Will the Government Bailout Work?

A reformed Wall Streeter explains the latest Treasury-Fed-SEC plan to revive the markets.

| Fri Sep. 19, 2008 3:00 AM EDT

Friday, like an electrical shock to a failed heart, federal money promises lifted the pulse of the financial markets. Unfortunately, Washington still doesn't know how much risk it's taking on.

Treasury Sec. Henry Paulson's multi-billion dollar market rescue includes four things to save the market: Creating a toxic waste fund for worthless mortgage assets, extending the Fed's discount window to investment banks, using a $50 billion Depression-era Exchange Stabilization Fund to guarantee money market investments, and installing a temporary ban on short-selling 799 financial stocks.

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The stock market loves all of them, finishing Friday's trading session with a flourish. Even Bush came out of hiding to optimistically note that, "in the short run, adjustments can be painful…in the long run, I'm confident that our capital markets are flexible and resilient and can deal with these adjustments."

The waste-removal vehicle that Paulson is proposing is similar to the S&L crisis one; the Resolution Trust Corporation created in 1989 to assume over $125 billion in bad assets owned by insolvent savings and loan companies. Its primary goal was to sell them into the market slowly, giving the industry time to heal.

Will that work now? Not really. The packaged mortgage assets today are much more complicated than they were 20 years ago, and the entangled credit default products less transparent. Plus, S&Ls were regulated by the government, whereas the institutions that could benefit from such a fund today, like investment banks and hedge funds and insurance companies, are not.

As for a short-sale ban—this isn't the first time that SEC Chairman Christopher Cox has proposed one under a measure provided by the 1934 Securities Exchange Act. After four months of deliberating the role that short selling might have played in the pummeling of Bear Stearns' stock, he installed a 10 day short-sale ban, between July 21st and 29th. That didn't work for long.

But, sort of like with Sarah Palin and the bridge to nowhere, before he was against short selling, he was for it. Last year, the SEC removed a post 1929 stock market crash rule that only allowed short selling when the stock price's last tick was positive, which was designed to prevent the kind of short selling he's concerned about now.

Meanwhile, Central Banks around the world are lavishing cash on the financial industry to keep liquidity alive. Today, Japan, Australia, India and Indonesia pumped $42 billion into their money markets, a day after the US Federal Reserve pushed through an $180 billion package. The Bank of England, Swiss National Bank, and European Central bank lent $70 billion of cash to their markets.

But,

Here's the thing. Bear Stearns and Lehman Brothers didn't go bankrupt because of individual mortgage loans defaults and foreclosures. These were simply the catalysts at the bottom of a huge pyramid of leverage that ultimately uncovered the sheer lack of transparency in the financial markets. Without a clear understanding of the risks in our US financial system, including huge new conglomerate balance sheets like that of Bank of America-Merrill Lynch, this euphoria will soon give way to further disintegration.

Using terms like 'adjustment' and 'correction' makes it seem like this episode of financial destruction can be cured by the equivalent of a chiropractor visit. What we really need is something more drastic: a Glass-Steagall style wall.

Already, the US national debt has nearly doubled in the past eight years, and it will keep going up. If Congress really wants to alleviate this crisis, they need to not set themselves up for another round of handouts while making the public shoulder the risk of the entire banking community.

Here's a breakdown of the $555 billion running total of Wall Street aid to date: The Fed backstopped $30 billion of Bear Stearns risk in its sale to JPM Chase in March, is loaning $85 billion to AIG in return for an 80 percent equity stake, opened a $150 billion window for banks who could use risky mortgage securities as collateral, and extended the use of its discount window to investments banks who aren't supposed to have that privilege, since they're not regulated by the Fed. The Treasury has pledged to backstop Fannie and Freddie up to $200 billion, created an emergency $40 billion worth of T-bills to be auctioned to spot the Fed some extra cash, and is using a $50 Depression-era emergency fund to support the money market industry.

Nothing converts free-marketers to pseudo-socialists like fear and an international spotlight. But instead of discussing intense new regulation, the US government is just writing out checks. The New Deal didn't just include the Glass-Steagall Act of 1933, which disentangled riskier speculative investment banks from the more consumer-oriented commercial banks, it provided safeguards to the entire financial system. Today, Washington is using the ones that it didn't destroy. It would be much better if they were discussing how to resurrect the ones they did.