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Credit Crisis Triggers Unprecedented U.S. Response
In April, Paulson helped the Department of Education set up emergency programs to ensure students could get loans as private lenders fled the business because of trouble in the credit markets. Education officials ramped up their direct lending, which some analysts say could reach $75 billion, and got new authority from Congress to buy loans outright from lenders.
Then, last month, Paulson pushed for new authority to lend or invest in mortgage giants, Fannie Mae and Freddie Mac, which the Congressional Budget Office said could impose a wide range of costs to taxpayers, from nothing to more than $100 billion.
Along the way, the Fed was injecting money into the banking system, including through several new, unusual programs.
At times, Paulson acted by interpreting Treasury's powers broadly and encouraging other agencies he worked with to expand their authorities. In other cases, such as the rescue plan for Fannie Mae and Freddie Mac, he needed congressional approval.
That forced him to reluctantly accept a major Democratic proposal that authorized FHA to spend up to $300 billion to help homeowners who, because of falling prices, owe more than their homes are worth. The expected cost to taxpayers of this program is $1.7 billion, the Congressional Budget Office said. "There were parts of this legislation that just got passed that a number of us found objectionable, unnecessary, extraneous, too much government involvement," Paulson said.
Even helping the mortgage finance companies, was "an unpleasant task," he said. "But I found it a simple decision to do so because there was no other good alternative," he added.
Martin Neil Baily, who chaired the Council of Economic Advisers in the Clinton administration and now is at the Brookings Institution, said he found the administration's actions "very ironic."
"Paulson and his colleagues philosophically are free market people. But when things go wrong you just don't have a lot of choice," he said. "There has been a change in perception, that the government needs to play a more active role when we get into a financial crisis. . . . The question is to what degree do you say we won't do this again."
Paulson raised similar concerns in an interview. He warned that if the government always tries to bail out failing banks and companies, they will be motivated to take excessive risks. Others won't push themselves to succeed because they can rely on the government to bail them out.
Yet despite these convictions, Paulson said his hand was forced after the markets fell dangerously "out of balance" due to the credit crisis. Backing Fannie and Freddie, the country's two largest and most important financiers of mortgages, was the only way to keep the housing market from falling into turmoil, he said. Allowing Bear Stearns to fail could have led to a string of collapses at other huge Wall Street firms.
In negotiations over the Bear Stearns rescue, the Fed agreed to back $30 billion worth of risky mortgage assets but persuaded J.P. Morgan to absorb the first $1 billion of any losses. At the end of July, the portfolio was worth $29.1 billion, according to the central bank. Because the Fed can be patient and sell the assets gradually over time, officials believe taxpayers are highly unlikely to lose more than a couple billion dollars and the central bank may ultimately make some money.
The Fed has also made extensive efforts to inject cash into the financial system, and at the end of July had $167 billion in loans extended to banks. But those debts are unlikely to incur losses since the Fed requires borrowers to put up collateral.
Taxpayers face more risk from novel Fed initiatives to help investment banks weather the financial crisis. In one program, the Fed lets investment firms swap highly rated mortgage-backed securities for Treasury securities.
Meanwhile, the Education Department may end up taking on far more loans than it ever has in its history. Last year it issued $14 billion in federally guaranteed loans directly to students. It has the ability to double that capacity in the coming academic year, according to the officials, though outside analysts predict it may have lend out $35 billion or more with the help of contractors.
The department may also be forced to take over much of the market that consolidates federally guaranteed loans for post-graduates, according to Mark Kantrowitz of FinAid.org, a Web site that provides financial information for students. This $47.4 billion business allows borrowers to combine all of their student loans into one package with a single, relatively low rate.
Education Department Under Secretary Sara Martinez Tucker, who oversees higher education, said as early as April the department "began to get nervous" about whether enough loans would be available to students in the fall. Department officials met with President Bush on April 19. "We told him we think we need to have an intervention," she said. The president agreed.
Some programs are not expected to cost taxpayers significantly, regulators said. Since last summer, the initiative called FHA Secure has helped 290,000 homeowners who hold $46.8 billion of mortgages. But taxpayers won't have to bear the cost if these homeowners default, unless the agency's $18.6 billion insurance fund is depleted.
"It's a good example of what government should be doing," FHA Commissioner Brian Montgomery said.