Orchestrating a Process Neither Neat Nor Fair

By Steven Pearlstein
Tuesday, September 16, 2008

When it comes to playing high stakes poker, Hank Paulson knows when to hold 'em and when to fold 'em.

Ever since last week, when it became apparent that Lehman Brothers had lost the confidence of investors, the Treasury secretary was ready to gamble that financial markets could withstand the collapse of one of its most venerable investment banks.

By that time, regulators had had enough time to comb through Lehman's books and determine that its assets were likely to cover most of its liabilities at the end of an orderly liquidation.

And having spent the previous weekend engineering a takeover of Fannie Mae and Freddie Mac, Paulson was desperate to demonstrate that the government was not going to be drawn into bailing out every financial institution that had gotten itself in trouble.

So when the masters of the financial universe gathered at the Federal Reserve Bank of New York over the weekend and told him they wouldn't participate in a Lehman rescue without some sort of government guarantee limiting their losses, Paulson was ready to call their bluff. He said to them, in effect, if you're not worried that a Lehman failure would trigger a market meltdown that would take you down with it, then neither am I.

In the end, it was the financiers who blinked. Although they weren't worried enough to underwrite a Lehman rescue, they were worried enough to commit resources to restoring stability to the markets and complete the restructuring and recapitalization of the industry. Bank of America, spotting what looked like a bargain, ponied up $50 billion in stock for Merrill Lynch, the next likely Wall Street domino to fall. And a group of the biggest banks agreed to make $70 billion available to any financial firm in need of short-term cash.

Normally, a 504-point drop in the Dow Jones industrial average would not be considered a cause for celebration. And if it is followed by another and another, then it will turn out that Paulson's gamble was a foolish one and that putting a bit more of taxpayer funds at risk would have been the better strategy.

But given the extraordinary circumstances, in which giant institutions were literally disappearing before our eyes, trading was remarkably orderly yesterday. If the 504-point drop turns out to be a one-day event, then Paulson will have succeeded in forestalling a market meltdown without having to resort to another government bailout.

While taxpayer money was not directly implicated, however, the government was deeply involved in yesterday's effort to erect financial firewalls around Lehman Brothers.

The Federal Reserve and other central banks spent the day frantically pumping cash into the banking system -- more than $100 billion in all. The Fed also agreed to loosen the requirement on two new lending facilities that will allow banks and investment houses to use much riskier securities as collateral for those loans.

At the same time, state and federal regulators were scrambling to help insurance giant AIG raise capital and avoid a dangerous downgrade of its credit ratings. As private equity firms considered making an equity investment, New York's state insurance commissioner gave the green light for AIG's parent company to invest $20 billion in its regulated insurer. And by day's end, Goldman Sachs and J.P. Morgan Chase were being urged by government officials to extend AIG a $70 billion bridge loan, according to several sources.

Meanwhile, the Securities and Exchange Commission hinted that it was prepared to move quickly to permanently ban hedge funds and other investors from selling short the stocks of major financial institutions without first arranging to borrow the shares from someone who actually owns them.

Many investors also are expecting the Fed to lower the federal funds rate today at the regularly-scheduled meeting of its monetary policy committee here in Washington. At 2 percent, the short-term rate is already below the rate of inflation and delivering plenty of economic stimulus. And with the Fed always reluctant to appear that it is manipulating markets, it is more likely that it will merely deliver a promise to cut if economic conditions deteriorate further.

And make no mistake, they will deteriorate. The developments of the last two weeks, while dramatic, are simply part of the process by which the markets and the economy are adjusting to the bursting of a massive credit bubble. That bubble, which artificially inflated the value of stocks, bonds, real estate and commodities, diverted too much talent and resources to the financial sector and encouraged households and governments to live beyond their means. The process for correcting these excesses is never neat or even fair. The challenge for policymakers is to keep that process as orderly as possible without trying to protect failing companies or prevent the inevitable decline in incomes and asset prices.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

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