The mortgage-rescue plan

Will the bail-out work?

The bail-out becomes law after the House reverses its rejection. Money markets call for urgent attention

“CRISES have the power to unite us in strange ways.” So said Steny Hoyer, the Democratic majority leader in the House of Representatives, in an article on Friday morning that pleaded for passage of the $700 billion bail-out plan. United they were. The House voted by a huge 263-171 margin for the bail-out, a dramatic reversal of the 228-205 rejection on Monday. On Friday October 3rd 172 Democrats backed the bill, up from 140; 91 Republicans did so, up from 65. As the Senate had already approved the bill, it was immediately signed by George Bush.

The rejection on Monday was caused by conservative Republicans who said it was socialism, by liberal Democrats who said it did not do enough for poor people, and fears by many that voters would fire them for bailing out Wall Street. The rejection triggered a plunge in stocks and a scramble to sweeten the bill. In the end numerous, mostly unrelated, items have been grafted on, from higher federal deposit-insurance limits to a tax exemption for wooden children’s arrows. The tide was turned because of that, nausea over market turmoil, news that non-farm employment sank by 159,000 in September (the steepest drop in five years) and because of furious business lobbying.

Now the real test comes: will it help? The Treasury is expected to take a week to set up the auctions for the first mortgage purchases, and the first purchases could therefore take place within weeks. Henry Paulson, the treasury secretary, could act sooner: he has the authority to buy mortgages from individual institutions or inject capital into them if they are nearing failure.

Speed is of the essence. Banks are loth to lend to each other, except at record punitive rates and for the shortest of periods. Most want their money back within a day. Massive liquidity injections by the Federal Reserve and other central banks have done little to unclog the pipes.

Worse, the availability of short-term loans to companies is shrinking at an alarming rate. The market for commercial paper has shrunk by around $600 billion since last summer, with almost $100 billion of the reduction coming in the past week alone. This hurts companies large and small. General Electric has had to raise new capital partly because of funding concerns. Retailers report problems financing purchases of holiday-season inventories. The head of AutoNation, a car dealer, told CNBC that “banks were looking for every excuse to say no…We’ve gone from a credit crunch to a credit panic.” Firms say that some banks are trying to invoke “market disruption” clauses to cut credit lines or raise the fees for renewing them, leaving corporate treasurers unsure how long they can pay employees or buy raw materials.

The pain is reaching municipalities and states. Alabama’s Jefferson County is on the verge of bankruptcy. California’s governor, Arnold Schwarzenegger, has reportedly given warning, in a letter to the Treasury, that his state is running out of cash to fund day-to-day operations and may need an emergency loan of $7 billion from the federal government.

While the Troubled Asset Relief Programme, or TARP, may ultimately unfreeze the mortgage market, restore confidence to banks and restart lending, that may take too long for a far more pressing problem, the blockage in the money markets. Tellingly, the yield on short-term government debt—the most popular destination for investors seeking safety—barely budged after the vote. Bank-to-bank loan spreads fell only slightly. American stockmarkets first gave up gains built up in the hours before the vote, then ended the day down by 159 points.

While the TARP may lift confidence, the timing and extent to which it boosts their capital will depend on the prices paid, which remain unclear. Moreover, the target is moving. Even if house prices stabilise soon, non-mortgage credit will go on deteriorating as the economy shrinks. Bank regulators will have their work cut out as failures mount among small and medium-sized lenders. More will seek sanctuary in the arms of stronger rivals. On Friday Wachovia threw itself at Wells Fargo, only four days after Citigroup had agreed to buy its banking operations in a government-backed deal. Citi threatened to sue.

The crisis is intensifying in Europe, where governments have been forced to prop up several banks in the past week. European leaders are due to meet this weekend to discuss forging a more co-ordinated response, possibly including a continent-wide bank-rescue fund. And doubts about solvency are spreading beyond banks. After a sharp drop this week in the share prices of large American insurers, such as MetLife and Prudential, they came under pressure to raise fresh capital as a bulwark against the storm.

Until the TARP shows results, the pressure remains on the Federal Reserve to contain the crisis. Ben Bernanke, the Fed chairman and the main driver behind the TARP’s creation, congratulated Congress for demonstrating the “government’s commitment to do what it takes to support and strengthen our economy”. His language was remarkably similar to what he used, as an academic, to describe Franklin D. Roosevelt’s attack on the Great Depression. Mr Bernanke made it clear that he included the Fed in that commitment: “We will continue to use all of the powers at our disposal to mitigate credit market disruptions and to foster a strong, vibrant economy.” The Fed has already expanded its balance sheet by around $600 billion since August, an amount not much smaller than the entire TARP, as it replaces evaporating private credit with central-bank credit. The odds are high that it will also cut its short-term interest rate, now at 2%, to 1.5% either at or before its policy meeting at the end of October.

Seeking Rational Exuberance

How we'll know when things are returning to normal.

• By L. GORDON CROVITZ

"Trust will eventually re-emerge as investors dip hesitantly back into the marketplace," predicts Alan Greenspan, whose Federal Reserve legacy depends on it. "Financial markets freeze up as an excess of fear displaces a protracted period of what some might call irrational exuberance. Eventually the market freeze will thaw as frightened investors take tentative steps towards re-engagement with risk." Mr. Greenspan's forecast last week on when markets will recover was only as precise as "sooner rather than later."

The credit crisis is a crisis of information -- or rather the lack of information -- so perhaps the focus of this column can help identify when "sooner" might be. At the risk of irrational exuberance at the thought that an end can ever be in sight, here are signs for knowing when we're past the worst of the credit crisis and at the start of a recovery:

- When prices are discovered. For all the complexities of the credit crisis, a basic rule applies: Prices require the interplay of supply and demand. Why don't mortgage-backed securities have prices? There's plenty of supply but no demand. Potential buyers of bad debt don't have the information they need. Acquisitions of troubled financial institutions by less troubled ones have been propped up by taxpayers, delaying the establishment of market-clearing prices. The end will be in sight when transactions happen without subsidies.

Friday's offer by Wells Fargo to buy Wachovia without government support is encouraging. Wells Fargo told investors that it calculates Wachovia's losses at some $75 billion out of $500 billion in loans. This is a fraction of the $300 billion in bad assets that Citigroup estimated when it agreed to buy Wachovia with government backing. If Wells Fargo is right, there could be less need for government capital to keep banks afloat.

- When messengers are no longer being shot. Investors don't trust markets that suppress accurate information, so look for recovery when short selling is decriminalized. The number of companies whose shares can't be sold short started at 19 in July, went to 799 and now is just under 1,000. A list that began with the too-big-to-fail financial firms now includes 20% of regularly traded stocks, including IBM and CVS Caremark.

Short sellers were the first to alert the market and regulators to troubles in financial services firms. Shooting the messenger didn't undo the message, but has delayed the day of reckoning. In the meantime, trading volume in the "protected" stocks has fallen by 50%, with an expanded spread in the bid-ask, forcing investors to pay more to trade them.

- When accounting approximates reality. One of the more arcane debates has been between those who defend the mark-to-market accounting rule even in an illiquid market where there are few transactions to establish market values, versus those who want financial firms to have flexibility to estimate the value of troubled securities. Marking to a nonexistent market communicates little information, but likewise a guestimate of ultimate value also conveys little. This debate mattered chiefly because bank capital requirements are based on accounting, but this is circular illogic: The federal regulators who review the accounts of banks know they can't trust either method of accounting. Accounting needs to fulfill its basic mission of being informative.

- When lawyers draft clear terms and conditions. More than a year into the crisis, banks still don't have a sound view of their assets and liabilities. One overlooked reason the problems seem so bottomless is that law firms representing banks failed to draft adequate disclosure about investments in mortgage-backed securities. Lawyers didn't fully explain the terms and conditions underlying securities, hiding their real risks.

Adequate disclosure would have made clear the payment and investment flows through each level of securities and where the risks lie, including when they are swapped to counterparties. Offering documents should be crisp on where and on whom investors take credit exposure at each step of the payment and investment flow. Disclosure for complex financial instruments via detailed diagrams would be progress. Meanwhile, the role of not-very-careful lawyers will be Exhibit A in inevitable lawsuits against banks.

- When moral hazard becomes political hazard. The toxin in the system was inserted by Washington. For over a decade, the government mandated mortgages to unqualified home buyers through Fannie Mae and Freddie Mac and through laws telling banks to make their own bad mortgage loans. Even after financial services firms are stable and investors return to the market, consumer confidence depends on Washington accepting its responsibility and backing off. Markets are complex enough, we are now reminded, without the poison of government-mandated bad loans.

Alas, it's one thing to demand that banks mark their mistakes to market. It may take our political system much longer to do so.

Democrats Shouldn't Coddle Chávez

The prospect of a nuclear Venezuela should be enough to unite allegiances in Washington.

• By MARY ANASTASIA O'GRADY

Hugo Chávez provoked nary a peep from the Bush administration when he recently welcomed Russian fighter jets to an air base in the state of Aragua. For a man desperate to prove his importance, nothing could have been more insulting than the yawn in Washington when the Russians touched down in Venezuela.

Jorge Enrique Botero/El Tiempo

Nancy Pelosi, Piedad Córdoba and Jim McGovern.

But the Venezuelan president will not be ignored and last week he tried again to command attention from someone, anyone, in Washington. This time he popped up at a local political rally to announce that Venezuela has accepted a Russian offer to build nuclear reactors in the socialist paradise.

Given the deterioration of the Venezuelan economy under Chávez management since 1999, it's hard to take the chatty dictator seriously as an evil genius. The Bolivarian Revolution has not even been able to run 20th-century oil technology efficiently. Intelligence sources say that much of Venezuela's military hardware is also suffering from neglect. Nevertheless, a nuclear threat in the region ought not be dismissed casually. Mr. Chávez is a great admirer of the mullahs in Iran and we know why they want nuclear "energy."

Mary O'Grady tells Kelsey Hubbard how Democrats in Washington are sending mixed signals to Venezuela. (Oct. 6)

How the U.S. answers matters a lot. State Department rhetoric directed at Caracas would only give Mr. Chávez the spitting match he wants with "the empire" ahead of the country's Nov. 23 gubernatorial elections. A more effective U.S. policy response would be a tripling of U.S. support for our staunchest ally in the region, Colombia, and a commitment to restoring a strong U.S. dollar.

Disillusion in Venezuela with the Bolivarian promise is growing. A corruption scandal involving an attempt to smuggle millions of dollars from the Venezuelan oil company into Buenos Aires for the campaign of Argentine President Cristina Kirchner is increasing the popular view that the oil wealth is being stolen by chavistas. Electric power outages have blanketed some 50% of the country over the past few months and the annual inflation rate is now 35%. It's easy to see how, in fair elections, the chavistas could lose a number of key gubernatorial races. This is why Mr. Chávez is engaging in a military buildup and trying to pick fights with Washington.

The Americas in the News

Get the latest information in Spanish from The Wall Street Journal's Americas page.

Treasury Secretary Henry Paulson's neglect of the U.S. dollar is one reason Mr. Chávez has thus far gone unchallenged. As the dollar has headed south, oil prices have skyrocketed and a mediocre Latin populist has transformed himself into a roaring mouse. Last month Mr. Chávez announced that he would buy 24 K-8 aircraft from China to "train fighter pilots." Jane's reports that total orders for Russian weaponry now top $4 billion. As documents captured in March from the rebel group FARC -- aka the Revolutionary Armed Forces of Colombia -- revealed, Mr. Chávez has also used his windfall of petrodollars to support terrorism.

Even if Mr. Paulson were to figure out the link between the weak dollar and oil dictators around the world, a greenback reversal would take time. The strongest immediate signal the U.S. could send Mr. Chávez and Latin American democracies is unequivocal support for Colombia. President Bush has tried to do that but the effort is being undermined by Congressional Democrats.

House Speaker Nancy Pelosi has refused to allow a vote on the Colombia-U.S. Free Trade Agreement, sending a message to Bogotá and any would-be friends in the region that we are unreliable. But trifling with Colombia-U.S. trade is only part of a larger outrage. The Democrats also are playing footsie with Mr. Chávez, as the nearby photo -- with the two women dressed in matching chavista red -- taken in Washington a year ago indicates.

Left-wing Colombian Sen. Piedad Córdoba is a close friend of Mr. Chávez and a frequent visitor to the Venezuelan presidential palace. She is also trusted by the FARC and is often photographed with its leaders. Her political activities among the rebels have provoked so many questions in Colombia that the government has launched an investigation into her FARC ties.

U.S. Rep. Jim McGovern's name is all over the captured FARC documents and when a Wall Street Journal editorial reported as much in March, the Massachusetts Democrat didn't deny it. But he howled in protest when this column reported that the FARC leaders wrote that Mrs. Pelosi had "designated" him to work on hostage negotiations. The FARC also expressed faith in Mrs. Pelosi as someone who "helps" in its effort to undermine Colombian President Alvaro Uribe. Mr. McGovern said in a letter to this newspaper that the FARC was engaging in fantasy. But maybe instead the rebels put their faith in Mrs. Pelosi because they perceive a common friend in the radicalized Ms. Córdoba, who can do their bidding in Washington.

If Mr. Chávez thinks he can go nuclear with no consequences it is because he understands the divided allegiances in Washington. One way to solve that problem would be for Democrats to come out and say whose side they are on.

The $700+ Billion Bailout--

Richard Posner

There has been such a flood of media coverage of the financial crisis that it is best to begin with some very simple, basic points.

Banks (broadly defined to include investment banks and the many other lenders) borrow--bank deposits, for example, are loans to banks--and then lend out what they have borrowed. As a result, their loans are much larger than their capital assets (cash, a building, etc.). If their capital shrinks in value, they have less protection against the possibility that the loans they make will not be repaid in full. If a bank's capital is 10, and it borrows 100 and lends 100, and the persons or firms it lends to return only 90, its net worth will fall to zero (10 [its capital] + 90 [the value of its loans] - 100 [the amount it owes its depositors] = 0.

Banks in recent years have increased the ratio of their loans to their capital because borrowing costs were low and financial experts thought they had discovered ways of reducing the risk of leverage (that is, of borrowing). Many of the loans were mortgage loans, and the value of those loans fell when the housing bubble burst. (Risky, and in some cases deceptive, mortgage practices had contributed to the bubble.) What made the situation worse was that rather than retaining the mortgages that they originated, banks (especially the major ones) sold the mortgages in exchange for securities backed by the mortgages. Those securities became a part of a bank's capital. The value of the securities depended on the value of the mortgages that the entity issuing the securities had bought; those mortgages were the entity's assets. As that value fell, the bank's capital fell.

The mortgage-backed securities achieved geographical diversification of mortgage risk. But the housing bubble, though not geographically uniform, was sufficiently widespread that geographical diversification did not reduce the risk of mortgage defaults sufficiently to avert the fall in the value of mortgage-backed securities.

A complicating factor was that the value of those securities was and is very difficult to determine, because each security represents a share in pieces of many different mortgages. The bank that owns the security cannot readily determine the value of all those different mortgages, since it has no direct relationship with the mortgagor, having sold the mortgage to the entity that issued the mortgage-backed securities.

Because the banking industry (and remember that I am defining "banking" very broadly, basically as all lending) was highly leveraged, and because much of its capital consisted of securities very difficult to value, the bursting of the housing bubble reduced the capital of the banks, but by an unknown amount. The reduction and uncertainty have curtailed lending by reducing the capital cushion that a bank needs to reduce to an acceptable level the risk that some of its loans will not be repaid. That is the "credit crunch,” and it is painful because so many individuals and businesses borrow to finance their activities.

Ordinarily one would expect a credit crunch to be self-correcting. As lending dropped because of the fall in bank capital, interest rates would rise and this would attract more capital to the financial markets. We have seen this process at work in Warren Buffett's $5 billion investment in Goldman Sachs. Buffett has capital, Goldman needs it, so Buffett gives it to Goldman in exchange for preferred stock (which is really a type of bond but one that does not have a term--it is never repaid) paying a handsome interest rate.

But Goldman is pretty healthy. Many lenders have so much of their capital tied up in mortgage-backed securities or other novel forms of capital that are difficult to value that they cannot attract new capital at a price that would enable the lender to continue in business. The sale of the securities would just expose their lack of value. The federal government, however, has essentially unlimited capital because of its taxing power. It is prepared at this writing to contribute perhaps as much as a trillion dollars to rebuild the capital of the banking industry. The Treasury wants to make this contribution in the form of buying the dubious securities, but that seems to be a mistake, unless pressure of time allows for no alternative. If the Treasury pays the actual value (if anyone can determine what that is) of the securities, it will not be injecting new capital into the banking industry, but merely swapping one form of capital for another. If the Treasury pays more than the securities are worth, then it is contributing capital to the industry all right, but it is also enriching the owners and managers of the banks, which creates the familiar moral hazard problem as well as upsetting people by rewarding careless management practices. The more it overpays, the most costly the bailout plan to the taxpayer.

A more palatable approach would be for the government to drive a Warren Buffett style hard bargain, in which, rather than buying anything from banks, the government would invest in them in a form, such as purchase of newly issued preferred stock, or bonds with a long maturity, that would augment the banks' capital and thus enable banks to make more loans. That would avoid conferring a windfall on the banks by overpaying them for their bad securities; no one thinks Buffett is conferring a windfall on Goldman Sachs. After the industry was back on its feet, the government could sell the bank stocks or bonds that it had acquired

Government Equity in Private Companies: A Bad Idea-

Gary Becker

The Federal government of the United States has seldom taken an equity interest in private companies, although this has been proposed sometimes, especially as a way to get higher returns on social security assets. However, the new financial bailout bill provides not only for the government to buy assets from banks, but that it also take an equity stake in the banks being helped. The purpose is to protect the government from paying too much for the many difficult to value assets that are acquired. The thinking is that if they overpay for some assets, they can make that back through a rise in the value of the stock or other equity interest that they would have.

However, the main purpose of the buyout is to increase the liquidity of the banking system and thereby reduce the banking system’s retreat from riskier investments. Yet the government's actions regarding an equity interest seem to be based on a fear that it will be outsmarted in the prices it pays for assets that are very difficult to value because they have no market. Whether the government will lose after the fact is not clear since it can afford to hold the assets to maturity. Moreover, taking an equity interest is also unnecessary in order to protect taxpayers from overpaying. Modern auction theory offers various ways to induce sellers (or buyers) of assets and other objects to "tell the truth"; that is, to bid their best estimate of an asset's worth. In using auction to buy bank assets it would be helpful if the government did not automatically take all assets offered by banks, so that banks have to compete against each other. Competition can also be increased by spreading the auctions out over time (I am indebted to my colleague Phil Reny for useful comments on optimal auction design). To be sure, the seller's estimates of the worth of their assets may turn out to be wrong, so the government would bear some risk. However, with an optimal auction mechanism design, the government need not fear grossly overpaying ex ante for the assets they acquire.

Even if the government were to lose money on this buyout, it is a bad precedent for it to take an equity interest in private companies. Inevitably, this leads to government involvement in business decisions and corporate governance. Experience shows that political rather than economic criteria tend to dominate in the pressures exerted by government shareholders on corporate decisions. This is already reflected in the bailout bill since it limits compensation for executives, including "golden parachutes" for executives of the companies helped. One can hardly have a high opinion of the executives who led such venerable institutions as Merrill Lynch and Lehman Brothers, and many other banks, into investment portfolios with such poor capacity to withstand a financial disturbance. Still, many of these executives have lost most of their very considerable fortunes since they usually owned or had options on many shares of their companies, and these shares have plummeted in price. It is appropriate that top executives suffer major losses when their companies collapse.

There is no good reason, however, for the government to interfere and impose limits on salaries and severance pay. Controls over wages and salaries have never worked well, and only encourage myriad ways to get around them, including generous housing allowances, vacation homes, easy access to private planes, large pensions, and other fringe benefits. There develops a war between the government's closing of loopholes, and the ingenuity of accountants and lawyers in finding new ones.

Governmental ownership of shares, with or without voting rights, opens up possibilities for much greater mischief than controlling executive salaries. For example, a bank or other company may want to reduce its employment in order to regain greater profitability. The government owners of these shares will be under pressure from congressman and senators who represent districts where employment would be affected to try to rescind or modify these cuts. Even without government ownership, congressmen protest corporate efforts to shift various activities overseas because labor and other resources are cheaper there. Such objections will be magnified when governments have direct equity stakes.

There are many illustrations of the bad influence on corporate governance exerted by the governments of France, Italy, Russia, and many other countries that own shares in private companies. One current appalling example is the situation of Alitalia Airlines, where the government owns almost half the stock. This has been a very inefficiently run airline that is hostage among others to powerful unions. Strikes have been common, flights frequently takeoff and arrive quite late, and baggage losses are high- experienced travelers try hard to avoid using Alitalia. Since Alitalia's command of routes into and out of Italy has market value, stronger European Airlines, such as Air France and Lufthansa, have wanted to take this airline over. However, the Italian government has resisted these efforts and continues to finance the sizeable monthly deficits of the airline. It fears the power of the unions who realize that many airline jobs at Alitalia will be lost if a more efficient airline takes charge.

This and other examples of harmful government interference in the running of companies where they have an equity interest provides a very good lesson for the United States. Avoid taking any equity interest in private companies when buying assets of banks under the bailout bill, or when investing other government revenues.