Pelosi, and Reid were operating.

Comments (83)

September 29, 2008, 8:41 am

21st century prewar crises
In Manhattan, at 85th Street and West End Ave., there’s an apartment building going up; the sign
advertises “21st century prewar living!” which only makes sense if you spend a lot of time in New York. But
I found myself thinking about that sign when reading this terrific WSJ article about how the fall of Lehman
triggered global panic.

One lesson of the article is that Paulson messed up very badly by letting Lehman fail; it’s not clear where
Bernanke stood, but it seems clear that Tim Geithner of the NY Fed was on the other side.

What the article really adds, though, is the details of the chain reaction that did the damage.(More for the
mixed metaphor bin: we already knew that the financial markets have melted down into a freezing crunchy
squeeze, but now we know that it was a chain reaction that did it.) There’s a great graphic in the print
edition, which doesn’t seem to be online: Lehman’s fall led to (1) a run on money market funds, causing
commercial paper rates to soar (2) soaring rates on credit default swaps, driving AIG over the edge and
sending LIBOR sky-high.

All in all, it’s the story of a massive run on the shadow banking system, the modern analogue of 1931 — a
21st-century prewar crisis.

PS: Commenter Mark asks what “21st century prewar living” means. In Manhattan, prewar apartments
have high ceilings and thick walls. So the builders of this thing are promising all that, plus modern
convenience. They’re also, if I remember rightly, offering places starting at $3.7 million; lotsa luck on that,
given the Wall Street implosion.

Comments (20)
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September 29, 2008, 8:27 am
Not so good morning
As of now, markets are not reassured. Three-month LIBOR at 3.88 percent, 3-month Treasuries at 0.75
percent (and one-month at only 0.16), hence TED spread at 3.1, the equivalent of a 105-degree fever.

All this shows that the flight to safety continues unabated.

We may be back to the drawing board very soon …

Update: Went out for my morning constitutional, and on return things look even grimmer. 1-month T-bill at
.05, 3-month at .36. Panic on the Street.

The world according to TARP

I don’t, in the end, have much more to say about the plan. It passes my test of no equity, no deal; that, plus
the danger of financial panic if it doesn’t go through, makes it worth passing, though celebration is not in
order.

I am surprised that they stayed with Troubled Asset Relief Program; isn’t everything these days supposed
to be MPAPRA (the motherhood, patriotism, and apple pie reconciliation act) or something like that?
Anyway, you know what comes next: an avalanche of TARP jokes. Say, throwing money into a TARP-pit.

Overall, Dodd and Frank succeeded in pushing Paulson a fairly long way back; probably as good a deal as
they could have gotten. But someday we’ll have an administration that actually proposes good policies to
start with.

TARP draft
So there’s a draft version of the bailout out there. Pretty much as expected. Section 113, MINIMIZATION
OF LONG-TERM COSTS AND MAXIMIZATION OF BENEFITS FOR TAXPAYERS, is where the rubber
meets the road — it’s where the plan says something about how the deals will be done.

As I read it, Treasury can (1) conduct reverse auctions and suchlike (2) buy directly — but only if it gets
equity warrants or, in companies that don’t issue stock, senior debt

My view is that (1) will be ineffective but also not a bad deal for taxpayers — firms that can afford to will
dump their toxic waste at low prices, the way some already have on the private market, and taxpayers may
end up making money in the end. Firms in big trouble will probably stay away from the auctions. The plan’s
real traction, if any, is in (2), which is a backdoor way to provide troubled firms with equity — and the bill
seems to say that taxpayers have to own this equity, although I wish it was clearer how much equity will be
judged sufficient.

Not a good plan. But sufficiently not-awful, I think, to be above the line; and hopefully the whole thing can
be fixed next year.

Add: House staff tells me that there are significant changes from this draft. More info when I get it.

The good, the bad, and the ugly

Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; he’s
right. I haven’t been clear enough about this, it seems, but it’s where my basic diagnosis leads: the
problem is insufficient capital, you want to inject capital, but you don’t want it to be a windfall to existing
stockholders — hence, take over and recapitalize the failing firms. By the way, that’s what we did with AIG
10 years days ago.

So that’s the good solution. The Paulson plan, which is some combination of sheer giveaway and mystic
faith that a slap in the market’s face will make everything OK, is a bad solution (and probably no solution at
all.)

But nationalization doesn’t seem like a politically realistic answer now. This leaves the rough question of
whether to hold out for a good solution, which won’t be possible until Jan. 21st, or accept the ugly
compromise that the WH and the Congressional Dems, once again, say they’ve reached. It’s a tough call,
but as I’ve written, I’ll probably hold my nose and say OK — as long as it has broad Republican support.

If not, go back to the good plan.

Tricky bailout politics

Nouriel Roubini has a characteristically scathing takedown of the Paulson plan, and here’s the thing:
language aside, his economic analysis is similar to mine. The fundamental problem in the financial system
is too little capital; bizarrely, the Treasury chose not to address that problem directly, by (say) purchasing
preferred shares in financial institutions. Instead, the plan is premised on the belief that toxic mortgage-
related waste is underpriced, and that the Treasury can recapitalize banks on the cheap by fixing the
markets’ error.

The Dodd-Frank changes make the plan less awful, mainly by creating an equity stake. Essentially, this
makes it possible for the plan to do the right thing through the back door: use toxic-waste purchases to
acquire equity, and hence inject capital after all. Also, the oversight means that Treasury can be prevented
from making the plan a pure gift to financial evildoers. But it’s still not a good plan.

On the other hand, there’s no prospect of enacting an actually good plan any time soon. Bush is still sitting
in the White House; and anyway, selling voters on large-scale stock purchases would be tough, especially
given the cynical attacks sure to come from the right. And the financial crisis is all too real.

So is it better to have no plan than a deeply flawed plan? If it was the original Paulson plan, no plan is
better. Dodd-Frank-Paulson may just cross the line — let’s see what details we have if and when
agreement is reached. If the plan looks not-awful enough, I’ll be pro. But I won’t be cheering — I’ll be
holding my nose.

Demolition accomplished
A few more thoughts about the incredible scene described in today’s Times (great reporting, by the way):

In the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulson Jr., literally bent down
on one knee as he pleaded with Nancy Pelosi, the House Speaker, not to “blow it up” by withdrawing her
party’s support for the package over what Ms. Pelosi derided as a Republican betrayal.

“I didn’t know you were Catholic,” Ms. Pelosi said, a wry reference to Mr. Paulson’s kneeling, according to
someone who observed the exchange. She went on: “It’s not me blowing this up, it’s the Republicans.”

Mr. Paulson sighed. “I know. I know.”

How did we get to this point? It’s the culmination of many past betrayals.

First of all, we have the Republican Study Committee blowing things up with a complete nonsense
proposal — solving the crisis with a holiday on capital gains taxes. How is that possible? Well, if a party
runs on economic nonsense for 25 years, eventually many of its foot soldiers will be people who actually
believe the nonsense.

More specifically, though, the failure to get a deal reflects the betrayals of the Bush years. Democrats
weren’t going to trust Henry Paulson, because behind him they see the ghost of Colin Powell (and
Paulson’s “all your bailout are belong to me” proposal, aside from being bad economics, showed an
incredible tone-deafness.)

And after the way the Bushies and their allies double-crossed the Democrats again and again in the
aftermath of 9/11 — demand national unity, then accuse you of being soft on terrorists anyway — there’s
no way Pelosi and Reed will do the responsible but unpopular thing unless the Republicans agree to share
ownership.

So what we now have is non-functional government in the face of a major crisis, because Congress
includes a quorum of crazies and nobody trusts the White House an inch.

As a friend said last night, we’ve become a banana republic with nukes.

Paulson’s pratfall
You know that Paulson produced a lemon when Glenn Hubbard and Greg Mankiw have basically the same
objections to the plan that I do. The plan doesn’t directly address the key issue of undercapitalized financial
institutions; instead, it relies on the assumption that mortgage-related toxic waste is under priced, and that
the Treasury can wave its $700 billion magic wand and make everything fine again.

Let me say, however, that this already seems like old news. Paulson plan 1.0 is dead; the question now is
whether Dodd-Frank, or something like it, will happen.

Madness on Pennsylvania Avenue

I hate nights like this — the news kept changing as I tried to finish the column. But this White House
meeting was obviously one for the ages:

House Financial Services Committee Chairman Barney Frank (D-Mass.) angrily accused House
Republicans — with the tacit support of Republican presidential candidate John McCain — of crafting an
alternative to undercut Treasury Secretary Henry Paulson.

Both McCain and his Democrat rival, Sen. Barack Obama, left without any joint endorsement. A
beleaguered President Bush had to struggle to maintain order and reassert himself. And when Democrats
left after the meeting to caucus in the Roosevelt Room, Paulson pursued them, begging that they not “blow
up” the legislation.

The former Goldman Sachs CEO even went down on one knee as if genuflecting, to which Speaker Nancy
Pelosi (D-Cal.) is said to have joked, “I didn’t know you were Catholic.”

I don’t even want to think about what tomorrow’s TED spread will look like.

A sneaking suspicion
So now the whole rationale for the plan is “price discovery”: we’re going to throw lots of taxpayer funds into
the pot because that will let us find the true values of troubled assets, which are higher than the fire sale
prices out there, and so balance sheet will improve, confidence will return, etc, etc..

So I just did a Nexis search trying to find out when Paulson and Bernanke started talking about price
discovery, which we’re now told are at the core of the plan’s logic. And the answer is …

Yesterday.

I can’t find any use of the term, or even a hint of the argument, until yesterday’s Senate hearings. One
possible explanation. It wasn’t until yesterday that they realized that it would actually be necessary to
explain themselves.

But there’s another possible explanation, which I find terrifyingly plausible: the plan came first, and all this
stuff about price discovery is an after-the-fact rationalization, invented when people started asking
questions.

It has seemed very strange to me that such a supposedly crucial economic program would be based on
such an exotic argument. My sneaking suspicion is that they started with a determination to throw money
at the financial

A $700 billion slap in the face

The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion
and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we
should believe the proposed intervention would work. So many of us turned to our own analyses, and
concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry.

Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing
theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve
the crisis so far.

Credit Default Swaps

Credit default swaps, which were invented by Wall Street in the late 1990's, are financial instruments that
are intended to cover losses to banks and bondholders when a particular bond or security goes into default
-- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were
promised.

In essence, it is a form of insurance. Its purpose is to make it easier for banks to issue complex debt
securities by reducing the risk to purchasers, just like the way the insurance a movie producer takes out on
a wayward star makes it easier to raise money for the star's next picture.

Here is a more detailed, but still simplified explanation of how they work, given by Michael Lewitt, a Florida
money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:

"Credit default swaps are a type of credit insurance contract in which one party pays another party to
protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank
loan, a mortgage) defaults, the insurer compensates the insured for his loss.

"The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to
support its payment obligation, but in the insane credit environment that preceded the credit crisis, this
collateral deposit was generally too small.

"As a result, the credit default market is best described as an insurance market where many of the
individual trades are undercapitalized."

The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion
to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp
contrast to traditional insurance, the swaps are totally unregulated.

When the mortgage-backed securities that many swaps were supporting began to lose value in 2007,
investors began to fear that the swaps, originally meant as a hedge against risk, could suddenly become
huge liabilities.

The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety.
Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge
in late 2007.

Credit default swaps also played an integral role in the federal government's decision to bail out the
American International Group, one of the world's largest insurers, in September 2008. The Federal
Reserve concluded that if A.I.G. failed and defaulted on its swaps, throwing the liability for the insured
securities onto the swaps' counterparties, the result could be a daisy chain of failures across the
international financial system.

Don't blame the New Deal for today's financial crisis

September 29, 2008
This year's serial bailouts are proof of a colossal regulatory failure. But it is not "the system" that failed, as
President Bush, Treasury Secretary Henry Paulson and others who are complicit in the calamity would like
Americans to believe. People failed.

For decades now, anti-regulation disciples of the Reagan Revolution have eliminated vital laws, blocked
the enactment of much-needed new regulations, or simply refused to exercise their legal authority.

The regulatory system for banks, securities, commodities and insurance is unwieldy and in need of
modernization. The system has gaps, like the absence of regulation for "innovations" such as credit default
swaps, the insurance-like contracts now valued at $62 trillion whose destructive potential prompted the
bailouts of Bear Stearns and the American International Group.

But the failures that have landed us in the mess we are in today are not mainly structural. To assert that
they are masks deeper failings and sets false terms for the coming debate on regulatory reform.

Under a law passed in 1994, for example, the Federal Reserve was obligated to regulate banks and
nonbank lenders to curb unfair, deceptive and predatory lending. Alan Greenspan, the former Federal
Reserve chairman, ignored his responsibility, even as junk mortgage lending proliferated in plain sight.

Greenspan later said the law defined "unfair" and "deceptive" too vaguely. If so, he should have asked
Congress for clarification. Instead, he did nothing - and the Republican-led Congress did not question him.
When Ben Bernanke took over as Fed chairman in early 2006, the negligence continued. It was not until
mid-2007, after the housing bubble had begun to burst, that federal regulators offered guidelines for
subprime lending.

The systematic dismantling of laws that called for regulation also contributed to the current crisis. In 1995,
Congress passed a law that restricted the ability of investors to sue companies, securities firms and
accounting firms for misstatements and pie-in-the-sky projections. That helped inflate the dot-com bubble
and contributed to the Enron debacle. It also engendered a sense of impunity that helped to foster the
excessive risk-taking so prevalent in the mortgage mess. Then, in 1999, Congress dismantled the Glass-
Steagall Act, a pillar of the New Deal, which separated commercial and investment banking.

That enormous change was undertaken with no effort to regulate the world that it would help to create.
Now we know that an entire "shadow banking system" has grown up, without rules or transparency, but
with the ability to topple the financial system itself.

It was in the Bush years that anti-regulation and deregulation found full expression, fueled by an ideology
that markets know best, government hampers markets, and problems will fix themselves. America is now
painfully relearning that the opposite is true.

Christopher Cox, chairman of the Securities and Exchange Commission, admitted on Friday that his
agency's "voluntary regulation" of investment banks was a failure that contributed to the current crisis. That
is a good starting point for a debate about how to get back on the road to sensible, responsible government
regulation.

Krugman: Where are the grown-ups?

By Paul Krugman
Many Americans on both the right and the left are outraged at the idea of using taxpayer money to
bail out the U.S. financial system. They're right to be outraged, but doing nothing isn't a serious
option. Right now, players throughout the system are refusing to lend and hoarding cash - and this
collapse of credit reminds many economists of the run on the banks that brought on the Great
Depression.

It's true that we don't know for sure that the parallel is a fair one. Maybe we can let Wall Street
implode and Main Street would escape largely unscathed. But that's not a chance we want to take.

So the grown-up thing is to do something to rescue the financial system. The big question is, are
there any grown-ups around - and will they be able to take charge?

Earlier this week, Henry Paulson, the Treasury secretary, tried to convince Congress that he was
the grown-up in the room, come to protect Americans from danger. And he demanded total
authority over the rescue: $700 billion to be used at his discretion, with immunity for future review.

Congress balked. No government official should be entrusted with that kind of monarchical
privilege, least of all an official belonging to the administration that misled America into war.
Furthermore, Paulson's track record is anything but reassuring: He was way behind the curve in
appreciating the depth of the nation's financial woes, and it's partly his fault that America has
reached the current moment of meltdown.

Besides, Paulson never offered a convincing explanation of how his plan was supposed to work -
and the judgment of many economists was, in fact, that it wouldn't work unless it amounted to a
huge welfare program for the financial industry.

But if Paulson isn't the grown-up America needs, are congressional leaders ready and able to fill the
role?

Well, the bipartisan "agreement on principles" released on Thursday looks a lot better than the
original Paulson plan. In fact, it puts Paulson himself under much-needed adult supervision, calling
for an oversight board "with cease and desist authority." It also limits Paulson's allowance: He only
(only!) gets to use $250 billion right away.

Meanwhile, the agreement calls for limits on executive pay at firms that get federal money. Most
important, it "requires that any transaction include equity sharing."

Why is that so important? The fundamental problem with the U.S. financial system is that the fallout
from the housing bust has left financial institutions with too little capital. When he finally deigned to
offer an explanation of his plan, Paulson argued that he could solve this problem through "price
discovery" - that once taxpayer funds had created a market for mortgage-related toxic waste,
everyone would realize that the toxic waste is actually worth much more than it currently sells for,
solving the capital problem. Never say never, I guess - but you don't want to bet $700 billion on
wishful thinking.

The odds are, instead, that the U.S. government will end up having to do what governments always
do in financial crises: Use taxpayers' money to pump capital into the financial system. Under the
original Paulson plan, the Treasury would probably have done this by buying toxic waste for much
more than it was worth - and gotten nothing in return. What taxpayers should get is what people
who provide capital are entitled to: a share in ownership. And that's what the equity sharing is
about.

The congressional plan, then, looks a lot better - a lot more adult - than the Paulson plan did. That
said, it's very short on detail, and the details are crucial. What prices will taxpayers pay to take over
some of that toxic waste? How much equity will they get in return? Those numbers will make all the
difference.

And in any case, lawmakers are still negotiating a deal.

This has to be a bipartisan plan, and not just at the leadership level. Democrats won't pass the plan
without votes from rank-and-file Republicans - and as of Thursday night, those rank-and-file
Republicans were balking.

Furthermore, one non-rank-and-file Republican, Senator John McCain, is apparently playing

spoiler. Earlier this week, while refusing to say whether he supported the Paulson plan, he claimed
not to have had a chance to read it; the plan is all of three pages long. And during Thursday's
meeting at the White House, reported Marc Ambinder of the Atlantic, McCain brought up proposals
that had already been rejected by congressional leaders of both parties and declared unworkable
by Paulson.

The bottom line, then, is that there do seem to be some adults in Congress, ready to do something
to help get the United States through this crisis. But the adults are not yet in charge.

U.S. House rejects plan for bailout

September 29, 2008
Defying President George W. Bush and the leaders of both parties, rank-and-file lawmakers in the
House on Monday rejected a $700 billion economic rescue plan in a revolt that rocked the Capitol,
sent markets plunging and left top lawmakers groping for a resolution.

The stunning defeat of the proposal on a 228-205 vote after marathon talks by senior congressional
and Bush administration officials lowered a fog of uncertainty over economies around the globe. Its
authors had described the measure as essential to preventing widespread economic calamity.

The markets began to plummet even before the 15-minute voting period expired on the House floor.
For 25 minutes, uncertainty gripped the nation as television showed party leaders trying, and failing,
to muster more support. Finally, Representative Ellen Tauscher, Democrat of California, pounded
the gavel and it was done.

In the end, only 65 Republicans — just one-third of those voting — backed the plan despite
personal pleas from President George W. Bush and encouragement from their presidential
nominee, Senator John McCain. By contrast, 140 Democrats, or 60 percent, voted in favor, many
after voicing grave misgivings. Their nominee, Senator Barack Obama, also backed the bill.

By the end of day, the Dow had fallen almost 778 points, or nearly 7 percent, to 10,365. Credit
markets also remained distressed, with bank lending rates rising and investors fleeing to the safety
of Treasury bills.

Among opponents of the rescue plan, some Republicans cited ideological objections to government
intervention, and liberal Democrats said they were of no mind to race to aid Wall Street tycoons.
Other critics complained about haste and secrecy in assembling the plan.

But lawmakers on both sides pointed to an outpouring of opposition from deeply hostile constituents
just five weeks before every seat in the House was up for election as a fundamental reason that the
measure was defeated. House members in potentially tough races and those seeking Senate seats
fled from the plan in droves.

"People's re-elections played into this to a much greater degree than I would have imagined," said
Representative Deborah Pryce of Ohio, a former member of the Republican leadership who is
retiring this year and voted for the plan.

Congressional leaders in both parties said they did not know how they would proceed but were
examining options, including having the Senate, where there was more support for the bailout,
advance a bill after the Jewish New Year on Tuesday. Congressional leaders said any doubt about
the need for action should have been removed by the market fall.

"We're not leaving town till we get it fixed," said Senator Mitch McConnell of Kentucky, the
Republican leader.
At the White House, Bush met with his economic advisers as well as the Federal Reserve
chairman, Ben Bernanke, to discuss next steps. "I was disappointed in the vote," Bush said,
appearing in the Oval Office with President Viktor Yushchenko of Ukraine. "Our strategy is to
continue to address this economic situation head on."

The Treasury secretary, Henry Paulson Jr., who was the main architect of the financial rescue plan,
said he would continue to work with congressional leaders "to find a way forward to pass a
comprehensive plan to stabilize our financial system and protect the American people." He added,
"This is much too important to simply let fail."

McCain and Obama renewed their calls for swift action, though each campaign sought to partly
blame the other for the defeat.

At the Capitol, Democrats accused Republicans of failing to deliver enough number of votes. "Sixty-
seven percent of the Republican Conference decided to put political ideology ahead of the best
interest of our great nation," the Democratic whip, Representative James Clyburn of South Carolina,
said after the vote.

Representative Roy Blunt of Missouri, the Republican whip, said that before the vote he had tallied
75 votes in his conference in favor of the plan. By the time the votes were cast, the Republicans
could deliver only 65 of them.

Other top Republicans pointed at what they saw as a partisan speech by Speaker Nancy Pelosi in
advance of the vote as a factor — a charge Democrats derided.

Republicans said they had alerted Democrats they might not have the numbers required. But they
never recommended the legislation be put off and in the end they were unable to win any last-
second converts to change the votes that would have been necessary to turn defeat into victory.

Representative John Boehner of Ohio, the House Republican leader, said he tried repeatedly and
unsuccessfully to sway a handful of holdouts, but eventually gave up.

"You can't break their arms, you can't put your whole relationship on the line with them and ask
them to do something they do not want to do and have that member regret that vote for the rest of
their life," said Boehner, who said he could not remember a time when the muscle of both parties
and the White House failed to produce a victory.

The outcome after a slightly more than 40-minute vote on the House floor left lawmakers almost
speechless. Even the strongest opponents of the measure did not expect to prevail, and the
leadership of both parties, while increasingly nervous, figured they would squeak out a victory
despite a parade of Republicans and Democrats to microphones to assail the measure. At the
White House, the deputy press secretary, Tony Fratto, said just before the vote: "We're confident
that it will pass."

Under the proposal, the Treasury Department could tap up to $700 billion in taxpayer money in
installments to buy troubled debt from financial firms, in the hopes of freeing up credit to fuel normal
economic activity.

In the final stages of negotiations, new provisions intended to recoup taxpayer losses were added.
They helped the measure win support from Boehner and some other House Republican leaders,
who had strongly opposed an earlier version of the bill. But they did not put the package over the
top.

In impassioned speeches on the House floor, Democrats and Republicans alike vented their
frustration over the nation's perilous economic condition and the uncomfortable position they were
in, facing pressure to approve an unpopular bailout package during an election year, with no
guarantee that it would work.
"This is a huge cow patty with a piece of marshmallow stuck in the middle of it and I am not going to
eat that cow patty," said Representative Paul Broun, Republican of Georgia.

"Nobody wants to do this," said Representative Edward Markey, Democrat of Massachusetts, who
nonetheless voted for it. "Nobody wants to clean up the mess created by Wall Street recklessness."

In the speech that Republicans said infuriated them, Pelosi accused Bush of squandering the
budget surpluses of the Clinton years. "They claim to be free-market advocates, when it's really an
anything-goes mentality," she said. "No supervision. No discipline. And if you fail, you will have a
golden parachute and the taxpayer will bail you out."

Democrats later said that if her speech truly cost votes, then Republicans, in the words of
Representative Barney Frank, Democrat of Massachusetts, were guilty of punishing the country
because Pelosi had hurt their feelings.

As the voting time expired on the floor, party leaders realized they were coming up far short. At 1:49
p.m., it was 205 for and 228 against. At 1:54 p.m., they inched closer: 207 to 226, as some
representatives changed their votes. What followed was a remarkable stalemate on the House
floor, with top lieutenants in both parties clutching lists of votes, as they clustered in the well and
made unusual forays into what is normally enemy territory across the aisle.

"I was asking where the hell their votes were," said Representative Rahm Emanuel of Illinois, the
No. 4 Democrat.

Blunt said he told Democrats he thought he could flip five votes, if Democrats could do the same.
Democrats had warned that the Republicans that they would need to produce 80 to 100 votes to
adopt an unpopular plan championed by the Republican White House. Ultimately, the Democrats
decided the votes were not there and they allowed the gavel to come down. Opponents of the
measure said they expected the administration and congressional leaders to try again on a rescue
proposal and were not worried about being held responsible for the stock decline or other economic
uncertainty.

"I think we will be back in a couple of days with a proposal more palatable to more members," said
Representative John Yarmuth, a Kentucky Democrat who voted against the plan. "You don't make
the biggest financial decision in the history of this country in a few days' time without hearings."

But Representative Tom Davis, a Virginia Republican who is retiring from Congress and who
backed the proposal, said those who opposed to the measure might be hearing a different message
from their voters if economic conditions worsen. "The members who voted no will have some
culpability," he said.

The House leadership said Monday night that the House would reconvene at noon Thursday,
though it was not known if another economic plan would be on the table.

"Stay tuned," said Pelosi, who seemed physically drained. But she added: "What happened today
cannot stand. We must move forward, and I hope that the markets will take that message."

Representative Greg Walden, an Oregon Republican who supported the bailout, said lawmakers
may quickly discover "whether this is as dire a situation as we were told."

"This is playing with fire," Walden said. "It's very, very dangerous."

HIGH & LOW FINANCE

After the Deal, the Focus Will Shift to Regulation
By FLOYD NORRIS
September 29, 2008
Even before Congress passes a $700 billion bank bailout that nearly all legislators believe to be
both necessary and unpopular, the jostling has begun over legislation that may prove to be the first
test for the next president: How to reshape the financial system and its regulation.

It is clear that the old system failed — it wouldn’t need the bailout otherwise — but the diagnosis of
why that happened may be crucial in deciding what changes are needed.

Already, liberals are blaming the deregulation that began under Ronald Reagan for letting a
financial system get out of control, and conservatives are pointing to market interventions by liberals
— notably efforts to assure mortgage loans for the poor and minorities — as being the root cause of
the mess.
Conservatives are also pointing to accounting rules, which forced banks to write down the value of
their loans, and to excesses by Fannie Mae and Freddie Mac, the government-sponsored mortgage
enterprises that have since been nationalized, whose troubles they have tried to tie to Democrats.

Both sides roundly denounce Wall Street greed, but there is no clear legislative solution to that, so
such rhetoric is more likely to shape the campaign than the post election legislative battle.
When the liberals talk about deregulation, they most often point to the Gramm-Leach-Bliley Act of
1999, which tore down the last remaining walls between commercial banks and investment banks.

But there is little evidence to tie much of the problem to that law. Most of the walls, erected during
the Depression, had already been breached over many years, with the approval of regulators.
Besides, the first major failures of this crisis, Bear Stearns and Lehman Brothers, were investment
banks that did not go into commercial banking in a big way.

Instead, it might be more appropriate to describe the problem as “unregulation.” That regulation was
scaled back was less of a factor than Wall Street’s finding ways around regulation by establishing
new products that could work between the cracks. Those new products grew to dominate the
financial system, and they turned out to be prone to collapse.

Both parties bear responsibility for that, because there was little controversy over it when it was
happening. Alan Greenspan, then the chairman of the Federal Reserve, believed that the new
products could distribute risk to investors, who were better able to bear it than was the banking
system he was charged with regulating, and few legislators were willing to challenge Mr. Greenspan
on what appeared to be an arcane issue.

But the family that can take the most credit for that is the Gramms, Phil and Wendy. It was Wendy
Gramm, as chairwoman of the Commodity Futures Trading Commission in the early 1990s, who
championed keeping her agency out of derivative trading. It was Phil Gramm, as the chairman of
the Senate Banking Committee, who pushed through legislation in 2000 to assure that no future
C.F.T.C., let alone any other regulator, would have jurisdiction over such products. At the same
time that the credit-default swap market was growing, so were hedge funds, which became
behemoths that were largely exempt from any regulation.

The logic behind both of those decisions was that regulation was about protecting individual
investors. Because small investors could not invest in hedge funds or mortgage-backed securities
or credit-default swaps, the government had no reason to interfere with private enterprise. It turns
out that those products could threaten the entire financial system, and their abuse could produce a
credit crisis affecting virtually everyone.

One obvious answer is that the new regulation system should not have so many loopholes. It is
possible that the old markets and old products do have too much regulation, and that deregulation
in some areas would be appropriate. But the guiding principle should be that similar products and
similar institutions deserve similar regulation. If large institutional investors are required to disclose
their positions every quarter, why should large hedge funds be treated differently?
That principle will need to be applied internationally as well, which will require diplomacy and a
willingness to consider views of governments that are much less sympathetic to financial
innovation.
The growth of the new financial system also tends to undermine the conservative argument that
much of the problem can be traced to the Community Reinvestment Act, which was passed by
Congress in 1977. It has been cited by some bankers as a reason they made what turned out to be
bad loans, but most of the worst loans appear to have been made outside of the banking system,
by mortgage brokers not subject to its rules. Similarly, Fannie Mae and Freddie Mac undoubtedly
bought many loans that should not have been made. But the worst loans were privately syndicated
and snapped up by investors.

The accounting rule requiring banks to mark their assets to their market value has been widely
blamed for producing losses that alarmed investors. Newt Gingrich, the former House speaker, said
Sunday on the ABC program “This Week” that “between half to 70 percent of the problem” was
caused by the rule, and some Republican legislators pushed to have the bailout bill suspend the
rule.
But if one wants to look at accounting rules as a cause, it would be more productive to examine the
rules that permitted the crisis to grow without being noticed, not at the rule that finally brought the
truth to public attention.

When the Financial Accounting Standards Board met after the Enron scandal to tighten the rules
over off-balance-sheet entities, it permitted banks to continue keeping many assets off their balance
sheets, under rules that now — belatedly — are being changed. Out of sight should not have meant
out of mind, as many of the off-balance-sheet items have produced major losses.

Similarly, the rules permitted banks to turn groups of mortgages into securities and report
profits even though they retained some of the risk that the mortgages would go bad. By
underestimating that risk, the banks reported higher profits than they should have, and the
executives qualified for larger bonuses. Many of the recent losses are just reversing profits that, in
reality, were never earned.
In any case, it is too late to abandon mark-to-market accounting. Just how reassuring to investors
would it be for the government to issue a rule saying it is O.K. for banks to value assets for far more
than anyone would pay for them?

Perhaps the most important cause of this disaster is one that probably does not need legislation:
belief in so-called rocket scientists and their computer models, which used the past to
forecast the future, and did so with complete, and completely unjustified, assurance. It was
that faith that led rating agencies to give top-grade classification to securities that were in fact very
risky and led investors to buy them. It was that faith that led regulators to defer to the banks’ own
risk models in determining how much capital they needed. It was that faith that led senior
managements of Wall Street firms — many of whom had only a general understanding of what their
traders were doing — to assume that risk was under control when it was not.

That faith is gone now. It will not come back soon.

The legislation next year will shape the efforts of the American financial system to right itself, and to
provide credit to families and businesses without taking undue risks that can again threaten to
destroy the system. The details of those decisions will be far more important than the details of the
bailout that is about to be approved.
The 3 A.M. Call
By PAUL KRUGMAN
September 29, 2008
It’s 3 a.m., a few months into 2009, and the phone in the White House rings. Several big hedge
funds are about to fail, says the voice on the line, and there’s likely to be chaos when the market
opens. Whom do you trust to take that call?
I’m not being melodramatic. The bailout plan released yesterday is a lot better than the proposal
Henry Paulson first put out — sufficiently so to be worth passing. But it’s not what you’d actually call
a good plan, and it won’t end the crisis. The odds are that the next president will have to deal with
some major financial emergencies.

So what do we know about the readiness of the two men most likely to end up taking that call?
Well, Barack Obama seems well informed and sensible about matters economic and financial. John
McCain, on the other hand, scares me.

About Mr. Obama: it’s a shame that he didn’t show more leadership in the debate over the bailout
bill, choosing instead to leave the issue in the hands of Congressional Democrats, especially Chris
Dodd and Barney Frank. But both Mr. Obama and the Congressional Democrats are surrounded by
very knowledgeable, clear-headed advisers, with experienced crisis managers like Paul Volcker
and Robert Rubin always close at hand.

Then there’s the frightening Mr. McCain — more frightening now than he was a few weeks ago.
We’ve known for a long time, of course, that Mr. McCain doesn’t know much about economics —
he’s said so himself, although he’s also denied having said it. That wouldn’t matter too much if he
had good taste in advisers — but he doesn’t.

Remember, his chief mentor on economics is Phil Gramm, the arch-deregulator, who took special
care in his Senate days to prevent oversight of financial derivatives — the very instruments that
sank Lehman and A.I.G., and brought the credit markets to the edge of collapse. Mr. Gramm hasn’t
had an official role in the McCain campaign since he pronounced America a “nation of whiners,” but
he’s still considered a likely choice as Treasury secretary.

And last year, when the McCain campaign announced that the candidate had assembled “an
impressive collection of economists, professors, and prominent conservative policy leaders” to
advise him on economic policy, who was prominently featured? Kevin Hassett, the co-author of
“Dow 36,000.” Enough said.

Now, to a large extent the poor quality of Mr. McCain’s advisers reflects the tattered intellectual
state of his party. Has there ever been a more pathetic economic proposal than the suggestion of
House Republicans that we try to solve the financial crisis by eliminating capital gains taxes?
(Troubled financial institutions, by definition, don’t have capital gains to tax.)

But even President Bush has, in the twilight of his administration, turned to relatively sensible
people to make economic decisions: I’m not a fan of Mr. Paulson, but he’s a vast improvement over
his predecessor. At this point, one has the suspicion that a McCain
Administration would have us longing for Bush-era competence. The real revelation of the last few
weeks, however, has been just how erratic Mr. McCain’s views on economics are. At any given
moment, he seems to have very strong opinions — but a few days later, he goes off in a completely
different direction.

Thus on Sept. 15 he declared — for at least the 18th time this year —that “the fundamentals of our
economy are strong.” This was the day after Lehman failed and Merrill Lynch was taken over, and
the financial crisis entered a new, even more dangerous stage. But three days later he declared
that America’s financial markets have become a “casino,” and said that he’d fire the head of the
Securities and Exchange Commission — which, by the way, isn’t in the president’s power.

And then he found a new set of villains — Fannie Mae and Freddie Mac, the government-
sponsored lenders. (Despite some real scandals at Fannie and Freddie, they played little role in
causing the crisis: most of the really bad lending came from private loan originators.) And he
moralistically accused other politicians, including Mr. Obama, of being under Fannie’s and Freddie’s
financial influence; it turns out that a firm owned by his own campaign manager was being paid by
Freddie until just last month.

Then Mr. Paulson released his plan, and Mr. McCain weighed vehemently into the debate. But he
admitted, several days after the Paulson plan was released, that he hadn’t actually read the plan,
which was only three pages long.

O.K., I think you get the picture.

The modern economy, it turns out, is a dangerous place — and it’s not the kind of danger you can
deal with by talking tough and denouncing evildoers. Does Mr. McCain have the judgment and
temperament to deal with that part of the job he seeks?

US 'casino' mentality blamed for planet's meltdown

September 30th

Astounded by the U.S. government's failure to resolve the financial crisis threatening the
foundations of the global free market, fingers of blame are pointing at America from around the
planet. Latin American leaders say the U.S. must quickly fix the financial crisis it created before the
rest of the world's hard-won economic gains are lost.

"The managers of big business took huge risks out of greed," said President Oscar Arias of Costa
Rica, whose economy is highly dependent on U.S. trade. "What happens in the United States will
affect the entire world and, above all, small countries like ours."

In Europe, where some blame a phenomenon of "casino capitalism" that has become deeply
engrained from New York to London to Moscow, there is more of a sense of shared responsibility.
But Europeans also blame the U.S. government for letting things get out of hand.

Amid harsh criticism is a growing consensus that stricter financial regulation is needed to prevent
unfettered capitalism from destroying economies around the globe.

And leaders of developing nations that kept spending tight and opened their economies in response
to American demands are warning of other consequences — a loss of U.S. influence globally and
the likelihood that the world's poor will suffer the most from greed by the biggest players in global
finance.

"They spent the last three decades saying we needed to do our chores. They didn't," a grim-faced
Brazilian President Luiz Inacio Lula da Silva said Tuesday.

Even staunch U.S. allies like Colombian President Alvaro Uribe blasted the world's most powerful
country for egging on uncontrolled financial speculation that he compared to a wild horse with no
reins.

"The whole world has financed the United States, and I believe that they have a reciprocal debt with
the planet," he said.

It's harder for European leaders to point the finger directly at the United States since many of their
financiers participated in the recklessness. London was home to the division of failed insurer AIG
that racked up huge losses on credit-default swaps, and many reputable European banks
disregarded risk to load up on higher yielding subprime assets.

But the House's rejection Monday of the U.S. bank bailout proposed by Treasury Secretary Henry
Paulson provoked a sharper tone and warnings that America must act. Though global markets on
Tuesday recovered some of the ground they lost in a worldwide slide the day before, politicians
from Europe to South America insisted the risk of a further plunge remains high.

German Chancellor Angela Merkel called on U.S. lawmakers to pass a package this week, saying it
was the "precondition for creating new confidence on the markets — and that is of incredibly great
significance."

In an unusually blunt statement from the 27-country European Union, EU Commission spokesman
Johannes Laitenberger said: "The United States must take its responsibility in this situation, must
show statesmanship for the sake of their own country, and for the sake of the world."

The crisis also has strengthened voices in France and Germany calling for EU regulations to
eliminate highly deregulated financial markets, despite objections from Britain, which along with the
U.S. is considered by some to practice a freer form of "Anglo-Saxon" capitalism.

"This crisis underlines the excesses and uncertainties of a casino capitalism that has only one logic
— lining your pockets," said German lawmaker Martin Schulz, chairman of the Socialists in the EU
assembly. "It also shows the bankruptcy of 'law of the jungle' capitalism that no longer invests in
companies and job creation, but instead makes money out of money in a totally uncontrolled way."

The U.S. government's failure to apply rules that might have prevented the crisis is seen as a
betrayal in many developing countries that faced intense U.S. pressures to liberalize their
economies. In some developing nations, state enterprises were privatized, currencies were allowed
to float against the U.S. dollar and painful measures were taken to bring down debts.

These advances are at risk now that credit is drying up. Countries with commodities-based
economies are particularly vulnerable since more industrialized nations could reduce their demand
for everything from soy to iron ore.

"It doesn't seem fair to me that those of us who endured so much hunger in the 20th century, who
began to improve in the 21st century, should have to suffer due to the international financial
system," Silva said. "There are going to be a lot of people going hungry in the world."

Just before meeting with Silva on Tuesday, Venezuelan leader Hugo Chavez said he believes a
new economic order is in store for the planet.

"What's to blame? Imperialism, the United States, the irresponsibility of the United States
government," said the self-avowed socialist and frequent U.S. critic. "From this crisis, a new world
has to emerge, and it's a multi-polar world."

China's influence in the outcome of all this could be profound because it is a huge investor in U.S.
debt. It is already calling for strict new international regulatory systems to apply to globalized
financial markets.

Liu Mingkang, chairman of the Chinese Banking Regulatory Commission, said Saturday before a
weeklong bank holiday in China that debt in the United States and elsewhere has risen to
dangerous and indefensible levels.

The rest of the world is taking notice. Many newspapers made references Tuesday to China's
increasing importance in global finance. In Algeria, a large cartoon on the front page of the
newspaper El-Watan showed Uncle Sam at prayer: "Save us!" he says, kneeling before a portrait of
China's Mao Zedong.

In London, Jane Ayerson, a 20-year-old Irish exchange student, said Europeans share the blame.
The problem started with America, but banks here have been greedy, too," she said.

Treasury Announces Temporary Guarantee Program for Money Market Funds

September 29, 2008
The U.S. Treasury Department today opened its Temporary Guarantee Program for Money Market
Funds. The U.S. Treasury will guarantee the share price of any publicly offered eligible money
market mutual fund – both retail and institutional – that applies for and pays a fee to participate in
the program.

All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act
of 1940, maintain a stable share price of $1, and are publicly offered and registered with the
Securities and Exchange Commission will be eligible to participate in the program. Treasury first
announced this program on Friday, September 19.

The temporary guarantee program provides coverage to shareholders for amounts that they held in
participating money market funds as of the close of business on September 19, 2008. The
guarantee will be triggered if a participating fund's net asset value falls below $0.995, commonly
referred to as breaking the buck.

The program is designed to address temporary dislocations in credit markets. The program will
exist for an initial three month term, after which the Secretary of the Treasury will review the need
and terms for extending the program. Following the initial three-month term, the Secretary has the
option to renew the program up to the close of business on September 18, 2009. The program will
not automatically extend for the full year without the Secretary's approval, and funds would have to
renew their participation at the extension point to maintain coverage. If the Secretary chooses not to
renew the program at the end of the initial three-month period, the program will terminate.

To participate in the program, the Treasury Department will require money market funds with a net
asset value per share greater than or equal to $0.9975 as of the close of business on September
19, 2008, to pay an upfront fee of 0.01 percent, 1 basis point, based on the number of shares
outstanding on that date. Funds with net asset value per share of greater than or equal to $0.995
and below $0.9975 as of the close of business on September 19, 2008, will be required to pay an
upfront fee of 0.015 percent, 1.5 basis points, based on the number of shares outstanding on that
date. These fees will only cover the first three months of participation in the program.

Funds with a net asset value below $0.995 as of the close of business on September 19, 2008, may
not participate in the program.

While the program protects the accounts of investors, each money market fund makes the decision
to sign-up for the program. Investors cannot sign-up for the program individually. Funds should
apply by October 8, 2008 for the program using the forms on the program webpage:
http://www.treas.gov/offices/domestic-finance/key-initiatives/money-market-fund.shtml.

Eligible funds include both taxable and tax-exempt money market funds. The Treasury and the IRS
issued guidance that confirmed that participation in the temporary guarantee program will not be
treated as a federal guarantee that jeopardizes the tax-exempt treatment of payments by tax-
exempt money market funds.

President George W. Bush approved the use of existing authorities by Secretary Henry M. Paulson,
Jr. to make available as necessary the assets of the Exchange Stabilization Fund to guarantee the
payment
 The Exchange Stabilization Fund was established by the Gold Reserve Act of 1934, as amended,
and has approximately $50 billion in assets. This Act authorizes the Secretary of the Treasury, with
the approval of the President, "to deal in gold, foreign exchange, and other instruments of credit and
securities" consistent with the obligations of the U.S. government in the International Monetary
Fund to promote international financial stability. More information on the Exchange Stabilization
Fund can be found at

Frequently Asked Questions: Treasury’s Temporary Guarantee Program for Money Market Funds
September 29, 2008

How does an investor sign up to participate in the Treasury's Temporary Guarantee Program for Money
Market Funds?

While the program protects the shares of all money market fund investors as of September 19, 2008, each
money market fund makes the decision to sign up for the program. Investors cannot sign up for the program
individually.

How will investors know if their money market fund participates in the program?

Investors should contact their money market fund directly to determine if it is participating in the program.

What type of funds does the program cover?

All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940, are
publicly offered, are registered with the Securities and Exchange Commission and maintain a stable share price
of $1 will be eligible to participate in the program. This includes both taxable and non-taxable funds.

Is an investor in a fund that is managed like a money market fund but that is not registered with the SEC
covered?

No, the program only covers money market funds that are regulated under Rule 2a-7 of the Investment Company
Act of 1940, are publicly offered, are registered with the Securities and Exchange Commission and maintain a
stable share price of $1 will be eligible to participate in the program. This includes both taxable and non-taxable
funds.

When will my fund be covered by the program?

Each fund must decide to participate in the program. If your fund participates in the program, your investment as
of September 19, 2008 will be covered.

How much of an investor's money market fund is insured? What happens if the number of shares held in
an investor's account increase above the level at the close of business on September 19, 2008? What
happens if the number of shares held in an investor's account decreases below the level at the close of
business on September 19, 2008?

The program provides a guarantee based on the number of shares held at the close of business on September
19, 2008. Any increase in the number of shares held in an account after the close of business on September 19,
2008 will not be guaranteed. If the number of shares held in an account fluctuates over the period, investors will
be covered for either the number of shares held as of the close of business on September 19, 2008 or the
current amount, whichever is less.

Examples include:

If an investor owned 100 shares in a money market fund as of close of business September 19, 2008, but
owns 50 shares on the day the guarantee payment is made, after the fund breaks the buck, then that
 investor will be guaranteed for 50 shares.
If an investor owned 100 shares in a money market fund as of close of business September 19, 2008, but
owns 150 shares on the day the guarantee payment is made, after the fund breaks the buck, then that
investor will be guaranteed for 100 shares. The fund, upon liquidation, will distribute proceeds to the
shareholder for the additional 50 shares, at net asset value.
If an investor owned 100 shares in a fund as of close of business September 19, 2008, subsequently sold 50
shares and later bought 25 shares, the investor owns 75 shares on the day the guarantee payment is
made and will be guaranteed for 75 shares.
If an investor owned no shares in a fund as of close of business September 19, 2008, but owns 100 shares on
the day the guarantee payment is made, none of the investor's shares are guaranteed by the program
and the investor will receive the net asset value directly from the fund.

What if another fund in an investor's fund family breaks the buck before this program starts? Is the
investor covered?

The program provides a guarantee on a fund-by-fund basis up to the amount of shares held as of the close of
business on September 19, 2008. The performance of a different fund, even one in the same fund family of the
investor's fund, doesn't affect the investor's fund's eligibility. Investors should contact their fund to determine if
their fund participates in the program.

When does the program terminate?

The program is designed to address temporary dislocations in credit markets. The program will be in effect for an
initial three month term, after which the Secretary of the Treasury will review the need and terms for the program
and the costs to provide the coverage. The Secretary has the option to extend the program up to the close of
business on September 18, 2009. In order to maintain coverage, funds would have to renew their participation in
the program after each extension. If the Secretary chooses not to extend the program at the end of the initial
three month period, the program will terminate.

Who provides this guarantee? Are investors able to get all of their money back whenever they want?

The U.S. Treasury Department, through the Exchange Stabilization Fund, is providing this guarantee. In the
event that a participating fund breaks the buck and liquidates, a guarantee payment should be made to investors
through their fund within approximately 30 days, subject to possible extensions at the discretion of the Treasury.

Is shareholder in a fund that broke the buck before September 19, 2008 covered?

No. This does not meet the program's eligibility criteria noted above.

What should shareholders in a participating fund that breaks the buck do? Who should they call?

If your fund enrolled in the program you will be covered and do not need to take any action. Shareholders should
contact their fund directly.

Who should a fund contact if it has further questions about this program?

U.S. Senate passes bailout plan; House to vote Friday

October 2, 2008
The Senate strongly endorsed the $700 billion economic bailout plan Wednesday, leaving backers
optimistic that the easy approval, coupled with an array of popular additions, would lead to House
acceptance by Friday and end the legislative uncertainty that has rocked the markets.

In stark contrast to the House rejection of the plan on Monday, a bipartisan coalition of senators —
including both presidential candidates — showed no hesitation in backing a proposal that had
drawn public scorn, though the outpouring eased somewhat after a market plunge following the
House defeat. The Senate margin was 74 to 25 in favor of the White House initiative to buy troubled
securities to ease a growing credit crunch.

The presence in the Senate of both presidential candidates in the final weeks of the campaign gave
weight to the moment. The political tension was clear as Senator Barack Obama walked to the
Republican side of the aisle to greet John McCain, who offered a chilly look and a brief return
handshake.

McCain did not make remarks on the legislation. Obama, in his speech, said the bailout plan was
regrettable but necessary and he referred to the stock market drop after the House vote. "While that
decline was devastating, the consequences of the credit crisis that caused it will be even worse if
we do not act now," he said.

In the House, officials of both parties said they were increasingly confident that politically enticing
provisions bootstrapped to the original bill — including $150 billion in tax breaks for individuals and
businesses — would win over at least the dozen or so votes needed to reverse Monday's outcome
and send the measure to President George W. Bush.

The stock market reflected nervous jitters over a vote that was to occur after it closed, but that could
affect the future of many Wall Street workers. The Dow Jones industrial average was off almost 220
points during the day, but recovered to close down just 19.6 points, or 0.2 percent, at 10,831.07.

Stock markets in Asia rose early Wednesday morning in anticipation of Senate passage of the
legislation, only to fall soon after the Senate had finished voting in what market analysts described
as a classic case of investors buying on the expectation of good news and then selling on
confirmation of the news.

Many investors in Asia are uncertain about whether the final details of the legislation will be enough
to help American financial institutions with their heavy losses or to prevent the United States
economy from slowing significantly, said Thomas Lam, the senior treasury economist at the United
Overseas Bank in Singapore. "The situation in the U.S. is still pretty hairy," he said.

By mid-morning on Wednesday, the Hang Seng Index was down 2 percent in Hong Kong, the
Nikkei 225 had fallen 1.1 percent in Tokyo, the Kospi had dropped 0.7 percent in Seoul and the
Standard and Poor's/Australian Stock Exchange 200 Index had dipped 0.5 percent in Sydney and
the Straits Times Index had declined 0.4 percent in Singapore.

Besides the tax breaks, senators also made a change that had drawn widespread support in recent
days — an increase in the amount of bank deposits covered by the Federal Deposit Insurance
Corp., to $250,000 from $100,000. And the entire package was attached to legislation requiring
insurers to treat mental health conditions more like general health problems — a long-sought goal
of Domenici and other lawmakers who demanded such parity.

As the shape of the new bill became clearer Wednesday, some House Republicans and Democrats
indicated that the changes were enough to get them to take another look at the measure and
perhaps change their minds — even though the new items being added would substantially
increase the burden on taxpayers.

Representative John Yarmuth, a Kentucky Democrat who on Monday voted no, said he found the
new proposal more acceptable, as did Representative Jim Ramstad, a retiring Republican from
Minnesota who voted in opposition as well.

"The inclusion of parity, tax extenders and the FDIC increases has caused me to reconsider my
position," Ramstad said. "All three additions have greatly improved the bill."
Leaders of both parties in the House, who spent much of Wednesday on the phone taking the
temperature of lawmakers not scheduled to return until Thursday, said they were identifying other
potential converts as well, and were finding a more receptive audience for the revised measure
because of the tax package and other changes.

Some conservative House Republicans and liberal Democrats remained adamantly opposed. "The
bailout legislation that the Senate is sending back to the House is a fraternal twin to the one I voted
against on Monday — meet the new bill, same as the old bill," said Representative Joe Barton,
Republican of Texas.

While popular, the tax breaks, which had been the center of a bitter dispute between House and
Senate Democrats, caused problems as well.

A coalition of centrist Democrats led by Representative Steny H. Hoyer of Maryland, the majority
leader, had refused to back the tax benefits unless they were deficit neutral — offset by tax
increases or spending cuts elsewhere. The bill now includes the Senate version of the tax plan,
which adds most of the cost to the deficit over the next decade.

But the Senate leaders decided to present the House with a take-it-or-leave-it choice, and it is
possible some Democrats could desert the bill over the tactic.

Hoyer said he was disappointed in the Senate's decision and worried it could cost Democratic
votes. "Certainly there are people who are upset we are making the deficit worse as we are trying to
stabilize the economy," Hoyer told reporters. But in a telephone conference call among the
Democratic leadership Wednesday morning, he told his colleagues he would back the measure
because the economic rescue needed to take priority, according to participants.

In the end, Senate leaders decided to overcome some of the ideological and political resistance that
doomed the measure in the House with the tried-and-true congressional approach of stuffing the bill
with provisions that would make it hard for many lawmakers to resist.

"All I'm trying to do is get this thing passed," said Senator Harry Reid, Democrat of Nevada and the
majority leader, denying he was trying to jam the House by giving members no choice but to accept
the tax proposal he favored or again reject the bailout.

The multiple tax breaks, called extenders in the Capitol because they renew or extend expiring tax
benefits, appeal to many lawmakers and could provide a political argument for backing a bill that
has otherwise been very unpopular.

Instead of siding with a $700 billion bailout, lawmakers could now say they voted for increased
protection for deposits at the neighborhood bank, income tax relief for middle class taxpayers and
aid for schools in rural areas where the U.S. government owns much of the land.

"This bill has been packaged with a lot of very popular things to give it even more momentum," said
Senator Jeff Sessions, a Republican from Alabama, who is an opponent.

The approximately $150 billion in new tax breaks, which offer incentives for the use of renewable
energy and relieve 24 million households from an estimated $65 billion alternative-minimum tax
scheduled to take effect this year, would be offset by only about $40 billion in spending cuts or tax
increases elsewhere.

Moreover, the increase in federal deposit insurance will not be funded over the short-term, as the
insurance program now is, by assessing premiums on banks that benefit. Instead, banks will get an
open-ended line of credit directly to the Treasury Department. But the congressional Budget Office
noted Wednesday that U.S. law requires the banks to eventually make up any shortfall and any
loans to be repaid, though not until at least 2010.
 The changes in the bill were measurable by volume. The initial proposal from the Treasury
Department ran just three pages; the latest version exceeds 450.

After receiving the proposal from Treasury Secretary Henry Paulson Jr. almost two weeks ago,
Congress instituted a series of changes, including additional oversight, steps to limit home
foreclosures and restrictions on the compensation of executives of institutions that take part in the
Treasury program.

Under pressure to tighten the plan even more, congressional and administration negotiators
decided to parcel out the $700 billion in installments, starting with a first tranche of $350 billion. And
during a weekend of negotiations, they added as a final backstop a requirement that in five years
the president must present Congress with a plan to make up any losses of tax funds by assessing
the financial community. The Congressional Budget Office pointed out, however, that the provision
does not require Congress to enact it.

Beyond what they described as the fragile economy, lawmakers and aides said they saw another
factor in the new drive to dispose of the bill and recess Congress for the elections. Polls suggest the
economic fight is taking a toll on Republicans and their presidential candidate, McCain, and they
want to put it behind them.

"We have to get out of here and get our guys back home campaigning," said a senior Senate
Republican aide who did not want to be quoted expressing

Foreign exchange--The buck swaps here

Oct 2nd 2008
Central banks ease the market’s pain

A BIG problem for the banks has been a shortage of dollars in the money markets; particularly in
the European morning before the New York market opens. That is one reason why dollar interest
rates have been so high relative to those for euros.

Normally, investors and banks would arrange foreign exchange swaps among themselves,
agreeing to switch euros into dollars for a set period. But banks are nervous about the risk that their
counterparty will go bust while the swap is being put in place and so are shying away from such
agreements.

Hence the facility set up by the Federal Reserve on September 29th to supply $620 billion to its
counterparts, so that they can lend them on to banks. At first glance, this may seem to be a back
door bail-out on a similar scale to the plan proposed by Hank Paulson, the American treasury
secretary.

There are some similarities in that the central banks involved in the swaps make loans secured on
assets that commercial banks pledge as collateral. If that collateral falls in value, the central banks
could lose money. But the collateral is generally of much higher quality than the troubled assets that
were the subject of the bail-out plan, and the central banks generally apply a discount when
assessing the collateral’s value. Furthermore, the Fed (and thus the American taxpayer) is lending
its currency directly to other central banks, and thus has no real credit risk.

Global banks--On life support

Oct 2nd 2008
Governments in America and Europe scramble to rescue a collapsing system

AFTER lurching robotically into their worst crisis in more than three-quarters of a century, the
fundamental weakness of banks in America and Europe has now become horribly clear. With funding
markets frozen and American plans to remove toxic assets from banks’ balance-sheets in limbo for much
of this week, confidence in a raft of institutions evaporated. Between September 28th and 30th,
governments on both sides of the Atlantic shored up or split up six banks threatened by failure. Other
institutions remain on high alert.

Observers scratch their heads to think of any other industry that has been reshaped so quickly or so
dramatically. In America, where the authorities have helped to shovel failing banks into the hands of
bigger ones, the retail-banking landscape now has three towering figures. On September 25th JPMorgan
Chase overtook Bank of America as the country’s largest deposit-taking institution by snapping up the
assets and deposits, but not the other liabilities, of Washington Mutual (WaMu), a Seattle-based savings-
and-loan bank that had been suffocated by bad mortgage loans.

Four days later Citigroup, its risks capped by a loss-protection agreement with the Federal Deposit
Insurance Corporation (FDIC), strengthened its domestic deposit base by acquiring the banking
operations of Wachovia. Further consolidation is likely. Jim Eckenrode, an analyst at Tower Group, a
consultancy, reckons that a top tier of five banks (Wells Fargo and US Bancorp are two other contenders)
may end up holding as much as half of America’s deposits.

In Europe the pace of consolidation has not been quite as rapid but the scale of government intervention
is just as breathtaking. The continent has turned into a laboratory of bank bail-outs. One approach has
been to inject equity into institutions and try to keep the show on the road. Fortis, a Belgo-Dutch bank
overstretched by its role in acquiring ABN AMRO, is now part-owned by the Benelux governments. The
Icelandic government has taken a 75% stake in Glitnir, a bank with outrageous reliance on gummed-up
wholesale funding markets. The French, Belgian and Luxembourgeois authorities stumped up €6.4 billion
($9.3 billion) to bolster the capital base of Dexia, a public-sector lender that dabbled fatally in bond
insurance.

Another approach has been to borrow from the American model, parceling out the good bits of failing
banks to solvent rivals and keeping the rest. The deposits and branches of Bradford & Bingley, a British
mortgage lender that made Northern Rock look well managed, are now in the hands of Santander, a
respected Spanish bank. Its mortgage book now rests with the luckless taxpayer. Germany’s Hypo Real
Estate, a commercial-property lender which found that the tenor of its funding was becoming shorter as
investors shied away from long-term lending, got help of a different sort—a €35 billion secured-credit
facility from a consortium of unnamed German banks and the government.

The most sweeping intervention of all came from Ireland’s government, where concerns about spiking
credit-default swap (CDS) spreads, falling share prices and jittery depositors led the finance minister to
announce, on September 30th, a blanket guarantee on the deposits and almost all the debts of the
country’s six biggest banks until September 2010. “The Irish move confirms that this is a systemic crisis
in certain countries,” says Simon Adamson of CreditSights, a research firm. Investors and creditors of
Irish banks liked the move, which recalled one of the actions taken by Sweden during its feted 1990s bail-
out. The European Commission and other banks, worried about deposit flight to Ireland, are bound to be
less enthused.

Safe as houses

All this activity had one immediate prize: not a single bank needed rescuing on October 1st. But for those
with longer-term horizons, the future remains bleak, and in some ways, worse than before. There are two
sources of pressure on the banks. To date government intervention has tended to focus on one or the
other, but not both.

The first source of pressure is concern about solvency, and the ability of banks to withstand further
losses. The unexpected rejection of the American bail-out plan on September 29th cast doubt on one
obvious mechanism to remove the worst-performing assets from banks’ balance-sheets. But even if it is
revived, as most expect, the cycle of losses will continue as the drumbeat of bad economic news
intensifies. WaMu and Wachovia were undone not by mark-to-market losses, after all, but by the
appalling quality of their loan books. It is the same story in many parts of Europe.
The second source of pressure is liquidity. Even the most solid-looking banks are having trouble raising
long-term debt. As their debt matures, they are having to refinance with shorter-term debt, ratcheting up
their costs and their vulnerability to a sudden withdrawal of credit. If banks have enough funding through
deposits, problems in the wholesale markets should be navigable. But others are much weaker. Witness
the continuing pressures on Morgan Stanley and Goldman Sachs, despite their conversion into bank
holding companies. Mitsubishi UFJ, a Japanese bank, lost more than $500m on its $9 billion investment
in Morgan Stanley on September 29th, the day the deal was inked.

The problem is that attempts to shore up liquidity do not necessarily address the capital shortfalls, and
vice versa. Even Ireland’s lavish guarantee does not quell concerns about rising impairments on the Irish
banks’ property portfolios. Glitnir’s capital ratio looks robust after the government’s investment, for
example, but its CDS spreads still surged, indicating rising fears of a national crisis (see chart).

Worse still, the effect of most government interventions, necessary as they are, is to make it even harder
for private investors to heal the system on their own. Shareholders are losing both money and
reputations as bank failures multiply. TPG, a vaunted private-equity firm, was wiped out by the collapse of
WaMu. Shareholders in Wachovia, Fortis and Bradford & Bingley had all recently dipped into their
pockets to raise fruitless capital. The risk of sudden dilution by governments, or worse, hangs darkly over
prospects for industry recapitalization. Creditors have also become far more risk-averse in recent days,
thanks to the bankruptcy of Lehman Brothers and the brutal treatment of WaMu’s senior creditors. Hypo
Real’s new credit line will presumably have shunted unsecured creditors down the queue too.

So far only the Irish solution has avoided this adverse effect, by indemnifying most creditors and allowing
shareholders to reap the subsequent gains. Moral hazard, it seems, can go hang. So too can other
governments, which are under pressure to match the Irish guarantee but may not be able to, either
because their sovereign-debt rating is less strong or because the liabilities of their banks are too big.

There are other dangers in the rapid consolidation of the sector. A world of fewer, bigger banks promises
even greater havoc if one was ever to fail. The universal banks have remained largely above the fray in
recent days, but on October 1st, UniCredit, a big Italian bank, announced plans to raise its capital ratio by
spinning off property assets. If banks of this size and geographical scope were to get sucked into the
mire, the consequences would be devastating. In the meantime, they have little choice but to present a
steely exterior and carry on as if nothing were wrong.

Rethinking Lehman Brothers

The price of failure
The government must privately rue its hard line towards Lehman

Oct 2nd 2008

CONFRONTED by blaze after blaze in recent weeks, America’s financial firemen have rushed to
douse the flames—with one exception. Unable to persuade any rival to take on a battered Lehman
Brothers, the government was left with a hard choice: spray the investment bank with public money
or let it burn. In choosing destruction, the government has provided a painful lesson in the dangers
of doing the right thing at the wrong time.

In a sense, Lehman’s misfortune was not to have hit trouble earlier. After broking the sale of Bear
Stearns, another Wall Street firm, and nationalizing the country’s mortgage agencies, officials felt
an example needed to be made so as to combat “moral hazard”, or the risk that banks will act
recklessly if they know they will be bailed out when their bets sour. Hank Paulson, the treasury
secretary, believed Lehman’s problems were sufficiently well advertised to have given derivatives
markets time to prepare for the worst.

He was partly right: the credit-default swaps market has buckled but not broken. But Lehman’s
bankruptcy shredded the last remnants of confidence in American International Group, an insurer,
and crystallized fears over the stability of the remaining free-standing investment banks, Goldman
Sachs and Morgan Stanley. Alarm over “counterparty” risk—the risk of a borrower or trading partner
failing to cough up—turned into outright terror, paralyzing money markets. “It was the mistake of a
lifetime,” says one senior bank executive, echoing the view across Wall Street.

Lehman went bust with $613 billion of debt, of which $160 billion was unsecured bonds held by an
array of investors around the world, including European pension funds and individuals in Asia who
had taken comfort in Lehman’s high credit rating. The price of this paper quickly collapsed to 15
cents on the dollar or less, destroying overnight twice as much value as Lehman’s shareholders
had seen evaporate over several months.

These losses set off a spiral in money markets. Investors yanked $400 billion from money-market
funds, a supposedly super-safe source of funding, when one fund that had loaded up on Lehman
debt suffered losses. The run was halted by a government pledge to guarantee money funds’ par
value, but it stripped money funds of all appetite for risk. Their flight into safe government and
mortgage-agency paper has left banks and companies struggling to raise working capital.

Had officials foreseen this debacle, Lehman would surely have been propped up. One theory doing
the rounds is that they seriously underestimated the money funds’ holdings of its debt. As they
fretted over Lehman’s vast notional exposures in swaps, they may have taken their eye off the
potential impact of its failure on more prosaic cash markets.

Taken aback, policymakers now seem unsure how much protection to offer creditors of other
basket-cases. When Washington Mutual (WaMu), America’s largest savings-and-loan institution,
was hurriedly sold to JPMorgan Chase on September 25th, its bondholders lost everything. This
infuriated senior debt holders, who felt the seizure deprived them of the chance to recover some of
their money through a public liquidation. Wachovia’s creditors were spared that fate in the bank’s
equally rushed sale to Citigroup a few days later. There was some justification for this different
treatment: Wachovia has much more short-term debt than WaMu, so wiping out its creditors would
have caused a bigger shock. Still, to some, America’s bail-out policy looks haphazard.

The full costs of Lehman’s failure have yet to be determined, both in terms of the damage to credit
markets and the losses inflicted on its creditors and trading partners. Its swap exposures are still
being unwound. Recovery values on its bonds could be anything from pennies to more than 30
cents on the dollar. Dozens of hedge funds that used Lehman as a prime broker are fighting for the
return of assets. The task is complicated by the fact that the firm used some of these as collateral
for its own loans. Its bankruptcy is by far the messiest in American corporate history.

Throughout this crisis, Mr Paulson’s Treasury has stressed the importance for the long-term health
of the financial system of letting sick financial institutions fail. In highly stressed markets, however,
there are short-term costs. In Lehman’s case they are proving almost unbearably onerous.

Thanks to the Wing Nuts

October 3, 2008

We all owe a debt of thanks to the wing nuts and the populists, the soldiers of the far left and (gulp)
the far right, the know-nothings and the know-it-alls, the income redistributionists and the free-
market fundamentalists -- all the skeptics who refused to be steamrollered by the Bush
administration's $700 billion financial bailout plan until we had at least some understanding of what
we were doing and why.

Since the risk of a Wall Street meltdown is still very real, and since nobody has come up with a
better idea, the bailout should go forward. It will probably save the homes and livelihoods of millions
of Americans. But it will do so by absolving some of our wealthiest citizens of the consequences of
their shortsightedness, dishonesty and greed.

Everyone knew we were in a housing bubble. Across the country, real estate prices were rising so
fast that anyone thinking about buying a home had one logical course of action: Do it now. Anyone
who already owned a home, especially in one of the red-hot markets, was building equity -- or what
looked like equity -- so rapidly that there seemed no harm in pulling money out, even to pay for
luxuries, since the property was going to keep appreciating. The nation was awash in cheap money,
and everyone who owned a house was going to be rich.

As long as housing prices continued to rise, all was well. Any individual homeowner who ran into
trouble with an adjustable-rate or interest-only mortgage could be refinanced back to financial
health.

But bubbles inevitably burst, and here's where the mendacity and greed come in.

Wall Street, in its collective wisdom, knew that housing prices couldn't rise indefinitely at such an
unprecedented rate. Yet Wall Street created a gargantuan market in securities and insurance, worth
many trillions of dollars, based on the premise that the impossible -- a housing bubble that expands
forever and lasts forever -- had become inevitable.

The traders who invented, sold and resold these mortgage-backed instruments, making profits and
commissions with every transaction, knew what legendary swindler Charles Ponzi knew: that those
who got into and out of the market while housing prices were still rising would make a lot of money,
and that when prices fell someone would be left holding the bag.

To find out who that someone is, dear reader, look in the mirror.

Unfortunately, telling Wall Street to clean up its own mess isn't an option. Already, the nation's
largest insurer, the nation's largest savings and loan, many of Wall Street's major investment banks,
and the mortgage giants Fannie Mae and Freddie Mac have either gone belly-up, been sold or
been nationalized. Commercial banks are gasping for air. Somebody has to do something to get
credit flowing through the economy again, and the only entity big enough for the job is the federal
government.

There may be more effective remedies than the one outlined by Treasury Secretary Henry Paulson.
But I'm persuaded that it would be unwise to spend a lot more time looking for a better solution --
and also that any solution is likely to be similarly expensive.

It's a good thing, though, that we've had a couple of weeks to take stock. Congress can call this a
"rescue plan" and festoon it with all kinds of bells and whistles, but it's still a bailout that lets Wall
Street off the hook. And in the end, despite some limits on executive compensation and stirring
words about oversight, it promises nothing but a temporary setback for the "greed is good" Wall
Street mentality that created this awful situation. Gordon Gekko will just lie low while the heat's on,
then come back with a vengeance. The environment's getting hot, in more ways than one; maybe
the next phantom market will be in pumped-up securities somehow based on "clean" technology.

Do we as a nation really care about those struggling homeowners who bought more house than
they could afford because that was the only way for them to keep from slipping out of the middle
class? Do we care that medical expenses, for the 46 million uninsured, are a chief cause of
bankruptcy? Do we care that income distribution is worsening and we're rapidly becoming a nation
not of haves and have-nots, but of haves and never-gonna-gets?

"Reform" has suddenly become a popular word in Washington. If it's to have any meaning at all,
Congress and the new president will have a lot more work to do.

SEC move may relax asset rule

By Floyd Norris-October 1, 2008
Under pressure from banks and legislators, the Securities and Exchange Commission issued an
interpretation of an accounting standard that could make it easier for banks to report smaller losses,
or perhaps even profits, when they announce results for the third quarter, which ended Tuesday.

The move on Tuesday drew praise from the American Bankers Association, which had complained
to the SEC that auditors were forcing banks to value assets at unrealistically low "fire sale" prices,
rather than at the higher values the banks believe the assets should be worth in an orderly market.

Some congressmen had pressed to order a suspension of the fair-value rule, known as SFAS 157,
as part of the bailout bill that the House defeated on Monday but that may be revived later in the
week. That bill stopped short of that, but did require a study of the rule and authorized the SEC to
suspend it.

The SEC said it was interpreting, not changing, the mark-to-market rule. Nonetheless, the
immediate praise from the bankers could reduce the pressure to drop the rule and make it easier for
some legislators to change their votes.

The commission’s chief accountant and the staff of the Financial Accounting Standards Board
issued the statement jointly. While the rule has been criticized by many banks, others have argued
that the problem was caused by the banks' purchase of risky assets.

In a report earlier this year, Dane Mott and Sarah Deans, analysts for JPMorgan, argued that
"blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and
then blaming him for telling you that you are sick."

On Tuesday, they said there was "nothing new" in the SEC statement, but some other analysts
thought it could make a difference.

Companies have long been required to mark many financial assets to their fair value, but rule 157
clarified how that was to be measured, saying that market values should be used if they are
available.

Many mortgage securities have plunged in value, forcing large write-offs by financial institutions that
own them. Bankers have argued that the current market prices are far below what the securities
should be worth, and say that they should not be forced to take write-downs that are sure to be
reversed later.

The rule had exceptions, saying that "distress sales" need not be used as the basis for reporting,
but it was unclear how broadly that could be interpreted. Some auditors argued that more than one
or two sales at a level provided a real market price, and thus should be used for valuing that
security and similar ones.

"More and more of our members in recent weeks have raised concerns that a number of accounting
firms were mistakenly interpreting SFAS 157 in a way that required marking assets to fire-sale
values," Edward Yingling, the president of the American Bankers Association, said as he praised
the SEC for the interpretation. "This guidance will help auditors more accurately price assets that
are difficult to value under current market conditions."

Yingling said the bankers had held "a productive meeting" on Thursday with staff members from
both the SEC and the accounting board, as well as representatives of the major accounting firms.

Under rule 157, there is a hierarchy of valuation techniques. The first is when there is an active
market for a security, which must always be used. If there is no such market, level two is based on
prices of similar securities. Only if those are not available is level three to be used, which depends
on the company's model of value in the absence of a usable market price.

"They're saying that in some cases, using level three might be more appropriate than using level
two," said Patrick Finnegan, the director of the financial reporting policy group of the CFA Institute,
a group of securities analysts.

The statement did that by providing more definition of what was an inactive market, whose prices
sometimes can be ignored, and of what constituted a disorderly market.

"The results of disorderly transactions are not determinative when measuring fair value," the
statement said. "The concept of a fair-value measurement assumes an orderly transaction between
market participants. An orderly transaction is one that involves market participants that are willing to
transact and allows for adequate exposure to the market. Distressed or forced liquidation sales are
not orderly transactions, and thus the fact that a transaction is distressed or forced should be
considered when weighing the available evidence. Determining whether a particular transaction is
forced or disorderly requires judgment."

Banks could use the phrase "adequate exposure to the market" to justify not using privately
negotiated sales of mortgage securities to value similar securities held by others. Finnegan pointed
to the sale this year by Merrill Lynch of mortgage-related securities at 22 cents on the dollar. The
sale was made to a private equity firm, and details of which securities were included was not
disclosed.

"This is probably giving you some leeway," he said. "With this guidance, you could say I can ignore
that transaction and use a level three approach. While it is not disorderly, it does not meet the
definition of orderly."

Finnegan said that while investors might not agree with those decisions, the interpretation would be
acceptable so long as it was accompanied by adequate disclosures.

"Investors can be well served if they understand that, from quarter two to quarter three,
management has developed a different interpretation of fair value, and they provide a reconciliation
of the changes," he said.

Companies now must report on assets moved between levels, but it is not clear if they would have
to disclose that the move came about because of a different interpretation of the rule, rather than a
change in the availability of market information.

Congress OKs historic bailout bill; Bush signs it

Oct. 3, 2008
With the economy on the brink and elections looming, Congress approved an unprecedented $700
billion government bailout of the battered financial industry on Friday and sent it to President Bush
who quickly signed it.

"We have acted boldly to help prevent the crisis on Wall Street from becoming a crisis in
communities across our country," Bush said shortly after the vote, although he conceded, "our
economy continues to face serious challenges."

Underscoring that somber warning, the Dow Jones industrials, up more than 200 points at the time
of the House vote, ended the day down 157.

The final vote, 263-171 in the House, capped two weeks of tumult in Congress and on Wall Street,
punctuated by daily warnings that the country confronted the gravest economic crisis since the
Great Depression if lawmakers failed to act. There were 58 more votes for the measure than an
earlier version that failed on Monday.

"We all know that we are in the midst of a financial crisis," House Republican leader John Boehner
of Ohio said shortly before casting his vote for a massive government intervention in private capital
markets that was unthinkable only a month ago. "And we know that if we do nothing, this crisis is
likely to worsen and to put us into an economic slump like most of us have never seen," he said.

House Speaker Nancy Pelosi, D-Calif., said the bill was needed to "begin to shape the financial
stability of our country and the economic security of our people." Treasury Secretary Henry
Paulson pledged to begin using his new authority quickly, and Federal Reserve Chairman Ben
Bernanke said the central bank would work closely with the administration.

Wall Street welcomed the action, but investors also were buffeted by a bad report on the job
market. The Labor Department said employers slashed 159,000 jobs in September, the largest cut
in five years and further evidence of a sinking economy.

At its core, the bill gives the Treasury Department $700 billion to purchase bad mortgage-
related securities that are weighing down the balance sheets of institutions that hold them.
The flow of credit in the U.S. economy has slowed, in some cases drying up, threatening the ability
of businesses to conduct routine operations or expand, and adversely affecting consumers seeking
financing for mortgages, cars and student loans. Some state governments have also experienced
difficulty borrowing money.

The House vote marked a sharp change from Monday, when an earlier measure was sent down to
defeat, largely at the hands of angry conservative Republicans.

On Friday, 91 Republicans joined 172 Democrats to support the bill, while 108 Republicans and 68
Democrats opposed it. Twenty-five Republicans and 33 Democrats switched their votes from "no" to
"yes." One Democrat who supported Monday's version, Rep. Jim McDermott of Washington,
opposed the bill Friday. One Republican, who didn't vote Monday, Rep. Jerry Weller of Illinois,
voted "yes" on Friday.

Several of the Democrats who switched were members of the Congressional Black Caucus who
said presidential candidate Barack Obama had pledged to support legislation easing the burden on
consumers if he wins the White House. Republican presidential candidate John McCain also
lobbied for the measure, according to aides who declined to release a list of lawmakers he called.

Following Monday's vote, Senate leaders quickly took custody of the measure, adding on $110
billion in tax and spending provisions designed to attract additional support, then grafting on
legislation mandating broader mental health coverage in the insurance industry. The revised
measure won Senate approval Wednesday night, 74-25, setting up a furious round of lobbying in
the House as the administration, congressional leaders, the major party presidential candidates and
outside groups joined forces behind the measure.

In addition, the measure was changed to broaden the federal government's deposit insurance
program, and the Securities and Exchange Commission loosened a regulation to ease the impact of
the distressed assets on the balance sheet of financial institutions.

Despite occasionally strong criticism of the added spending and tax measures, the maneuvers
worked — augmented by a sudden switch in public opinion that occurred after the stock market
took its largest-ever one-day dive on Monday. "No matter what we do or what we pass, there are
still tough times out there. People are mad — I'm mad," said Republican Rep. J. Gresham Barrett of
South Carolina, who opposed the measure the first time it came to a vote. Now, he said, "We have
to act. We have to act now."
Rep. John Lewis, D-Ga., another convert, said, "I have decided that the cost of doing nothing is
greater than the cost of doing something."

Critics were unrelenting.

"How can we have capitalism on the way up and socialism on the way down," said Rep. Jeb
Hensarling of Texas, a leader among conservative Republicans who oppose the central thrust of
the legislation — an unprecedented federal intervention into the private capital markets.

It was little more than two weeks ago that Paulson and Bernanke concluded that the economy was
in such danger that a massive government intervention in the private markets was essential.

White the main thrust of their initial proposal was unchanged, lawmakers insisting on greater
congressional supervision over the $700 billion, measures to protect taxpayers and steps to crack
down on so-called "golden parachutes" that go to corporate executives whose companies fail.

Earlier in the week, the legislation was altered to expand the federal insurance program for
individual bank deposits, and the Securities and Exchange Commission took steps to ease the
impact of the questionable mortgage-backed securities on financial institutions.

In the moments before the vote, Rep. Barney Frank, D-Mass., chairman of the House Financial
Services Committee, pledged "serious surgery" next year to address the underlying causes of the
crisis.

If anything, the economic news added to the sense of urgency.

The Labor Department said initial claims for jobless benefits had increased last week to the highest
level since the gloomy days after the 2001 terror attacks. The news of the payroll cuts came on top
of Thursday's Commerce Department report that factory orders in August plunged by 4 percent.

Typifying arguments the problem no longer is just a Wall Street issue but also one for Main Street,
lawmakers from California and Florida said their state governments were beginning to experience
trouble borrowing funds for their own operations.

Pelosi said, "We must win it for Mr. and Mrs. Jones on Main Street."

One month before Election Day, the drama unfolded in an intensely political atmosphere. Members
of the Congressional Black Caucus credited Obama with changing their minds.

Reps. Elijah Cummings and Donna Edwards, both Maryland Democrats, were among them. They
said Obama had pledged if he wins the White House that he would help homeowners facing
foreclosure on their mortgages. He also pledged to support changes in the bankruptcy law to make
it less burdensome on consumers.

Obama's rival, Republican Sen. McCain, announced a brief suspension in his campaign more than
a week ago to try and help solve the financial crisis.

Republican Rep. Sue Myrick of North Carolina, who switched her vote to favor the measure, said, "I
may lose this race over this vote, but that's OK with me. This is the right vote for the country."

Myrick said she hadn't heard from McCain as she made up her mind about how to vote. "They told
me he was going to call me. He didn't," she said.

The vote on Monday had staggered the congressional leadership and contributed to the largest
one-day stock market drop in history, 778 points as measured by the Dow Jones Industrials.

36 hours of alarm and action as crisis spiraled

October 2, 2008

It was early on Wednesday, Sept. 17, when executives at Pershing Square, Bill Ackman's hedge
fund, began getting nervous calls and e-mail messages from investors. Ackman, 42, has been a top
Wall Street player for 15 years, making his clients - and himself - billions of dollars.

But now, Ackman and his colleagues were taken aback by what they were hearing. His big
investors were worried about all of the Pershing assets held by Goldman Sachs, the blue-chip
investment bank, whose stock had come under siege.

Never mind that Goldman kept Pershing's assets in a segregated account, and that the money was
safe. And never mind that Ackman believed Goldman was the world's best-run investment bank and
would come through the credit crisis unscathed. Pershing investors still feared their money might be
exposed.

Ackman advised Goldman executives to do something to restore confidence - like getting an

infusion of capital from Warren Buffett, the billionaire investor. And while Ackman kept his assets at
Goldman, he hurriedly set up accounts at three other institutions - just in case things got much
worse.

Pershing had more faith than most. Up and down Wall Street, hedge funds with billions of dollars at
Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out
and looking for safer havens.

Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors
in the United States and other financial centers around the world - not small investors - were
panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a global credit crisis looks like. It is not like a stock market crisis, where the scary
plunge of stocks is obvious to all. The credit crisis has played out in places most people cannot see.
It is banks refusing to lend to other banks - even though that is one of the most essential functions
of the banking system. It is a loss of confidence in seemingly healthy institutions like Morgan
Stanley and Goldman - both of which reported profits, even as the pressure was mounting. It is
panicked hedge funds pulling out cash.

It is frightened big investors protecting themselves by buying credit default swaps - a financial
insurance policy against potential bankruptcy - at prices 30 times what they normally would pay. It
was this 36-hour period two weeks ago - from the morning of Sept. 17 in New York and
Washington, to the afternoon of Sept. 18 - that spooked policy makers by opening fissures in the
worldwide financial system.

In their rush to do something, and do it fast, the Federal Reserve chairman, Ben Bernanke, and the
Treasury secretary, Henry Paulson Jr., concluded that the time had come to use the "break-the-
glass" rescue plan they had been developing.

But in their urgency, they bypassed a crucial step in Washington. They fashioned their $700 billion
bailout without doing political spadework, which led to a resounding rejection Monday in the House
of Representatives.
On that Thursday evening, however, time was of the essence. In a hastily convened meeting in the
conference room of the House speaker, Nancy Pelosi, the two men presented, in the starkest terms
imaginable, the outline of the $700 billion plan to congressional leaders. "If we don't do this,"
Bernanke said, according to several participants, "we may not have an economy on Monday."

Setting the stage

Wall Street executives and federal officials had known since the previous weekend that it was likely
to be a difficult week. With the government refusing to offer the same financial guarantees that had
helped save Bear Stearns, Fannie Mae and Freddie Mac, efforts Saturday to find a buyer for
Lehman Brothers had failed.

Sunday was spent preparing to deal with Lehman's bankruptcy, which was announced Monday
morning, thrusting global markets into a new phrase of the 14-month-old financial crisis because of
the intricate web of connections between Lehman and just about every international bank.
Merrill Lynch, fearing it would be next, had agreed to be bought by Bank of America. American
International Group was near collapse. (It would be rescued with an $85 billion loan from the
Federal Reserve on Tuesday evening.)

With government policy makers appearing to career from crisis to crisis, the Dow Jones industrial
average plunged 504 points on Monday, Sept. 15. Panic was in the air. At those weekend
meetings, Wall Street executives and federal officials talked about the possibility of contagion - that
the Lehman bankruptcy might set off so much fear among global investors that the market "would
pivot to the next weakest firm in the herd," as one federal official put it.

That firm, everyone knew, was likely to be Morgan Stanley, whose stock had been dropping since
the previous Monday, Sept. 8. In the space of three hours Tuesday, Sept. 16, Morgan Stanley
shares fell an additional 28 percent, and the rising cost of its credit default swaps suggested
investors were predicting bankruptcy.

To allay the panic, the firm decided to report its earnings a day early - after the market closed
Tuesday afternoon instead of Wednesday morning. The firm's profits were terrific - $1.425 billion, a
decline of just 3 percent from 2007 - and the thinking was that would give investors the night to
absorb the good news. "I am hoping that this will generally help calm the market," Morgan Stanley's
chief financial officer, Colm Kelleher, said in an interview late that afternoon.

The spreading contagion

But contagion was already spreading. The problem posed by the Lehman bankruptcy was not the
losses suffered by hedge funds and other investors who traded stocks or bonds with the firms. As
federal officials had predicted, that turned out to be manageable. (That was one reason the
government had not stepped in to save the firm.)

The real problem was that a handful of hedge funds that used the firm's London office to handle
their trades had billions of dollars in balances frozen in the bankruptcy. Diamondback Capital
Management, for instance, a $3 billion hedge fund, told its investors that 14.9 percent of its assets
were locked up in the Lehman bankruptcy - money it could not extract. A number of other hedge
funds were in the same predicament. (When called for comment, Diamondback officials did not
answer the phone.)

As this news spread, every other hedge fund manager had to worry about whether the balances
they had at other Wall Street firms might suffer similarly. And Morgan Stanley and Goldman Sachs
were the two biggest firms left that served this back-office role. That is why Ackman's investors
were calling him.

And that is what caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs,
hedge their exposure by buying credit default swaps that would cover losses if either firm could not
pay money they owed - or do both.
It was fear, not greed that was driving everyone's actions.

Breaking the buck

There was another piece of bad news spooking investors - and government officials. On Tuesday,
the Reserve Primary Fund, a $64 billion institutional money market fund, and two smaller, related
funds, disclosed that they had "broken the buck" and would pay investors no more than 97 cents on
the dollar.

Money market funds serve a critical role in greasing the wheels of commerce. They use investors'
money to make short-term loans, known as commercial paper, to big corporations like General
Motors, IBM and Microsoft. Commercial paper is attractive to money market funds because it pays
them a higher interest rate than, say, U.S. Treasury bills, but is still considered relatively safe.

A run on money funds could force fund managers to shy away from commercial paper, fearing they
were no longer safe. One reason given by the Reserve Primary Fund for breaking the buck was that
it had bought Lehman commercial paper with a face value of $785 million that was now worth little
because of Lehman's bankruptcy.

If money market funds became afraid of buying commercial paper that would make it far more
difficult for companies to raise the cash needed to pay employees, for instance. At that point, it
would not just be the credit markets that were frozen, but commerce itself. Just as important, in the
eyes of federal officials, was that money market funds had long been viewed by investors as akin to
bank accounts - a safe place to store cash and earn interest on that money.

Even though they lacked federal deposit insurance, these funds held $3.4 trillion in assets.
Since that Monday, big institutional investors like pension funds and college endowments had been
pulling money out of money funds. On Tuesday, individual investors joined the stampede.
"We were saying to Treasury and the Fed, at a very high level: Pay attention to this issue. This will
have an impact," recalled Greg Ahern, the chief communication officer for the Investment Company
Institute, the trade group for the mutual fund industry.

But government officials monitoring the crisis did not need the warning. They were already watching
money fund outflows with alarm. Surprisingly, stock investors - feeling better because of the
government's AIG rescue plan - either did not comprehend or ignored the growing chaos in credit
markets; the Dow actually rose 141.51 points on Tuesday.

A dark day

The respite was brief. Wednesday, Sept. 17, was one of those dark, ugly market days that offers
not even a glimmer of hope. Fearing the worst, Alex Ehrlich, the global head of prime services at
the Swiss bank UBS, arrived at work in New York at 5 a.m. and immediately started putting out
fires. Because he ran the firm's prime brokerage unit, clients were calling to see whether their
money was safe. "We were being flooded with client requests to move positions, and the funding
markets, which are critically important to prime brokers, were extremely volatile," he said.
Within seconds of the market opening, the Dow was down 160 points.

Among the big losers was Morgan Stanley. Despite its having disclosed strong earnings late
Tuesday, its stock continued to plummet. The Dow rallied in the afternoon, but went into free fall in
the last 45 minutes, closing down 449 points.

And that was just what investors could see. Behind the scenes, the credit markets had almost
completely frozen up. Banks in the United States and Europe were refusing to lend to other banks,
and spreads on credit default swaps on financial stocks - the price of insuring against bankruptcy -
veered into uncharted waters.

The drain on money funds continued. By the end of business Wednesday, institutional investors
had withdrawn more than $290 billion from U.S. money market funds. In what experts call a "flight
to safety," investors were taking money out of stocks and bonds and even money market funds and
were buying the safest investments in the world: Treasury bills. As a result, yields on short-term
Treasury bills dropped close to zero. That was almost unheard of.

A chief executive's anger

A week before, Morgan Stanley stock had been trading in the mid-40s. On Wednesday, it fell from
$28.70 a share to $21.75 - down about 50 percent over a week. "There is no rational basis for the
movements in our stock or credit default spreads," Morgan Stanley's chief executive, John Mack,
wrote in a company-wide memo Wednesday. Mack lashed out at the people he felt were
responsible for Morgan Stanley's troubles: the short-sellers, who profit by betting that a stock will
fall.

Like most Wall Street firms, Morgan Stanley over the years had handled transactions for short-
sellers, despite complaints by other companies that short-sellers unfairly ganged up on their stock.
Nevertheless, Mack called Senator Charles Schumer, a Democrat of New York, and Christopher
Cox, the chairman of the Securities and Exchange Commission, pressing them to ban short-selling.
He raged about what he viewed as a concerted effort to drive down the firm's stock. "He got
emotional," says one person who knows him well.
Meeting with staff members on Thursday morning as the stock plunged further - hitting a low of
$11.70 at midday - Mack said: "Listen. I know everybody is anxious about the stock price. I'm not
selling any shares, and neither is my team. But I understand if you're nervous and want to sell some
shares." Some did.
At the same time, Mack began talks to merge with Wachovia and called other banks about possible
combinations. He also called Buffett for advice, while aides in Tokyo made contact with Mitsubishi
UFJ, the biggest lender in Japan, hoping to raise additional capital.
A run on a fund
Even as stocks tanked, turmoil was worsening in money markets. On Wednesday evening, Paul
Schott Stevens, the head of the Investment Company Institute, learned about a problem with
another money fund.
"This time it was Putnam," recalled Stevens, referring to the Boston-based mutual fund company
Putnam Investments.
Out of the blue, it seemed, there was a run on the $12.3 billion Putnam Prime Money Market Fund. That
meant the money fund contagion was spreading. Because of huge withdrawals, Putnam decided it had
to shut the fund, and distribute the cash to shareholders.
Executives of the Investment Company Institute and fund officials scrambled to find a solution that
would keep Putnam from having to take that step, but they failed. On Thursday, Putnam shuttered
the fund, then sold it to another company.

The Fed takes action

Ben Bernanke had spent his career studying financial crises. His first important work as an
economist had been a study of the events that led to the Great Depression. Along with several
economists, he came up with a phrase, "the financial accelerator," which described how
deteriorating market conditions could gather speed until they became unmanageable.

To an alarming degree, the credit crisis had played out precisely as his academic work predicted.
But his research had also led Bernanke to the view that "situations where crises have really spiraled
out of control are where the central bank has been on the sideline," according to Mark Gertler, a
New York University economist who has collaborated with Bernanke on some papers.
Bernanke had no intention of keeping the Fed on the sidelines. As the crisis deepened, it took more
aggressive steps.
Among the steps, it agreed to absorb as much as $29 billion in Bear Stearns losses and made an
$85 billion loan to keep AIG afloat. Representative Barney Frank, a Democrat of Massachusetts
who leads the House Financial Services Committee, asked Bernanke if the Fed had $85 billion to
spare. "We have $800 billion," Bernanke replied, according to Frank.

Since the Bear Stearns bailout, Treasury and Fed officials had been discussing what a broad
government intervention might look like. Paulson and Bernanke had both assembled teams to map
out drastic rescue plans - the "break-the-glass" plans. Almost from the start, they concluded the
best systemic solution was to buy hard-to-sell mortgage-backed securities.

On Wednesday morning, during a conference call with other top officials, including Jean-Claude
Trichet, the president of the European Central Bank, Bernanke sounded them out on a big
government bailout. The other officials sounded relieved; their main questions were about whether
Congress could act quickly. That evening, Bernanke told Paulson during a conference call: "You
have to go to Congress. This is pervasive." Paulson agreed.

Asian markets fall

By Thursday morning, the need for dramatic action had grown even more urgent.
In Asia, where the markets had already closed, stocks in Hong Kong had dropped 4.7 percent, and
2.2 percent in Tokyo. To quell fears before the opening of European markets, the Fed and other
central banks announced, at 9 a.m. in Europe, that they would make $180 billion available, in an
effort to get banks to start lending to each other again. The Fed had agreed to open its discount
window to make loans available to money market funds to prevent further runs.

For a time in Europe the central bank actions succeeded in breaking the panic in credit markets and
encouraging a brief rally in the stock markets. But at 8:30 Thursday morning in Washington, when
Paulson and Bernanke reviewed the state of affairs, they remained convinced that the crisis was
not easing up.

One bank's solution

Lloyd Blankfein, Goldman Sachs's chief executive, had arrived at the firm's office in Manhattan just
before 7 a.m. Thursday, anticipating another bad day. The investment bank's stock had already
been pummeled. From a peak of nearly $250 a share last October, it had fallen to $114.50 on
Wednesday - after hitting a low of $97.78 during the day.

One idea Blankfein had been exploring was to transform Goldman into a bank holding company.
Mack, meantime, was also considering such a move for Morgan Stanley, and both were in separate
discussions with the Fed.
There was safety in that notion - they would become depository institutions regulated by the Fed
and others - even though it also meant they would not be able to pile on as much debt as they had
as investment banks. That would hurt profits. But now profits were less pressing than survival.
Blankfein accelerated the planning.

By 1 p.m., the Dow had fallen another 150 points - meaning that in a day and a half it was down
nearly 600 points. Goldman's stock dropped to $85.88, its lowest in nearly six years.
Just then, a prankster piped the national anthem "The 'Star Spangled Banner" over the firm's
loudspeaker system on the 50th floor. Fixed-income traders stopped and stood at attention, some
with hands on their hearts. Oddly, it was at precisely that moment that the U.S. market - and
Goldman's shares - started to rise. The traders began to cheer.

Curbing short-selling

What happened? At 1 p.m. New York time, Britain's Financial Services Authority, which regulates its
financial institutions, announced a ban on short-selling of 29 financial stocks that would last at least
30 days. Realizing that the Securities and Exchange Commission was likely to follow suit, U.S.
hedge funds began "covering their shorts" - that is, buying the stocks they had borrowed to short,
even if it meant taking a loss.

That caused all kinds of stocks to begin rising. Sure enough, the SEC followed suit the next day -
placing a temporary short-selling ban on 799 financial stocks. A few hours later came the second
event. At 3:01 CNBC reported that the Treasury and the Fed were planning a giant fund to buy toxic
mortgage-backed assets from financial institutions. Though there had been hints of this earlier in
the afternoon, and stocks had started rising around 2:30, the wide dissemination set off a huge
rally. In a 45-minute burst, the Dow gained another 300 points, closing the day up 410 points.

Meeting on Capitol Hill

Two hours later, Paulson and Bernanke trooped up to Capitol Hill for a somber session with
congressional leaders. "That meeting was one of the most astounding experiences I've had in my
34 years in politics," recalled Schumer.

As the congressmen and their aides listened, the two laid out their plan. They would begin offering
federal insurance to money market funds immediately, in order to stop the run on money funds.
In addition, the SEC would institute a ban on short-selling of financial stocks. Although Treasury
officials concede the move was mostly symbolic - investors can still buy put options that have the
same effect as shorting stocks - they did it mainly "to scare the hell out of everybody," as one official
put it.

After Bernanke made his remark about the possibility that there might not be an economy on
Monday without this plan, you could hear a pin drop.
Congressional leaders were near unanimous in saying that it needed to be done for the good of the
country. Representative John Boehner of Ohio - the Republican House leader - said it was time to
put politics aside and move quickly, according to several participants. (An aide to Boehner denied
that he voiced support for the plan, only that he made a plea for cooperation.)

Hearing that Bernanke and Paulson wanted legislation passed in a matter of days, Senator Harry
Reid, the majority leader, expressed astonishment. "This is the United States Senate," he said. "We
can't do it in that time frame." His Republican counterpart, Senator Mitch McConnell, replied, "This
time we can."

He was wrong. After a week of wrangling, political in-fighting and compromise, the House on
Monday voted down the legislation. The Dow plunged nearly 778 points, and credit markets had
worsened, with interest rates rising and loans becoming harder to obtain.

On Wednesday, the Senate approved the bailout. And two weeks after Paulson and Bernanke
made their appeal, the House plans to try again.

Timeline Graphic from IHT

 How U.S. regulators laid the groundwork for disaster
October 3, 2008
"We have a good deal of comfort about the capital cushions at these firms at the moment." —
Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was
told by his staff that Bear Stearns had $17 billion in cash and other assets — more than enough to
weather the storm.

Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged
marriage with JPMorgan Chase backed by a $29 billion taxpayer dowry.

Within six months, other lions of Wall Street would also either disappear or transform themselves to
survive the financial maelstrom Merrill Lynch sold itself to Bank of America, Lehman Brothers filed
for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial
banks.

How could Cox have been so wrong?

Many events in Washington, on Wall Street and elsewhere around the country have led to what has
been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting
on April 28, 2004, explain why the problems could spin out of control. The agency's failure to follow
through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met
in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount
of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a
cushion against losses on their investments. Those funds could then flow up to the parent
company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities;
credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry
M. Paulson Jr. Two years later, he left to become Treasury secretary. A lone dissenter a software
consultant and expert on risk management weighed in from Indiana with a two-page letter to warn
the commission that the move was a grave mistake. He never heard back from Washington.

One commissioner, Harvey Goldschmid, questioned the staff about the consequences of the
proposed exemption. It would only be available for the largest firms, he was reassuringly told those
with assets greater than $5 billion.

"We've said these are the big guys," Goldschmid said, provoking nervous laughter, "but that means
if anything goes wrong, it's going to be an awfully big mess."

Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in

2002 to Senator Paul Sarbanes when he rewrote the nation's corporate laws after a wave of
accounting scandals. "Do we feel secure if there are these drops in capital we really will have
investor protection?" Goldschmid asked. A senior staff member said the commission would hire the
best minds, including people with strong quantitative skills to parse the banks' balance sheets.

Annette Nazareth, the head of market regulation, reassured the commission that under the new
rules, the companies for the first time could be restricted by the commission from excessively risky
activity. She was later appointed a commissioner and served until January 2008.

"I'm very happy to support it," said Commissioner Roel Campos, a former federal prosecutor and
owner of a small radio broadcasting company from Houston, who then deadpanned: "And I keep my
fingers crossed for the future."

The proceeding was sparsely attended. None of the major media outlets, including The New York
Times, covered it.

After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The
Times, the then-chairman, William Donaldson, a veteran Wall Street executive, called for a vote. It
was unanimous. The decision, changing what was known as the net capital rule, was completed
and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency
also decided to rely on the firms' own computer models for determining the riskiness of investments,
essentially outsourcing the job of monitoring risk to the banks themselves.

Over the following months and years, each of the firms would take advantage of the looser rules. At
Bear Stearns, the leverage ratio a measurement of how much the firm was borrowing compared to
its total assets rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt.
The ratios at the other firms also rose significantly.

The 2004 decision for the first time gave the SEC a window on the banks' increasingly risky
investments in mortgage-related securities. But the agency never took true advantage of that part of
the bargain. The supervisory program under Cox, who arrived at the agency a year later, was a low
priority.

The commission assigned seven people to examine the parent companies — which last year
controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the
office has not had a director. And as of last month, the office had not completed a single inspection
since it was reshuffled by Cox more than a year and a half ago.

The few problems the examiners preliminarily uncovered about the riskiness of the firms'
investments and their increased reliance on debt clear signs of trouble were all but ignored.

The commission's division of trading and markets "became aware of numerous potential red flags
prior to Bear Stearns's collapse, regarding its concentration of mortgage securities, high leverage,
shortcomings of risk management in mortgage-backed securities and lack of compliance with the
spirit of certain" capital standards, said an inspector general's report issued last Friday. But the
division "did not take actions to limit these risk factors."

Drive to Deregulate

The commission's decision effectively to outsource its oversight to the firms themselves fit squarely
in the broader Washington culture of the last eight years under President George W. Bush.

A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation
throughout the government, from the Consumer Product Safety Commission and the Environmental
Protection Agency to worker safety and transportation agencies.

"It's a fair criticism of the Bush administration that regulators have relied on many voluntary
regulatory programs," said Roderick Hills, a Republican who was chairman of the SEC under
President Gerald Ford. "The problem with such voluntary programs is that, as we've seen
throughout history, they often don't work."

As was the case with other agencies, the commission's decision was motivated by industry
complaints of excessive regulation at a time of growing competition from overseas. The 2004
decision was aimed at easing regulatory burdens that the European Union was about to impose on
the foreign operations of United States investment banks.

The Europeans said they would agree not to regulate the foreign subsidiaries of the investment
banks on one condition that the commission regulate the parent companies, along with the
brokerage units that the SEC already oversaw.

A 1999 law, however, had left a gap that did not give the commission explicit oversight of the parent
companies. To get around that problem, and in exchange for the relaxed capital rules, the banks
volunteered to let the commission examine the books of their parent companies and subsidiaries.

The 2004 decision also reflected a faith that Wall Street's financial interests coincided with
Washington's regulatory interests.

"We foolishly believed that the firms had a strong culture of self-preservation and responsibility and
would have the discipline not to be excessively borrowing," said Professor James Cox, an expert on
securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).
"Letting the firms police themselves made sense to me because I didn't think the SEC had the staff
and wherewithal to impose its own standards and I foolishly thought the market would impose its
own self-discipline. We've all learned a terrible lesson," he added.

In letters to the commissioners, senior executives at the five investment banks complained about
what they called unnecessary regulation and oversight by both American and European authorities.
A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso,
Indiana, who said the computer models run by the firms which the regulators would be relying on
could not anticipate moments of severe market turbulence.

"With the stroke of a pen, capital requirements are removed!" the consultant, Leonard Bole, wrote to
the commission on Jan. 22, 2004. "Has the trading environment changed sufficiently since 1997,
when the current requirements were enacted, that the commission is confident that current
requirements in examples such as these can be disregarded?"

He said that similar computer standards had failed to protect Long-Term Capital Management, the
hedge fund that collapsed in 1998, and could not protect companies from the market plunge of
October 1987.

Bole, who earned a master's degree in business administration at the University of Chicago, helps
write computer programs that financial institutions use to meet capital requirements. He said in a
recent interview that he was never called by anyone from the commission. "I'm a little guy in the
land of giants," he said. "I thought that the reduction in capital was rather dramatic."

Policing Wall Street

A once-proud agency with a rich history at the intersection of Washington and Wall Street, the
Securities and Exchange Commission was created during the Great Depression as part of the
broader effort to restore confidence to battered investors. It was led in its formative years by
heavyweight New Dealers, including James Landis and William O. Douglas. When President
Franklin D. Roosevelt was asked in 1934 why he appointed Joseph Kennedy, a spectacularly
successful stock speculator, as the agency's first chairman, Roosevelt replied: "Set a thief to catch
a thief."

The commission's most public role in policing Wall Street is its enforcement efforts. But critics say
that in recent years it has failed to deter market problems. "It seems to me the enforcement effort in
recent years has fallen short of what one Supreme Court justice once called the fear of the shotgun
behind the door," said Arthur Levitt Jr., who was SEC chairman in the Clinton administration. "With
this commission, the shotgun too rarely came out from behind the door."

Christopher Cox had been a close ally of business groups in his 17 years as a House member from
one of the most conservative districts in Southern California. Cox had led the effort to rewrite
securities laws to make investor lawsuits harder to file. He also fought against accounting rules that
would give less favorable treatment to executive stock options.

Under Cox, the commission responded to complaints by some businesses by making it more
difficult for the enforcement staff to investigate and bring cases against companies. The
commission has repeatedly reversed or reduced proposed settlements that companies had
tentatively agreed upon. While the number of enforcement cases has risen, the number of cases
involving significant players or large amounts of money has declined.

Cox dismantled a risk management office created by Donaldson that was assigned to watch for
future problems. While other financial regulatory agencies criticized a blueprint by Paulson, the
Treasury secretary, that proposed to reduce their stature and that of the SEC Cox did not challenge
the plan, leaving it to three former Democratic and Republican commission chairmen to complain
that the blueprint would neuter the agency.
In the process, Cox has surrounded himself with conservative lawyers, economists and accountants
who, before the market turmoil of recent months, had embraced a far more limited vision for the
commission than many of his predecessors.

'Stakes in the Ground'

Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to
anticipate the problems at Bear Stearns and the four other major investment banks. "The last six
months have made it abundantly clear that voluntary regulation does not work," Cox said. The
decision to shutter the program came after Cox was blamed by Senator John McCain, the
Republican presidential candidate, for the crisis. McCain has demanded Cox's resignation.

Cox has said that the 2004 program was flawed from its inception. But former officials as well as the
inspector general's report have suggested that a major reason for its failure was Cox's use of it.

"In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that
would have been critical to sensible monitoring, and yet the SEC didn't oversee well enough,"
Goldschmid said in an interview. He and Donaldson left the commission in 2005.

Cox declined requests for an interview. In response to written questions, including whether he or
the commission had made any mistakes over the last three years that contributed to the current
crisis, he said, "There will be no shortage of retrospective analyses about what happened and what
should have happened." He said that by last March he had concluded that the monitoring program's
"metrics were inadequate."

He said that because the commission did not have the authority to curtail the heavy borrowing at
Bear Stearns and the other firms, he and the commission were powerless to stop it.

"Implementing a purely voluntary program was very difficult because the commission's regulations
shouldn't be suggestions," he said. "The fact these companies could withdraw from voluntary
supervision at their discretion diminished the mandate of the program and weakened its
effectiveness. Experience has shown that the SEC could not bootstrap itself into authority it didn't
have."

But critics say that the commission could have done more, and that the agency's effectiveness
comes from the tone set at the top by the chairman, or what Levitt, the longest-serving SEC
chairman in history, calls "stakes in the ground."

"If you go back to the chairmen in recent years, you will see that each spoke about a variety of
issues that were important to them," Levitt said. "This commission placed very few stakes in the
ground."

Paul Krugman: A leadership vacuum

October 3, 2008
As recently as three weeks ago it was still possible to argue that the state of the U.S. economy,
while clearly not good, wasn't disastrous - that the financial system, while under stress, wasn't in full
meltdown and that Wall Street's troubles weren't having that much impact on Main Street.

But that was then.

The financial and economic news since the middle of last month has been really, really bad. And
what's truly scary is that we Americans are entering a period of severe crisis with weak, confused
leadership.

The wave of bad news began on Sept. 14. Henry Paulson, the Treasury secretary, thought he could
get away with letting Lehman Brothers, the investment bank, fail; he was wrong. The plight of
investors trapped by Lehman's collapse - as an article in The New York Times put it, Lehman
became "the Roach Motel of Wall Street: They checked in, but they can't check out" - created panic
in the financial markets, which has only grown worse as the days go by. Indicators of financial
stress have soared to the equivalent of a 107-degree fever, and large parts of the financial system
have simply shut down.

There's growing evidence that the financial crunch is spreading to Main Street, with small
businesses having trouble raising money and seeing their credit lines cut. And leading indicators for
both employment and industrial production have turned sharply worse, suggesting that even before
Lehman's fall, the economy, which has been sagging since last year, was falling off a cliff.

How bad is it? Normally sober people are sounding apocalyptic. On Thursday, the bond trader and
blogger John Jansen declared that current conditions are "the financial equivalent of the Reign of
Terror during the French Revolution," while Joel Prakken of Macroeconomic Advisers says that the
economy seems to be on "the edge of the abyss."

And the people who should be steering us away from that abyss are out to lunch.

The House will probably vote Friday on the latest version of the $700 billion bailout plan - originally
the Paulson plan, then the Paulson-Dodd-Frank plan, and now, I guess, the Paulson-Dodd-Frank-
Pork plan (it's been larded up since the House rejected it on Monday). I hope that it passes, simply
because we're in the middle of a financial panic, and another no vote would make the panic even
worse. But that's just another way of saying that the economy is now hostage to the Treasury
Department's blunders.

For the fact is that the plan on offer is a stinker - and inexcusably so. The financial system has been
under severe stress for more than a year, and there should have been carefully thought-out
contingency plans ready to roll out in case the markets melted down. Obviously, there weren't: the
Paulson plan was clearly drawn up in haste and confusion. And Treasury officials have yet to offer
any clear explanation of how the plan is supposed to work, probably because they themselves have
no idea what they're doing.

Despite this, as I said, I hope the plan passes, because otherwise we'll probably see even worse
panic in the markets. But at best, the plan will buy some time to seek a real solution to the crisis.
And that raises the question: Do we have that time?

A solution to America's economic woes will have to start with a much better-conceived rescue of the
financial system - one that will almost surely involve the U.S. government taking partial, temporary
ownership of that system, the way Sweden's government did in the early 1990s. Yet it's hard to
imagine the Bush administration taking that step.

We also desperately need an economic stimulus plan to push back against the slump in spending
and employment. And this time it had better be a serious plan that doesn't rely on the magic of tax
cuts, but instead spends money where it's needed. (Aid to cash-strapped state and local
governments, which are slashing spending at precisely the worst moment, is also a priority.) Yet it's
hard to imagine the Bush administration, in its final months, overseeing the creation of a new Works
Progress Administration.

So we probably have to wait for the next administration, which should be much more inclined to do
the right thing - although even that's by no means a sure thing, given the uncertainty of the election
outcome. (I'm not a fan of Paulson's, but I'd rather have him at the Treasury than, say, Phil "nation
of whiners" Gramm.)

And while the election is only 32 days away, it will be almost four months until the next
administration takes office. A lot can - and probably will - go wrong in those four months.
One thing's for sure: The next administration's economic team had better be ready to hit the ground
running, because from day one it will find itself dealing with the worst financial and economic crisis
since the Great Depression.

For bailout to work, housing market needs to mend

Oct. 3rd
Washington's financial bailout plan is now law. So the credit spigot will start flowing again, banks
will resume lending, and an economic recovery can begin, right?

Wrong--Experts say the most important thing that needs to happen before the $700 billion bailout
even has a chance of working: Home prices must stop falling. That would send a signal to banks
that the worst has passed and it's safe to start doling out money again.

The problem is the lending freeze has made getting a mortgage loan tough for everyone except
those with sterling credit. That means it will take several months or longer to pare down the glut of
houses built when times were good — and those that have come on the market because of soaring
foreclosures — before home prices start appreciating.

Housing is a critical component to the U.S. economy and by extension the availability of credit.
Roughly one in eight U.S. jobs depends on housing directly or indirectly — from construction
workers to bank loan officers to big brokers on Wall Street. A turnaround in housing prices would
boost confidence in the wider economy and, experts hope, goad banks into lending again.

"Housing traditionally does lead the economy through a recovery. I think it's going to be critical for a
sustained recovery in this cycle, too," said Gary Thayer, senior economist at Wachovia Securities.

The dilemma boils down to a matter of trust.

"Credit, by definition, means trust and faith, and for many reasons trust and faith have been
damaged," said Sung Won Sohn, an economics professor at California State University, Channel
Islands. Sohn said the near certainty of a recession makes it too risky for the thousands of small
and medium-sized banks across the country to lend to people like Elliot.

"Banks know the economy is getting worse, so ... they will keep being cautious," said Sohn, a
former banking executive.

Still, the government hopes that by scooping up billions of dollars in bad mortgage debt and other
toxic assets, banks eventually can clean up their shaky balance sheets, crack open the vaults and
send money washing through the system again.

The rescue plan also raises the federally insured deposit limit from $100,000 to $250,000, a move
that could boost banks' reserves and further grease the lending wheels.

Rep. Barney Frank, D-Mass., the Financial Services Committee chairman and a key negotiator over
the past weeks, said the measure was just the beginning of a much larger task Congress will tackle
next year: overhauling housing policy and financial regulation in a legislative effort comparable to
the New Deal.

In the meantime, the Treasury Department is moving swiftly to get the plan started. Treasury
Secretary Henry Paulson said Friday he did not wait for final approval of the measure to begin
preparation. He has been lining up outside advisers as his staff works out details on a multitude of
complex issues.

But several hurdles could trip up the plan. For starters, even when the Treasury starts buying bad
assets, some banks may hoard the cash they receive in return until they see how the plan pans out.
That has the potential to make the lending logjam worse, said Vincent R. Reinhart, former director
of the Federal Reserve's monetary affairs division.

"They may sit on the sidelines and wait to see (the bailout) get some traction. The problem is if
everybody sits on the sidelines, nobody gets in the game. It's a risk," he said.

It also creates a vicious cycle: No trust means no lending; tight credit means it's harder to buy a
home; the more difficult it is to buy or sell a home, the further home prices will fall; and the further
prices drop, the more foreclosures there will be.

U.S. home prices — down 20 percent from their peak in July 2006 — still have further to fall, and
must hit bottom before demand picks up. The long-awaited bottom in prices could be a year or
more away.

But Jim Gillespie, chief executive of Coldwell Banker Real Estate, said he hopes that lower prices,
combined with the government's actions will jump-start stagnant demand. The federal bailout plan,
he said, "will give people reassurance that mortgage money is available."

Jobs are another big concern. The stranglehold on credit has choked companies big and small that
depend on regular inflows of borrowed money to pay employees and stay afloat.

The Labor Department said Friday that employers cut 159,000 jobs in September, the fastest pace
of losses in more than five years. Experts say that number will grow as the effects of the credit
gridlock course through the economy in coming days and weeks.

The nation's unemployment rate is now 6.1 percent, up from 4.7 percent a year ago. Over the last
year, the number of unemployed people has risen by 2.2 million to 9.5 million. The unemployment
rate could rise to as high as 7.5 percent by late 2009, economists predict. If that happens, it would
mark the highest since after the 1990-91 recession.

Boosting employment is critical to kick-starting lending because "if jobs are growing, then incomes
are a growing, and if incomes are growing then people are consuming," Reinhart said.

Consumers and businesses have retrenched so much that some analysts fear the economy stalled
or shrank in the third quarter that ended last week. The Labor Department report Friday showed
wage growth for workers is slowing, meaning they'll be more hard-pressed to spend, especially for
something as expensive as a home.

Many economists predict the economy will contract in the final quarter of 2008 and the first quarter
of next year. That would meet the classic definition of a recession — two consecutive quarters of a
shrinking economy.

One bright spot: optimism hasn't been totally squashed yet.

Morgan Cavanaugh, proprietor of Moriarty's Pub in downtown Cleveland, has been trying to sell
another bar he owns to ease his workload, but the prospective buyer hasn't been able to raise the
money. Now that the bailout legislation has the green light, he's hopeful he'll get a deal done.
"It passed. Let's work something out," Cavanaugh told the man over a cell phone Friday just after
the House approved the plan. He flipped the phone shut and smiled from behind the weathered
mahogany bar of his 75-year-old Irish pub. "He's going to put the loan request in again. It's looking
up," Cavanaugh said.

A Snarl of Regulation
October 5, 2008
Who's to blame for the implosion of financial markets? The finger-pointing has gone in every
direction, and it's easy to see why: the regulatory structure points in every direction.

The apparatus that oversees the nation's financial system is an ad hoc creation: every time there is
a fiscal panic, new agencies are formed and existing ones receive new responsibilities. This is the
first crisis since the 1987 market crash, and financial institutions and products have changed rapidly
in the last 20 or so years, exposing regulatory redundancies and enormous gaps, like a lack of
oversight for some derivatives and credit default swaps.

In March, Treasury Secretary Henry M. Paulson Jr. issued a plan to revamp regulation and
modernize the system, but at the time, most lawmakers and lobbyists considered it far down the list
of priorities and unlikely to be adopted.

"Few, if any, will defend our current Balkanized system as optimal," Mr. Paulson shot back to critics
in a speech that month at the Treasury Department.

One change in the Treasury's plan would have expanded the role of the President's Working Group
on Financial Markets, which is headed by the Treasury secretary and consists of the top officials
from the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures
Trading Commission. Other proposed changes would have broadened the authority of the Federal
Reserve. The plan offered both regulatory and deregulatory elements and seemed to satisfy no
one.

With a growing chorus of officials saying the present system is in shambles, however, a regulatory
overhaul by the next Congress seems likely.

Howell E. Jackson, a Harvard Law professor and author of a book on the regulation of financial
institutions, says it is likely that lawmakers will give the Federal Reserve more regulatory power and
they may forge new oversight agencies.

"If history is a guide," he said, "you'd have to bet that the most likely result is for us to come out of
the crisis with more regulatory agencies than we had going in."

Europeans scramble to save failing banks

Germany joined Ireland and Greece on Sunday in guaranteeing all private savings accounts,
putting Europe's biggest economy at odds with calls for a unified European response to the global
financial meltdown.

The decision came as governments across Europe scrambled to save failing banks, working largely
on their own a day after leaders of the continent's four biggest economies called for tighter
regulation and a coordinated response.

Chancellor Angela Merkel said that no citizen should fear for the safety of their investments,
speaking to reporters as her government held crisis talks on the collapse of a ballyhooed euro35
billion (US$48.4 billion) bailout of Hypo Real Estate AG, the country's second- biggest property
lender.

In Iceland — particularly hard-hit by the credit crunch — government officials and banking chiefs
were discussing a possible rescue plan for the country's overstretched commercial banks.

Belgian Prime Minister Yves Leterme said he aims to find a new owner for troubled bank Fortis NV
to restore confidence in the company before the opening of markets on Monday.

Leterme told two media outlets that government officials were going over a takeover bid for Fortis'
Belgian operations. The bank's Dutch operations were nationalized amid fears they could go
insolvent.

British treasury chief Alistair Darling said that he was ready to take "pretty big steps that we wouldn't
take in ordinary times" to help the country in weather the credit crunch.

In the past year the government has acted to nationalize struggling mortgage lenders Northern
Rock and Bradford & Bingley.

"The European banking industry is feeling the wind of default blowing from the other side of the
Atlantic," said Axel Pierron, senior vice president at Celent, a Boston, Massachusetts-based
financial research and consulting firm.

The erosion has also been seen in overall confidence and concern among investors, politicians and
the European public, too.

The leaders of Germany, France, Britain and Italy met Saturday to discuss the growing meltdown
which has leapfrogged across the Atlantic from the U.S. to Europe, but shied away from the
massive US$700 billion (euro506 billion) bailout passed by the U.S. Congress a day earlier that
President Bush signed into law.

Their failure to agree an EU-wide plan showcased the divisions in Europe on how to deal with the
crisis.

France had suggested a multibillion-euro (multibillion-dollar) EU-wide government bailout plan, but
backed off after Germany said banks must find their own way out.

Hypo Real Estate said Saturday that the rescue plan had fallen apart after private lenders withdrew
support, a key element to the proposal that had already been approved by the EU earlier this week.

Icelandic banks expanded rapidly after deregulation of the domestic financial market in the 1990s
and now have combined foreign liabilities in excess of euro100 billion (US$138.34 billion) —
dwarfing the tiny country's gross domestic product of euro14 billion (US$19.37 billion.

The government last week took over Iceland's third-largest bank, Glitnir, a decision that prompted
major credit ratings agencies to downgrade both Iceland's four major banks and its government
credit rating.

Looming large was a growing sense that the Federal Reserve and Europe's major central banks —
which have been flooding euros and dollars to banks that have become increasingly stingy about
lending money even to themselves — were ready to institute emergency cuts to their benchmark
interest rates this week.

None of the banks, including the European Central Bank and Bank of England, have commented on
potential rate hikes or cuts. But analysts believe the Bank of England, which meets this Thursday,
will likely lower its rate from 5 percent. The ECB left its rate unchanged at 4.25 percent on
Thursday, but opened the door to a rate cut.

Robert Brusca, chief economist at the New York-based Fact and Opinion Economics, said that the
ECB does issue such a cut it would a be a sign "that they're really, really scared."

The bailout bill passes, but the meltdown continues

October 5, 2008

After the U.S. Senate approved the $700 billion bank bailout, the majority leader, Harry Reid, tried
to persuade his colleagues to address another economic calamity before they left town for the long
election recess. He urged them to extend unemployment benefits for 800,000 jobless Americans.

In the face of Republican opposition, the measure failed. Benefits start expiring this week. So much
for Main Street.

If it works as promised, the bailout will thaw the credit freeze and keep more banks from going
under. But it is unlikely to save even more Americans from losing their jobs and homes.

The Labor Department reported Friday that 159,000 jobs were lost in September. That is the biggest
monthly drop in five years and the ninth straight month of job contraction. It brings total job losses
for this year to 760,000.

Of the 9.5 million Americans now out of work, two million have been jobless for more than six
months. Nearly 6.1 million people are working part time because they cannot find full-time work or
because slack business conditions have led to fewer hours - and less pay.

Cutbacks in hours and pay are especially pernicious because for most of the Bush years, wage
growth has lagged behind worker productivity and prices. As Americans have worked harder they
have fallen further behind. The only good news - if you can call it that - was that credit was easy.

As a result, many Americans today have no savings and are deep in debt. That means they are even
less prepared to take care of themselves and their families when they lose their jobs.

Conditions are only getting worse. Personal spending stagnated in August, the latest month with
government data. Auto sales plunged in September. Factory orders are off. New home sales fell to a
17-year low in August, according to the Census Bureau. And home prices continued to fall sharply
in July, for a decline of 16.3 percent over 12 months, according to the Standard & Poor's/Case-
Shiller index of prices in 20 major cities. There is no sign that prices have hit their bottom.

Exports, the one bright spot, are also set to fall, because many other nations took part in America's
financial follies and are now faltering as well.

All that weakness means that more Americans will lose their jobs in the months to come. Extending
unemployment benefits is the least that Congress can do to help. The House overwhelmingly passed
a bill to do that before it left Washington last week. The Senate must take the bill up as soon as it
returns for its lame duck session.

There is a lot more work to do to fill in the gaps of the bailout bill. It does virtually nothing to
prevent foreclosures and keep Americans in their homes. Congress must finally change the code to
allow a bankruptcy court to reduce the size of bankrupt borrowers' mortgages.

A new stimulus bill must also be crafted. It must include bolstered food stamps and aid to states and
cities, so that they can continue to provide health care and keep paying for construction and other
projects that provide desperately needed jobs.

The meltdown on Wall Street is only part of a larger meltdown, and the bailout bill is only one
attempt at a fix.

Financial crises spread in Europe

By Floyd Norris
October 6, 2008
European nations scrambled on Sunday night to prevent a growing credit crisis from bringing down
major banks and alarming savers as troubles in financial markets spread around the world,
accelerating economic downturns on three continents.

The German government moved to guarantee all private savings accounts in the country on
Sunday, hoping to reassure depositors who had grown nervous as efforts to bail out a large
German lender and a major European financial company failed.

Late Sunday, it was disclosed that new bailouts had been arranged for both of those companies,
Hypo Real Estate, the German lender, and Fortis, a large banking and insurance company based in
Belgium but active across much of the Continent.

The spreading worries came days after the United States Congress approved a $700 billion bailout
package that officials had hoped would calm financial markets globally.

The moves came as a merger fight in the United States continued to be played out. Court hearings
were under way in New York on Sunday over competing efforts by Citigroup and Wells Fargo to
acquire Wachovia, a large bank that nearly failed a week ago.

In Europe, meanwhile, the crisis appears to be the most serious one to face the Continent since a
common currency, the euro, was created in 1999. Jean Pisani-Ferry, director of the Bruegel
research group in Brussels, said Europe confronted "our first real financial crisis and it's not just any
crisis. It's a big one."

The European Central Bank has aggressively lent money to banks as the crisis has grown. It had
resisted lowering interest rates, but signaled on Thursday that it might cut rates soon. The extra
money, aimed at ensuring that banks would have adequate access to cash, has not reassured
savers or investors, and European stock markets have performed even worse than the American
markets.

In Berlin, Chancellor Angela Merkel and her finance minister, Peer Steinbrück, appeared before
television cameras to promise that all bank deposits would be protected, although it was not clear
whether legislation would be needed to make that promise good.

Mindful of the rising public anger at the use of public money to buttress the business of high-earning
bankers, Merkel promised a day of reckoning for them as well. "We are also saying that those who
engaged in irresponsible behavior will be held responsible," she said. "The government will ensure
that. We owe it to taxpayers."

Stock markets fell sharply in early trading on Monday in Asia on growing fears about the health of
European banks and the resilience of the global economy.

The Nikkei 225 index dropped 3 percent in Tokyo on Monday, while Kospi index in Seoul and the
Standard and Poor's/Australian Stock Exchange 200 index in Sydney both declined 3.3 percent.
The events in Berlin and Brussels underscored the failure of Europe's case-by-case approach to
restoring confidence in the Continent's increasingly jittery banking sector. A European summit
meeting Saturday night did little to calm worries.

President Nicolas Sarkozy of France and his counterparts from Germany, Britain and Italy vowed to
prevent a Lehman Brothers-like bankruptcy in Europe but they did not offer an American-style
bailout package.

The crisis has underlined the difficulty of taking concerted action in Europe because its economies
are far more integrated than its governing structures.

"We are not a political federation," Jean-Claude Trichet, the president of the European Central
Bank, said. "We do not have a federal budget."

Last week, Ireland moved to guarantee both deposits and other liabilities at six major banks. There
was grumbling in London and Berlin about the move giving those banks an unfair advantage. But
Germany proposed its deposit guarantee Sunday after Britain raised its guarantee to £50,000, or
almost $90,000, from £35,000.

Unlike in the United States, where deposits are fully guaranteed up to a limit of $250,000 — a figure
that was raised from $100,000 last week — deposits in most European countries have been only
partially guaranteed, sometimes by groups of banks rather than governments. In Germany, the first
90 percent of deposits up to 20,000 euros, or about $27,000, was guaranteed.

The Paris meeting produced a promise that European leaders would work together to halt the
financial crisis and reassure nervous investors, but even before the meeting began it was becoming
clear that two bailouts announced the week before had not succeeded and that a major Italian bank
might be in trouble. That bank, UniCredit, announced plans on Sunday to raise as much as 6.6
billion euros, or $9 billion, in capital.

Fortis, which only a week ago received 11.2 billion euros from the governments of the Netherlands,
Belgium and Luxembourg, was unable to continue its operations. On Friday, the Dutch government
seized its operations in that country, and Sunday night the Belgian government helped to arrange
for BNP-Paribas, the French bank, to take over what was left of the company.

In Berlin, the government arranged a week ago for major banks to lend 35 billion euros to Hypo, but
that fell apart when the banks concluded that more money would be needed. Late Sunday, the
government said a 50 billion euro package had been arranged, with the government and other
banks participating.

The credit crisis began in the United States, a fact that has led European politicians to claim
superiority for their country's financial systems, in contrast to what Silvio Berlusconi, Italy's prime
minister, called the "speculative capitalism" of the United States. On Saturday, Gordon Brown, the
British prime minister, said the crisis "has come from America," and Berlusconi bemoaned the lack
of business ethics that had been exposed by the crisis.
Many of the European banks' problems have stemmed from bad loans in Europe, and Fortis got
into trouble in part by borrowing money to make a major acquisition. But activities in the United
States have played a role. Bankers said Sunday that the additional need for funds at Hypo came
from newly discovered guarantees it had issued to back American municipal bonds that it had sold
to investors.

The credit market worries came on top of heightening concerns about economic growth in Europe
and the United States. Many economists think there are recessions in both areas, and one also
appears to have started in Japan, where the Nikkei newspaper reported Monday that a poll of
corporate executives found that 94 percent thought the country's economy was deteriorating.

"Unless there is a material easing of credit conditions," said Bob Elliott of Bridgewater Associates,
an American money management firm, after the retail sales figures were announced, "it is unlikely
that demand will turn around soon."

Almost unnoticed as the United States Congress approved a $700 billion bailout for banks last
week, it also agreed to guarantee $25 billion in loans for America's troubled automakers. European
automakers said Sunday they would seek similar aid from the European Commission.

Henry Paulson Jr., the United States Treasury secretary, hoped that approval of the American
bailout, which will involve buying securities from banks at more than their current market value,
would free up credit by making cash available for banks to lend and by reassuring participants in
the credit markets.

But that did not happen last week. Instead, credit grew more expensive and harder to get as
investors became more skittish about buying commercial paper, essentially short-term loans to
companies. Rates on such loans rose so fast that some feared the market could essentially close,
leaving it to already-stressed banks to provide short-term corporate loans.

Altria, the parent company of the cigarette maker Philip Morris, said lenders wanted it to delay its
planned $10.3 billion acquisition of UST, another tobacco maker, until 2009, but promised it would
complete the deal.

Europe's need to scramble is in part the legacy of a decision to establish the euro, which 15
countries now use, but not follow up with a parallel system of cross-border regulation and oversight
of private banks.

"First we had economic integration, then we had monetary integration," said Sylvester Eijffinger, a
member of the monetary expert panel advising the European parliament. "But we never developed
the parallel political and regulatory integration that would allow us to face a crisis like the one we
are facing today," he added.

In Brussels, Daniel Gros, director of the Center for European Policy Studies, agreed. "Maybe they
will be shocked into thinking more strategically instead of running behind events," he said. "The
later you come, the higher the bill."

While the European Central Bank has power over interest rates and broader monetary policy, it was
never granted parallel oversight of private banks, leaving that task to dozens of regulators across
the Continent.

This patchwork system includes national central banks in each of the euro-zone's 15 members and
they still retain broad powers within their own borders, further complicating any regional approach to
problem-solving.
The European economic landscape today bears little resemblance to the 1990s, when the
groundwork for the euro was laid. Back then, Pisani-Ferry recalled, few banks in Europe had cross-
border operations on a significant scale.

It was a wave of mergers over the last decade that created giants like HSBC and Deutsche Bank,
which straddle countries and continents and have major American exposure.

"The European banking landscape was transformed fairly recently," Pisani-Ferry said. "When the
euro was first introduced, the question of cross-border regulation didn't really arise."

Optimists say one potential long-term benefit from the current turmoil is that it often takes a crisis to
propel European integration forward.

"Progress in Europe is usually the result of a crisis," Eijffinger said. "This could be one of those rare
moments in EU history."

How an embrace of risk tripped up Fannie Mae

October 5, 2008

"Almost no one expected what was coming. It's not fair to blame us for not predicting the
unthinkable." - Daniel Mudd, former chief executive of Fannie Mae.

When the mortgage giant Fannie Mae recruited Daniel Mudd, he told a friend he wanted to work for
an altruistic business. Already a decorated U.S. Marine and a successful executive, he wanted to
be a role model to his four children - just as his father, the television journalist Roger Mudd, had
been to him.

Fannie, a government-sponsored company, had long helped Americans get more affordable home
loans by serving as a powerful middleman, buying mortgages from lenders and banks and then
holding or reselling them to Wall Street investors. This allowed banks to make even more loans -
expanding the pool of homeowners and permitting Fannie to ring up handsome profits along the
way.

But by the time Mudd became Fannie's chief executive in 2004, his company was under siege.
Competitors were snatching lucrative parts of its business. Congress was demanding that Mudd
help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall
Street unless Fannie bought a bigger chunk of their riskiest loans.

So Mudd made a fateful choice. Disregarding warnings from his managers that lenders were
making too many loans that would never be repaid, he steered Fannie into more treacherous
corners of the mortgage market, according to executives.

For a time, that decision proved profitable. In the end, it nearly destroyed the company and
threatened to drag down the U.S. housing market and the economy.

Dozens of interviews, most with people who requested anonymity to avoid legal repercussions,
offered an inside account of the critical juncture when Fannie Mae's new chief executive took
additional risks that pushed his company, and, in turn, a large part of the country's financial health,
to the brink.

From 2005 to 2008, Fannie purchased or guaranteed at least $230 billion in loans to risky
borrowers - more than three times as much as in all its earlier years combined, according to
company filings and industry data.
"We didn't really know what we were buying," said Marc Gott, a former director in Fannie's loan
servicing department. "This system was designed for plain vanilla loans, and we were trying to push
chocolate sundaes through the gears."

Last month, the White House had to orchestrate a $200 billion rescue of Fannie and its corporate
cousin, Freddie Mac. On Sept. 26, the companies disclosed that U.S. government prosecutors and
the Securities and Exchange Commission were investigating potential accounting and governance
problems.

Mudd said during an interview that he responded as best he could given the company's challenges,
and worked to balance risks prudently.

"Fannie Mae faced the danger that the market would pass us by," he said. "We were afraid that
lenders would be selling products we weren't buying, and Congress would feel like we weren't
fulfilling our mission. The market was changing, and it's our job to buy loans, so we had to change
as well."

When Mudd arrived at Fannie eight years ago, it was the beginning a rapid expansion that, at its
peak, had it buying 40 percent of all U.S. mortgages.

Just two decades earlier, Fannie had been on the brink of bankruptcy. But chief executives like
Franklin Raines and the chief financial officer J.Timothy Howard built it into a financial juggernaut by
aiming to tap new markets.

Fannie never actually made loans. It was essentially a mortgage insurance company, buying
mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan
if the borrower defaulted. The only real danger was that the company might guarantee questionable
mortgages and lose out when large numbers of borrowers walked away from their obligations.

So Fannie constructed a vast network of computer programs and mathematical formulas that
analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools
of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged
to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from
low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie's stock price and rewarded top executives with tens of millions
of dollars. Raines received about $90 million from 1998 to 2004, while Howard was paid about
$30.8 million, according to regulators. Mudd collected more than $10 million in his first four years at
Fannie.

Whenever competitors asked Congress to rein in the company, lawmakers were besieged with
letters and phone calls from angry constituents, some orchestrated by Fannie itself. One automated
phone call warned voters: "Your congressman is trying to make mortgages more expensive. Ask
him why he opposes the American dream of home ownership."

The ripple effect of Fannie's plunge into riskier lending was profound. Fannie's stamp of approval
made shunned borrowers and complex loans more acceptable to other lenders, particularly small
and less sophisticated banks.
From 2001 to 2004, the overall subprime mortgage market - loans to the riskiest borrowers - grew
to $540 billion from $160 billion, according to Inside Mortgage Finance, a trade publication.
Communities were inundated with billboards and fliers from subprime-loan providers offering to help
almost anyone buy a home.

Within a few years of Mudd's arrival, Fannie was the most powerful mortgage company on earth.

Then it began to crumble.

Regulators, incited by the revelation of a wide-ranging accounting fraud at Freddie Mac, began
scrutinizing Fannie Mae's books. In 2004 they accused Fannie of fraudulently concealing expenses
to make its profits look bigger.

Howard and Raines resigned. Mudd was quickly promoted to the top spot.

But the company he inherited was becoming a shadow of its former self.

Washington bore down on Mudd as well. The same year he took the top position, regulators sharply
increased Fannie's affordable-housing goals. Democratic lawmakers demanded that the company
buy more loans that had been made to low-income and minority home buyers.

"When homes are doubling in price in every six years and incomes are increasing by a mere 1
percent per year, Fannie's mission is of paramount importance," Senator Jack Reed, Democrat of
Rhode Island, lectured Mudd at a congressional hearing in 2006. "In fact, Fannie and Freddie can
do more, a lot more."

But Fannie Mae's computer systems were not able to fully analyze many of the risky loans that
customers, investors and lawmakers wanted Mudd to buy. Many of them - like balloon-rate
mortgages or mortgages that did not require paperwork - were so new that dangerous bets could
not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans. In one meeting, according to two
people present, Mudd told employees to "get aggressive on risk-taking, or get out of the company."
During the interview, Mudd said he did not recall that conversation and that he always emphasized
taking only prudent risks.

Employees, however, say they got a different message. "Everybody understood that we were now
buying loans that we would have previously rejected, and that the models were telling us that we
were charging way too little," said a former senior executive at Fannie. "But our mandate was to
stay relevant and to serve low-income borrowers. So that's what we did."

From 2005 to 2007, the company's acquisitions of mortgages with down payments of less than 10
percent almost tripled. As the market for risky loans soared to $1 trillion, Fannie expanded in white-
hot real estate areas like California and Florida.

For two years, Mudd operated without a permanent chief risk officer to guard against unhealthy
hazards. When Enrico Dallavecchia was hired for that position in 2006, he told Mudd that the
company should be charging more to handle risky loans. In the following months, Dallavecchia
warned that some markets were becoming overheated and argued that a housing bubble had
formed, according to a person with knowledge of the conversations. But many of the warnings were
rebuffed.
Mudd told Dallavecchia that the market, shareholders and Congress all thought the companies
should be taking more risks, not fewer, according to a person who observed the conversation.
"Whom am I supposed to fight with first?" Mudd asked.

During the interview, Mudd said he never made those comments. Dallavecchia was among those
whom Mudd pushed out of the company during reorganization in August. Mudd added that it was
almost impossible during most of his tenure to see trouble on the horizon, because Fannie
interacted with lenders rather than borrowers, which created a delay in recognizing market
conditions.

He said Fannie sought to balance market demands prudently against internal standards that
executives always sought to avoid unwise risks and that Fannie bought far fewer troublesome loans
than many other financial institutions. Mudd said he heeded many warnings from his executives and
that Fannie refused to buy many risky loans, regardless of outside pressures.

"You're dealing with massive amounts of information that flow in over months," he said. "You almost
never have an 'Oh my God' moment. Even now, most of the loans we bought are doing fine."

But, of course, that moment of truth did arrive. In the middle of last year it became clear that millions
of borrowers would stop paying their mortgages. For Fannie, this raised the terrifying prospect of
paying billions of dollars to honor its guarantees.

Europe governments strive to avoid bank meltdown

October 6th
European governments struggled to find a coordinated response to the crisis sweeping financial
markets Monday, as countries one after the other announced sweeping deposit guarantees on their
own to try and shore up their banks. Stock markets plunged.

Iceland and Denmark became the latest countries to declare a deposit guarantee Monday after a
startling announcement by German Chancellor Angela Merkel on Sunday that her government
would guarantee all private bank savings and CDs held in the euro zone's largest economy. "We
want to tell people that their savings are safe," she said.

Faltering confidence in the financial system, undermined by a series of bank bailouts, was
precipitating the measures, analysts said, since a failure to match guarantees by Ireland, France,
Greece and Sweden could risk a massive fund outflow. Yet the guarantees themselves raised
questions about their potential impact on government finances, and showed European governments
were unable to find a unified approach despite a weekend summit where they agreed to do just
that.

"Governments have no choice but to give the guarantees on deposits, otherwise we will see runs on
banks and a complete loss of business and consumer confidence," said Neil Mackinnon, chief
economist at ECU Group.

"The stakes have never been higher," he added.

Markets responded to the disarray by sinking rapidly, following sell offs in Asia. Russia shut down
both its stock markets after they fell more than 15 percent. Germany's DAX was down 428.04, or
7.4 percent, at 5,368.99, while France's CAC-40 was 350.74 points, or 8.9 percent, lower at
3,730.01. The CAC's fall in afternoon trading exceeded the record one-day decline of 7.39 percent
from Sept. 11, 2001.
The FTSE 100 index of leading British shares was down 269.30 points, or 5.5 percent, at 4,601.04.

Wall Street took its cue from Europe, with the Dow Jones industrials down 430.81 points, or 4.2
percent at 9,907.55 amid growing fears that the credit crisis is spreading around the world.

Meanwhile, the euro slid below the $1.36 mark for the first time in over a year.

The crisis engulfing Europe and its markets has fueled talk of coordinated interest-rate cuts by the
world's leading central banks, possibly as early as Monday.

Analysts said they wouldn't be surprised if the U.S. Federal Reserve, the European Central Bank
and the Bank of England instigate the first joint action on interest rates since the September 2001
terrorist attacks on the U.S.

"I think we will see interest-rate cuts this week," said ECU Group's Mackinnon.

So far, the banks have continued to flood the money markets with additional liquidity. On Monday,
the ECB injected another $50 billion into money markets while the BoE added another $10 billion.
The Swedish Central Bank increased its lending to 100 billion kronor ($14.2 billion).

Additionally, the Fed said that 28-day and 84-day cash loans being made available to banks will be
boosted to $150 billion each, effective Monday. Those increases will eventually bring the amounts
outstanding under the program to $600 billion.

British Prime Minister Gordon Brown planned a call to Merkel to discuss the crisis, and Britain's
Treasury chief, Alistair Darling, was due to make a statement to Parliament later. So far, Britain has
raised its deposit guarantee only to 50,000 pounds ($87,900), but was under pressure to guarantee
all deposits.

French President Nicolas Sarkozy spoke by telephone in the morning with Brown, ECB President
Jean-Claude Trichet and European Commission President Jose Manuel Barroso and was due to
speak to Merkel later too.

"We need a coordinated response," Sarkozy said during a visit to a Renault car plant in Normandy.
Meanwhile European Union finance ministers were set to begin two days of talks on the crisis in
Luxembourg.

"This is a very serious situation and one that needs to be addressed," said EU spokesman
Johannes Laitenberger.

"Obviously there is a great effort under way. Nobody is suggesting that this is business as usual,
but it's true that there is not one single magic bullet that will solve this."

The renewed effort to coordinate a response came after the weekend commitment by Europe's four
leading economic powers — Germany, France, Britain and Italy — to work together. That
commitment fell apart on Sunday when Merkel announced that all 568 billion euros ($786 billion)
worth of private deposits held in Germany would be guaranteed, alongside a new 50 billion euros
($69 billion) bailout package for Hypo Real Estate AG, Germany's second-biggest mortgage lender.

"The EU is liable to be exposed as a fair weather construction, lacking the means of swift response
and the hold over its citizens' loyalties to survive really adverse conditions," said Stephen Lewis, an
analyst at Monument Securities.

In a joint statement Monday, Merkel and Finance Minister Peer Steinbrueck said the guarantee was
"an important step at the right moment."

In response to the German move, the Danish Economy Ministry said commercial lenders had
agreed to contribute up to 35 billion kroner, or about $6.4 billion over two years to a fund that will
help insure account holders from losses. Austrian officials have indicated they might join in as well.

That was followed this afternoon by Iceland's guarantee of all deposits after trading was halted in
six bank stocks. Icelandic banks' assets dwarf the rest of its economy and its currency has fallen
sharply in the past week.

The markets are skeptical that Europe's piecemeal response to the crisis so far will work to stem
the selling tide. "The main problem for Europe is that a coordinated response has proved
impossible to reach, and the case-by-case approach that has so far been applied has clearly failed
to restore confidence," said Dragana Ignjatovic, European analyst at Global Insight.

Meanwhile, Iceland halted trading in six bank stocks while the government drafted a crisis plan.
Icelandic banks' assets dwarf the rest of its economy and its currency has fallen sharply in the past
week.

Wall Street tumbles amid global sell-off

Monday October 6
Stocks decline amid global worries credit crisis is spreading--Dow falls below 10,000

Financial markets took a bleak view of the future Monday, seeing contagion in a credit crisis that
threatens to cascade through economies globally despite government efforts to provide relief. The
Dow Jones industrials skidded more than 500 points and fell below 10,000 for the first time in four
years, while the credit markets remained under strain.
Investors around the world have come to the sobering realization that the Bush administration's
$700 billion rescue plan won't work quickly to unfreeze the credit markets. Global banks, hobbled by
wrong-way bets on mortgage securities, remain starved for cash as credit has dried up.

That has sent stocks spiraling downward in the U.S., Europe and Asia, and driven investors to sink
money into the relative safety of U.S. government debt. Fears about a global recession also caused
oil to drop below $90 a barrel.
"The fact is people are scared and the only thing they're doing is selling," said Ryan Detrick, senior
technical strategist at Schaeffer's Investment Research. "Investors are cleaning out portfolios and
getting rid of everything because nothing seems to be working."

The selling was so extreme that only 98 stocks rose on the NYSE -- and 3,114 dropped. That's a
telling sign considering the stock market is considered a leading economic indicator, with investors
tending to buy and sell based on where they believe the economy will be in six to nine months.

Monday's steep decline on Wall Street indicates that investors are becoming more convinced that
the country is leading a prolonged economic crisis that is spreading to other nations. Over the
weekend, governments across Europe rushed to prop up failing banks, while the governments of
Germany, Ireland and Greece also said they would guarantee bank deposits.

As the U.S. tries to repair its battered banking system, the German government and financial
industry agreed on a $68 billion bailout for commercial-property lender Hypo Real Estate Holding
AG. And France's BNP Paribas agreed to acquire a 75 percent stake in Fortis's Belgium bank after
a government rescue failed.
The Fed also took fresh steps to help ease credit markets. The central bank said Monday it will
begin paying interest on commercial banks' reserves and will expand its loan program to squeezed
banks.

Joseph V. Battipaglia, chief investment officer at Ryan Beck & Co., said government intervention
certainly might help. However, he believes investors are sensing that what's happening in the
economy is a shift in the extent to which consumers and businesses take on debt, a change that will
take years to play out.

"This is a global deleveraging of many economies," he said. "It might appear that you're going into
the abyss where the economy grinds to a halt and the financial system goes into complete disarray.
But, what the market is really reading here is that this is a global phenomenon, and when you
delever like this, it is a process that takes a very long period of time measured in years, not
quarters."

That, he said, is being reflected in major stock indexes being repriced significantly lower. In early
afternoon trading, the Dow Jones industrial average fell 446.49, or 5.39 percent, to 9,768.89,
dropping below 10,000 for the first time since Oct. 29, 2004. At one point, the Dow was down nearly
600.

Broader indexes also tumbled. The Standard & Poor's 500 index shed 65.13, or 5.93 percent, to
1,034.10; and the Nasdaq composite index fell 128.88, or 6.62 percent, to 1,818.51. The Russell
2000 index of smaller companies dropped 36.45, or 5.88 percent, to 582.95.

In Asia, the Nikkei 225 closed 4.25 percent lower. Europe's stock markets also declined, with the
FTSE-100 down 5.20 percent, Germany's DAX down 7.07 percent, and France's CAC-40 down
9.04 percent.

The anxiety was again obvious in the credit markets. The yield on the three-month Treasury bill
slipped to 0.42 percent from 0.50 percent late Friday. Demand for bills remains high because of
their safety; investors are willing to take extremely low returns just to have their money in a secure
place.

Investors also moved into longer-term Treasury bonds. The yield on the 10-year note fell to 3.49
percent from 3.60 percent late Friday.

Anthony Sabino, a professor of law and business at St. John's University, said the "market is
displaying one of its worst traits with a herd mentality, and investors have an appetite for feeding on
fear." He cautions that, while there are deep economic and financial problems being faced, it is still
not a nightmare scenario.

"Most certainly, this is not the Great Depression of the 1930s, but (is like) the savings and loan
crisis of the 1980s -- and we bailed them out," he said. "Once people catch their breath, they'll see
this is the proper analogy and this will breathe life back into banking institutions."

Banks' hesitation to lend to one another and to many businesses and individuals is the result of the
bad mortgage debt that the financial rescue is supposed to sweep up. But it's still unclear how
quickly financial institutions will be able to hand that debt to the U.S. government and convince the
markets they are healthy again.

There has been some hope that perhaps the Fed, in concert with other central banks, might cut
interest rates to help stimulate the economy. With oil prices well off their midsummer highs and
indicators pointing to a slower economy, the Fed's worries about inflation are less than they had
been, making it easier to justify a rate cut.
Investors might get some indication about a potential rate cut with several policymakers slated to
speak this week. Dallas Fed President Richard Fisher and Chicago Fed President Charles Evans
will speak on the U.S. economy on Monday. Federal Reserve Chairman Ben Bernanke is due to
speak on Tuesday.

Frederick Dickson, chief market strategist at D.A. Davidson & Co., believes investors are eager for
any signs about the well being of the economy. He doesn't believe that will happen until Wall Street
overhauls its expectations for growth of corporate earnings and the overall economy.

"Wall Street at this point is shifting its attention from whether Congress was going to act on the
emergency stabilization bill to the realization that the economy is slowing significantly faster than
most analysts had expected," he said. "The downturn has shifted from first gear to about third gear
in about two weeks.

U.S. Implements Bailout as Global Markets Plunge

October 6, 2008

U.S. officials began putting the newly approved financial bailout plan into effect this morning, even
as global stock markets plummeted on new concerns about the health of the European banking
system and the likelihood of a global recession.

The Federal Reserve announced steps to funnel more money into the banking system while the
U.S. Treasury said it would increase its bond sales to pay for the $700 billion rescue package
signed Friday by President Bush.

The Fed today used its newly granted authority to begin paying interest on the reserves that banks
must keep with it -- a step meant to encourage banks to keep more funds on hand with the Fed,
and in turn give the Fed more leeway in putting cash back into the banking system. At the same
time, the Fed said that during the next two months it would double, to $900 billion, the short-term
loans it would make available to financial institutions.

In a statement, the President's Working Group on Financial Markets, a consortium of such key
agencies as the Fed and the Treasury, said that U.S. agencies in coming days would be "moving
with substantial force on a number of fronts" to try to shore up confidence in global markets.

But on the first day of trading since the bailout package was signed into law, the focus instead
seemed to rest on developing problems among European banks, as well as worry in Asia that a
global recession will undercut that continent's export-dependent economies.

The Dow Jones industrial average dropped below 10,000 for the first time in four years, at one point
falling by more than 700 points, or just under 6.9 percent. However, shortly after 3 p.m. the markets
staged a modest recovery and the Dow was off 5 percent, about 552 points, at 3:45 p.m. The
Nasdaq was down about 5.6 percent and the Standard & Poor's 500-stock index was off 5.4
percent at 3:45 p.m.

Losses in Asia were comparable, but European indexes suffered even steeper declines. London's
FTSE 100 and Germany's DAX 30 closed down more than 7 percent, while Paris's CAC 40 had lost
9 percent of its value.

In Washington today, World Bank President Robert B. Zoellick said that the financial crisis could
dampen global enthusiasm for free markets and proposed a new approach to international
cooperation on financial issues.

In addition to the seven major developed countries whose finance ministers meet regularly to plot a
course for the global economy, major developing nations should be part of such efforts, Zoellick
said in a speech at the Peterson Institute for International Economics.
He suggested that Brazil, China, India, Mexico, Russia, Saudi Arabia and South Africa be involved
in these collaborations, which now occur among the Group of Seven, or G-7, finance ministers. The
G-7 includes the United States, Japan and large Western European nations.

The group must work to identify problems in the global economy early and aggressively, he said.
"We need this mechanism," Zoellick said, "so that global problems are not just mopped up after the
fact, but anticipated."

In Europe, officials and investors focused on the cracks appearing in European companies, with
some officials wondering if the region needed its own comprehensive rescue package.

Leaders of the G-7 group of industrialized nations are expected to meet this week in Washington to
discuss the global financial system. But in the meantime European governments moved to convince
depositors and investors that the banking system was safe.

Germany, Denmark, Sweden and Austria expanded guarantees for private bank accounts, while
other steps were taken to help ailing companies. Officials in Iceland announced plans for its banks
to sell their large overseas holdings as a way to raise cash; Russian stock markets were shuttered
temporarily after a 14 percent drop in a major index, the Reuters wire service reported.

German Chancellor Angela Merkel announced deposit guarantees in her country Sunday, in an
attempt to calm depositors as officials tried to resurrect a failed bailout plan for a blue-chip lender.
"We want to tell savers that their deposits are safe," Merkel told reporters at a hastily called news
conference a day after she returned from an emergency summit of European leaders in Paris. "The
government will vouch for that."

The German government's guarantee was prompted by the collapse of a $50 billion plan to rescue
Hypo Real Estate, a large commercial-property lender, after its liabilities were discovered to be
worse than expected, German officials said.

Saudi Arabia's stock market, the Arab world's largest, suffered one of its worst trading days on
record as Persian Gulf investors returned from last week's Eid al-Fitr holiday to face the local and
global glut of bad news. The Saudi market fell 9.8 percent, ending the day at 6,726.60 points. All of
the 124 stocks traded Monday suffered a loss at or near 10 percent, the daily maximum allowed
under Saudi law.

The stock market in Dubai, the boomtown of the Persian Gulf's United Arab Emirates, fell 7.6
percent today after posting nearly as great a loss yesterday. Property developers led losses as
overseas investors pulled out. Emaar, Dubai's property giant, lost more than 10 percent for a
second day.

Kuwait's stock exchange, the region's second-largest after Saudi Arabia's, sank by 3.45 percent.
Abu Dhabi's exchange dropped 5.6 percent.

Until late in this year, the biggest worry for the Gulf's government financial officials was how to
handle record surpluses from oil profits. Gulf officials went into the long holiday saying publicly they
still believed their economies were immune from the West's financial turmoil.

But liquidity problems, withdrawal of foreign cash and fears of sagging demand for oil all were
bringing the crisis home. Crude oil fell below $90 a barrel today, its lowest price since February.

In Dubai, the weekend announcement of merger talks between two of the emirates' biggest
mortgage lenders and government offers of cash infusions for local banks failed to ease local
traders' worries.

In Asia, pessimism about a prolonged recession in Japan, where business confidence was
measured last week at a record low, pushed Tokyo's two leading stock indexes to their lowest
levels in nearly five years. The 225-issue Nikkei average was off 4.25 percent and the broader
Topix was down 4.67 percent.

Hiroichi Nishi, equities chief at Nikko Cordial Securities Inc., told the Kyodo news service that
Washington's approval on Friday of a $700 billion bailout package is not enough to calm nervous
investors. The market "is now concerned about the new law's effectiveness" in easing the crisis in
the U.S. credit market, he said.

Stocks in Shanghai, where markets had been closed for a week because of a Chinese holiday, fell
about 5 percent, as did Hong Kong's Hang Seng index, which closed at its lowest level in more than
two years. India's Mumbai stock exchange fell 724 points, or more than 4 percent.

Unlike the United States or much of Europe, anxiety about tight credit does not appear to be driving
Asian stock markets down, analysts say. With large reserves of cash and relatively limited exposure
to toxic U.S. mortgage securities, most Asian banks are in much better shape than those in the
United States or in much of Europe.

What has alarmed investors in Japan and across Asia is a rapid falloff in exports, especially to the
United States. Friday's report that American employers cut 159,000 jobs, the largest cuts since
2003, deepened concern here that a recession in the United States would depress exports well
beyond 2009.

The concern was reflected in the stock price of Toyota, down nearly 6 percent and Sony, down just
over 6 percent. Exporters were also hurt by the rising value of the yen against the dollar, which was
up about 2 percent this afternoon.

Japan's largest banks and investment firms were among the biggest losers today. Mitsubishi UFJ
Financial Group, Japan's largest bank, was down more than 9 percent, while Nomura Holding, the
largest investment house, fell nearly 8 percent.

Europe Struggles for a Response to the Bank Crisis

Oct. 07, 2008

European bank stocks continued to take a beating on Tuesday following a series of ad hoc steps by
national governments to try to shore up confidence in financial institutions. By the day's close,
Britain's troubled HBOS was down 41.5%, and the Royal Bank of Scotland's shares had lost 39% of
their value; Germany's Commerzbank fell 14% and Deutsche Bank was down 8.9%. The
pummeling followed a black Monday in which stock exchanges across Europe dropped by up to
9%, suggesting that the markets were casting a doleful eye on the $700 billion U.S. bailout package
passed by Congress on Friday.

Europe was looking askance not just at the U.S., but also at tiny Iceland, whose government on
Monday completed what amounts to an emergency seizure of its oversized banking sector. Prime
Minister Geir Haarde went on television Monday night to warn his compatriots that "the Icelandic
economy, in the worst case, could be sucked with the banks into the whirlpool and the result could
be bankruptcy." That's not just talk: Iceland's GDP amounts to less than a tenth of the total assets
of its three biggest banks, all of which are in trouble. British financial authorities warned on Tuesday
that Icesave, a subsidiary of Landsbanki, Iceland's second biggest bank, might not be able to pay
out the estimated $7.8 billion in deposits of some 300,000 British customers, who would then have
to file claims to deposit guarantees set by Iceland and Britain, which would cover up to $87,000 of
an individual's savings. One London-based customer said she had tried over a week ago to
withdraw her money from Icesave, but was told she could not. "I didn't think it was exposed to the
mortgage market," she says. "Where did all that money go?"
But scary conditions elsewhere hardly drew attention away from the underlying weakness in
Europe's own supervision of its financial institutions. Most of the continent is conjoined into a
political union of 27 countries, 15 of which use the euro under the monetary authority of the
European Central Bank. But as the recent days' fraught activity proved, coordination between
governments on fiscal and supervisory measures remain strictly voluntary.

Europe's bank-by-bank, country-by-country fixes of its endangered banks have so far failed to
bolster the confidence of investors and depositors. "Europe must prepare to put in place a collective
line of defense," Dominique Strauss-Kahn, director general of the International Monetary Fund, said
in a speech in Paris on Monday. "The stability of the world economy is at stake."

European governments can certainly talk the talk of coordination. Following a meeting with Italian
Prime Minister Silvio Berlusconi in Berlin yesterday, German Chancellor Angela Merkel said: "We
both agree that Europeans of course need to display a coherent course of action." President
Nicolas Sarkozy of France, which currently holds the rotating E.U. Presidency , read on television a
common statement from all 27 members pledging to adopt "all necessary measures to protect the
stability of the financial system."
But those words have been notably lacking in any concrete policy to back them up, particularly with
the crisis moving so rapidly. "Uncoordinated rescue operations, far from restoring confidence, are
further fueling fears among savers and investors," said Daniel Gros, director of the Center for
European Studies in Brussels. Such actions are pushing Europe "toward a full-fledged banking
crisis," he said, with the "likelihood of a serious economic downturn [looming] ever larger."

There was a modicum of cooperation on Tuesday, when E.U. finance ministers, meeting in
Luxembourg, agreed to increase the minimum value of deposits guaranteed by member states to
$68,000 from a previous floor of $20,000. But beyond that there appeared little movement toward
international coordination. On Monday Germany reaffirmed its determination not to participate in
France's plan for a Europe-wide bank bailout plan, modeled on the U.S.'s $700 billion effort.
Without Germany's participation, no such plan can proceed. "The Chancellor and I reject a
European shield," German Social Democrat Finance Minister Peer Steinbrück told German radio on
Monday in reference to the plan, "because we as Germans do not want to pay into a big pot where
we do not have control and where we do not know where German money might be used."

The comments came a day after Merkel befuddled her neighbors by announcing a guarantee on
100% of all private deposits — the largest such guarantee in history, according to one leading
banking expert. The fact that Ireland had previously issued an even more sweeping guarantee
hardly shielded Germany from criticism: as Europe's biggest economy, it sets a massive precedent.
Indeed, since Merkel's announcement, Denmark, Sweden and Austria have taken steps to offer
stronger guarantees to their depositors. Spain is reportedly considering a move to follow suit and
British politicians were in talks with banks on Monday night about a stopgap measure to inject
government funds into selected institutions.

German officials say that the guarantee was necessary to shore up confidence, not least because
Germans hold a higher proportion of their savings in banks than many industrialized nations — and
still harbor a deep collective memory of the perils of economic uncertainty from the interwar years of
the Weimar Republic. "We had to do it," says Reinhard Schmidt, a professor of international
banking and finance at Goethe University in Frankfurt. "I have friends. I have neighbors. I have
family. You wouldn't believe how many people have been calling me to ask about their deposits.
The fears are extremely strong now."

Germany's refusal to sign on to a continent-wide bailout plan was no less necessary, says Schmidt.
Such a plan would have triggered a backlash in Germany against the E.U., egged on by the ready
arguments of the anti-Europe German press that Germans were paying to bail out other Europeans,
he says. "It would have destroyed the idea of European integration," he says.
 Which still leaves the problem of how to address the broader crisis now that the country-by-country
approach appears to be failing. Gros recommends a common European scheme to shore up capital
of distressed banks and the establishment of a "clear center of joint responsibility for the
supervision and liquidity support of cross-border European banks," which he says should be housed
in the European Central Bank. (At present the chief tool available to the ECB is lowering interest
rates.)

If a shock is what is needed to restructure the banking rules in Europe, one may be underway.
Economists are warning that the continent is facing its biggest crisis since the Depression — when
Europeans also first mistakenly thought the problem would remain confined to the U.S. One leading
German politician, Interior Minister Wolfgang Schäuble, even raised the specter of the kind of
longer term economic dislocation that led to the rise of Adolf Hitler. "Four months ago," says
economist Schmidt, "I might have said that it may not get worse. But we have not seen anything like
this before. I cannot say that we have reached the bottom," he says. "I am afraid that may not be
the case."

Fed to buy massive amounts of short-term debt

Fed in bold move to thaw credit markets says it will buy massive amounts of short-term debt
October 7th
The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term
debt in a dramatic effort to break through a credit clog that is imperiling the economy. Invoking
Depression-era emergency powers, the Fed will buy commercial paper, a short-term financing
mechanism that many companies rely on to finance their day-to-day operations, such as purchasing
supplies or making payrolls.

In more normal times, about $100 billion of these short-term IOUs were outstanding at any given
time, sold by companies to buyers that included money market mutual funds, pension funds and
other investors. But this market has virtually dried up as investors have become too jittery to buy
paper for longer than overnight or a couple days.
That has made it increasingly difficult and expensive for companies to raise money to fund their
operations. Commercial paper is a way of borrowing money for short periods, typically ranging from
overnight to less than a week.

The unstable situation has left many companies vulnerable. The notion under the plan is for the
government to provide a "backstop" that would give companies a new place to get cash, the Fed
said. The action makes the Fed a crucial source of credit for nonfinancial businesses in addition to
commercial banks and investment firms.

The Fed's action initially helped lift investors' spirits, although concerns about the economy
dampened their enthusiasm. The Dow Jones industrials -- which gained about 145 points just after
the open -- fell nearly 40 points in late morning trading. Monday, a huge sell off put the Dow below
10,000 for the first time in four years.

Concerns about the credit markets pushed investors into longer-term Treasury bonds, considered a
secure place to park money in times of turmoil. The rush to safety drove yields lower, though.

European stocks posted modest gains on hopes that central banks around the globe would
coordinate on rate cuts. Share prices in Britain and in Germany, Europe's largest economy, rose.
Iceland, however, is facing the prospect of bankruptcy, according to the Prime Minister Geir H.
Haarde, after its banks went on a buying spree across Europe, accumulating massive debts in the
process.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed
commercial paper directly from eligible companies. It hopes to have the program up and running
soon, Fed officials said.

Fed officials said they’d buy as much of the debt as necessary to get the market functioning again.
They refused to say how much that might be, but they noted that around $1.3 trillion worth of
commercial paper would qualify.

"The commercial paper market has been under considerable strain in recent weeks as money
market mutual funds and other investors" have become increasingly reluctant to buy commercial
paper, especially longer-dated maturities. As the market for commercial paper shrank, the Fed said
rates on the longer-term debt "increased significantly," making it more expensive for companies to
borrow.

The Treasury Department, which worked with the Fed on the program, said the action is "necessary
to prevent substantial disruptions to the financial markets and the economy."
The Treasury will provide money to the Federal Reserve Bank of New York to support the new
program, the Fed said. Fed officials would not say how much but believed it would be substantial.
The money would not come from the $700 billion financial bailout President Bush signed into law on
Friday.

If a company's commercial paper is not backed by assets or other forms of security acceptable to
the Fed, the company could pay an upfront fee, the central bank said. The amount of such a fee
has not yet been determined. The Fed said it hoped its effort would jolt the commercial paper
market back to life.

"This facility should encourage investors to once again engage in term lending in the commercial
paper market," the Fed said. That should eventually spur financial companies to lend to each other
and to their customers, including consumers, the Fed said.

The Fed said it planned to stop buying commercial paper on April 30, 2009, unless the Federal
Reserve board agrees to extend the program. The Fed created a separate entity to pool and hold
the commercial paper it buys. The Fed said this should allow the central bank to more easily
manage the program and better control risk.
There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of
last Wednesday, according to the most recent data from the Fed. That was down from $1.70 trillion
in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2
trillion.

Pressure also is growing on the Fed to reverse course and order a deep reduction in its key interest
rate, now at 2 percent. Such a move would be aimed at reviving the moribund economy by
encouraging consumers and businesses to boost their spending. Many predict the Fed will act on or
before its next meeting on Oct. 28-29. And, some believe it could be part of a broader coordinated
move with central banks in other countries.
Fed Chairman Ben Bernanke may offer clues on the Fed's next move when he speaks Tuesday
afternoon on the economic outlook and developments in financial markets.
President Bush also was set to talk about the government's bailout effort, which lets the government
buy rotten mortgages and other bad debts from banks and other financial institutions. By getting
these bad debts off bank's balance sheets, they might be in a better position to raise capital and
more willing to lend to each other and to customers.

As the number of failed banks has gone up sharply this year, Sheila Bair, head of the Federal
Deposit Insurance Corp., wants to boost fees to financial institutions to replenish the insurance fund
that backs the nation's deposits. The increase would double the average paid by U.S. banks and
thrifts next year.
The Fed pledged Monday to take "additional measures as necessary" to battle the worst credit
crisis in decades.

Treasury Secretary Henry Paulson has tapped a former Goldman Sachs executive to be director of
the government's bailout program. Neel Kashkari, who has worked with Paulson at the department
since July 2006, was chosen Monday as the interim head of the government's unprecedented effort
to unclog the credit markets. Kashkari, who was a vice president in Goldman's San Francisco office
before joining the department, is one of four former executives from the firm now working feverishly
to resolve the financial crisis.

The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money
freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital
investments. Consumers have retrenched.
The unintended consequences
October 7, 2008
Running through Heathrow Airport this spring, late for a flight connection, my eye briefly caught a
tabloid newspaper with the glaring headline: "End of 105-percent Mortgages!!!" Recovering my
sanity on the plane a half-hour later, I began to ponder what that meant. And it wasn't a pleasant
discovery.

What 105-percent mortgages meant was that foolish banks had lent to foolish people (at very low
interest rates) not only the entire capital for buying a house or apartment without the purchaser
putting up funds, but an extra 5 percent to, say, improve the kitchen.

This foolishness was not confined to Britain, although its habits of excess may have gone beyond
all others. And, truth be told, if only the British home-lending system had been badly hurt that would
not have raised many eyebrows in Singapore or Dubai.

The problem was that the same sort of fiscal recklessness was rampant in the world's largest
economy and, more importantly, that this cancer of home-loans-without-responsibility had sucked in
banks and investors across most of the globalized world.

Sub-prime mortgages in the United States had been eagerly funded by hitherto austere Swiss
banks and normally Dickensian North-Yorkshire building societies. They had also been funded
indirectly (but what is "indirectly" these days?) by Norwegian and Chinese investment corporations.
And the physical result was as plain as a pikestaff; it can now be seen in all those photographs of
hundreds of half-built McMansions running straight into the cactus fields of Arizona. Here was the
equivalent of the early-18th-century Dutch tulip bulb frenzy. And now it has collapsed, and rightly
so.
But it is not just those foolish banks and foolish borrowers who have been hurt by the sub-prime
meltdown, the collapse of venerable financial institutions, and the clumsy reactions of legislators
(none of whom seem to understand how modern capital markets work). The so-called "ripple effect"
is surging much further afield, inflicting a lot of damage.

One is reminded, with mixed feelings, of the great Austrian economist Joseph Schumpeter's phrase
about "the perennial gale of creative destruction" that accompanies all capitalism. Some of the
casualties have been at the forefront of all media headlines: Bear Stearns, Northern Rock, Lehman
Brothers, Washington Mutual, the Halifax Bank of Scotland. Others, like Morgan Stanley and
Goldman Sachs, have had to turn themselves into a different sort of financial creature to survive.

Even those entities with capital assets enough to pick through and purchase parts of their fallen
comrades in this gigantic yard sale (I'm thinking here of Barclays, Lloyds, Goldman Sachs, Bank of
America, Morgan Stanley, Warren Buffett) are themselves diminished in their absolute capital
standings, though they will surely stand stronger in a couple of years.

It is unlikely that this board game of "roadkill and vultures" will stop soon, since a lot more medium-
sized banks are on the verge and probably wouldn't have received much help from the Congress'
first gigantic, ill-focused recovery package, which rightly met its nemesis Monday afternoon.

In the meantime, tens of thousands of highly paid traders and bank employees are losing their jobs
and their spending habits are contracting, which in turn will hit many more jobs further down the
pecking order. Small businesses that hoped to expand, or young couples wanting to buy their first
apartment will find themselves hampered. Small and big people are hurt. The Chinese investment
agency, which put many billions into Fannie Mae and Freddie Mac, is licking its wounds, too.

But cast a glance at some of the other unintended consequences of the sub-prime debacle. As the
so-called globalized economy contracts, many of the companies that provide its underpinnings will
feel the pain. Expect to read that Boeing and Airbus have accepted significantly longer delivery
schedules to various airlines for their super-long-range jetliners; and expect that Korean
shipbuilders will note a marked reduction in future container-ship orders.

Expect that the providers of high-tech office equipment, desktops and super-computers will see a
tumbling of orders. This is not a time to be in Silicon Valley. Better by far to be producing single-
malt Scotch whiskey. At least you can sip it.

This contraction is also witnessing a tumble in the price of all commodities, especially oil. It is not a
bad thing to have the future per-barrel oil price fall to, say, a mere $85, especially as winter
approaches. Moreover, those tumbling oil prices will also, and more sharply, hit the arrogant
petroleum-peacock-states of Chávez's Venezuela and Putin's Russia. They, too, will recognize
more than they ever did before that they have become to a large extent dependent upon the
London Interbank Offered Rate (the mysterious Libor) and the forward market price of West Texas
Intermediate crude. Having to close the Russian stock market, as happened again last week, and
yet also watch venture capital flow out of that country, may prove to be a nice curb on Kremlin
foreign-policy posturings.

Even the rising Chinese superpower is being blasted by these distant capitalistic convulsions. How
could its Finance Ministry, seduced by the advice of Wall Street bankers and consultants to place
billions of dollars into American so-called "safe havens," not be badly shaken by the financial
tumults of the past few weeks?

Should China trust the Yankee capitalist system? What will happen to its vital exports to that
enormous, volatile consumer market? Already The People's Daily in Beijing has published a
noteworthy piece by the economist Shi Jianxun calling upon the world to create "a diversified
currency and financial system and (a) fair and just financial order that is not dependent on the
United States." Where goes the dollar then, and its reputation as a safe haven?
At the end of the day, then, the biggest loser may well be the United States itself, and by that I
mean not just the standards of living of tens of millions of its citizens but its relative military-
diplomatic "heft" in world affairs.

If a country's great-power status is underpinned by its economic muscle, then the present credit-
market crisis cannot be anything other than detrimental, one late blow at the end of an eight-year
presidency that has already weakened America's position in many other ways. One can only admire
John McCain and Barack Obama for their courage (or worry at their lack of imagination) for actively
desiring to get into a White House so full of broken china.

And such a lot of this has to do with those 105-percent mortgages and the arrogance, greed and
foolishness of those who handed them out, those who took them, and the legislatures who
dismantled prudent fiscal oversight.

Ruefully, and as I cast a glance at my own pension holdings, I see I was right to worry about what
that tabloid headline meant. In this globalized, interconnected world of ours, no man is an island.
So, in John Donne's immortal words, "Never send to know for whom the bell tolls. It tolls for thee."

What is commercial paper, and why does it matter?

October 7, 2008
Why is the commercial paper market so pivotal to easing the credit crunch that the Federal Reserve
announced Tuesday it will intervene to prop up the market? The Associated Press offers some
insight based on interviews with experts:

Q: What exactly is the commercial paper market?

A: It's a low-cost source of cash for companies to meet short-term financial needs. A key advantage
is that it's cheaper than tapping a line of credit from a bank. The market really began to grow in the
1970s with the emergence of money-market mutual funds that became large buyers of commercial
paper.

Q: What type of companies raise money on the commercial paper market, and what do they do with
it?

A: The big and financially sound firms that typically issue commercial paper have plenty of revenue
to fund long-term needs. But they also sometimes need short-term cash to cover everything from
buying supplies, paying vendors and making payroll, so they turn to the commercial paper market.

When such a firm temporarily has extra cash and wants to get a decent return to offset inflation, it
can switch roles and serve as a buyer of commercial paper to make cash available to other
companies.

Such borrowing is often unsecured, with no assets serving as collateral. Such transactions are
backed by the borrowing company's high credit ratings and regular cash flow, and expectation that
it can make repayment once it receives money due from its own customers. It's less common, but
asset-backed commercial paper can be secured by assets such as consumer loans.

Companies with low credit ratings generally raise cash through bond offerings rather than short-
term commercial paper.

Q: How long do companies borrowing in the commercial paper market have to make repayment,
and what are the terms?

A: Commercial paper carries shorter repayment dates than bonds, with maturities running
anywhere from overnight to as long as nine months. The longer the maturity, the higher the interest
rate. Because of their short maturities, commercial paper is exempt from registering with the
Securities and Exchange Commission, which helps keep borrowing costs low. Interest rates
fluctuate with market conditions, but are typically lower than banks' rates.

Q: Besides corporations with extra cash, who supplies the money to the commercial paper market?

A: Money-market mutual funds and other funds open primarily to institutional investors buy about 60
percent of the commercial paper in the market, according to Peter Crane, president of fund-tracking
firm Crane Data. "Money-market funds are the 800-pound gorilla in the commercial paper market,"
Crane said. By participating, money funds typically generate a higher yield than from investing in
safer government debt such as Treasury bills.

Q: What's happened to commercial paper amid the recent volatility?

A: While commercial paper is still generally a safe investment, its risks were highlighted last month
as a large money-market fund called the Reserve Primary Fund "broke the buck" — meaning the
value of its underlying assets fell below $1 for each investor dollar put in. Investors were exposed to
losses after the fund conceded that $785 million it had invested in debt of Lehman Brothers became
worthless after the investment bank's bankruptcy. That instance, and the broad turmoil in markets,
have made investors wary of even the smallest risk that a borrower may default.

The commercial paper market has shrunk to about $1.6 trillion in outstanding borrowing, down from
$2.2 trillion in July 2007. Institutional investors in money-market funds, such as pension funds, have
led the pullout. Over the four-week period ended Friday, assets in so-called "prime" money-market
funds investing in commercial paper dropped by more than $514 billion, or about 25 percent,
according to fund-tracking firm iMoneyNet. Meanwhile, reflecting a shift to security, assets in
money-market funds investing in government debt gained $380 billion during the same four weeks.

Q: How are the commercial paper market's troubles affecting businesses?

A: The flight of money funds and other participants from commercial paper has left companies
facing higher interest rates to raise short-term cash, especially for borrowing with repayment
periods of weeks or months rather than days. That means they must rely on higher-cost credit from
banks, or forgo borrowing at all.

Consequently, as the freeze persists, companies could have to scramble to find cash for short-term
needs. The Federal Reserve's move Tuesday to begin buying three-month unsecured and asset-
backed commercial paper directly from eligible companies is intended to head off such problems.

"Until last week, the word of a company like Chevron or Toyota was good enough for the
commercial paper market," said Crane, of Crane Data. "It still is, but investors are demanding a
premium, and the money-market funds are having to deal with forced liquidations, and panic
outflows."

Crane and Ben Garber, an economist with Moody's Investors Service, said they have not yet heard
of instances of major companies being unable to meet short-term obligations because of the freeze
in the market. But such instances would likely begin to crop up in coming weeks, absent any
catalyst to thaw the market, they said.

"The odds of a company like Chevron or IBM not being able to meet payroll is ridiculously low, but
after a while it might become an issue," Crane said. "It's like you're an ocean liner approaching an
iceberg. You have to adjust your course from a long way off to avoid hitting it."

The danger of ignoring reality

October 8, 2008
Thirty billion dollars to keep Bear Stearns from collapsing. Another $85 billion for AIG. Hundreds of
billions, here and there, lent to banks.
All told, the U.S. Federal Reserve has pumped $800 billion into the financial system, Ben Bernanke, its
chairman, estimated on Tuesday. That figure doesn't include the untold sum that the Fed now plans to
spend buying short-term debt so that companies can continue to pay for their daily operations. And it
doesn't include any of the money the Treasury Department is laying out, like the $700 billion bailout fund
or the $200 billion that could be spent propping up Fannie Mae and Freddie Mac.

After 14 months of financial crisis, the U.S. government - which means the U.S. taxpayers - has put
serious money on the line. As a point of comparison, the entire annual U.S. budget is about $3 trillion.

Just how are Americans going to pay for all this?

The short answer is that the budget problems the country seemed to have a year ago are now even
worse. Next year's deficit (relative to the economy's size) will probably be the biggest since 1992, and
maybe since 1983. Taxes will have to rise or government spending will have to fall, if not both. Trying to
contain the mess created by a bubble costs serious money.

Yet this is also a case in which the short answer isn't the full answer, or even the best answer.

As expensive as the damage control may be, it isn't likely to cost anywhere near as much as the headline
numbers suggest. More to the point, the alternative - not spending some serious money to deal with the
crisis - would probably end up costing a lot more. As it is, the various bailouts are not the main reason
next year's deficit is growing. The deteriorating state of the economy is.

So if you want to conjure up some doomsday stories about the U.S. budget, I'm happy to play along (and
will do so momentarily). But those stories aren't mainly about the credit crisis. They're about the dangers
of ignoring economic realities - which, when you think about it, is how we ended up in this credit crisis in
the first place.

The most newsworthy part of Bernanke's lunchtime speech on Tuesday was his sober overview of the
economy. He called the financial crisis "a problem of historic dimensions" and indicated that the Fed
would soon cut its benchmark interest rate once again, as it did Wednesday.

But the bulk of the speech was a catalog of the extraordinary steps that the Fed and the Treasury have
taken since August and the delicate line they have tried to walk along the way. To try to restore some
confidence to the credit markets, they have lent enormous amounts of money to banks and trumpeted
those efforts. Fed officials have pointed out that they are nowhere close to being out of bullets, either.
They work for the central bank, after all. They can always print money.

But Bernanke and Henry Paulson Jr., the Treasury secretary, have also emphasized that they're not
being too generous. They are mainly making loans and investments, and they expect to recoup much of
the money they're spreading around.

Outside the government, economists differ about whether Bernanke and Paulson have been too
aggressive or not aggressive enough and whether they have been aggressive in the right ways. But there
is not much concern that they are taking on additional debt - or even about the amount of it.

"The policy actions are not likely to have a large effect on the budget over the next 5 or 10 years,"
Douglas Elmendorf, who has become a go-to Democratic economist during the crisis, told me.

John Makin of the rightist American Enterprise Institute said: "The last thing I'm worried about right now is
additional government indebtedness. There really isn't an alternative."

Makin pointed out that during the long malaise in Japan, the government passed a stimulus package
almost every year that was equal to more than 2 percent of the country's gross domestic product
(equivalent to about $400 billion in the United States today). But interest rates in Japan remained low, a
sign that economic weakness, not deficits, was still the problem.
That being said, today's ever-expanding bailouts do create some dangers. You've probably heard the
term moral hazard, which is shorthand for the idea that the government's rescues may lead investors to
take new, unwise risks - and ultimately require yet more rescues.

The Fed is also setting itself up for tough decisions about when to end its various emergency programs. If
it waits too long, it could leave so much money sloshing around the economy that inflation will take off.
Fed officials have suggested they understand that they made precisely this mistake after the 2001
recession, when they kept interest rates low and added to the mania in the housing market.

Finally, there is the net cost of the bailouts, which may well be bigger than Bernanke has acknowledged.
Under the program announced Tuesday, the Fed will own the commercial paper that serves as short-
term loans for companies. If some of those companies go bankrupt, the Fed could suffer some losses.

The Treasury's $700 billion bailout fund, meanwhile, is based on the premise that investors are
collectively undervaluing assets and that the government can pay above current market prices without
losing much money.

"One has to be at least a bit skeptical," Greg Mankiw, the Harvard economics professor, says, "about the
idea that government policy makers gambling with other people's money are better at judging the value of
complex financial instruments than are private investors gambling with their own."

After talking with budget analysts, I think it's reasonable to assume that the bailouts will end up costing
several hundred billion dollars, spread over several years. Perhaps $100 billion of that cost may come
next year. Add in another $100 billion or so for the weakening economy - specifically the fall in tax
revenues, increases in spending on social programs and the possibility of another stimulus package.

Even before the crisis, President George W. Bush was set to bequeath a $550 billion deficit in the coming
year to his successor. Now, a better estimate appears to be $750 billion - or 5 percent of gross domestic
product. The only years since the 1960s that the deficit has been nearly so large were the early 1990s
(almost 4.5 percent of GDP) and the mid-1980s (with a peak of 6 percent in 1983).

Obviously, next year's deficit is a problem. And if you assume the credit crisis isn't about to lift - which
seems smart at this point - the ultimate cost of the bailouts could conceivably go higher. Whatever the
final figure, it should still be put in some context.

Despite everything, the biggest fiscal problem remains, far and away, health care. Based on the rate that
medical spending has been rising, the Congressional Budget Office forecasts that Medicare and
Medicaid will make up 10 percent of GDP within two decades, up from about 4 percent now. In today's
terms, that would be the equivalent of adding at least $900 billion to the deficit every single year, in
perpetuity. It makes the cost of the bailouts look like a rounding error.

When it comes to health care, the United States has a situation that is blatantly unsustainable. With the
right choices, we can prevent that. But so far, we instead seem to be hoping that the situation will
magically resolve itself, which is a recipe for big problems and perhaps even a crisis.

Let's see. That doesn't sound familiar, does it?

Globalizing the Crisis Response

Op-ed in the Washington Post October 8, 2008

The financial crisis has gone global. Stock indexes have fallen and credit markets are seizing up
around the world. In recent days, as most Americans focused on the political drama of the rescue
package, a number of European banks have failed or been taken over. Several in Russia and
Eastern Europe are teetering on the verge of insolvency. Many Latin American countries are newly
vulnerable because foreign banks are big players there. Few nations can escape the financial
contagion.
Global oversight of both financial regulation and currencies can no longer be neglected.
Also looming is an even more virulent form of contagion: decreased levels of economic activity
because of contracting trade flows. Japan and several European countries are already in recession.
If the United States and the entire European Union sink further, as looks increasingly possible,
emerging markets and developing countries will face lower exports and less growth. Even China will
experience a sharp slowdown because of its heavy reliance on overseas markets. Unemployment
will soar almost everywhere.

Globalization of the crisis requires a globalized response. While the consequences of financial
crises are clearly international, the regulation of finance remains almost wholly national. And
national efforts, including the US rescue plan and European governments' remedies for their
nations' bank problems, will continue to be the first responses.

Yet an internationally coordinated strategy, ranging far beyond the heroic efforts of the world's
leading central banks, is essential now that the US rescue plan is in place. When finance ministers
convene in Washington this week for the annual International Monetary Fund meeting, they should
adopt several initial components of such a strategy. Not doing so would be almost as serious as if
Congress had adjourned without passing the rescue legislation.

First, heading off a precipitous decline in world economic activity requires a global stimulus
program. Different governments can use different policy tools. China has room for fiscal expansion,
while Europe could ease monetary policy. The United States can combine the two. A coordinated
effort should boost confidence and would deter individual countries from attempting to escape the
downturn via trade controls and other beggar-thy-neighbor policies.

Second, coordination of the parallel national efforts to recapitalize tottering banking systems would
pack a powerful psychological punch. The United States, European Union, and some others are
moving rapidly to shore up their financial institutions. But countries need both to do more and to
avoid gaps in their rescue programs by agreeing on how to handle cross-border loans and financial
institutions that operate across jurisdictions. Widespread international participation in the
recapitalization effort, including by the highly liquid sovereign wealth funds, could be of substantial
help.

Third, as the United States and some Europeans are already doing, many countries will need to
expand coverage of their deposit insurance programs to discourage bank runs. Parallel or uniform
policy steps through which unlimited insurance is provided for at least a temporary period, as
Germany and Ireland have done for their banks and the Treasury has for US money market funds,
will be mutually reinforcing and help prevent panic.

Beyond the short term, countries will need to develop a cooperative framework to prevent and
resolve such crises, most urgently within Europe. There is inherent tension as finance becomes
global but its regulation remains national. The current crisis originated in the United States but was
importantly affected by massive savings surpluses in some countries and the resulting surfeit of
liquidity, which drove down interest rates and encouraged irresponsible lending here. Those
international imbalances were in turn partly caused by misaligned exchange rates. Global oversight
of both financial regulation and currencies can no longer be neglected.

Our policy responses must reflect the interdependent vulnerability of the world economy. Although
the Europeans rebuffed a recent US initiative for a cooperative strategy and are having trouble
getting their region-wide act together, it is too late to assign blame over responsibility for the crisis,
within or among countries. The traditional Group of Seven industrial countries have mounted
coordinated economic programs of this type in the past, with considerable success; now they must
be joined by the chief emerging markets, particularly China. The G-7 finance ministers should fully
include the five or six main emerging markets in their upcoming meeting and seek to forge a global
strategy. This week's IMF conclave offers a unique opportunity to add a critical international
dimension to the crisis response.
 By: C. Fred Bergsten and Arvind Subramanian, Peterson Institute

The credit crunch

Saving the system
Economist--Oct 9th 2008

At last a glimmer of hope, but more boldness is needed to avert a global economic
catastrophe

CONFIDENCE is everything in finance. Until this week the politicians trying to tackle the credit
crunch had done little to restore this essential ingredient. In America Congress dithered over the
Bush administration’s $700 billion bail-out plan. In Europe governments have casually played
beggar-my-neighbor politics, with countries launching deposit-guarantee schemes that destabilized
banks elsewhere. This week, however, saw the first glimmers of a comprehensive global answer to
the confidence gap.

One clear sign was an unprecedented co-ordinated interest-rate cut on October 8th by the world’s
main central banks, including the Federal Reserve, the European Central Bank, the Bank of
England and (officially a coincidence) the People’s Bank of China. Various continental European
countries also set about recapitalizing their banks. But the most astounding developments were in
America and Britain. The Fed doubled the amount of money available to banks on a short-term
basis to $900 billion and announced that it would buy unsecured commercial paper directly from
corporate borrowers. More surprisingly, Gordon Brown’s government, hitherto the ditherer par
excellence, produced the first systemic plan for dealing with the crisis, not just providing capital and
short-term loans to banks but also offering to guarantee new debt for up to three years

This is certainly progress, but it is not enough. The world’s finance ministers and central bankers,
gathering in Washington, DC, this weekend for the annual meetings of the IMF and World Bank,
should deliver a simple message: more will be done. The world economy is plainly in a poor state,
but it could get a lot worse. This is a time to put dogma and politics to one side and concentrate on
pragmatic answers. That means more government intervention and co-operation in the short term
than taxpayers, politicians or indeed free-market newspapers would normally like.

The patient writhing on the floor

If the panic that has choked the arteries of credit across the globe is not calmed soon, the danger
will increase that output in rich economies will not simply shrink, but collapse. The same could
happen in many emerging markets, especially those that rely on foreign capital. No country or
industry would be spared from the equivalent of a global financial heart attack.

Stockmarkets are in a funk. But the main problem remains the credit markets. In the interbank
market the prices banks pay to borrow money from each other are still near record highs.
Meanwhile corporate borrowers have found it hard to issue commercial paper, as money-market
funds have fled from all but the safest assets. In emerging markets bond spreads have soared and
local currencies plunged. And whole countries have begun to get into trouble. The government of
Iceland has had to nationalize two of its biggest banks and is frantically seeking a lifeline loan from
Russia. Robert Zoellick, president of the World Bank, says there could be balance-of-payments
problems in up to 30 developing countries.

The damage to the real economy is becoming apparent. In America consumer credit is now
shrinking, and around 159,000 Americans lost their jobs in September, the most since 2003. Some
industries are hurting badly: car sales are at their lowest level in 16 years as would-be buyers are
unable to get credit. General Motors has temporarily shut some of its factories in Europe. Across
the globe forward-looking indicators, such as surveys of purchasing managers, are horribly gloomy.

If the odds of a rich-world recession have risen towards a near certainty, the emerging world as a
whole is slowing rather than slumping. China still seems fairly resilient. Taken as a whole, though,
growth in the world economy seems likely to slow below 3% next year—a pace that many count as
recessionary. So the prospects are grim enough, but a continuing credit drought would make this
much worse.

Lessons old and new

The lesson of history is that early, decisive government action can stem the pain and cost of
banking crises. In the 1990s Sweden moved to recapitalize its banks quickly and recovered quickly;
in Japan, where regulators failed to tackle toxic debt, the slump lasted for most of the decade. The
twist is that this credit crisis is deeper (it affects many more types of markets) and broader (many
more countries). Any solution has to be both more systemic and more global than before. One
country trying to mend one part of its banking system will not work.

The idea of a comprehensive solution sounds simple, if expensive. But politicians have found it hard
to grasp. Europeans have remained stubbornly wedded to the notion that the mess was “Made in
America”; John McCain and Barack Obama talk as if it was all down to the greed of modern
bankers. But financial excesses existed centuries before a brick had been laid on Wall Street. As
our special report this week lays out, today’s bust—and the bubble that preceded it—had several
causes besides dodgy lending, including a tide of cheap money from emerging economies,
outdated regulation, government distortions and poor supervision. Many of these failures were as
evident outside America as within it.

With a flawed diagnosis of the causes of the crisis, it is hardly surprising that many policymakers
have failed to understand its progression. Today’s failure of confidence is based on three related
issues: the solvency of banks, their ability to fund themselves in illiquid markets and the health of
the real economy. The bursting of the housing bubble has led to hefty credit losses: most Western
financial institutions are short of capital and some are insolvent. But liquidity is a more urgent
problem. America’s decision last month to let Lehman Brothers fail—and the losses that implied to
money-market funds that held its debt—prompted a global run on wholesale credit markets. It has
become hard for banks, even healthy ones, to find finance; large companies with healthy cash flows
have also been cut off from all but the shortest-term financing. That has increased worries about the
real economy, which itself adds to the worries about banks’ solvency.

This analysis suggests that governments must attack all three concerns at once. The priority, in
terms of stemming the panic, is to unblock clogged credit markets. In most cases that means using
central banks as an alternative source of short-term cash. This week the Fed took another step in
that direction: by buying commercial paper, it is now in effect lending direct to companies. The
British approach is equally bold. Alongside the Bank of England’s provision of short-term cash, the
Treasury says it will sell guarantees for as much as £250 billion ($430 billion) of new short-term and
medium-term debts issued by the banks. That is risky: if left for any length of time, those pledges
give banks an incentive to behave recklessly. But a temporary guarantee system offers the best
chance of stemming the panic, and if it were internationally co-ordinated it would be both more
credible and less risky than a collection of disparate national promises.

The second prong of a crisis-resolution strategy must aim to boost banks’ capital. A new IMF report
suggests Western banks need some $675 billion of new equity to prevent banks from rapidly
reducing the number of loans on their books and hurting the real economy. Although there is plenty
of private capital sloshing around, there is a chicken-and-egg problem: nobody wants to buy equity
in an industry without enough capital. It is becoming abundantly clear that government funds—or at
least government intervention—will be necessary to catalyze the rebuilding of banks’ balance
sheets. Initially, America focused more on buying tainted assets from banks; now it seems keener
on the “European” approach of injecting capital into their banks. Some degree of divergence is
inevitable, but more co-ordination is needed.

Third, policymakers should act together to cushion the economic fallout. Now that commodity prices
have plunged, the inflation risk has dramatically receded across the rich world. With asset prices
plummeting and economies shrinking, deflation will soon be a bigger worry. The interest-rate cuts
are an important start. Ideally, policymakers would not use only monetary policy. For instance,
China could do a lot to help the rest of the world economy (and itself) by loosening fiscal policy and
allowing its currency to appreciate more quickly.

A long wait
Even in the best of circumstances, the consequences of the biggest asset and credit bubble in
history will linger. But if the panic is stemmed, it could be a manageable problem, cushioned by the
economic strength in the emerging world. Efforts at international economic co-operation have a
patchy record. In the 1980s the Plaza and Louvre accords, designed respectively to push the dollar
down and to prop it up, met with mixed success. Today’s problems are deeper and more countries
are involved. But the stakes are also much higher.

The End Of American Capitalism?

October 10, 2008

The worst financial crisis since the Great Depression is claiming another casualty: American-style
capitalism.

Since the 1930s, U.S. banks were the flagships of American economic might, and emulation by
other nations of the fiercely free-market financial system in the United States was expected and
encouraged. But the market turmoil that is draining the nation's wealth and has upended Wall Street
now threatens to put the banks at the heart of the U.S. financial system at least partly in the hands
of the government.

The Bush administration is considering a partial nationalization of some banks, buying up a portion
of their shares to shore them up and restore confidence as part of the $700 billion government
bailout. The notion of government ownership in the financial sector, even as a minority stakeholder,
goes against what market purists say they see as the foundation of the American system.

Yet the administration may feel it has no choice. Credit, the lifeblood of capitalism, ceased to flow.
An economy based on the free market cannot function that way.

The government's about-face goes beyond the banking industry. It is reasserting itself in the lives of
citizens in ways that were unthinkable in the era of market-knows-best thinking. With the recent
takeovers of major lenders Fannie Mae and Freddie Mac and the bailout of AIG, the U.S.
government is now effectively responsible for providing home mortgages and life insurance to tens
of millions of Americans. Many economists are asking whether it remains a free market if the
government is so deeply enmeshed in the financial system.

Given that the United States has held itself up as a global economic model, the change could shift
the balance of how governments around the globe conduct free enterprise. Over the past three
decades, the United States led the crusade to persuade much of the world, especially developing
countries, to lift the heavy hand of government from finance and industry.

But the hands-off brand of capitalism in the United States is now being blamed for the easy credit
that sickened the housing market and allowed a freewheeling Wall Street to create a pool of toxic
investments that has infected the global financial system. Heavy intervention by the government,
critics say, is further robbing Washington of the moral authority to spread the gospel of laissez-faire
capitalism.

The government could launch a targeted program in which it takes a minority stake in troubled
banks, or a broader program aimed at the larger banking system. In either case, however, the move
could be seen as evidence that Washington remains a slave to Wall Street. The plan, for instance,
may not compel participating firms to give their chief executives the salary haircuts that some in
Congress intended. But if the plan didn't work, the government might have to take bigger stakes.
"People around the world once admired us for our economy, and we told them if you wanted to be
like us, here's what you have to do -- hand over power to the market," said Joseph Stiglitz, the
Nobel Prize-winning economist at Columbia University. "The point now is that no one has respect
for that kind of model anymore given this crisis. And of course it raises questions about our
credibility. Everyone feels they are suffering now because of us."

In Seoul, many see American excess as a warning. At the same time, anger is mounting over the
global spillover effect of the U.S. crisis. The Korean currency, the won, has fallen sharply in recent
days as corporations there struggle to find dollars in the heat of a global credit crunch.

"Derivatives and hedge funds are like casino gambling," said South Korean Finance Minister Kang
Man-soo. "A lot of Koreans are asking, how can the United States be so weak?"

Other than a few fringe heads of state and quixotic headlines, no one is talking about the death of
capitalism. The embrace of free-market theories, particularly in Asia, has helped lift hundreds of
millions out of poverty in recent decades. But resentment is growing over America's brand of
capitalism, which in contrast to, say, Germany's, spurns regulations and venerates risk.

In South Korea, rising criticism that the government is sticking too close to the U.S. model has
roused opposition to privatizing the massive, state-owned Korea Development Bank. South Korea
is among those countries that have benefited the most from adopting free-market principles,
emerging from the ashes of the Korean War to become one of the world's biggest economies. It has
distinguished itself from North Korea, an impoverished country hobbled by an outdated communist
system and authoritarian leadership.

But the repercussions of crisis that began in the United States are global. In Britain, where Prime
Minister Margaret Thatcher joined with President Ronald Reagan in the 1980s to herald capitalism's
promise, the government this week moved to partly nationalize the ailing banking system. Across
the English Channel, European leaders who are no strangers to regulation are piling on Washington
for gradually pulling the government watchdogs off the world's largest financial sector. Led by
French President Nicolas Sarkozy, they are calling for broad new international codes to impose
scrutiny on global finance.

To some degree, those calls are even being echoed by the International Monetary Fund, an
institution charged with the promotion of free markets overseas and that preached that less
government was good government during the economic crises in Asia and Latin America in the
1990s. Now, it is talking about the need for regulation and oversight.

"Obviously the crisis comes from an important regulatory and supervisory failure in advanced
countries . . . and a failure in market discipline mechanisms," Dominique Strauss-Kahn, the IMF's
managing director, said yesterday before the fund's annual meeting in Washington.

In a slideshow presentation, Strauss-Kahn illustrated the global impact of the financial crisis.
Countries in Africa, including many of those with some of the lowest levels of market and financial
integration and openness, are now set to weather the crisis with the least amount of turbulence.

Shortly afterward, World Bank President Robert Zoellick was questioned by reporters about the
"confusion" in the developing world over whether to continue embracing the free-market model. He
replied, "I think people have been confused not only in developing countries, but in developed
countries, by these shocking events."

In much of the developing world, financial systems still remain far more governed by the state,
despite pressure from the United States for those countries to shift power to the private sector and
create freer financial markets. They may stay that way for some time.

China had been resisting calls from Washington and Wall Street to introduce a broad range of
exotic investments, including many of the once-red-hot derivatives now being blamed for
magnifying the crisis in the West. In recent weeks, Beijing has made that position more clear,
saying it would not permit an expansion of complex financial instruments.

With the U.S. government's current push toward intervention and the soul-searching over the role of
deregulation in the crisis, the stage appears to be at least temporarily set for a more restrained
model of free enterprise, particularly in financial markets.

"If you look around the world, China is doing pretty good right now, and the U.S. isn't," said C. Fred
Bergsten, director of the Peterson Institute for International Economics. "You may see a push back
from globalization in the financial markets."

THE ECONOMIST SPECIAL REPORT ON THE FINANCIAL CRISIS

(WITHOUT GRAPHICS)

When fortune frowned

Oct 9th 2008
From The Economist print edition

The worst financial crisis since the Depression is redrawing the boundaries between
government and markets, says Zanny Minton Beddoes (interviewed here). Will they end up in
the right place?

AFTER the stockmarket crash of October 1929 it took over three years for America’s government to
launch a series of dramatic efforts to end the Depression, starting with Roosevelt’s declaration of a
four-day bank holiday in March 1933. In-between, America saw the worst economic collapse in its
history. Thousands of banks failed, a devastating deflation set in, output plunged by a third and
unemployment rose to 25%. The Depression wreaked enormous damage across the globe, but
most of all on America’s economic psyche. In its aftermath the boundaries between government
and markets were redrawn.

During the past month, little more than a year after the financial storm first struck in August 2007,
America’s government made its most dramatic interventions in financial markets since the 1930s. At
the time it was not even certain that the economy was in recession and unemployment stood at
6.1%. In two tumultuous weeks the Federal Reserve and the Treasury between them nationalized
the country’s two mortgage giants, Fannie Mae and Freddie Mac; took over AIG, the world’s largest
insurance company; in effect extended government deposit insurance to $3.4 trillion in money-
market funds; temporarily banned short-selling in over 900 mostly financial stocks; and, most
dramatic of all, pledged to take up to $700 billion of toxic mortgage-related assets on to its books.
The Fed and the Treasury were determined to prevent the kind of banking catastrophe that
precipitated the Depression. Shell-shocked lawmakers caviled, but Congress and the administration
eventually agreed.

The landscape of American finance has been radically changed. The independent investment
bank—a quintessential Wall Street animal that relied on high leverage and wholesale funding—is
now all but extinct. Lehman Brothers has gone bust; Bear Stearns and Merrill Lynch have been
swallowed by commercial banks; and Goldman Sachs and Morgan Stanley have become
commercial banks themselves. The “shadow banking system”—the money-market funds, securities
dealers, hedge funds and the other non-bank financial institutions that defined deregulated
American finance—is metamorphosing at lightning speed. And in little more than three weeks
America’s government, all told, expanded its gross liabilities by more than $1 trillion—almost twice
as much as the cost so far of the Iraq war.

Beyond that, few things are certain. In late September the turmoil spread and intensified. Money
markets seized up across the globe as banks refused to lend to each other. Five European banks
failed and European governments fell over themselves to prop up their banking systems with
rescues and guarantees. As this special report went to press, it was too soon to declare the crisis
contained.

Anatomy of a collapse
That crisis has its roots in the biggest housing and credit bubble in history. America’s house prices,
on average, are down by almost a fifth. Many analysts expect another 10% drop across the country,
which would bring the cumulative decline in nominal house prices close to that during the
Depression. Other countries may fare even worse. In Britain, for instance, households are even
more indebted than in America, house prices rose faster and have so far fallen by less. On a
quarterly basis prices are now falling in at least half the 20 countries in The Economist’s house-
price index.

The credit losses on the mortgages that financed these houses and on the pyramids of complicated
debt products built on top of them are still mounting. In its latest calculations the IMF reckons that
worldwide losses on debt originated in America (primarily related to mortgages) will reach $1.4
trillion, up by almost half from its previous estimate of $945 billion in April. So far some $760 billion
has been written down by the banks, insurance companies, hedge funds and others that own the
debt.

Globally, banks alone have reported just under $600 billion of credit-related losses and have raised
some $430 billion in new capital. It is already clear that many more write-downs lie ahead. The
demise of the investment banks, with their far higher gearing, as well as deleveraging among hedge
funds and others in the shadow-banking system will add to a global credit contraction of many
trillions of dollars. The IMF’s “base case” is that American and European banks will shed some $10
trillion of assets, equivalent to 14.5% of their stock of bank credit in 2009. In America overall credit
growth will slow to below 1%, down from a post-war annual average of 9%. That alone could drag
Western economies’ growth rates down by 1.5 percentage points. Without government action along
the lines of America’s $700 billion plan, the IMF reckons credit could shrink by 7.3% in America,
6.3% in Britain and 4.5% in the rest of Europe.

Much of the rich world is already in recession, partly because of tighter credit and partly because of
the surge in oil prices earlier this year. Output is falling in Britain, France, Germany and Japan.
Judging by the pace of job losses and the weakness of consumer spending, America’s economy is
also shrinking.

The average downturn after recent banking crises in rich countries lasted four years as banks
retrenched and debt-laden households and firms were forced to save more. This time firms are in
relatively good shape, but households, particularly in Britain and America, have piled up
unprecedented debts. And because the asset and credit bubbles formed in many countries
simultaneously, the hangover this time may well be worse.

But history teaches an important lesson: that big banking crises are ultimately solved by throwing in
large dollops of public money, and that early and decisive government action, whether to
recapitalize banks or take on troubled debts, can minimize the cost to the taxpayer and the damage
to the economy. For example, Sweden quickly took over its failed banks after a property bust in the
early 1990s and recovered relatively fast. By contrast, Japan took a decade to recover from a
financial bust that ultimately cost its taxpayers a sum equivalent to 24% of GDP.

All in all, America’s government has put some 7% of GDP on the line, a vast amount of money but
well below the 16% of GDP that the average systemic banking crisis (if there is such a thing)
ultimately costs the public purse. Just how America’s proposed Troubled Asset Relief Program
(TARP) will work is still unclear. The Treasury plans to buy huge amounts of distressed debt using a
reverse auction process, where banks offer to sell at a price and the government buys from the
lowest price upwards. The complexities of thousands of different mortgage-backed assets will make
this hard. If direct bank recapitalization is still needed, the Treasury can do that too. The main point
is that America is prepared to act, and act decisively.

For the time being, that offers a reason for optimism. So, too, does the relative strength of the
biggest emerging markets, particularly China. These economies are not as “decoupled” from the
rich world’s travails as they once seemed. Their stockmarkets have plunged and many currencies
have fallen sharply. Domestic demand in much of the emerging world is slowing but not collapsing.
The IMF expects emerging economies, led by China, to grow by 6.9% in 2008 and 6.1% in 2009.
That will cushion the world economy but may not save it from recession.

Another short-term fillip comes from the recent plunge in commodity prices, particularly oil. During
the first year of the financial crisis the boom in commodities that had been building up for five years
became a headlong surge. In the year to July the price of oil almost doubled. The Economist’s food-
price index jumped by nearly 55%. These enormous increases pushed up consumer prices across
the globe. In July average headline inflation was over 4% in rich countries and almost 9% in
emerging economies, far higher than central bankers’ targets (see chart 2).

High and rising inflation coupled with financial weakness left central bankers with perplexing and
poisonous trade-offs. They could tighten monetary policy to prevent higher inflation becoming
entrenched (as the European Central Bank did), or they could cut interest rates to cushion financial
weakness (as the Fed did). That dilemma is now disappearing. Thanks to the sharp fall in
commodity prices, headline consumer prices seem to have peaked and the immediate inflation risk
has abated, particularly in weak and financially stressed rich economies. If oil prices stay at today’s
levels, headline consumer-price inflation in America may fall below 1% by the middle of next year.
Rather than fretting about inflation, policymakers may soon be worrying about deflation.

The trouble is that because of its large current-account deficit America is heavily reliant on foreign
funding. It has the advantage that the dollar is the world’s reserve currency, and as the financial
turmoil has spread the dollar has strengthened. But today’s crisis is also testing many of the
foundations on which foreigners’ faith in the dollar is based, such as limited government and stable
capital markets. If foreigners ever flee the dollar, America will face the twin nightmares that haunt
emerging countries in a financial collapse: simultaneous banking and currency crises. America’s
debts, unlike those in many emerging economies, are denominated in its own currency, but a
collapse of the dollar would still be a catastrophe.

Tipping point
What will be the long-term effect of this mess on the global economy? Predicting the consequences
of an unfinished crisis is perilous. But it is already clear that, even in the absence of a calamity, the
direction of globalization will change. For the past two decades the growing integration of the world
economy has coincided with the intellectual ascent of the Anglo-Saxon brand of free-market
capitalism, with America as its cheerleader. The freeing of trade and capital flows and the
deregulation of domestic industry and finance have both spurred globalization and come to
symbolize it. Global integration, in large part, has been about the triumph of markets over
governments. That process is now being reversed in three important ways.

First, Western finance will be re-regulated. At a minimum, the most freewheeling areas of modern
finance, such as the $55 trillion market for credit derivatives, will be brought into the regulatory orbit.
Rules on capital will be overhauled to reduce leverage and enhance the system’s resilience.
America’s labyrinth of overlapping regulators will be reordered. How much control will be imposed
will depend less on ideology (both of America’s presidential candidates have promised reform) than
on the severity of the economic downturn. The 1980s savings-and-loan crisis amounted to a
sizeable banking bust, but because it did not result in an economic catastrophe, the regulatory
consequences were modest. The Depression, in contrast, not only refashioned the structure of
American finance but brought regulation to whole swathes of the economy.

That leads to the second point: the balance between state and market is changing in areas other
than finance. For many countries a more momentous shock over the past couple of years has been
the soaring price of commodities, which politicians have also blamed on financial speculation. The
food-price spike in late 2007 and early 2008 caused riots in some 30 countries. In response,
governments across the emerging world extended their reach, increasing subsidies, fixing prices,
banning exports of key commodities and, in India’s case, restricting futures trading. Concern about
food security, particularly in India and China, was one of the main reasons why the Doha round of
trade negotiations collapsed this summer.

Third, America is losing economic clout and intellectual authority. Just as emerging economies are
shaping the direction of global trade, so they will increasingly shape the future of finance. That is
particularly true of capital-rich creditor countries such as China. Deleveraging in Western
economies will be less painful if savings-rich Asian countries and oil-exporters inject more capital.
Influence will increase along with economic heft. China’s vice-premier, Wang Qishan, reportedly
told his American counterparts at a recent Sino-American summit that “the teachers now have
some problems.”

The enduring attraction of markets

The big question is what lessons the emerging students—and the disgraced teacher—should learn
from recent events. How far should the balance between governments and markets shift? This
special report will argue that although some rebalancing is needed, particularly in financial
regulation, where innovation outpaced a sclerotic supervisory regime, it would be a mistake to
blame today’s mess only, or even mainly, on modern finance and “free-market fundamentalism”.
Speculative excesses existed centuries before securitisation was invented, and governments bear
direct responsibility for some of today’s troubles. Misguided subsidies, on everything from biofuels
to mortgage interest, have distorted markets. Loose monetary policy helped to inflate a global credit
bubble. Provocative as it may sound in today’s febrile and dangerous climate, freer and more
flexible markets will still do more for the world economy than the heavy hand of government.

Taming the beast

Oct 9th 2008
From The Economist print edition

How far should finance be re-regulated?

“WALL STREET got drunk.” “Bankers deserve D.” A few years ago those phrases might have
appeared on placards held by purple-haired protesters at anti-globalization rallies. Now they come
from the president of the United States and a former chairman of the Federal Reserve. Thinking the
microphones were off, George Bush told a group of Republicans in July that Wall Street needed to
“sober up” and wean itself from “all these fancy financial instruments”. And long before September’s
events, Paul Volcker gave financiers their D grade along with a devastating critique. “For all its
talented participants, for all its rich rewards,” he said in April, the “bright new financial system” has
“failed the test of the marketplace”.

In light of the events of recent weeks, it is hard to disagree. A financial system that ends up with the
government taking over some of its biggest institutions in serial weekend rescues and which
requires the promise of $700 billion in public money to stave off catastrophe is not an A-grade
system. The disappearance of all five big American investment banks—either by bankruptcy or
rebirth as commercial banks—is powerful evidence that Wall Street failed “the test of the
marketplace”. Something has gone awry.

But what exactly, and why? The fashionable answers come in sweeping indictments of speculators,
greedy Wall Street executives and free-market ideologues. France’s president, Nicolas Sarkozy,
recently said that the world needed to “bring ethics to financial capitalism”. Brazil’s president, Luiz
Inácio Lula da Silva, wants to combat the “anarchy of speculation”. A more serious analysis,
however, needs to distinguish between three separate questions. First, what is Mr Volcker’s “bright
new financial system”? Second, how far was today’s mess created by instabilities that are
inseparable from modern finance, and how far was it fuelled by other errors and distortions? Third,
to the extent that modern finance does bear the blame, what is the balance between its costs and
its benefits, and how can it be improved?

An Anglo-Saxon invention
Put crudely, the bright new finance is the highly leveraged, lightly regulated, market-based system
of allocating capital dominated by Wall Street. It is the spiffy successor to “traditional banking”, in
which regulated commercial banks lent money to trusted clients and held the debt on their books.
The new system evolved over the past three decades and saw explosive growth in the past few
years thanks to three simultaneous but distinct developments: deregulation, technological
innovation and the growing international mobility of capital.

Its hallmark is securitisation. Banks that once made loans and held them on their books now pool
and sell the repackaged assets, from mortgages to car loans. In 2001 the value of pooled securities
in America overtook the value of outstanding bank loans. Thereafter, the scale and complexity of
this repackaging (particularly of mortgage-backed assets) hugely increased as investment banks
created an alphabet soup of new debt products. They pooled asset-backed securities, divided the
pools into risk tranches, added a dose of leverage, and then repeated the process several times
over.

Meanwhile, increasing computer wizardry made it possible to create a dizzying array of derivative
instruments, allowing borrowers and savers to unpack and trade all manner of financial risks. The
derivatives markets have grown at a stunning pace. According to the Bank for International
Settlements, the notional value of all outstanding global contracts at the end of 2007 reached $600
trillion, some 11 times world output. A decade earlier it had been “only” $75 trillion, a mere 2.5 times
global GDP. In the past couple of years the fastest-growing corner of these markets was credit-
default swaps, which allowed people to insure against the failure of the new-fangled credit products.

The heart of the new finance is on Wall Street and in London, but the growth of cross-border capital
flows vastly extended its reach. Financial markets, particularly in the rich world, have become
increasingly integrated. Figures compiled by Gian Maria Milesi-Ferretti, an economist at the IMF,
show that the stock of foreign assets and liabilities held by rich countries has risen fivefold relative
to GDP in the past 30 years and doubled in the past decade. The financial integration of emerging
economies has been more modest, but has also increased considerably in recent years—though
with a peculiar twist. Emerging economies, in net terms, have exported capital to the rich world as
their central banks have built up vast quantities of foreign-exchange reserves.

The innovations of modern finance generated great profits for its participants. But were these
innovations the root cause of today’s mess? That depends, in part, on whether you begin from the
premise that financial markets are efficient, or that they are inherently prone to irrational behavior
and speculative excess.

The rationale behind financial deregulation was that freer markets produced a superior outcome.
Unencumbered capital would flow to its most productive use, boosting economic growth and
improving welfare. Innovations that spread risk more widely would reduce the cost of capital, allow
more people access to credit and make the system more resilient to shocks.
Today, however, a different premise has become popular: that financial markets are inherently
unstable. Periods of stability always lead to excess and eventual crisis, and freer financial markets
only lead to greater damage. This view was famously expounded by Hyman Minsky, a 20th-century
American economist. Minsky argued that economic stability encouraged ever-greater leverage and
ambitious debt structures. Stable finance was an illusion.

The trouble is that financial innovation did not occur in a vacuum but in response to incentives
created by governments. Many of the new-fangled instruments became popular because they got
around financial regulations, such as rules on banks’ capital adequacy. Banks created off-balance-
sheet vehicles because that allowed them to carry less capital. The market for credit-default swaps
enabled them to convert risky assets, which demand a lot of capital, into supposedly safe ones,
which do not.

Politicians also played a big part. America’s housing market—the source of the greatest excesses—
has the government’s fingerprints all over it. Long before they were formally taken over, the two
mortgage giants, Fannie Mae and Freddie Mac, had an implicit government guarantee. As Charles
Calomiris of Columbia University and Peter Wallison of the American Enterprise Institute have
pointed out, one reason why the market for subprime mortgages exploded after 2004 was that
these institutions began buying swathes of subprime mortgages because of a political edict to
expand the financing of “affordable housing”.

History also shows that financial booms tend to occur when money is cheap. And money,
particularly in America, was extremely cheap in the past few years. That was partly because a long
period of low inflation and economic stability reduced investors’ perception of risk. But it was also
because America’s central bank kept interest rates too low for too long, and a flood of capital swept
into Western financial instruments from high-saving emerging economies.

So modern finance should not be indicted in isolation. Its costs and benefits are, at least in part, the
result of the incentives to which the money men were responding. But given those distortions, did
the new-fangled finance boost economic growth, welfare and stability?

Costs versus benefits

Critics answer no on all three counts. Mr Volcker, for instance, points out that the American
economy expanded as briskly in the financially unsophisticated 1950s and 1960s as it has done in
recent decades. But plenty of things other than finance were different in the 1950s, so such a
simple comparison is hardly fair. And although economists have long been divided on the
theoretical importance of finance for growth, the balance of the evidence suggests that it does
matter.

According to Ross Levine, an economist at Brown University who specializes in this subject,
numerous cross-country studies show that countries with deeper financial systems tend to grow
faster, particularly if they have liquid stockmarkets and large, privately owned banks. Growth is
boosted not because savings rise but because capital is allocated more efficiently, improving
productivity.

Within America several studies have shown that states which did most to deregulate their banking
systems in the 1970s grew faster than other states. In 2006 economists at the IMF compared
deregulated Anglo-Saxon financial systems with more traditional bank-dominated systems, such as
Germany’s or Japan’s, and found that Anglo-Saxon systems were quicker to reallocate resources
from declining sectors to new, fast-growing ones.

Many economists argue that financial innovation, and the quick reallocation of capital that it
promotes, was one reason why America’s productivity growth accelerated in the mid-1990s.
Technology alone cannot explain that advance, because inventions such as the internet and
wireless communications were available to any country. What set America apart was the strong
incentives it offered for deploying the new technology. Corporate managers knew that if they
adapted fast, America’s flexible financial system would reward them with access to cheaper capital.

Just because financial innovation can boost growth does not mean it always will. Not every
technological breakthrough improves productivity. The bonanza in mortgage-backed securities
helped create a glut of new homes that did little to promote long-term growth. But finance’s recent
focus on housing, rather than more productive forms of investment, may have had more to do with
the government guarantees inherent in housing than finance itself.

What about people’s lives? Even if financial innovation does not boost growth, it is a good thing if it
improves welfare. Modern finance improved people’s access to credit. Computers enabled lenders
to use standardized credit scores, and the risk-spreading from securitisation made it safer to lend to
less creditworthy borrowers. This “democratization of credit” let more people own homes (and even
now it is worth remembering that most subprime borrowers are keeping up with their payments). It
enabled more households to smooth their consumption over time, reducing their financial hardship
in lean times. Studies show that consumers in Anglo-Saxon economies cut their spending by less
when they suffer temporary shocks to their income than those in countries with less sophisticated
financial systems. Smoother household consumption often means a smoother economic cycle, too.
Many economists believe that financial innovation, including easier access to credit, is one reason
for the “Great Moderation” in the business cycle in the past few decades.

Still, in the light of today’s bust that welfare calculus needs revisiting, not least because broader
access to credit plainly fuelled the housing bubble. Demand for complex mortgage securities led to
a loosening of lending standards, which in turn drove house prices higher. Wall Street’s fancy
computer models, based on recent price histories, underestimated how much the innovation was
pushing up house prices, understated the odds of a national house-price decline in America and so
encouraged an unsustainable explosion of debt. The country’s household debt rose steadily, from
just under 80% of disposable income in 1986 to almost 100% in 2000. By 2007 it had soared to
140%. Once asset prices started to come down and credit conditions tightened, this borrowing
binge left households—and the broader economy—extremely vulnerable. Not surprisingly, the
“wealth effect” (the extent to which a change in asset prices affects people’s spending) is bigger in
the indebted Anglo-Saxon economies than elsewhere. If financial innovation fuelled the bubble, so it
will exaggerate the bust.

That leads to the critics’ third point: that far from enhancing economies’ resilience, modern finance
has added to their instability. Mr Volcker, for instance, points to the absence of financial crises just
after the second world war. At that time finance was tamed by the rules and institutions introduced
after the Depression. But the 1950s were unusual. In a forthcoming book, “This Time is Different:
Eight Centuries of Financial Folly”, Carmen Reinhart of the University of Maryland and Ken Rogoff
of Harvard University survey eight centuries of financial crises. Their numbers suggest that, despite
all that financial innovation, recent years have seen a surprising period of quiet—at least until the
current crash.

Sowing the storm

The incidence of crashes is only one measure of risk, however: their severity also matters. In
theory, derivatives, securitisation and a choice of financing should spread risk, increase the
financial sector’s resilience and reduce the economic damage from a shock. Before securitisation,
the effect of a crash was intensely concentrated. A property bust in Texas meant mortgages held by
Texan banks failed, starving Texan companies of capital. The expectation was that today’s
decentralized and global system would spread risk and reduce the economic impact of a financial
shock. In his book, “The Age of Turbulence”, Alan Greenspan points to the aftermath of the
telecoms bust in the late 1990s, when billions of dollars went up in smoke but no bank got into
trouble.

At first that resilience seemed to be on display during this crisis too. The fact that mortgage defaults
in Cleveland or Tampa triggered bank losses in Germany was a sign of the system working. But
that resilience proved ephemeral. One reason was that risk was more concentrated than anyone
had realized. Many banks originated mortgage-backed securities but then failed to distribute them,
holding far too much of the risk on their own balance-sheets. That was a perversion of
securitisation, rather than an indictment of it.

More troubling to proponents of modern finance was the crippling impact on market liquidity of
uncertainty about the scale of risks and who held them. To work efficiently, markets must be liquid.
Yet the past year has shown that uncertainty breeds illiquidity. High leverage ratios and a reliance
on short-term wholesale funding rather than retail deposits, two features of the new finance, left the
system acutely vulnerable to such a panic. Forced to shrink their balance-sheets faster than
traditional banks, the investment banks, hedge funds and other creatures of the new finance may
have made the economy less resistant to a financial shock, not more.

That is the conclusion of a new analysis by Subir Lall, Roberto Cardarelli and Selim Elekdag,
published in the IMF’s latest World Economic Outlook, which argues that the economic impact of
financial shocks may be bigger in countries with more sophisticated financial markets. The study
looks at 113 episodes of financial stress in 17 countries over the past three decades and assesses
the effect they had on the broader economy. Financial crises, the authors find, are as likely to cause
downturns in countries with sophisticated financial systems as in those where traditional bank
lending dominates. But such downturns are more severe in countries with the Anglo-Saxon sort of
financial system, because their lending is more procyclical. During a boom, highly leveraged
investment banks encourage a credit bubble, whereas in a credit bust they have to deleverage
faster.

Excessive and excessively pro-cyclical leverage is clearly dangerous, but was it caused by the new
financial instruments and deregulation? Again, not alone. Financial excesses often occur in the
aftermath of innovation: think of the dotcom bubble or the 19th-century railways boom and bust. But
throughout history, loose monetary conditions have fuelled the cycle: cheap money encourages
leverage which boosts asset prices, which in turn encourage further leverage. Sophisticated finance
meant that havoc spread in a new way.

Tackling leverage
Given the past year’s calamity, how far must Anglo-Saxon finance be remade? The market itself
has already asked for dramatic changes—away from highly geared investment banks towards the
safety of lower leverage and more highly regulated commercial banks. Some sensible
improvements to the financial infrastructure are already in the works, such as the creation of a
clearing house for trading credit-default swaps, so that the collapse of a big force in the market,
such as AIG, does not threaten to leave its counterparties with billions of dollars in worthless
contracts.

The harder question is where—and by how much—financial regulation should be extended.

Proposals for reform are pouring out from central banks, securities regulators, finance ministries,
bank and universities, much as securitized mortgage debt once poured out from Wall Street. But
just as financial innovation bears only part of the blame, so regulatory reforms will, at best, yield
only part of the solution.

Indeed, some popular suggestions will not yield much. There is a lot of talk, for instance, of
reforming credit-rating agencies, which encouraged the creation of mortgage securities by
publishing misleading assessments of their quality. But the problem with credit-rating agencies lies
in the tension between their business model and their use as a regulatory tool. The markets and
regulators use ratings to determine the riskiness of an asset. Yet credit-rating agencies are paid by
the issuers of securities and so have an inbuilt incentive to tailor their ratings to their clients’ needs.

Another popular suggestion is to change the incentive structures within financial institutions to
discourage reckless and short-term behavior. The American government’s bail-out will include
curbs on the pay of the bosses of troubled banks that benefit from it. This is a poor route to follow.
Governments are ill placed to micromanage the incentive structure within banks. Besides, even
firms with compensation systems that encouraged their managers to lend carefully got into trouble.
In both Bear Stearns and Lehman Brothers, for instance, employees owned a large part of the
firms’ shares.

Could tighter government oversight produce better results? No one doubts that America’s
complicated, decentralised and overlapping system of federal and state financial supervisors could
be improved. (AIG, for instance, is technically supervised by New York state.) Nor that the
enormous new markets, such as the $55 trillion global market in credit-default swaps, need more
oversight. Nor that better disclosure and transparency are necessary in many of the newest
financial instruments. But it would be unwise to expect too much. An entire government agency was
devoted to overseeing the housing-finance giants, Fannie Mae and Freddie Mac, but that did not
stop them behaving recklessly. So far, at least, a striking feature of the crisis has been that hedge
funds, the least regulated part of the finance industry, have proved more stable than more heavily
supervised institutions.

Similarly, re-regulation should proceed cautiously and with an eye to unintended consequences.
Just as many of the innovations of modern finance, such as credit-default swaps, have been used
to avoid the strictures of today’s bank regulation, so tomorrow’s innovations will be designed to
arbitrage tomorrow’s rules. Even after today’s bust, bankers will be better paid and more highly
motivated than financial regulators. The rule-makers are fated to be one step behind.

Nonetheless, improvements are possible. The most promising avenue of reform is to go directly
after the chief villain: excessive and excessively procyclical leverage. That is why regulators are
now rethinking the rules on banks’ capital ratios to encourage greater prudence during booms and
cushion deleveraging during a bust. It also makes sense for financial supervisors to look beyond
individual firms, to the stability of the financial system as a whole—and not just at the national level.

Leverage can be tackled in other ways too. For a start, governments should stop subsidising it.
America, for example, should no longer allow homeowners to deduct mortgage interest payments
from their taxable income. And governments should stop giving preferential treatment to corporate
borrowing as well. Private-equity firms and the like are encouraged to load up companies with debt
because tax codes favour debt over equity.

The bigger point is that governments should not view financial reform in a vacuum. Modern finance
arose in an environment created by regulators and politicians. As Hank Paulson, the treasury
secretary, told Congress during hearings about the American government’s bail-out plan: “You’re
angry and I’m angry that taxpayers are on the hook. But guess what: they are already on the hook
for the system we all let happen.” Whether that system is improved depends in part on whether
politicians recognise their own role in shaping—and distorting—financial markets. The example of
another recent crisis—in commodities—does not bode well.

Of froth and fundamentals

Oct 9th 2008
From The Economist print edition

The real lesson from volatile commodity prices

CLIMB a steep flight of stairs down a small side street in Fatehpuri, part of the bustling commercial
hub of Old Delhi, and you will come to a set of rooms overlooking an imposing internal courtyard. In
one of them, half a dozen men lounge on mats beneath a poster of Lakshmi, the Hindu goddess of
wealth. Next to them is a clutch of telephone sets, each on a long wire cord. Outside hangs a
blackboard with prices scrawled in chalk. This is the trading floor of the Rajdhani Oils and Oilseeds
Exchange, where futures contracts for soyabean oil, mustard seed and jaggery (sugar) are bought
and sold.
It seems a long way from the New York Mercantile Exchange, but the political heat on both places
has been much the same of late. Over the past couple of years India’s government has banned
futures trading on commodities that include rice, wheat and lentils to rein in prices and stop what it
sees as dangerous speculation. And in recent months America’s Congress has been mulling a
series of measures to discourage similar speculation in oil markets. On September 18th the House
of Representatives passed a bill that would limit how much speculative traders, such as hedge
funds or pension funds, could invest in commodities, and closed the “Enron loophole”, which allows
energy traders to escape government regulation when buying and selling over the counter or on
electronic platforms. Japan’s government has tightened controls on futures trading and China has
restricted foreign trading in its commodities markets.

Speculators have long been a popular target for politicians frustrated by volatile commodity prices.
In 1947, when wartime controls ended and food prices soared, Harry Truman raised margin
requirements (the share of the value of a futures contract that a trader must post upfront with an
exchange) to 33%, vowing that food prices should not be a “football to be kicked about by
gamblers”. In 1958 America’s Congress banned futures trading in onions for much the same
reason.

But this time politicians are not the only ones who blame financiers for distorting prices. George
Soros, a veteran investor, declared earlier this year that commodities were a “bubble”. Michael
Masters, a hedge-fund manager, caused a storm when he told a congressional committee in June
that the price of oil (then $130 a barrel) might be halved were it not for financial speculation. Even
Shyam Aggarwal, the chief executive of the Rajdhani exchange, says futures trading in food
products should be banned, at least temporarily.

Broadly, these men all make the same argument: that the flood of money from pension funds,
hedge funds and the like that has poured into commodity futures in recent years is distorting spot
markets for physical commodities. Rather than helping producers and consumers to hedge their
risks and set commodity prices more transparently and efficiently, futures markets have become
dominated by hedge funds, sovereign-wealth funds and so on seeking to diversify their portfolios.
The speculative tail is wagging the spot dog.

If that argument were true, the consequences would be profound. Commodity prices have a more
immediate impact on people’s lives than do stock or bond prices, particularly in poorer countries,
where many households spend much of their budgets on food. If speculators are distorting
commodity prices rather than improving price discovery, there may be good reason to shift the
balance between government and market.

Speculating about speculators

At first sight the finger does seem to point to the speculators. Commodities have become a popular
alternative asset class for investors. According to Barclays Capital, institutional investors had
around $270 billion in commodity-linked investments at the end of June, up from only $10 billion six
years ago. The number of futures contracts on commodities exchanges has quadrupled since 2001.
The notional value of over-the-counter commodity derivatives has risen 15-fold, to $9 trillion (see
chart 6).

The timing of this increase coincides neatly with the long commodities boom. Prices since 2002
have soared by any yardstick. The climb has been most pronounced in dollars, the currency in
which most globally traded commodities are priced, because the dollar itself has weakened. But
over the past six years commodity prices have also risen in euros or indeed any other currency.

Speculation might also explain the extraordinary volatility of prices since the financial turmoil struck
last August. As large swathes of debt instruments suddenly became illiquid and risky, investors—so
the argument goes—sought safety in commodities. As America’s Federal Reserve slashed interest
rates, so money managers, fearful of inflation, fled to hard assets, particularly oil. That surge of
cash created a new bubble that has recently burst.

On closer inspection, however, the speculation theory stands up less well. First, there is no
consistent pattern between the scale of investors’ purchases of a commodity and the behavior of
spot prices. For example, as investment funds piled into hog futures the price fell sharply—even as
prices of other commodities rose. Second, many of the commodities in which prices have soared
over the past few years, from iron ore to molybdenum, are not traded on exchanges and thus offer
less opportunity for investors. Third, much of the surge of cash that has gone into commodities
futures is due to rising prices. As the price of a commodity goes up, so does the value of a
commodity-linked fund, even without any new money.

Lastly, stocks of most commodities have been low compared with their historical averages. This is
important, because rising stocks are the channel through which speculation in futures markets
affects the spot price. When speculators push up the futures prices of oil, for instance, they create
an incentive for someone to buy oil in the spot market, sell a futures contract on it and store the oil
until delivery is due. This hoarding should show up in higher stocks of unsold oil, but official oil
stocks are well below their average of the past five years. The same is true for many other
commodities.

The absence of hoarding is not conclusive proof of speculators’ innocence. As Roger Bootle of
Capital Economics has pointed out, arbitrageurs must simply want to hold bigger stocks; they do
not have to succeed. In markets where supply is constrained, their attempts to hoard could push up
spot prices without any increase in physical stocks, at least temporarily. Moreover, in some
commodities, particularly those that are mined or pumped, producers can reduce supply simply by
holding back production. Oil producers, for instance, can simply pump less. But there is scant
evidence that this has happened. As prices soared in the first half of this year, oil experts reckoned
that most producers were pumping at full capacity. Saudi Arabia is the only large producer with
spare capacity; if anything, it pushed up production this year.

All told, the case that speculators drove the commodity boom is weak. To be sure, futures markets
can overshoot, and investors may have added temporary fuel, particularly in the first half of 2008.
But the long rise in commodity prices—and their recent decline—can be explained much more
easily by economic fundamentals.

Too much, too little, too late

Over the past 50 years commodity prices have, on average, fallen relative to other goods and
services as their supply has more than kept up with demand. As population growth and greater
affluence increased the world’s demand for calories, for instance, agricultural productivity grew,
which in turn increased supply. But this broad downward trend included plenty of volatility and
several big shocks, notably in the 1970s when commodity prices of all sorts soared for several
years.

One reason for those price swings was that neither the supply of nor the demand for commodities
can change quickly. People have to eat, even if a bad harvest temporarily reduces the world’s grain
stocks. It takes years to develop an oil field. In economists’ jargon, the price elasticity of both
demand and supply is low in the short term. So any surprises on either side quickly translate into
big price changes.

The 1970s commodity shocks were mostly set off by unexpected shortfalls in supply. Culprits
included the Arab oil embargo of 1973, catastrophic harvests in 1972 and 1974 and the Iranian
revolution in 1979. This decade’s boom, by contrast, was due largely to unexpectedly strong
demand.

The world economy grew faster for longer than anyone foresaw. In its forecasts of April 2003, for
instance, the IMF expected average global growth below 4% a year over the following three years.
In fact, the world economy grew at an annual average of 4.5% between 2003 and 2007. This boom
was driven by emerging economies, which grew at an average pace of 7.3% a year. In 2003 the
IMF expected China’s economy, for example, to grow by 7.5% a year, but in fact it has grown at an
average annual rate of 10.6% a year since then. Not only did emerging economies grow
unexpectedly fast, but at this stage of development their use of commodities becomes more intense
as they get richer. The result was a dramatic rise in demand, particularly for energy and industrial
commodities.

Take oil. In the four years from 1998 to 2002 world oil demand grew at an average rate of 1.1% a
year. Between 2003 and 2007 the pace almost doubled, to an average of 2.1%, and almost all the
increase came from the emerging world (oil demand in the OECD countries has been falling since
2006). In 2007 China alone accounted for one-third of the increase in global oil demand. In products
such as most metals it made up an even bigger share.

Where governments have gone wrong

Rising prosperity, however, is not the whole story behind stronger demand. Government-induced
distortions have also blunted price signals. In many emerging economies governments control the
prices of important fuels, such as diesel, and keep them below world-market levels. Oil-exporting
countries are the worst offenders. Whereas the American price is close to a dollar per litre, for
instance, Saudi Arabia sells petrol at 13 cents and Venezuela at 16 cents. Tellingly, the Middle
Eastern oil exporters have seen a big increase in oil consumption. In 2007 they accounted for a
quarter of the rise in global oil demand even though they represent a far smaller share of the world
economy.

As oil prices rose, some countries decided to start unwinding these distortions. Oil-importing
countries such as Malaysia, Taiwan, Indonesia, China and India have pushed up fuel prices in
recent months. China has raised prices twice, in November 2007 and again in June this year. Its
petrol prices are now not far off America’s (though other energy prices in China are still artificially
low). But many other countries kept prices fixed and increased the size of their subsidies. This has
hurt their government finances and, more importantly, has made price volatility worse by obstructing
the route from higher prices to weaker demand.

The distortions that governments introduce are even more evident in foodstuffs, and this time the
culprits are rich countries, particularly America and Europe. Ostensibly to reduce carbon emissions,
governments in both places have introduced policies to encourage biofuels (corn-based ethanol in
America and biodiesel in Europe). Thanks to these subsidies and regulations, demand for maize
and vegetable oils (on which biodiesel is based) has exploded and these crops have displaced
others, such as wheat.

Analysts from the OECD to the World Bank argue that biofuel demand is the biggest single reason
why food prices have soared in the past couple of years, accounting for as much as 70% of the rise
in maize prices and 40% of the rise in soyabean prices. Higher energy prices have also made a
difference as fertilizer and other input costs have risen.

Rather than recognize their own role in creating the food-price spike, many Western politicians
(notably President George Bush) have pointed to rising affluence in emerging economies. Richer
Indian and Chinese consumers are indeed eating more meat than they did—though a lot less than
people do in the West—but that shift has not been sudden enough to explain the price surges since
2006. It is biofuels that have made the difference.

Demand shocks and misguided government policies go a long way towards explaining the behavior
of commodity prices in recent years. But supply surprises have also played a role, particularly in oil,
where the supply response to higher prices has been sluggish even by its standards.

After years of low oil prices in the 1990s the OPEC group of producers began the recent boom with
plenty of spare capacity. That spare capacity has all but disappeared, largely because production
outside OPEC has been disappointing. Again, government policy played a part. The vast majority of
the world’s oil reserves are in the hands of government-owned oil companies. Too often these firms
use their revenues for political purposes rather than invest it to raise output.

In agriculture emerging governments restricted supply, aggravating the problems caused by

demand in the rich world. Panicked by rising food prices in 2007, more than 30 governments, from
Ukraine to China, introduced export restrictions for farm produce. This cut the supply of food on
world markets, sending prices even higher. Rice was worst hit because only 4% of its global crop is
traded across borders, compared with 13% for maize and 19% for wheat. On news of bans in
China, Vietnam, Cambodia, India and Egypt (which between them grew 40% of world rice exports
in 2007), the price tripled within a few weeks.

In this panicked environment, futures prices for all food commodities shot up. At times investment
funds may have exacerbated fears about scarcity. But for food, as for fuel, the main reason for the
price rises of recent years has been unexpected demand growth, often compounded by
government distortions.

Contrary to what the critics of speculation suppose, the main task of futures markets has been to
signal these fundamentals to firms and households, speeding up their adjustment to the changing
balance of supply and demand for physical commodities. In the absence of such signals, it would
have taken even bigger and more extended swings in the prices of physical commodities to bring
supply and demand into balance.

The same mix of fundamentals and government action, but in reverse, helps explain the easing of
prices in recent months. The drop in commodity prices in dollar terms partly reflected a
strengthening of the greenback. Oil prices in euros, for instance, have fallen by 25% less from their
peak than oil prices in dollars. A series of sensible moves by governments, such as the decision by
some big exporters to lift export controls, helped ease the panic in food markets. The prospect of
bumper cereal crops has boosted confidence about short-term supply. The Economist’s food-price
index at end-September was down 23% from its peak. Yet nobody is denouncing speculators for
driving prices down.

The oil market is also adjusting. A new Saudi field has come on stream, improving the prospect of a
supply boost. On the demand side, consumers have started to respond. Faced with petrol at $4 a
gallon, American drivers changed their habits faster than expected, switching to smaller cars,
driving less and using public transport more.

Most important, the world economy has suddenly slowed, and its prospects have darkened
dramatically. Thanks, in part, to the shock of higher oil prices, output growth in Japan and Europe
ground to a halt at the beginning of the summer. By August even the big emerging economies were
showing signs of slowing from their breakneck pace. As the scale of the global slowdown became
clearer, so commodity prices weakened.

If persistent and unexpected demand fuelled much of the commodities boom, so surging prices
may, at least in part, have been a symptom of a global economy that was overheating. That is now
changing fast. But it suggests that the world’s politicians, rather than point the finger at speculators,
might look first at their own policies—and then at the mistakes of their central bankers.

A monetary malaise
Oct 9th 2008
From The Economist print edition
Central bankers helped cause today’s mess. Will they be able to clean it up?

FOUNDED in 1930, the Bank for International Settlements (BIS) is the oldest and chummiest of the
international financial institutions. Based in Basel (with its famously good food), the central bankers’
club is the nerve centre for international co-operation on monetary technicalities. How ironic, then,
that the BIS’s economists put much of the blame for the current mess on central bankers and
financial supervisors.

For years, BIS reports have given warning about excess global liquidity, urged central bankers to
worry about asset bubbles even when consumer-price inflation was low, encouraged policymakers
in a global economy to pay more attention to global measures of economic slack, and argued that
banking supervisors needed to look beyond individual firms to the soundness of the financial
system as a whole. Today’s calamity, in the BIS’s view, stems from one fundamental source: a
world where credit-driven excesses went on for too long. “The unsustainable has run its course,”
thundered the organization’s annual report in June.

The case against central bankers comes in two parts. The first is that they, along with other
financial regulators, were asleep at the wheel, failing to appreciate the scale of risks being built up
in the “shadow” banking system that modern finance had created. The second is that they fuelled a
credit bubble by keeping money too cheap for too long.

The criticisms are most often directed at the Fed. This is because America is the world’s biggest
economy; because its interest-rate decisions affect prices across the world; because the Fed has
shown a penchant for cheap money in recent years; and because America’s mortgage mess fed the
financial crisis. The Fed carries a disproportionately large weight among America’s patchwork of
financial regulators.

Supervision cannot work miracles, but the Fed clearly could have done better. It did not have direct
jurisdiction over the independent mortgage brokers who were making the dodgiest loans during the
height of the housing boom (they were notionally supervised by their states). But it had plenty of
chances to sound the alarm and could have calmed the frenzy by tightening federal rules designed
to protect consumers. However, Alan Greenspan, the Fed’s chairman during the bubble years, saw
little risk in the housing boom and followed his hands-off instincts. His successors now admit that
was a mistake. Supervision has been tightened.

What about monetary policy? Here the problem is the Fed’s asymmetric approach. By ignoring
bubbles when they were inflating, whether in share prices or house prices, but slashing interest
rates when those same bubbles burst, America’s central bankers have run a dangerously biased
monetary policy—one that has fuelled risk-taking and credit excesses.

In the most recent episode the Fed stands accused of three main errors. Mistake number one was
to loosen the monetary reins too much for too long in the aftermath of the 2001 recession. Fearing
Japan-style deflation in 2002 and 2003, the Fed cut the federal funds rate to 1% and left it there for
a year. Mistake number two was to tighten too timidly between 2004 and 2006. Mistake number
three was to lower the funds rate back to 2% earlier this year in an effort to use monetary policy to
alleviate financial panic. The first two failures fuelled the housing bubble. The third aggravated the
commodity-price surge.

With hindsight, there is merit to the first two charges. The Fed did worry unduly about Japanese-
style deflation in the early part of this decade, though it was a defensible decision at the time. The
failure to tighten policy more quickly from 2004 onwards was a bigger mistake. Low short-term rates
encouraged the boom in adjustable-rate mortgages that added to the housing bubble, and the
predictability and gradualness of the Fed’s eventual tightening encouraged broader risk-taking on
Wall Street.

From a narrowly American perspective, the case against the Fed’s rate cuts this year is weaker.
Long before last month’s calamities, the turmoil on Wall Street kept overall financial conditions tight
even as the Fed slashed the price of short-term money. Because risk spreads have soared,
borrowing costs for firms and individuals have barely budged even as lending standards have
tightened dramatically. Given the economy’s weakness, it is now hard to argue that the Fed was
wrong to cut rates so enthusiastically this year.
But should the Fed be judged just by American criteria? Its actions—both during the bubble and the
subsequent bust—took place against the backdrop of rapid financial globalization and choices
made by central bankers elsewhere. The most important of these was the emergence of large
saving surpluses in many big emerging economies, especially China, and their (related) decision to
link their currencies to the dollar, in a system often called the Bretton Woods II regime. (Bretton
Woods I was the global monetary system in force between 1944 and the early 1970s under which
countries fixed their currencies to the dollar, which in turn was tied to gold.)

Wall of money
The large saving surplus in emerging economies caused a flood of capital to rich ones, largely
America. That surplus had several causes. Investment in many Asian economies collapsed after
their financial crises in the late 1990s. The rapid increase in the price of oil over the past few years
shifted wealth to oil exporters, such as Saudi Arabia and Russia, faster than they could spend it.
But policy choices, especially emerging-economies’ currency management, played a big role. The
rapid rise in China’s saving surplus between 2004 and 2007 stemmed in part from an undervalued
exchange rate. Emerging-economy central banks now hold over $5 trillion in reserves, a fivefold
increase from 2000 (see chart 9).

This flood of capital fuelled the financial boom by pushing long-term interest rates down. Long rates
fell across the rich world and stayed perplexingly low even as the Fed (and other rich-world central
banks) began raising short-term rates in 2004. Mr Greenspan famously dubbed this a “conundrum”
but did nothing to counter it by increasing rates more quickly.

Eventually Bretton Woods II began to fuel credit booms and economic overheating in the emerging
world. That is no surprise. When capital is mobile, countries that fix their currencies lose control
over their domestic monetary conditions. When foreign capital flows in they must buy foreign
currency and pay out their own one, increasing the money supply and stoking inflation. Central
banks can try to keep foreign capital out, and can “sterilize” the effect of buying foreign currency by
selling bonds or forcing banks to hold higher reserves. Some countries, particularly China, have
been surprisingly successful at this. But none of these methods works perfectly: eventually
domestic credit takes off and inflation accelerates.

That is particularly likely when there is a large divergence in economic conditions between the
anchor country (in this case America) and those that shadow its currency. The Fed’s interest-rate
cuts in late 2007 and early 2008 may have been appropriate for a weak and financially stressed
American economy. But they sent the dollar tumbling and left monetary conditions far too loose in
many emerging markets whose economies had long been growing beyond their sustainable pace.

By 2008, according to the IMF’s estimates, emerging economies were growing above their trend
rate for the fourth year in a row and had more than exhausted their spare capacity. Underlying
inflation (excluding food and fuel) was beginning to rise. Everything pointed to the need to raise
interest rates. Yet by March of this year short-term real interest rates in emerging economies
(based on the weighted average of 26 central-bank policy rates) were negative (see chart 10). That
suggests rising inflation was the consequence of a “decoupled” world economy in which emerging
economies were booming even as America stumbled, and a misguided monetary regime that linked
the two.

The upshot was a commodity-price spike and a rise in inflation the world over even as the financial
crisis was deepening in rich countries. Ordinarily a banking crisis leads to disinflation (or even
deflation) as asset prices fall, credit shrinks and economies slow. Yet in America, the centre of the
storm, inflation rose this summer to levels not seen in almost two decades.

The role of commodity prices made the inflation risk hard to interpret. Central bankers had to decide
whether the accelerating prices of food and fuel were a temporary surge in their price relative to
other goods (in which case economic damage would be minimized by temporarily allowing overall
inflation to rise); or whether the rising prices were a symptom of generalized price pressure (which
would argue for higher interest rates).

Central bankers responded to this challenge in a variety of ways. Some emerging economies,
particularly in Latin America, took an orthodox approach, raising interest rates quickly to get inflation
back towards its target. Others, especially in Asia, took longer to adjust, even though wages were
rising fast and demand was strong. Worried by double-digit inflation, some countries, such as India,
eventually began to tighten sharply. Others, such as Malaysia, with inflation at 8.5%, did not budge.

In the rich world, central bankers in Europe were more worried about inflation than the Fed, partly
because many pay deals in Europe are set centrally and wages have been more inclined to rise
along with prices. The ECB raised interest rates in July, and Sweden’s Riksbank increased them as
recently as September. But everybody was perplexed by the combination of financial crisis and
rising inflation. “I don’t understand what the hell is going on,” said one honest official in June.

In recent weeks those tensions have abated, though not in a comforting way. Global demand
dropped sharply over the summer and the outlook for the world economy darkened. That slowdown
helped to bring commodity prices down, transforming the inflation outlook in rich countries. Simple
mathematics suggests that if oil prices stay around $100 a barrel, headline inflation in the euro area
could fall towards 2% within a year; in America it could be down to 1%. Since both these regions
are in, or close to, recession, economic slack is increasing fast, which in turn will bring down
inflation further. Add in September’s financial calamities and the risk of entrenched and out-of-
control inflation seems slim. Suddenly the idea of deflation—a generalized drop in prices—no
longer seems far-fetched.

From inflation to deflation?

That is a worrying prospect. Deflation that reflects a slump in demand and excess capacity is
always dangerous. Falling prices can cause consumers to put off purchases, leading to a downward
spiral of weak demand and further price falls. That outcome is particularly pernicious in economies
with high levels of debt, as Japan painfully discovered in the 1990s. The real value of the debt
burden grows as prices fall—precisely the opposite of what a country needs when it is weighed
down by excessive debts already.

The rich world’s economies are already suffering from a mild case of this “debt-deflation”. The
combination of falling house prices and credit contraction is forcing debtors to cut spending and sell
assets, which in turn pushes house prices and other asset markets down further. Irving Fisher, an
American economist, famously pointed out in 1933 that such a vicious downward spiral can drag
the overall economy into a slump. A general fall in consumer prices would make matters even
worse. Since central banks cannot cut nominal interest rates below zero, deflation raises real
interest rates, slowing the economy further and raising the real value of debts. Private-sector debts
are now much larger than they were in the 1930s, so a modern depression could be even nastier.
But there are four reasons why a deflationary spiral should be still a remote risk—and a risk that
policymakers can avoid.

First, although food and fuel prices are volatile, most other prices do not drop so easily. In most rich
countries “core” inflation is still a long way from zero. That will not change quickly. In Japan
deflation did not set in until four years after that country’s financial bubble burst.

Second, central bankers—at least outside America—have plenty of monetary ammunition left. At
4.25%, the ECB’s policy rate still leaves plenty of scope for downward adjustment.

Third, American policymakers, at least, have understood that public money is necessary to counter
a spiral of debt-deflation. They are now spraying taxpayers’ money at the financial crisis like firemen
with hoses. This will help slow the deleveraging.

Lastly, and less happily, several years of rising oil prices may have slowed the rich world’s
underlying economic speed limit, by reducing the productivity of energy-guzzling machinery and
raising transportation costs. Economic weakness may therefore be less disinflationary than it used
to be.

All in all, then, the rich world’s policymakers have plenty of tools with which to beat off deflation. But
just as the bubble was inflated by the interaction of monetary policy in the rich and the emerging
world, so today’s macroeconomic outlook will be influenced by decisions made outside America,
Japan and Europe.

So far, emerging economies have been playing a positive role. If, as still seems likely, the biggest
among them slow but do not slump, then some sort of floor will be put under commodity prices and
robust consumers in the emerging world will prop up exports from fragile debt-laden rich countries.

But the emerging markets’ resilience cannot be taken for granted. They suffered their own version
of the cycle that Bretton Woods II inflicted on the rich world: surplus savings flowed in, stoking asset
prices. Now many stockmarkets and currencies have plunged as the pendulum has swung back
again. Investors worry about continuing high inflation (in emerging Asia) and lower commodity
prices (in Latin America). Countries, especially in eastern Europe, that built up current-account
deficits when cheap money made these easy to finance now look vulnerable. But the biggest
economies, notably China’s, appear robust. And if the world economy darkens further, China will
emerge as the likeliest savior.

China to the rescue?

China’s government has already shown concern about its economic slowdown, lowering reserve
requirements for small banks and cutting interest rates. But from a global perspective it would be
best for China to loosen fiscal policy and allow the currency to strengthen. The country has ample
room to boost spending. And by allowing its currency to rise faster, it would counter the deflationary
risks in the rich world as both the dollar and the euro weaken against the yuan.

Misguided currency rigidity helped cause today’s mess; enlightened flexibility could help solve it.
And in the longer term the lessons that emerging economies draw from today’s turmoil will help
define the direction of global finance.

Charting a different course

Oct 9th 2008
From The Economist print edition
Will emerging economies change the shape of global finance?

“THE United States has been a model for China,” says Yu Yongding, a prominent economist in
Beijing. “Now that it has created such a big mess, of course we have to think twice.”

The future of global finance depends on what kind of rethinking takes place in Beijing and the rest
of the emerging world. So far the signals have been mixed, even within the same country. In India,
for instance, the central bank—long a reluctant liberalizer—recently changed its mind about
allowing credit-default swaps, arguing that the subprime crisis showed the time was not “opportune”
for such innovations. But at the end of August India launched exchange-traded currency
derivatives, giving people a means to hedge against fluctuations in the rupee.

Chinese officials have been unusually outspoken about Wall Street’s failures. But just as several
rich countries, from Britain to Australia, have banned or reined in short-selling (selling borrowed
shares) in a misguided effort to stop share prices falling, China’s cabinet agreed to allow investors
to buy shares on credit and sell shares short.

By and large, emerging economies’ attitude to Anglo-Saxon finance is deeply pragmatic, defined
more by the lessons of their own financial crises in the 1990s than by today’s calamities on Wall
Street. Those crises inflicted far greater economic pain than anything the rich world has seen so far.
Mexico’s GDP, for instance, fell by 6% in 1995 and Indonesia’s by 13% in 1998.
Those collapses held powerful lessons: foreign-currency debt was dangerous, the IMF was to be
avoided at all costs and prudence demanded the build-up of vast war chests of foreign-exchange
reserves. Rich countries typically have foreign-currency reserves worth about 4% of their GDP. The
level in emerging economies used to be much the same, but over the past decade that ratio has
risen to an average of over 20% of GDP. China has a whopping $1.8 trillion, and eight other
emerging economies have more than $100 billion apiece.

At first sight, fat cushions of reserves have stood emerging economies in good stead. They are one
reason why these countries have proved so resilient in today’s global turmoil. But, as this special
report has argued, these war chests introduced many distortions and rigidities that helped to inflate
the global financial bubble and stoke domestic inflation. The challenge for emerging economies is to
create a system of global finance that is more flexible yet still safe.

The academic evidence is not reassuring. After the 1990s crisis economists began to look closely at
what poor countries gained from integration with global capital markets. The answer appeared to be
not much. An influential study for the Brookings Institution in 2007 by Eswar Prasad of Cornell
University, Raghu Rajan of the University of Chicago and Arvind Subramanian of the Peterson
Institute showed that poor countries that relied on domestic savings to finance their investment
grew faster than those that relied more on foreign money.

Nor did foreign capital seem to help emerging economies to cope better with sudden income
shocks. In another paper Mr Prasad, together with Ayhan Kose and Marco Terrones of the IMF,
showed that the volatility of consumption in emerging economies has increased in recent years.
Poor countries with weak financial systems, it appears, cannot cope with floods of foreign capital.
The money is often channeled to unproductive areas such as property. Such inflows seem to make
boom-bust cycles worse.

The news was not all bad. Studies also showed that foreign direct investment and equity flows
brought in know-how and improved corporate governance. And the evidence also suggests that
competition from foreign banks and foreigners’ money in stockmarkets can improve emerging
economies’ own financial systems. But long before Mr Volcker questioned the wisdom of globalized
finance in America, academics were having second thoughts about the wisdom of financial
globalization for the emerging world.

Ignore the ivory tower

Ironically, this intellectual backlash was taking place even as emerging economies were becoming
financially ever more integrated with the rest of the world. All in all, the citizens of emerging
countries now have some $1 trillion deposited in foreign banks, a threefold increase since 2002. By
every measure, the gross flows of capital involving emerging economies have grown since the mid-
1990s and accelerated in the past few years. The composition of those flows has changed: foreign
direct investment and equity flows have risen much faster than debt. But the overall level of
financial integration is up significantly.

Financial globalization sped up partly because governments did not listen to the academic skeptics.
Most continued to open up, particularly to equity and foreign direct investment. According to the
IMF’s index of capital controls, only two emerging economies closed their capital accounts between
1995 and 2005, whereas 14 countries opened up fully. The rest came somewhere in-between but
were mostly moving towards greater openness.

At the same time foreign banks were playing an ever bigger role. By 2007 almost 900 foreign banks
had a presence in developing countries. On average they accounted for some 40% of bank lending,
up from 20% a decade earlier. In some places, particularly in eastern Europe and Latin America,
foreign banks dominate the domestic financial system. Even China and India, which have been
slow to allow in foreign banks, have opened up more in the past decade.

More important, financial integration was accelerating regardless of any deliberate policy choices. In
a fast-globalizing world even countries with strict capital controls saw an increase in actual capital
flows. One explanation is that more trade inevitably produces more capital integration. A financial
infrastructure grows up to support global supply chains. Larger trade flows make it easier for firms
to evade capital controls, by over- or under-invoicing their transactions. And fast growth has made
emerging economies an attractive target for foreign investors and their own citizens living abroad,
who can find ways to get around capital controls.

The distortions and costs associated with capital controls are rising as emerging economies
become more globalized. Temporary taxes to discourage sudden surges of capital may still have a
role to play, even though they can sometimes prove counterproductive. Thailand, for example,
imposed a tax on foreign capital inflows into its stockmarket in 2006 but saw the market plunge and
quickly reversed the decision. In the longer term the distortions caused by such measures become
more burdensome. China, for instance, has some of the strictest controls among large emerging
economies, partly insulating itself from global capital markets, but the controls needed to deter
speculative capital are becoming ever more intrusive. Since July the State Administration of Foreign
Exchange (SAFE) has demanded more information on export earnings. For many small-scale
exporters that is a big burden. Globalized finance, it turns out, is an inextricable part of global
integration.

That means the right question for emerging economies to ask is not whether global finance is a
good thing but how to maximize the gains and minimize the costs. The answer is to rely more on
markets, not less, but try to avoid the mistakes that the rich world made.

At home that means adopting more of the new finance. Emerging economies vary enormously in
their domestic financial development, but some of the biggest are still surprisingly primitive. India,
for instance, has highly sophisticated equity markets but its banking system is underdeveloped and
distorted by government edicts. Some 40% of India’s bank loans are directed to “priority sectors”
such as agriculture, and the main source of credit for the typical citizen is the informal moneylender.

The harder question is how to deal with foreign capital. Top of the list should be greater currency
flexibility. The risk for emerging economies that open themselves up to global capital flows is
destabilization. Money will slosh in and out, driving underdeveloped local asset markets up and
down and affecting the level of demand in the real economy. Countries that allow foreign banks to
enter their markets will be affected by these banks’ fortunes elsewhere in the world. Losses that
European banks make on American mortgage products, for instance, may cause tighter credit in
Hungary.

To deal with such volatility, emerging markets need to manage demand in the way that rich nations
do: through more flexible interest rates and exchange rates. By allowing their exchange rates to rise
and fall as capital flows wax and wane, emerging economies should be able to keep a measure of
control over their domestic monetary conditions. Firms and investors in developing countries also
need the risk-sharing derivatives developed by Anglo-Saxon finance. Some already have them.
Brazil’s market for foreign-exchange derivatives, for instance, is one of the most sophisticated and
transparent in the world. Others, particularly in Asia, have much further to go, though India’s recent
innovations are encouraging.

By removing the need to accumulate vast foreign-exchange reserves, greater currency flexibility
would also create a more stable global monetary system. The war chests of reserves could be used
to boost domestic financial development. In the summer 2008 issue of the Journal of Economic
Perspectives, Messrs Prasad and Rajan offer an intriguing proposal. Countries with plenty of
reserves, such as China or India, could allow mutual funds (domestic or foreign) to issue shares in
domestic currency with which they could buy foreign exchange from the central bank. These mutual
funds would then invest abroad on behalf of domestic residents.

The result would be a controlled liberalization of capital outflows, along with the creation of new
financial institutions and instruments at home. Oil-exporting countries could achieve much the same
effect by issuing their citizens with an oil dividend that could be invested abroad through similar
mutual funds. Under both models the management of emerging economies’ foreign assets would
be shifted increasingly to the private sector. That would allow private investors from China or Saudi
Arabia to pick over the carcass of Wall Street.

The heavy hand of the state

At present, though, the trend is still in the opposite direction. Governments in Asia and emerging oil
exporters already control some $7 trillion of financial assets, most of it in currency reserves, the rest
in sovereign-wealth funds. Analysts at the McKinsey Global Institute reckon that the total could
reach $15 trillion by 2013. That would make government-controlled funds a large force in global
capital markets, with the equivalent of 41% of the assets of global insurance companies, 25% of
global mutual funds and a third of the size of global pension funds (see chart 11).

There is an irony here. By and large, emerging economies shut their ears to the anti-market
skeptics who argued that global capital flows were dangerous. But in resisting one statist temptation
they have succumbed to another: they have accumulated vast sums of capital in government
hands, transforming the nature of global finance long before Wall Street’s implosion. However
professionally these funds are managed, such huge government-controlled assets will change the
balance between state and market. They will also add to the biggest risk for global integration:
rising protectionism.

Beyond Doha
Oct 9th 2008
From The Economist print edition
Freer trade is under threat—but not for the usual reasons

DURING a summer when the economic shadows darkened so dramatically, few paid attention to
the collapse—yet again—of the Doha round of global trade talks. Champions of liberal trade, such
as this newspaper, wrung their hands, but no one else cared much. The failure in Geneva, where
the World Trade Organization (WTO) is based, seemed something of a sideshow.

In a global survey of business executives, conducted for this special report by the Economist
Intelligence Unit, a sister company to The Economist, over half the respondents regarded the Doha
round as minimally or not at all important, and only 10% thought it very important. One in ten saw
protectionism as the biggest threat to the world economy, but far more were worried about
recession, inflation and the financial crisis.

At first sight that seems a reasonable judgment to make. With so many barriers already removed,
the immediate economic stakes in the Doha round are modest: gains of some $70 billion a year,
according to one recent estimate, little more than 0.1% of global GDP. Add in the likely boost to
productivity growth and the eventual impact will be higher, but it is still hard to argue that the Doha
round, taken in isolation, could dramatically change the world’s fortunes.

That is partly because the negotiations were about “bound” tariff rates—the maximum permitted by
global trade rules. But most countries have already slashed their tariffs unilaterally to well below the
bound rates—and it is actual trade barriers, not the highest permissible ones, that businesspeople
worry most about. Tellingly, the scale of corporate lobbying around the Doha negotiations has been
much lower than in previous global talks, such as the Uruguay Round.

Nor is it hard to see why many companies discount the risks of protectionism. Rich countries,
particularly America, have grumbled a lot about trade with China, but nothing much has happened
to obstruct the spread of commerce. Congress has threatened to punish China’s currency policy
with tariffs and to “get tough” with other supposedly unfair trade behavior, but no laws have
emerged. Globally, the use of anti-dumping duties, a popular protectionist tool, has fallen. With
supply chains so integrated, it is tempting to conclude that multilateral negotiations are no longer
necessary and new trade barriers have become implausible.
Tempting but wrong. In an increasingly integrated world, multilateralism matters more than ever.
The inability to get a Doha deal done is a worry not because of the modest amount of freer trade
forgone but because of the symbolic importance of the talks and the reasons for the impasse. This
trade round is the first international forum in which big emerging economies, such as India, Brazil
and China, have played an influential role. Failure to reach agreement thus bodes ill for future
multilateral co-operation of any sort.

If the talks continue to flounder, negotiating momentum will shift to (far less desirable) regional and
bilateral trade deals, of which there are already some 400 in place or under negotiation. The WTO
itself may be weakened. India signed a regional trade deal with the ASEAN group of Asian
countries less than a month after the Doha talks fell. If countries lose faith in multilateral
negotiations as a means to achieving better market access, they may turn to litigation to reach their
trade goals.

Perhaps most worrying, the Doha impasse in part reflects the intellectual shifts that this special
report has described. The July summit failed because of China’s and India’s insistence on
maintaining the right to impose “safeguard” tariffs to protect their own farms in case of a sudden
surge in food imports. India, which has over 200m farmers, has long been reluctant to expose them
to international competition. China, which had kept a low profile throughout Doha’s six years of
tortured talks, swung behind India’s position at the last minute, worried about food security in the
wake of the commodity-price surge.

Security-conscious
The centerpiece of the Doha trade round is freer trade in farm goods, a shift that will benefit poor
countries disproportionately. But the round was launched in 2001, well before the commodities
boom, so its main emphasis was on government policies that kept prices artificially low, such as
production and export subsidies in rich countries. Today, the main concern is policies that push
prices up: unilateral export bans, subsidies for consumers and the pursuit of biofuels. The fear is
about security of supply. Food self-sufficiency has become a political rallying cry.

That instinct is plainly misguided. The food with the most volatile price over the past year is rice,
precisely because it is the least traded. Freer trade in food is the best way to ensure stable access
and prices. But an efficient global market needs strictures against unilateral barriers to exports as
much as imports, and the WTO’s current rules do little to control export restrictions. Nor are current
trade rules much use for controlling the use of regulations to boost biofuels. Fixing that requires
multilateral talks of a different sort.

The irrelevance of the global negotiating agenda to today’s trade concerns goes beyond agriculture.
In a provocative new paper, Aaditya Mattoo of the World Bank and Arvind Subramanian of the
Peterson Institute argue that global talks should concentrate on fears over “security”—of food,
energy, environment and income. They point out that there are strikingly few rules governing trade
in oil, the world’s single most important commodity. The WTO prohibits export quotas, but not the
production quotas on which the OPEC oil cartel is based. More broadly, the WTO, at least in its
present form, is ill-equipped to deal with other potential flashpoints, from “green tariffs” (barriers
imposed against countries that do not take action on climate change) to complaints about
undervalued currencies or investment protectionism, particularly the backlash against sovereign-
wealth funds and other investors owned by the state.

The risk of a wholesale retreat into beggar-thy-neighbor tariffs may be remote, but a proliferation of
new kinds of barriers is all too plausible. Take green tariffs. The most prominent climate-change bill
in America’s Congress makes reference to trade restrictions against countries that do not take
equivalent actions to control carbon emissions. European leaders, too, have talked of trade
sanctions to punish the laggards in the fight against global warming. As tools to promote global
carbon reduction, such tariffs have a theoretical rationale. But in practice they would almost
certainly set back the cause of global co-operation on climate change.
Although capital-starved Western banks are desperately seeking cash infusions from sovereign-
wealth funds and other state-owned investors, the threat of investment protectionism is growing,
with control of natural resources being a prime worry. Many commodity-rich countries are becoming
increasingly jittery about China’s thirst for direct control of natural resources. Faced with a surge in
applications for foreign direct investment from China, most of them in the mining industry, Australia
is now “closely examining” those that involve government-controlled entities and natural resources.

A new study for the Council on Foreign Relations by Matthew Slaughter of Dartmouth College and
David Marchick of the Carlyle Group points out that in the past two years at least 11 big economies,
which together made up 40% of all FDI inflows in 2006, have approved or are considering new laws
that would restrict certain types of foreign investment or expand government oversight. A
“protectionist drift”, they conclude, is already under way. If state-based investors play an ever bigger
role in global capital markets, that protectionist drift may become irresistible.

Many of the politicians’ fears about foreign investors are surely misguided. Most sovereign-wealth
funds are run by professional managers to maximize returns, and international codes to improve
their transparency are in the process of being drawn up. Countries already have plenty of rules to
prevent foreign control of strategic assets. And provided that markets are competitive and well
regulated, it does not make much difference who owns the firms concerned.

A question of leadership
At a macroeconomic level, however, it is reasonable to fret about the growing clout of state-based
investors, not least because most of this money will be held by a small group of (authoritarian)
countries including China, Saudi Arabia and Russia. China is piling up foreign-exchange reserves
so fast that if it were to put them into American shares instead of bonds, it would already be buying
more than all other foreigners put together. As Brad Setser of the Council on Foreign Relations
points out in a new report, concentrated ownership by authoritarian governments is a strategic as
well as an economic concern, particularly for America.

Both the risks of this new protectionism and the odds of it being countered depend heavily on the
relationship between America and the biggest emerging economies. As the Doha malaise has
shown, active American leadership, although no longer sufficient, is still necessary for multilateral
progress. Yet the politics of trade has become increasingly difficult in America, compromising the
country’s ability to take the lead. Support for more open markets is weaker than almost anywhere
else in the world. According to this year’s Pew Global Attitudes Survey, only 53% of Americans
think trade is good for their country, down from 78% in 2002. Several other surveys in America
suggest that supporters have become a minority. In other countries support is far higher. Some
87% of Chinese and 90% of Indians say trade is good for their country, along with 71% of
Japanese, 77% of Britons, 82% of French and 89% of Spaniards.

America’s popular disillusionment has been accompanied by a growing intellectual one. Several
well-known American economists, including Paul Krugman, a professor at Princeton and prominent
New York Times columnist, Alan Blinder of Princeton and Larry Summers, a Harvard economist
and former treasury secretary, have begun to doubt whether increased globalization is good for the
American middle class. Rather than improving typical Americans’ living standards, they suggest,
global integration may be causing wage stagnation, widening inequality and greater insecurity.

Mr Blinder worries that offshoring—the outsourcing of services to countries such as India—will pose
problems for tens of millions of Americans over the coming decades. Mr Krugman, who pioneered
research in the 1990s that found trade played only a small part in explaining wage inequality, now
believes that the effect is much bigger, because America trades more with poorer countries and
more tasks can be traded. Mr Summers has similar concerns, arguing that the increasing mobility of
global capital limits the government’s ability to act as firms move away from America in search of
low-tax regimes.

These economists all eschew protectionism as a solution, arguing instead for domestic changes,
such as health-care and education reform as well as greater redistribution through the tax system.
But they have helped change the terms of the political debate in America—a shift that has not been
lost on policymakers in the emerging world, many of whom are irritated by America’s double
standards. One Indian official talks of an “intellectual climate change” and a “betrayal” by
globalization’s erstwhile champions.

Middle-class Americans’ living standards have stagnated over the past few years and income
inequality has widened. Globalization could be a culprit, because the integration of hundreds of
millions of workers from emerging economies increases the global supply of labour and presents
less skilled American workers with more competition. But academic analyses suggest that this
effect is modest compared with other factors, such as the decline of trade unions and, particularly,
technological innovation that has raised the demand for skilled workers.

Nor is there much evidence to support the revisionist view. In a recent Brookings paper Mr
Krugman searched for statistics to show that trade now plays a bigger role in wage inequality but
failed to find them. Several other new studies point in the opposite direction. A paper by Runjuan
Liu of the University of Alberta and Dan Trefler of the University of Toronto shows that the effect on
American workers of outsourcing service work to India and China has been tiny and, if anything,
modestly positive.

In a recent book, “Blue-Collar Blues”, Robert Lawrence of Harvard University shows that the
chronology of America’s widening income inequality makes it hard to blame trade with poorer
countries. Low-skilled workers lost out in the 1980s, long before trade with China surged. Most of
the latest rise in inequality is due to the soaring incomes of the very rich. A study by Christian Broda
and John Romalis of the University of Chicago argues that trade with China has helped reduce
inequality in living standards, because poorer folk benefit disproportionately from lower prices for
manufactured goods (though higher commodity prices have recently been pushing in the opposite
direction).

But whether or not the evidence justifies it, America’s intellectual climate has shifted. Advocates of
globalization are on the defensive, particularly in the Democratic party. That, alas, augurs badly for
the new kind of multilateralism that the world economy urgently needs.

Shifting the balance

Oct 9th 2008
From The Economist print edition
More than a new capitalism, the world needs a new multilateralism

JUST under ten years ago, during the emerging-market financial crises, Time magazine ran a cover
headlined “The committee to save the world”. It showed Alan Greenspan, then chairman of the
Federal Reserve; Robert Rubin, the treasury secretary; and Larry Summers, his deputy. Inside was
a breathless account of how this trio of Americans had saved the world economy from calamity by
masterminding IMF rescue packages for cash-strapped Asian countries through weekend meetings
and late-night conference calls.

Today the threats facing the global economy are graver than they were a decade ago, yet it would
be hard to know whom to put on such a cover. Wall Street is at the centre of the mess, so
America’s stature and intellectual authority has plunged. Rather than staving off defaults in Asia, Mr
Paulson, today’s treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, are
battling to prevent the implosion of their own financial system. Instead of dictating tough terms to
Asian governments, they have been begging Congress for public money to deal with Wall Street’s
most toxic securities.

But even as the crisis spreads far beyond America, few others have so far shown much sign of
leadership. Europe is rife with Schadenfreude at America’s travails but its politicians have been
slow to recognize the scale of their own problems. China, the biggest, most resilient emerging
economy and the one with the deepest pockets, has stood quietly on the sidelines. The IMF
provides useful analysis but has no political clout.

The only institutions that have co-operated, and creatively so, are the rich world’s central banks.
Even as many politicians have grandstanded and pointed fingers, the ECB, the Fed, the Bank of
England and others have tried to stem panic by flooding financial markets with liquidity, lending eye-
popping sums of money against all manner of collateral.

Unfortunately, central bankers—however creative—cannot sort out this mess with injections of
liquidity alone. That is because it is a crisis of solvency as well as liquidity. The bursting of the
biggest housing and credit bubble in history has caused a banking bust that will probably turn out to
be the biggest since the Depression, affecting many countries simultaneously. Across the rich world
banks are short of capital; many are insolvent. As they deleverage, they will force down asset prices
and weaken economies that are already stumbling, so the mess will only worsen. Uncertainty and
panic have already amplified the problem as banks hoard cash.

The urgent task is to prevent a grave multi-country banking crisis from becoming a global economic
catastrophe. That ought not to be too hard. Thanks to the growing importance of emerging markets,
the world economy has become more resilient to trouble in its richer corners. Capital is plentiful
outside Western finance. Now that commodity prices have tumbled, the rich world’s central banks
have plenty of room to cushion their weakened economies with lower interest rates. And although
public-debt burdens are already heavy, notably in Italy, Europe’s governments, like America’s, have
enough public funds to prevent a capital-starved banking system dragging their economies down.

This has already started to happen, most strikingly with the American government’s $700 billion
plan to take over mortgage-backed securities. But other governments too are stepping in. Five
European banks were nationalized or bailed out with public funds in the last week of September.
Several European governments have guaranteed the deposits and in some cases the debts of their
banks.

Yet these disparate rescues are likely to be more expensive and less effective than a more co-
ordinated policy that reaches beyond the financial system alone. The panic in the markets would be
stemmed if the rich world’s governments agreed on a common approach for stabilizing and
recapitalizing banks. Equally, a co-ordinated interest-rate cut would boost confidence and make
economic sense: the inflation threat is receding simultaneously across the rich world.

Any such policy co-ordination must include the big emerging markets as well. By boosting domestic
spending and allowing its currency to appreciate faster, China could counter deflationary pressures
in the rest of the world economy and help support growth in Europe and America just when this is
needed most.

There are precedents for high-profile international economic co-operation, notably the Plaza and
Louvre Accords in the 1980s. Designed, respectively, to push the dollar down and to prop it up,
these agreements met with mixed success. Today’s problems are deeper, and the number of
parties is larger. But if there were ever a time for a new multilateralism, this, the biggest financial
crisis since the 1930s, is surely it.

Learning the right lessons

A successful multilateral strategy to staunch the crisis would also make it more likely that the world
will rise to the second challenge: learning the right lessons. Too many people ascribe today’s mess
solely to the excesses of American finance. Putting the blame on speculators and greed has a
powerful appeal but, as this special report has argued, it is too simplistic. The bubble—and the
bust—had many causes, including cheap money, outdated regulation, government distortions and
poor supervision. Many of these failures were as evident outside America as within it.

New-fangled finance has its flaws, from the procyclicality of its leverage to its fiendish complexity.
But the crisis is as much the result of policy mistakes in a fast-changing and unbalanced world
economy as of Wall Street’s greedy innovations. The rapid build-up of reserves in the emerging
world fuelled the asset and credit bubbles, and rich-world central bankers failed to counter it.
Misguided monetary rigidity caused financial instability. Much though people now blame
deregulation, flawed regulation was more of a problem. Banks set up their off-balance sheet
vehicles in response to capital rules.

It is the same story with the spike in food and fuel prices over the past year. To be sure,
commodities markets can overshoot—but rather than pointing the finger at speculators,
governments should look in the mirror. Rich countries’ biofuel policies pushed up the cost of food.
Poor countries’ food-export bans and fuel subsidies compounded the problems. In many ways
today’s mess is a consequence of policymakers’ misguided reactions to globalization and the
increasing economic heft of the emerging world.

If markets are not always dangerous and governments not always wise, what policy lessons follow?
In the aftermath of the crisis the battle will be to ensure that finance is reformed—and in the right
way. The pitfalls are numerous. Banning the short-selling of stocks, for instance, makes for a good
headline; but it deprives markets of liquidity and information, the very things that they have lacked in
this crisis. Even if the easy mistakes are avoided, improving supervision and regulation is hard.
Financial regulators must look beyond the leverage within individual institutions to the stability of
complex financial systems as a whole. Wherever the state has extended its guarantee, as it did with
money-market funds, it will now have to extend its oversight too. As a rule, though, governments
would do better to harness the power of markets to boost stability, by demanding transparency,
promoting standardization and exchange-based trading.

Over-reaction is a bigger risk than inaction. Even if economic catastrophe is avoided, the financial
crisis will impose great costs on consumers, workers and businesses. Anger and resentment
directed at modern finance is sure to grow. The danger is that policymakers will add to the damage,
not only by over-regulating finance but by attacking markets right across the economy.

That would be a bitter reverse after a generation in which markets have been freed, economies
have opened up—and prospered. Hundreds of millions have escaped poverty and hundreds of
millions more have joined the middle class. As the world reconsiders the balance between markets
and government, it would be tragic if the ingredients of that prosperity were lost along the way.

Mixed Signals for Mortgage Giants

Despite Exceeding Requirements, Firms Called Undercapitalized
October 10, 2008

Reading the latest report from the federal regulator running mortgage finance giants Fannie Mae
and Freddie Mac could give you whiplash.

Fannie Mae and Freddie Mac had said at the end of June that they had billions of dollars more of a
financial cushion than required by their regulator. The report by the Federal Housing Finance
Agency yesterday reaffirmed that, saying Fannie Mae had $9.4 billion and Freddie Mac had $2.7
billion more capital than required.

But, even though the companies were adequately capitalized, the regulator yesterday declared
them undercapitalized. How did it square that circle?

The regulator, in essence, said capital wasn't a good enough barometer of the companies' financial
footing. The law gives the regulator the authority to designate the companies undercapitalized even
if they technically have enough capital. In its report, the FHFA said that the sharp downturn in the
mortgage market over the summer "raised significant questions about the sufficiency of capital."

The report listed six points supporting the regulator's determination, citing concerns about the
companies' overall "safety and soundness."

For the first time, the regulator expressed concerns about whether too much of the capital was
made up of what it called "intangible assets." Analysts raised questions about these assets, which
included tax credits due the companies, in the weeks leading up to the takeover. In the case of the
tax credits, they were useful as capital only if the companies had profits; instead, the companies
were posting big losses.

The regulator's conclusion comes after it used the companies' capital position to bolster confidence
in the firms over the summer.

"They had a bunch of safety and soundness issues in the second quarter, but at that point [the
regulator] was putting the sunniest possible face on it," said Karen Shaw Petrou, an analyst at
Washington-based Federal Financial Analytics.

Some believe that the government's actions in the weeks leading up to the takeover put the
companies in a worsened capital position by making it difficult to raise money by issuing new stock.

"I believe the conservatorship of Fannie and Freddie became almost necessary because secretary
of Treasury [Henry M.] Paulson [Jr.] was indicating that if the government had to intervene, they
would be sure to wipe out the shareholders," said Dwight Jaffee, a finance professor at the
University of California at Berkeley. "This made it impossible for Fannie and Freddie to raise any
more capital."

The companies' third quarter closed at the end of September. Financial results will not be released
for another month. But the decision to declare them undercapitalized suggests the numbers won't
be pretty.

"One has to believe that the government came to understand that the financial situation of Fannie
and Freddie was much more distressed than the reports of June 30 had indicated," Jaffee said.

Usually, being declared undercapitalized would subject the companies to modest penalties, but
none will be exacted while they are under government control. The FHFA also has suspended the
capital requirements, though the companies will continue to disclose capital figures in their quarterly
reports. The government set up a program to lend money or inject capital if the companies falter.

"As a practical matter, the government is now running Fannie and Freddie to bail out a sinking
economy and a sinking housing market," Jaffee said. "And they're going to do everything
reasonable to achieve those goals, and that may involve taking more risks than they would
ordinarily do and accepting a lower return on the assets than they normally do."

A report from Federal Financial Analytics, called "Don't Ask, Don't Tell," noted that ambiguities still
surround the firms. For instance, their debt is backed fully by the U.S. government, but the cost of
their debt is much greater than government debt such as Treasury bills. That suggests investors
don't have full confidence in the companies.

Taking a hard look at a Greenspan legacy

October 9, 2008
"Not only have individual financial institutions become less vulnerable to shocks from underlying risk
factors, but also the financial system as a whole has become more resilient." — Alan Greenspan,
former Federal Reserve chairman, 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives
"because we don't really understand how they work." Felix Rohatyn, the investment banker who
saved New York from financial catastrophe in the 1970s, described derivatives as potential
"hydrogen bombs."
And Warren Buffett presciently observed five years ago that derivatives were "financial weapons of
mass destruction, carrying dangers that, while now latent, are potentially lethal."

One prominent financial figure, however, has long thought otherwise. And his views held the
greatest sway in debates about the regulation and use of derivatives — exotic contracts that
promised to protect investors from losses, thereby stimulating riskier practices that led to the
financial crisis. For more than a decade, Alan Greenspan has fiercely objected whenever
derivatives have come under scrutiny in Congress or on Wall Street.

"What we have found over the years in the marketplace is that derivatives have been an
extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are
willing to and are capable of doing so," Greenspan told the Senate Banking Committee in 2003.
"We think it would be a mistake" to more deeply regulate the contracts, he added.

Today, with the world caught in an economic tempest that Greenspan recently described as "the
type of wrenching financial crisis that comes along only once in a century," his faith in derivatives
remains unshaken.

The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A
lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University,
intimating that those peddling derivatives were not as reliable as "the pharmacist who fills the
prescription ordered by our physician."

But others hold a starkly different view of how global markets unwound, and the role that
Greenspan played in setting up this unrest.

"Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the
deregulation of derivatives," said Frank Partnoy, a law professor at the University of San Diego and
an expert on financial regulation.

The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two
decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts
instead have stoked uncertainty and actually spread risk amid doubts about how companies value
them.

If Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to
2006, many economists say, the current crisis might have been averted or muted.

Over the years, Greenspan helped enable an ambitious American experiment in letting market
forces run free. Now, the nation is confronting the consequences.

Derivatives were created to soften — or in the argot of Wall Street, "hedge" — investment losses.
For example, some of the contracts protect debt holders against losses on mortgage securities.
(Their name comes from the fact that their value "derives" from underlying assets like stocks, bonds
and commodities.) Many individuals own a common derivative: the insurance contract on their
homes.

On a grander scale, such contracts allow financial services firms and corporations to take more
complex risks that they might otherwise avoid — for example, issuing more mortgages or corporate
debt. And the contracts can be traded, further limiting risk but also increasing the number of parties
exposed if problems occur.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and
inscrutable that they required federal oversight to protect the financial system. In meetings with U.S.
officials, celebrated appearances on Capitol Hill and heavily attended speeches, Greenspan
banked on the good will of Wall Street to self-regulate as he fended off restrictions.
Ever since housing began to collapse, Greenspan's record has been up for revision. Economists
from across the ideological spectrum have criticized his decision to let the nation's real estate
market continue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out
price increases with higher rates. Others have criticized Greenspan for not disciplining institutions
that lent indiscriminately.

But whatever history ends up saying about those decisions, Greenspan's legacy may ultimately rest
on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and
calamitous bust in derivatives trading.

Faith in the System

Some analysts say it is unfair to blame Greenspan because the crisis is so sprawling. "The notion
that Greenspan could have generated a totally different outcome is naïve," said Robert Hall, an
economist at the conservative Hoover Institution, a research group at Stanford.

Greenspan declined requests for an interview. His spokeswoman referred questions about his
record to his memoir, "The Age of Turbulence," in which he outlines his beliefs.

"It seems superfluous to constrain trading in some of the newer derivatives and other innovative
financial contracts of the past decade," Greenspan writes. "The worst have failed; investors no
longer fund them and are not likely to in the future."

In his Georgetown speech, he entertained no talk of regulation, describing the financial turmoil as
the failure of Wall Street to behave honorably.

"In a market system based on trust, reputation has a significant economic value," Greenspan told
the audience. "I am therefore distressed at how far we have let concerns for reputation slip in recent
years."

As the long-serving chairman of the Fed, the nation's most powerful economic policy maker,
Greenspan preached the transcendent, wealth-creating powers of the market. A professed
libertarian, he counted among his formative influences the novelist Ayn Rand, who portrayed
collective power as an evil force set against the enlightened self-interest of individuals. In turn, he
showed a resolute faith that those participating in financial markets would act responsibly.

An examination of more than two decades of Greenspan's record on financial regulation and
derivatives in particular reveals the degree to which he tethered the health of the nation's economy
to that faith. As the nascent derivatives market took hold in the early 1990s, and in subsequent
years, critics denounced an absence of rules forcing institutions to disclose their positions and set
aside funds as a reserve against bad bets.

Time and again, Greenspan — a revered figure affectionately nicknamed the Oracle — proclaimed
that risks could be handled by the markets themselves.

"Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various
people in the Treasury," recalled Alan Blinder, a former Federal Reserve board member and an
economist at Princeton University. "I think of him as consistently cheerleading on derivatives."

Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, says Greenspan
opposes regulating derivatives because of a fundamental disdain for government. Levitt said that
Greenspan's authority and grasp of global finance consistently persuaded less financially
sophisticated lawmakers to follow his lead. "I always felt that the titans of our legislature didn't want
to reveal their own inability to understand some of the concepts that Greenspan was setting forth,"
Levitt said. "I don't recall anyone ever saying, 'What do you mean by that, Alan?' "
Still, over a long stretch of time, some did pose questions. In 1992, Edward Markey, a Democrat
from Massachusetts who led the House subcommittee on telecommunications and finance, asked
what was then the General Accounting Office to study derivatives risks.

Two years later, the office released its report, identifying "significant gaps and weaknesses" in the
regulatory oversight of derivatives.

"The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could
cause liquidity problems in the markets and could also pose risks to others, including federally
insured banks and the financial system as a whole," Charles Bowsher, head of the accounting
office, said when he testified before Markey's committee in 1994. "In some cases intervention has
and could result in a financial bailout paid for or guaranteed by taxpayers."

In his testimony at the time, Greenspan was reassuring. "Risks in financial markets, including
derivatives markets, are being regulated by private parties," he said. "There is nothing involved in
federal regulation per se which makes it superior to market regulation."

Greenspan warned that derivatives could amplify crises because they tied together the fortunes of
many seemingly independent institutions. "The very efficiency that is involved here means that if a
crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater
virulence," he said.

But he called that possibility "extremely remote," adding "risk is part of life."

Later that year, Markey introduced a bill requiring greater derivatives regulation. It never passed.

Resistance to Warnings

In 1997, the Commodity Futures Trading Commission, a federal agency that regulates options and
futures trading, began exploring derivatives regulation. The commission, then led by a lawyer
named Brooksley Born, invited comments about how best to oversee certain derivatives.

Born was concerned that unfettered, opaque trading could "threaten our regulated markets or,
indeed, our economy without any federal agency knowing about it," she said in Congressional
testimony. She called for greater disclosure of trades and reserves to cushion against losses.

Born's views incited fierce opposition from Greenspan and Robert Rubin, the Treasury secretary
then. Treasury lawyers concluded that merely discussing new rules threatened the derivatives
market. Greenspan warned that too many rules would damage Wall Street, prompting traders to
take their business overseas.

"Greenspan told Brooksley that she essentially didn't know what she was doing and she'd cause a
financial crisis," said Michael Greenberger, who was a senior director at the commission. "Brooksley
was this woman who was not playing tennis with these guys and not having lunch with these guys.
There was a little bit of the feeling that this woman was not of Wall Street."

Born declined to comment. Rubin, now a senior executive at the banking giant Citigroup, says that
he favored regulating derivatives — particularly increasing potential loss reserves — but that he
saw no way of doing so while he was running the Treasury. "All of the forces in the system were
arrayed against it," he said. "The industry certainly didn't want any increase in these requirements.
There was no potential for mobilizing public opinion."

Greenberger asserts that the political climate would have been different had Rubin called for
regulation.

In early 1998, Rubin's deputy, Lawrence Summers, called Born and chastised her for taking steps
he said would lead to a financial crisis, according to Greenberger. Summers said he could not recall
the conversation but agreed with Greenspan and Rubin that Born's proposal was "highly
problematic."

On April 21, 1998, senior federal financial regulators convened in a wood-paneled conference room
at the Treasury to discuss Born's proposal. Rubin and Greenspan implored her to reconsider,
according to both Greenberger and Levitt.

Born pushed ahead. On June 5, 1998, Greenspan, Rubin and Levitt called on Congress to prevent
Born from acting until more senior regulators developed their own recommendations. Levitt says he
now regrets that decision. Greenspan and Rubin were "joined at the hip on this," he said. "They
were certainly very fiercely opposed to this and persuaded me that this would cause chaos."

Born soon gained a potent example. In the fall of 1998, the hedge fund Long Term Capital
Management nearly collapsed, dragged down by disastrous bets on, among other things,
derivatives. More than a dozen banks pooled $3.6 billion for a private rescue to prevent the fund
from slipping into bankruptcy and endangering other firms.

Despite that event, Congress froze the Commodity Futures Trading Commission's regulatory
authority for six months. The following year, Born departed. In November 1999, senior regulators —
including Greenspan and Rubin — recommended that Congress permanently strip the CFTC of
regulatory authority over derivatives.

Greenspan, according to lawmakers, then used his prestige to make sure Congress followed
through. "Alan was held in very high regard," said Jim Leach, an Iowa Republican who led the
House Banking and Financial Services Committee at the time. "You've got an area of judgment in
which members of Congress have nonexistent expertise."

As the stock market roared forward on the heels of a historic bull market, the dominant view was
that the good times largely stemmed from Greenspan's steady hand at the Fed.

"You will go down as the greatest chairman in the history of the Federal Reserve Bank," declared
Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee
when Greenspan appeared there in February 1999. Greenspan's credentials and confidence
reinforced his reputation — helping him to persuade Congress to repeal Depression-era laws that
separated commercial and investment banking in order to reduce overall risk in the financial
system.

"He had a way of speaking that made you think he knew exactly what he was talking about at all
times," said Senator Tom Harkin, a Democrat from Iowa. "He was able to say things in a way that
made people not want to question him on anything, like he knew it all. He was the Oracle, and who
were you to question him?"

In 2000, Harkin asked what might happen if Congress weakened the CFTC's authority. "If you have
this exclusion and something unforeseen happens, who does something about it?" he asked
Greenspan in a hearing.

Greenspan said that Wall Street could be trusted. "There is a very fundamental trade-off of what
type of economy you wish to have," he said. "You can have huge amounts of regulation and I will
guarantee nothing will go wrong, but nothing will go right either," he said.

Later that year, at a Congressional hearing on the merger boom, he argued that Wall Street had
tamed risk. "Aren't you concerned with such a growing concentration of wealth that if one of these
huge institutions fails that it will have a horrendous impact on the national and global economy?"
asked Representative Bernard Sanders, an independent from Vermont.
"No, I'm not," Greenspan replied. "I believe that the general growth in large institutions have
occurred in the context of an underlying structure of markets in which many of the larger risks are
dramatically — I should say, fully — hedged."

The House overwhelmingly passed the bill that kept derivatives clear of CFTC oversight. Senator
Gramm attached a rider limiting the CFTC's authority to an 11,000-page appropriations bill. The
Senate passed it. President Bill Clinton signed it into law.

Pressing Forward

Still, savvy investors like Buffett continued to raise alarms about derivatives, as he did in 2003, in
his annual letter to shareholders of his company, Berkshire Hathaway. "Large amounts of risk,
particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers,"
he wrote. "The troubles of one could quickly infect the others."

But business continued.

And when Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street was
using derivatives, he said in a 2004 speech, to share risks with other firms. Shared risk has since
evolved from a source of comfort into a virus. As the housing crisis grew and mortgages went bad,
derivatives actually magnified the downturn.

The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers, and
imperiled the insurance giant American International Group, has been driven by the fact that they
and their customers were linked to one another by derivatives.

In recent months, as the financial crisis has gathered momentum, Greenspan's public appearances
have become less frequent.

His memoir was released in the middle of 2007, as the disaster was unfolding, and his book tour
suddenly became a referendum on his policies. When the paperback version came out this year,
Greenspan wrote an epilogue that offers a rebuttal of sorts.

"Risk management can never achieve perfection," he wrote. The villains, he wrote, were the
bankers whose self-interest he had once bet upon.

"They gambled that they could keep adding to their risky positions and still sell them out before the
deluge," he wrote. "Most were wrong."

No federal intervention was marshaled to try to stop them, but Greenspan has no regrets.

"Governments and central banks," he wrote, "could not have altered the course of the boom."

U.S. considers taking stakes in banks

October 9, 2008

Having tried without success to unlock frozen credit markets, the U.S. Treasury Department is
considering taking ownership stakes in many U.S. banks to try to restore confidence in the financial
system.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash
directly into banks that request it. Such a move would quickly strengthen banks' balance sheets
and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right
to take ownership positions in banks, including healthy ones.
"These capital injections are something that" Secretary Henry Paulson Jr. "is actively considering,"
the White House press secretary, Dana Perino, said Thursday.

The Treasury plan was still preliminary and it was unclear how the process would work, but it
appeared that it would be voluntary for banks, government officials said earlier.

The proposal resembles one announced Wednesday in Britain. Under that plan, the British
government would offer banks like Royal Bank of Scotland, Barclays and HSBC Holdings up to $87
billion to shore up their capital in exchange for preference shares. It also would provide a guarantee
of about $430 billion to help banks refinance debt.

"The market for medium term funding is currently frozen across the globe, with potentially serious
economic consequences," Prime Minister Gordon Brown wrote in a letter to the French president,
Nicolas Sarkozy, who currently holds the EU's rotating presidency. "This is an area where a
concerted international approach could have a very powerful effect."

The letter, dated Wednesday, was seen by the International Herald Tribune on Thursday.

At his news conference Wednesday, Brown hinted that Washington also would have to follow suit.
Yet word that the United States was considering doing just that did little to cheer global markets on
Thursday. Major indexes in Asia and Europe all ended lower. Wall Street opened higher but quickly
fell and remained volatile in afternoon trading. Morgan Stanley shares fell as much as 25 percent as
a ban on short selling expired.

With the spiral of fear unbroken, leaders were scrambling to find some way to restore confidence.

Perino said President George W. Bush would take the unusual step of meeting at the White House
on Saturday with the Group of 7 finance ministers and the heads of the International Monetary Fund
and the World Bank.

The Italian Prime Minister, Silvio Berlusconi, said Bush had proposed holding an extraordinary
summit meeting of the Group of 8 leaders next Tuesday, according to Reuters, but Berlusconi said
Sarkozy was "cautious" about the date.

EU leaders are to meet for a scheduled summit meeting in Brussels next Wednesday and
Thursday, which is expected to be dominated by the financial crisis.

Still, the U.S. ambassador to France, Charles Stapleton, said Thursday that Bush and Sarkozy
were "talking on a regular basis about the status of financial institutions in the world," according to
Reuters.

The American recapitalization plan, officials say, has emerged as one of the most favored new
options being discussed in Washington and on Wall Street. The appeal is that it would directly
address the worries that banks have about lending to one another and to customers.

This new interest in direct investment in banks came after the Federal Reserve and five other
central banks on Wednesday marshaled their combined firepower to cut interest rates but failed to
stanch the global financial panic.

The muted market response sent U.S. policy makers and outside experts scrambling for additional
remedies to stabilize the banks and reassure investors.

There is no shortage of ideas, ranging from the partial nationalization proposal to a guarantee by
the Fed of all lending between banks.

On Wednesday, Senator John McCain, the Republican presidential candidate, refined his proposal
- announced in a debate with the Democratic nominee, Senator Barack Obama, the night before -
to allow millions of Americans to refinance their mortgages with government assistance.

As Washington casts about for Plan B, investors are clamoring for the Fed to lower interest rates to
nearly zero. Some are also calling for governments worldwide to provide another round of economic
stimulus through expensive public works projects.

Yet behind the scramble for solutions lies a hard reality: The financial crisis has mutated into a
global downturn that economists warn will be painful and protracted, and for which there is no quick
cure.

"Everyone is conditioned to getting instant relief from the medicine, and that is unrealistic," said
Allen Sinai, president of Decision Economics, a forecasting firm in Lexington, Massachusetts. "As
hard as it is for investors and jobholders and politicians in an election year, this crisis will not end
without a lot more pain."

One concern about the Treasury's bailout plan is that it calls for limits on executive pay when capital
is directly injected into a bank.

The law directs Treasury officials to write compensation standards that would discourage
executives from taking "unnecessary and excessive risks" and that would allow the government to
recover any bonus pay that was based on stated earnings that turned out to be inaccurate. In
addition, any bank in which the Treasury holds a stake would be barred from paying its chief
executive a "golden parachute" severance package.

Treasury officials worry that aggressive government purchases, if not done properly, could alarm
bank shareholders by appearing to be punitive or could be interpreted by the market as a sign that
target banks were failing.

At a news conference Wednesday, Paulson, the Treasury secretary, pointedly named the
Treasury's new authority to inject capital into institutions as the first in a list of new powers included
in the bailout law.

"We will use all the tools we've been given to maximum effectiveness," Paulson said, "including
strengthening the capitalization of financial institutions of every size."

The idea is gaining support even among longtime Republican policy makers who have spent most
of their careers defending laissez-faire economic policies.

"The problem is the uncertainty that people have about doing business with banks, and banks have
about doing business with each other," said William Poole, a staunchly free-market Republican who
stepped down as president of the Federal Reserve Bank of St. Louis, Missouri, on Aug. 31. "We
need to eliminate that uncertainty as fast as we can, and one way to do that is by injecting capital
directly into banks. I think it could be done very quickly."

Paulson acknowledged that the flurry of emergency steps had done little to break the cycle of fear
and mistrust, and he pleaded for patience.

"The turmoil will not end quickly," he said. "Neither the passage of this law nor the implementation
of these initiatives will bring an immediate end to the current difficulties."

Paulson will play host to finance ministers and central bankers from the Group of 7 on Friday. But
he cautioned against expecting a grand plan to emerge from the gathering.

More likely, the participants will compare notes about the measures they are adopting in their own
countries. David McCormick, the Treasury's under secretary for international affairs, said there was
no "one size fits all" remedy for the crisis, though countries were cooperating through the
coordinated cuts in interest rates, with guarantees on bank deposits and in regulations.

In the past month, both the Treasury and the Fed took extraordinary steps toward nationalizing
three of the biggest financial companies in the country. Last month, the Treasury took over Fannie
Mae and Freddie Mac, the giant government-sponsored mortgage finance companies that were on
the brink of collapse. A week later, the Fed took control of American International Group, the failing
insurance conglomerate, in exchange for agreeing to lend it $85 billion.

On Wednesday, the Federal Reserve announced that it would lend AIG an additional $37.8 billion.

But neither the individual corporate bailouts nor the Fed's enormous emergency lending programs -
including up to $900 billion through its Term Auction Facility for banks - have succeeded in jump-
starting the credit markets.

"The core problem is that the smart people are realizing that the banking system is broken," said
Carl Weinberg, chief economist at High Frequency Economics. "Nobody knows who is holding the
tainted assets, how much they have and how it affects their balance sheets."

Global crisis erupted because many underestimated damage

By Floyd Norris--October 9, 2008

Imagine what Republicans would have said a few months ago had someone proposed that the
government should lend money to companies that could not get credit in the free market.

Imagine what Democrats would have said if it turned out that those loans were to be made at low
interest rates, with no equity for the government and with no controls on how the money was spent.

Then contemplate how both would have reacted to the idea that plan would be imposed without
Congressional approval.

That all happened this week, and neither of the two presidential candidates deemed it worth
mentioning in their debate.

It ought to make anyone nervous to have the government allocating capital, which in this
environment could mean it is making the decision to let companies live or fail.

The Federal Reserve could avoid that dilemma by agreeing to buy all the commercial paper it is
offered, up to the amount any company had outstanding before the market caved in, and its public
announcements make it sound as if that is possible. The only sure way a company can be cut off is
if one of the rating agencies downgrades it.

Doesn't it make you feel better to know that the Fed has subcontracted its investment decisions to
Moody's and its competitors?

Ideologically, this is not what either party wanted. But desperate times produce desperate tactics.

"The central bankers all learned the lesson of the 1930s," said Robert Barbera, the chief economist
of ITG, a Wall Street firm. That lesson was that if the choice is between allowing the system to
collapse and writing a lot of checks, you write the checks and forget about ideology.

Unfortunately, none of them learned the lesson of the 1920s, which is that when asset prices soar,
it is not a good idea to sit around doing nothing, as the Fed did for most of the housing boom.
Cheerleading, which it sometimes did, is even worse.

One aspect of the story of this financial meltdown is that the people in charge of the financial
system - in the banks, at the Fed and other central banks and at the Treasury Department and
other finance ministries - consistently underestimated the damage, both to the system and to the
world economies. At first, many thought the damage would be limited to losses from a small group
of mortgages. Banks raised a little capital, but not nearly enough.

As the problems spread, they kept offering reassuring words, which they may well have believed.
Those words provided brief comfort for some, but destroyed a lot of credibility.

As recently as Sept. 18, after Lehman Brothers had gone broke and it was clear that consumers
were cutting back, the Federal Open Market Committee thought the economy could come through.

"Participants agreed that economic growth was likely to be sluggish in the second half of 2008,"
said the minutes of the meeting. "Several participants had marked down their near-term outlook for
economic activity and some judged that downside risks had increased, but most continued to
expect a gradual recovery in 2009."

We should be so lucky as to get sluggish growth for the remainder of 2008. The gross domestic
product seems likely to show significant declines.

The real problem, which many preferred to ignore because they had no ready answer, was that the
financial system was breaking down. The excesses of lending and gambling had destroyed the new
financial system - the one built on securities as an alternative to bank lending - and left the old
commercial banks too weakened to step in.

Or, in the words of Paul Volcker, a former Fed chairman: "In the U.S., the market took over. The
market has flopped."

Now, he added, "everybody is running back to Mother, the commercial banking system."

Unfortunately, Mother is very ill. Even worse, her children do not trust each other. In normal times,
loans between banks are viewed as virtually risk-free. Now banks deem them too risky to make.

The eventual, and very expensive, solution will be to recapitalize the banking system. The
sovereign wealth funds that provided the first round of capital now feel like they were played for
suckers, and there are good regulatory reasons not to let private equity funds buy banks. It looks
like it will be the public that pays the tab.

The bailout passed by Congress supposedly was going to provide capital indirectly, by having the
Treasury purchase dodgy assets for more than current market value. Now few are confident that
will work. That also would have the odd side effect of giving the most money to the banks with the
largest amount of bad assets. It might make more sense to funnel money to the banks whose
managements were the smartest, or at least the least dumb.

Europe was slower to realize it had a problem, and slower still to admit it was not all the Americans'
fault. It still seems to be unable to agree on any coordinated action, but individual countries are
doing more than the United States.

In Denmark, the government stepped up to guarantee not only deposits, but interbank lending. It
also put limits on the banks. It ordered them to stop paying dividends or buying back shares, and
not to begin new stock option programs for executives.

It is absurd that American banks now are paying any dividends at all. Even after reductions, most
big American bank shares now yield more than 3 percent, and some more than 7 percent. None of
them are confident they have enough capital, or that their competitors do, which is why they are
reluctant to lend.

In that atmosphere, does it make any sense to reduce capital by paying dividends? Should the
government funnel money to companies whose owners are getting big payouts while the banks
report large losses?

Britain announced its government will buy preferred stock in banks, and a few hours later the
American Treasury secretary, Henry Paulson Jr., was saying that he might do the same. That is
probably what will happen, eventually if not immediately.

In 1933, when Franklin Roosevelt became president amid a panic, he declared a bank holiday that
closed the banks while federal examiners went over their books. When the holiday was over, the
government closed some banks and declared the rest were healthy.

In reality, there was no way the government could be sure of that. But the public accepted it, and
the bank runs stopped. This time, the government has offered too many assurances that turned out
to be false. It will take cash to persuade the public - and the other banks - that the survivors are
safe.

The World’s Banks Could Prove Too Big to Fail — or to Rescue

By FLOYD NORRIS--October 10, 2008

As the banking system quaked this week in many countries, and various governments took steps to
bail out their banks or at least guarantee deposits, one question was asked quietly: Can the
governments afford it?

That is not a question for the United States, which can print dollars and has a banking system that
is the largest in the world but is small in relation to the national economy.

The country where that worry first surfaced was Iceland, whose three major banks had greatly
expanded overseas, including starting substantial retail operations in a number of European
countries. The government has taken control of all three banks, and is not guaranteeing that foreign
customers will be protected.

Iceland is also the only country to have its sovereign debt rating downgraded so far as a result of
the financial crisis.

The accompanying chart shows the size of national banking systems relative to their countries’
economies, measured in two ways, and also show how well capitalized the banks appear to be,
through the latest reported data.
In general, higher figures in any of the graphics indicate increased danger. They do not pretend to
show what shape the banks are in, but they do reflect the size of the problem each country would
face if its banking system did get into trouble.

The first two charts look not at deposits but at short-term debt carried by the banks. The banks
usually have long-term debt as well. But by its nature, that debt cannot be withdrawn if worries about
a bank’s solvency suddenly increase. They also have deposits, but deposits are less likely to flee, at
least if deposit guarantee systems are trusted. Short-term debt, on the other hand, matures within a
year and may not be available to a bank that is in trouble.

The first comparison — the tinted circles — looks at the size of bank short-term debt as a percentage
of a country’s gross domestic product. Such figures are not directly comparable, since one is the total
amount of income in a country over a year, and the other is the amount owed by banks that may have
to be paid over that year. But the comparisons do show relative sizes.

In the United States, the banks have total short-term debt that is equal to 15 percent of G.D.P. But in
some countries where banking systems have grown to international proportions, the debt exceeds
G.D.P. That is true in Switzerland, Belgium, Iceland and Britain.

The second comparison — the open circles — looks at the short-term bank debt in relation to each
country’s national debt. Again, the relationship is not direct, because a country may have excellent
credit that would enable it to borrow much more, but large numbers still raise questions.

“Can they guarantee the deposits if the bank owes 3.5 times the national debt?” asked Bob Prince,
the co-chief investment officer of Bridgewater Associates, which provided the data.

For countries in the euro zone, there is an additional consideration. They do not have the right to print
money. That may also be true for some other banking systems, if the liabilities are primarily in
currencies other than their own. Those countries could face special problems if they needed to come
up with huge amounts of cash to rescue banks.

Finally, the leverage ratio gives a rough indication of how risky a nation’s banking system might be. It
is the ratio of total bank assets to the net worth of the bank. That could be misleading if the assets are
very safe — government bonds, for example, versus subprime mortgage loans — but in general the
higher the ratio the smaller the margin of safety.

There again, the United States appears to face a relatively small problem, with an average leverage
ratio of 12. The figures range up to 52 in Germany. Theoretically, a 2 percent drop in the value of all
German bank assets would wipe out the net worth of the banking system.

These figures will be meaningless if the governments retain the trust of depositors and creditors. “It
becomes a matter of psychology,” Mr. Prince said. If governments say the deposits are safe “and the
market believes them, then they don’t have to have any money to back up their promises.”

White House overhauling rescue plan

October 12, 2008
As international leaders gathered here on Saturday to grapple with the global financial crisis, the
Bush administration embarked on an overhaul of its own strategy for rescuing the foundering
financial system. Two weeks after persuading Congress to let it spend $700 billion to buy distressed
securities tied to mortgages, the Bush administration has put that idea aside in favor of a new
approach that would have the government inject capital directly into the nation's banks — in effect,
partially nationalizing the industry. As recently as Sept. 23, senior officials had publicly derided
proposals by Democrats to have the government take ownership stakes in banks.
The Treasury Department's surprising turnaround on the issue of buying stock in banks, which has
now become its primary focus, has raised questions about whether the administration squandered
valuable time in trying to sell Congress on a plan that officials had failed to think through in
advance. It has also raised questions about whether the administration's deep philosophical
aversion to government ownership in private companies hindered its ability to look at all options for
stabilizing the markets.

Some experts also contend that Treasury's decision last month to not use taxpayer money to save
Lehman Brothers worsened the panic that quickly metastasized into an international crisis.
The administration's new focus was announced late Friday as part of a rescue plan in coordination
with six of the world's richest nations. It came during a week when the Dow Jones industrial
average plummeted 18 percent, one of the worst weeks in stock market history.
While the Treasury says it still plans to buy distressed assets, the scope of that plan is unclear.
Treasury Secretary Henry Paulson Jr. has refused to say whether the capital infusion program for
banks would be bigger than the original plan to buy troubled assets.

Still, Treasury has directed Fannie Mae and Freddie Mac, the government-controlled mortgage
giants, to ramp up their purchases of hard-to-sell mortgage bonds, in what could be a speedier and
less formal process than the auctions proposed by the Treasury.
Underscoring the gravity of the situation, President George W. Bush convened an early morning
meeting at the White House on Saturday with finance ministers from the Group of 7 industrialized
countries.

"All of us recognize that this is a serious global crisis, and therefore requires a serious global
response, for the good of our people," Bush said afterward in the Rose Garden, flanked by the
ministers, who are in Washington for the annual meetings of the International Monetary Fund and
the World Bank.

Bush said the countries had agreed to general principles to respond to the crisis, including working
to prevent the collapse of important financial institutions and protecting the deposits of savers. But
he offered no details on other measures, suggesting that there were still differences among
countries about which steps to take to shore up their respective financial systems.
To some extent, the effort to agree on a coordinated plan is being driven less by the hope that such
measures will carry more punch than by the fear that nations acting alone could destabilize the
system.

Those worries grew in recent days when Iceland seized its three major banks, which were failing,
and appeared to guarantee the deposits of Icelanders over those of foreigners. That provoked a
fierce reaction from Britain, which is now in talks with Iceland to get back the deposits of British
citizens.

With the United States and Europe working together on ways to secure their banking systems,
economists are concerned that money may flow out of other countries, particularly emerging
markets, to Western countries if investors decide that those markets are not as safe.
The United States sought to reassure these countries in a meeting on Saturday evening of the
Group of 20, which includes countries with large emerging markets, like China and Russia.
"We want to reaffirm, reinforce our commitment that we're going to take these actions in a way that
doesn't undermine the economies of other countries," said David McCormick, the under secretary of
the Treasury for international affairs.

Like the United States, Britain plans to provide capital directly to banks. But the United States and
other countries have not adopted Britain's proposal to guarantee lending between banks as a way
to unlock the credit market. Germany has been reluctant to put state capital directly into banks,
though officials said there were signs of movement in that position on Saturday. Europeans leaders
were scheduled to meet in Paris on Sunday, amid reports that Germany may announce a large
rescue plan of its own.
Some experts said the delay in carrying out the Bush administration's $700 billion bailout plan had
only hurt its prospects for success.

"Even if it was adequate before, it's not adequate now," said Frederic Mishkin, a professor of
economics at Columbia University's business school who stepped down as a Federal Reserve
governor at the end of August. "If you delay and create uncertainty, the amount of money you have
to put up goes up."

As recently as late September, the idea of letting the government buy part of the banking system
had been unthinkable in the Bush administration. To many officials, such intervention seemed like a
European-style government intrusion in the markets. "Some said we should just stick capital in the
banks, take preferred stock in the banks. That's what you do when you have failure," Paulson told
the Senate Banking Committee on Sept. 23. "This is about success." Paulson told lawmakers it
made more sense to jumpstart the frozen credit markets with "market measures," by which he
meant buying up assets rather than institutions. He staunchly resisted Democratic proposals to
require that the government receive an equity stake in the companies it was helping.

But on Friday, Paulson not only confirmed his intention to buy stakes in banks but gave the idea
central billing. "We can use the taxpayer's money more effectively and efficiently, get more for the
taxpayer's dollar, if we develop a standardized program to buy equity in financial institutions,"
Paulson said.

Treasury officials said they hoped to make the first capital investments within the next two weeks.
That would be earlier than any government purchases of unwanted mortgage-backed securities.
One reason for Paulson's rapid reconsideration was that global financial markets have been going
downhill faster than anyone had seen before.

Credit markets seized up and all but stopped functioning, making it impossible for most companies
to borrow money on more than an overnight basis. Bank stocks plummeted, making it much more
difficult to shore up their balance sheets by raising more capital from investors.
Investors panicked as the House initially rejected the bailout bill on Sept. 29. They panicked even
more after Congress passed a bill on Oct. 3 that was packed with sweeteners that added $110
billion to the price tag.

By the closing bell last Friday, the Standard & Poor's 500-stock index had suffered its worst week
since 1933. A growing number of analysts argue that Paulson's original plan, called the Troubled
Assets Relief Program, would have been unhelpful and possibly unworkable. Some noted that
Paulson presented Congress a proposal that was only three pages long and that Treasury officials
have yet to provide details how the auctions will work.
As envisioned, the Treasury or its agents would hold so-called "reverse auctions" in which financial
institutions are invited to compete against each other in offering to sell their mortgage-backed
securities at a low price.

Though auctions are common for all sorts of products, including electricity that utilities sell one
another, experts said that mortgage-backed securities would pose difficult headaches because they
are extraordinarily complex, difficult to value and come in almost limitless varieties.
The bonds for a single pool of mortgages are divided into more than a dozen "tranches," or slices,
which have different seniority, different credit ratings and different rules for being paid off. The
performance of the underlying mortgages varies greatly from one pool to another, even if both pools
are made up of seemingly similar loans.

"I am not aware that the Treasury Department presented any evidence on auctions that have been
successful when they are used for assets that are so heterogeneous," said William Poole, who
retired in August as president of the Federal Reserve Bank of St. Louis.
Because Fannie Mae and Freddie Mac, the mortgage giants, buy and sell mortgage securities
every day, they could absorb some of the hard-to-sell securities without going through the untested
auction process.

The Federal Housing Finance Agency, which last month seized the companies and placed them
into a conservatorship, lifted capital restrictions on them last week and effectively gave them a
green light to buy more mortgage securities of all types, including those backed by subprime loans,
given to borrowers with weak credit.

The companies have a lot of money; Congress authorized Treasury to lend them as much as $100
billion each as part of the rescue plan created for them. That could free up money in the separate
$700 billion bailout plan for injecting capital directly into the banks. People familiar with the early
planning efforts for a systemic bailout said the chairman of the Federal Reserve, Ben Bernanke,
argued that it would be easier and more efficient to inject capital directly into banks. But Treasury
officials balked, in part because they were ideologically opposed to direct government involvement
in business.

But as the financial markets spiraled further downward during the last 10 days, a growing number of
top-tier institutions, including Goldman Sachs and Morgan Stanley, became worried about their
survival. "The crisis in confidence goes way beyond the actual losses that will be incurred from debt
securities," Mickey Levy, chief economist for Bank of America, said in an interview on Friday. "It's
truly incumbent on policy makers to address that crisis."

Treasury officials began canvassing banks and investment firms about the possibility of having the
government buy stakes in them. The new bailout law gave the Treasury the authority to buy up
almost any kind of asset it wanted, including stock or preferred shares in banks.
Industry executives quickly told Paulson that they liked the idea, though they warned that the
Treasury should not try to squeeze out existing shareholders. They also begged Paulson not to
impose tough restrictions on executive pay and golden-parachute deals for executives who are
fired.

Paulson heeded those pleas. In his remarks on Friday, he carefully noted that the government
would acquire only "nonvoting" shares in companies. And officials said the law lets the Treasury
write most of its own restrictions on executive pay, and those restrictions can be lenient if they are
applied to a set of fairly healthy companies.

European banks share blame

October 13, 2008

On the evening of Oct. 4, Italy's prime minister made abundantly clear just who he thought was to
blame for the global credit crisis. From risk-taking Wall Street bankers to home buyers who
borrowed more than they could afford, Silvio Berlusconi declared that Americans had embraced
"the capitalism of adventurers."

By contrast, "Europeans set aside money in savings," he added, as the leaders of Britain, Germany
and France looked on following a crisis meeting of European officials. "Europe is not facing and has
never faced the risks in the American system."

Gordon Brown, the British prime minister, pointedly added that the crisis had "come from America."

The next 24 hours would dramatically undercut that view.

On Oct. 5 the board of Italy's second-largest bank called an emergency meeting to raise $9 billion in
fresh capital, while German authorities hastily agreed to guarantee all bank accounts held by
ordinary consumers and provide $67 billion to save a stricken property lender, Hypo Real Estate.
And within days, the British government would roll out a plan to commit £150 billion, or $256 billion,
in government funds to shore up its own shaky banking system.

Europe's leaders have repeatedly pointed fingers at the United States since the latest wave in the
credit crisis crossed the Atlantic this month. But the reality is that many European banks emulated
the riskiest characteristics of their American counterparts, bulking up on what turned out to be toxic
debt and relying on short-term loans, rather than deposits, to finance their operations.

By some measures, in fact, European banks exposed themselves to even higher levels of risky debt
than American banks did.

While most European institutions don't face the kind of losses that brought down everybody from
Lehman Brothers to Washington Mutual in the United States, heavy borrowing has made them
vulnerable now that easy credit is a thing of the past, while plunging stock prices make it all but
impossible to raise money without government help.

And though they did not provide mortgages to borrowers with dubious credit like their American
counterparts, giants like UBS of Switzerland bought tens of billions in American subprime debt in a
bid for higher yields.

In Germany, Hypo's loans exceeded its deposit base by more than eight times, forcing it to rely on
short-term borrowing that dried up when credit markets tightened in recent months.

Two other troubled institutions, Royal Bank of Scotland and Fortis, a Dutch-Belgian lender, took on
huge amounts of debt to finance expansions. "Our balance sheets are overleveraged," said Vasco
Moreno, who tracks European banks for Keefe, Bruyette & Woods, a research firm.

By one commonly used yardstick to measure borrowing, the ratio of assets to equity, European
banks employed more than twice as much leverage as their American counterparts, according to
Moreno. To make matters worse, an ocean of short-term debt issued by European banks is coming
due soon, with $375 billion maturing in the fourth quarter of 2008 and another $339 billion in the first
quarter of 2009. "We do not see an easy solution to this problem, and more importantly, neither do
the authorities," Moreno added.

The deposit guarantees and capital injections deployed in Britain, Ireland and now across the rest
of Europe might allay the immediate panic, but they will not free up credit for businesses already
hard-hit by the global economic slowdown.

"If the banks do not manage to roll over" the debts coming due over the next few quarters, Moreno
said, "we may witness balance sheet contraction with major negative implications for the real
economy or more bank failures."

Even as excessive leverage emerges as the most pressing concern, the decision by some
European institutions to wade into the market for complicated, mortgage-backed American
securities and other derivatives overhangs the system.

After Fortis was divided up earlier this month, with the Dutch government nationalizing local
operations, and Belgian authorities selling most of the remainder to BNP Paribas of France, experts
found that it owned more than 10 billion, or $13.4 billion worth of toxic, illiquid securities.

The mostly American asset-backed securities have been placed within a separate "ring-fenced"
entity. As part of the deal, Belgian taxpayers got stuck with nearly a quarter of this hard-to-sell
portfolio.

The failure of Dexia, a French-Belgian lender to municipalities that was saved by a government-led
$9.2 billion capital injection, can be traced to a similar mix of American troubles and European
missteps.

In 2000, Dexia entered the fast-growing market for municipal bond insurance in the United States,
acquiring Financial Security Assurance. To lift profit, the unit relied on credit default swaps and
other now beaten-down derivatives, ultimately draining Dexia's capital and forcing the recent
government intervention. "Using credit-default swaps was cheaper, but it was opaque, and the
board of Dexia couldn't follow all that," said one government official who was involved in the rescue.
Officials from Dexia and Fortis declined to comment.

Even worse, added this official, who spoke on condition of anonymity because he was not
authorized to discuss internal matters, oversight of Dexia was split between Paris and Brussels.
French regulators oversaw the unit of the company that included FSA, while Belgian authorities
were responsible for monitoring the entire company.

"Nobody understood it," the government official said.

THE LAST WORD

First, Let's Stabilize Home Prices
(with emphasis and underlines added)
OCTOBER 2, 2008
By R. GLENN HUBBARD and CHRIS MAYER

We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank
capital, thereby tightening lending and causing house prices to fall further. The cycle has spread
beyond housing, but the housing market is at the source of this problem and the best place to break
up the adverse sequencing of cause and effect events that have evolved from it. (This is the key to
‘stopping the bleeding’ and stabilizing the housing market.)

Housing starts are at their lowest level since the early 1980s, while simultaneously there are now
more vacant houses than at any time since the Census Bureau started keeping such data in 1960.
Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are
accelerating. House prices continue to fall, weakening household balance sheets and the balance
sheets of financial institutions.

But this can stop. The price of a home is partially dependent on the mortgage interest rate -- lower
mortgage rates will raise housing prices over time. (However, this will only occur with dynamic
market conditions in which houses are bought and sold on a regular basis in a rationale, steady and
not speculation driven, housing market)

We propose that the Bush administration and Congress allow all residential mortgages on primary
residences (the key here is owner-occupied primary residences only! No vacation homes or condos
bought for speculation would qualify) to be refinanced into 30-year fixed-rate mortgages at 5.25%;
matching the lowest mortgage rate in the past 30 years, and place those mortgages with Fannie Mae
and Freddie Mac. Corporate investors and speculators in real estate should not be allowed to
qualify.

The historical spread of the 30-year, fixed-rate conforming mortgage over 10-year Treasury bonds is
about 160 basis points. So a rate of 5.25% would be close to where mortgage rates would be today
with normally functioning mortgage markets. One of us (Chris Mayer) recently published a study
showing that -- assuming normally functioning mortgage markets -- the cost of buying a house is
now 10% to 15% below the cost of renting across most of the country. Rising mortgage spreads and
down-payment requirements are both factors that are still driving down housing prices. We need to
stop this decline.

The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes
less on the house than it is worth. (This could be a sticking point, as the entire property appraisal
system has to be restructured away from the valuation based on comparable neighborhood sales
and controlled through more direct regulation) Lower interest rates would have a positive impact on
stopping the slide in values and mean higher overall house prices. The present day reality is that the
government now controls nearly 90% of the mortgage market and can (and should) act on this
realization.

Remove the refinancing option and you can have lower rates without substantial cost to the
taxpayer. Homeowners would have to give up the right to refinance their mortgage if rates fall,
although homeowners could pay off their mortgage by selling their home (no prepayment penalties).
For borrowers with lower credit scores, the mortgage rate would be greater than 5.25%, but it would
be less than their current rate. (Individual credit scores, if truly important to the lenders, could also
be adjusted upwards by a pre-determined factor for any previous diminution that can be shown as
directly related to the current housing crisis.)

Now, what about mortgages on homes that are worth less than the total amount of the loan? These
mortgages could be refinanced into a 30-year fixed-rate loan to be held by a new agency modeled
on the 1930s-era Homeowners Loan Corporation. New mortgages would be made of up 95% of the
current value of a home. (95% loan-to-value is probably necessary under the circumstances; I’d
prefer the more traditional and conservative 80% LTV. If a borrower is able to meet such a level,
then the interest rate could be adjusted downward)

The government might use two approaches to mitigate its losses. It could offer owners and servicers
the opportunity to split the losses on refinancing a mortgage with the new agency. Servicers would
have to agree to accept these refinancings on all or none of their mortgages, to avoid cherry-picking.
(Yes) Or the government should take an equity position in return for the mortgage write-down so that
the taxpayers profit when the housing market turns around. (Careful—a temporary government
ownership position in the banks is acceptable but if they mean the loan service industry-this would
unnecessarily complicate the structure of this work-out and keep the government bureaucracy
involved in the private sector far longer than required. The loan servicing on any refinanced
mortgages should stay with the banks for further market discipline)

Our calculations based on deeds and Census data suggest that the total amount of negative equity
for all owner-occupied houses is $593 billion. However, capping an individual's write-down to
$75,000 would reduce the government's total liability to $338 billion and cover 68% of individuals
with negative equity. (this is quite similar to the work-out we designed for depositors in Maryland—it
shows that on an individual basis the negative equity is not that great and that no one would
received an inequitable level of relief over most others in the same deteriorating situation. Raising
the $75,000 to a maximum of $100,000 would probably ‘capture’ over 85% of the borrowers eligible
for this program. Variations on this theme could be structured to include retirees and perhaps include
some state cost-sharing and/or property tax relief programs). Even this loss will be reduced as the
proposal spelled out here raises housing values and economic activity, and contemplates loss
sharing with lenders, hopefully matching the experience of the old Homeowners Loan Corporation.

While the net cost is modest compared with many plans on the table, it would require that the
government could assume trillions of dollars of additional mortgages on its balance sheet. But we
have already crossed this bridge with the explicit "conservatorship" of Fannie Mae and Freddie Mac.
In any event, these mortgages would be backed by houses and the verified ability to repay the debt
by millions of Americans. (This is by far the most important facet to any bad loan work out. Collateral
(i.e. foreclosures) has never been a primary or effective source of repayment—loans must be repaid
through earnings and cash flow). In addition, by putting a floor under house prices, this proposal
would raise the value to taxpayers of trillions of existing (no one seems to wants to remember this
fact—these loans have already been disbursed and they are the basis for all the mortgage-backed
securities that have been created since!) home mortgage assets already owned or guaranteed by
the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others.

Improvements in household and financial institution balance sheets will increase investment and
consumer spending, which will mitigate the extent of the current downturn. Americans, on average,
spend about 5% of the equity of their homes on consumer goods and services. So if home prices
increased 10% above where they would have been without government intervention, we estimate
consumers will have an additional $100 billion annually to spend. (¿ Where is the actual cash for this
presumed increase in consumer spending to come from?)

In addition to focusing on the very real problem in the housing market, the plan could be
implemented immediately. As a result of the U.S. government's conservatorship of Fannie Mae and
Freddie Mac, origination of new mortgages can be financed quickly. Congress would have to raise
the overall borrowing limit and approve the new federal purchases of negative equity loans. But it will
likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would
have to seek the involvement of many additional private actors, as opposed to using vehicles
already in place.
The decline in housing prices remains the elephant in the room in the discussion of the credit market
deterioration. Let's start there.

Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic
Advisers under President George W. Bush. Mr. Mayer is a professor of finance and economics
and senior vice dean of Columbia Business School.

Mel’s Cogitations

I’m sure many uninformed conservatives will see this proposal as a socialist program with overtones
of nationalization—shades of FDR and all that. Most conservative Republicans will probably scream
that this is a bailout of people who got into mortgages that they couldn’t afford in the first place and is
rewarding their ‘bad behavior’ This is simply not true for the majority of people who find themselves
on the brink of foreclosure—too many other economic factors enter into this debacle to make this
obdurate claim stick.

If one wants to get to the root of the problem, blame has to go all the way back to that uniquely
American concept of homeownership—the entrenched belief that the great ‘American dream’ is
some sort of constitutional right. Mix this belief with the greed of capitalism and worship to the false
God of Ever Increasing Home Value, and there is more than enough blame for every participant.

There is an element of moral hazard hidden in this proposal as regards the ‘unfairness’ of treating
homeowners who; while they may be upside-down in their mortgage to value ratio—are nonetheless
keeping current on their existing mortgages differently than those who must refinance in this manner
or face foreclosure. Eligibility criteria and some sort of upside profit cap must be incorporated into to
the program so that homeowners who do take advantage of this refinancing program (at lower rates
and decreased values) do not gain unfairly over others when the market stabilizes and home values
begin their predictable upward trend once again.

This can easily be done with the involvement of Fannie and Freddie—who have not gone away. In
fact using these two GSEs as the lender of last resort for weak mortgage assets (and forcing them
to hold them on their books instead of immediately creating mortgage-backed securities) would
effectively recapitalize them as well. Fannie and Freddie will be very significant partners in any
mortgage workout program now that they are essentially wards of the state exempt from the capital
and market discipline constraints. They can immediately purchase assets out of the TARP, doing so
with considerably more flexibility than anyone else of size
The way the $700 billion ‘solution’ has been structured so far this approach may look to some like a
bailout on top of a bailout. BUT this is not really the case as the Treasury already has the authority to
allocate its new-found dollars into purchasing primary mortgages instead of the villainous third-level
Credit Default Swaps (CDS) and other toxic derivatives that only covered up the true level of basic
credit risk. The only question is whether or not Secretary Paulson will actually approach the problem
on multiple fronts and exercise this option as part of a comprehensive plan or stick with the his
stated goal to resolve the crisis through the credit markets as currently structured.

In reality this approach is exactly the opposite of the current Save Wall Street program that has been
falsely sold to the public as helping Main Street—and then could only pass Congress with the
inclusion of an additional $100billion + in earmarks designed to help their cronies and get
themselves re-elected. It should be better understood by all that the stockmarket. with all its direct
and indirect investment assets, is merely a vehicle, even a side-show, for the banking system to
operate in today’s era of instant communications and globalization of risk. We must return to the
fundamentals here and attack the problem, not only at the level of the capital markets, but at the
level of the individual bank which originated the original primary mortgage and is critical to the
financial well-being of the average person. Without consumer faith in the fundamental soundness in
his local bank, the financial panic will rapidly become endemic.

This type of program should be an integral component of the resolution as it is exactly what the
whole bailout program should have been designed to do in the first place—Stop the bleeding and
save the homeowners, not the investment bankers! In addition to directly involving the very people
most affected by the collapse of the housing market, we should begin to see a revival of bank
lending in all markets. Nonetheless, all should realize that instituting a program to resolve the multi-
faceted mortgage market issues will, in itself, not provide the desired quick fix panacea that many
desire. The long-term stabilization and possible recovery of the global capital markets will take years
of further government interventions, both in terms of cash and a re-regulation of future activities.

The critical slowdown in inter-bank funding and new credit extensions to small businesses would be
reversed--although banks had best return to the fundamentals and be more conservative in whom
they lend to and on what terms. The Federal Reserve has already taken steps to address this aspect
of the problem, pledging to fund banks directly and/or buy several billion dollars worth of commercial
paper themselves. Combined with the raising of the deposit insurance limits to $250,000.00 and the
announced plans to invest in the recapitalization of commercial banks through direct equity
purchases, these programs should go a long way in restoring faith in the financial sector from the
true foundation of the system—the American consumers and taxpayers.

It is politically interesting—but totally disingenuous; that McCain is trying to take credit for this ‘plan’
by declaring in the latest debate that he would ‘order’ the Treasury secretary to buy up all the ‘bad’
mortgages to ‘save the taxpayer’. As can be expected in this period of bizarre campaign rhetoric, his
‘idea’--half-baked and poorly expressed as it is, has hastily been politicized and is now so
bastardized from the intention of the model proposed, as to be totally unrealizable. This is not his
idea and in fact is not a new idea at all. I, as well as many others, have been thinking along these
lines since late last year and these two professors have succeeded in structuring and articulating the
main issues involved much better than I have ever been able to.

In this time of crisis it is important that this process not be further politicized and that the operational
details not be allowed to deter the serious consideration of the type of mortgage refinancing program
proposed by professors Hubbard and Mayer as an integral part of the overall solution. At least under
this program, there would be no extravagant costs for mortgage holders to attend a ‘work-out’ retreat
at a spa resort, as did the AIG executives last month.

Mel Brown
October 2008