Financial Times Editorial Comment: Paulson’s plan still needs some work AND One size fits all

Financial Times Editorial Comment: Paulson’s plan still needs some work
Copyright The Financial Times Limited 2008
Published: September 22 2008 19:35 | Last updated: September 22 2008 19:35

Hank Paulson, the US Treasury secretary, compared his powers over Freddie Mac and Fannie Mae to a bazooka. His new plan to buy up mortgage-backed securities is nothing short of a B-52 bomber. He will need to make some modifications to it before it flies, but Mr Paulson should also seek an even bigger weapon – a plan for the public recapitalisation of US banks.

As the value of mortgage-backed securities has fallen, some institutions find themselves with too little capital to support lending. Some are also unable to raise the money they need to finance the securities. By selling assets, to raise money, they have depressed prices further. This has weakened balance sheets, forcing them to dump yet more.

Mr Paulson’s plan is to buy up $700bn of these securities, to put a floor under the price and end this vicious spiral. It has deep inherent flaws. A central feature of the crisis is that no one knows what these assets are really worth: the Treasury has no greater insight than private investors. If the Treasury pays too little, it may well fail to solve the crisis. If it pays too much, it will inflict huge losses on taxpayers, for the benefit of a reckless and incompetent financial sector. Indeed, such a scheme inevitably directs most help at the most reckless banks.

Yet there are also avoidable mistakes. The current draft legislation would set up a huge fund answerable to the Treasury secretary. Any scheme should, instead, be run by an independent board – led by someone of the stature of Paul Volcker, former Federal Reserve chairman – and guided by a tight remit.

Bailing out Wall Street while Main Street is hit by foreclosures would be politically unacceptable, for good reasons. A package to help homeowners and small businesses is a political necessity. It is also a reasonable request, once such government bail-outs are in the offing. But these objectives should be met elsewhere. The new institution should focus on the financial crisis.

Such a body is, however, only a part of the solution. Even if the prices for the securities stabilised, some banks would remain undercapitalised. It may prove necessary for the authorities to be able to deleverage institutions directly, by injecting new capital, perhaps as preference shares, or by turning debt into equity on a large scale.

If the real problem is that banks are insolvent, Mr Paulson’s B-52 may well prove to have been an expensive and ineffective diversion. In any case, the US authorities need a nuclear option for recapitalising the financial system. What is more, they are likely to need such an alternative option quite soon.





Financial Times Editorial Comment: One size fits all
Copyright The Financial Times Limited 2008
Published: September 22 2008 19:43 | Last updated: September 22 2008 19:43

In the space of a week, the four remaining large independent investment banks have disappeared. Lehman Brothers collapsed, Bank of America is taking over Merrill Lynch and Morgan Stanley and Goldman Sachs are turning themselves into regulated banks. In return for tighter regulation, the two last can look forward to stable funding. But the demise of stand-alone investment banks does not purge the system of risk – it merely shifts it.

Morgan Stanley and Goldman Sachs were under pressure from investors and regulators alike to change their business models. Forcible deleveraging would have come anyway. Their metamorphosis beat the authorities to it.

Investors also needed reassurance that reliance on wholesale markets would be reduced. As ordinary banks, they should find funding easier: both banks will now have permanent – not just temporary – access to the Federal Reserve primary credit facility, while being able to build deposit bases. Besides diversifying into retail banking, Morgan Stanley and Goldman Sachs can go about their investment banking business, albeit with lower leverage, profits and pay cheques.

So far so good. But we should remember what the reasoning was behind separating investment and commercial banks through the Glass-Steagall Act in 1933. Banks had entered into ever riskier deals, consumers lost confidence and withdrew their money. The bank runs of the Great Depression ensued.

That act, of course, was repealed in 1999, whereupon universal banks, such as JPMorgan Chase and Citigroup, emerged. They could compete for risky business with investment banks because stable deposit bases reduced funding costs.

Like the investment banks, universal banks have had to write down billions of dollars in the credit squeeze. But so far neither investors nor deposit customers have taken flight. Risk in these entities is partly born by shareholders and lenders. But ultimately government insures the deposits.

While the former investment banks may gain deposit bases, the sheer size of the existing businesses means risk-taking cultures are likely to continue to dominate – yet now with state guarantees that could encourage fresh excessive risk-taking. That would make further regulation inevitable.

Unless this shift in systemic risk is tackled, gambling may well continue on a huge scale. Despite the metamorphosis of the independents, nobody should ignore the reality that they are likely to remain much the same as before.