Nationalizing bad debt
BBC
Robert Peston
September 19, 2008

The breathtaking rises in the price of bank shares this morning are symptomatic of a stock market that is bereft of reason and is being driven almost purely by hysteria and momentum.

They are surging in part because of the FSA's crackdown on short-sellers but mostly because of the overnight news that the US Treasury Secretary, Hank Paulson, and the Chairman of the Federal Reserve, Ben Bernanke, are preparing a bold - or possibly impetuous - plan to tackle what can now be classified as the most severe and intractable malfunction of the banking system since the late 1920s.

As I put it on the Ten O'Clock News last night, yesterday's co-ordinated intervention by central banks, led by the US Federal Reserve, to pump an additional $180bn of short-term loans into the banking system treats only a symptom, not the cause, of banks' reluctance to lend to each other and to us.

It's a stopgap, while Paulson prepares to absolve many of the world's biggest banks of their idiocy during the boom years, by nationalising their bad debts.

To understand the pros and cons of what's being considered by Paulson, it's worth reminding ourselves of what created the latest terrifying phase of the credit crunch.

The ultimate cause is the chronic downturn in the US housing market. The proximate causes are the rotten loans to US homeowners sitting on banks' and other financial institutions' balance sheets that has mullered their capacity to make new loans.

The recent trigger has been the crises at Lehman, AIG, Fannie Mae and so on, which have created a climate of fear, in which bankers and managers of money appear to believe that almost any bank could collapse.

One important new stress has been a significant withdrawal of investors' cash from US money-market funds, because of the perception that the funds aren't as safe as was widely thought - which has in turn deprived banks of an important source of wholesale deposits (this sudden rise in the perceived riskiness of these funds was sparked by the announcement of a loss at the Reserve Primary Fund).

The drying-up of liquidity from money-market funds is in part what drove HBOS to acknowledge that the game was up, and that a rescue takeover by Lloyds TSB was the best form of protection for its savers and shareholders.

To reiterate, the big point is that Paulson is working with Congress on a package of measures that - he hopes - will attack the roots of the crisis.

It would involve buying many hundreds of billions of the banks' bad loans to overstretched US homeowners.

And it would also attempt to re-establish confidence in money-market funds by insuring them, in the way that retail bank deposits are insured against loss.

This would be the mother of all bailouts. It would certainly involve the deployment of hundreds of billions of US taxpayers' money, possibly more than a trillion dollars.

And it comes on top of the $300bn commitment of public money already made by Paulson to the rescue of Fannie, Freddie and AIG.

It all represents a massive humiliation for Wall Street, the giant US financial services industry and bankers supposed to be the canniest on the planet.

Paulson, himself, was one of their ilk, as the former boss of Goldman Sachs.

There will be serious long-term damage to the ability of the US to export its way of doing business to the rest of the world.

The American way of capitalism doesn't seem all that brilliant right now.

In that sense, a degree of moral authority - as well as financial clout - will shift east.

It'll also damage the robustness of the US public finances.

Possibly the biggest risk for the US is that in bailing out the finances of the private sector, Paulson would dent international investors' confidence in the American government's balance sheet - which could ultimately undermine the dollar, push up inflation even more and raise the cost of servicing debt for the US authorities.

Maybe the US is still big enough and powerful enough to persuade the rest of the world to pay for the mistakes of its financial sector - which is broadly what's being proposed.

But, as I mentioned here yesterday, surely it would be more rational for the Chinese to own the American financial system itself, rather than lend to the US Government (and in that context, it's resonant that Morgan Stanley may well be close to selling almost half of itself to CIC, China's state investment fund).

In this game of Wall Street Monopoly, there's no "get-out-of-jail-free" card.

Original Text