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To Plan B, With All Deliberate Speed

Global stocks have experienced wild fluctuations this week in the wake of the U.S. government's seizure of insurance giant American International Group, the failure of Lehman Brothers, the disappearance of Merrill Lynch as an independent company and reports the U.S. government will set up a government entity to take on bad debts from financial institutions.

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By Steven Pearlstein
Friday, September 19, 2008

In an effort to restore investor confidence, ease the anxieties of election-year voters and get out ahead of a financial crisis that threatens to spin out of control, Washington is moving toward creation of a new government entity to . . . .

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Well, that's the question, isn't it: to do what?

Judging from the sobering statements of administration and congressional leaders last night, there is a strong political instinct at the White House and on Capitol Hill to do something. Everyone agrees that there's a better solution than having the Treasury and the Federal Reserve continue to do these ad-hoc, midnight rescues, stretching their balance sheets and their legal authority. And everyone agrees that we had better do something quickly, before there's even more of a run on the money markets and the stock market does another nosedive.

As it now appears, the mission of the new entity would probably be as buyer of last resort for securities that are now almost impossible to sell but are weighing heavily on the balance sheets of banks, investment banks, pension funds, insurance companies and even hedge funds. Once the government takes these securities off the books of these institutions, new investors presumably would be willing to come in with additional capital to restore them to financial health. The aim would be for the government to eventually make money by buying only those securities priced well below the value of the underlying assets and waiting for the markets and the economy improve.

Alternatively, there's the idea put forward yesterday by Sen. Chuck Schumer (D-Wall Street). Schumer would have the new agency inject capital directly into struggling financial institutions, in exchange for a government ownership stake and a promise to renegotiate troubled mortgage loans rather than pushing them to foreclosure. The obvious downside, of course, is that his plan would blur the line between public and private ownership and put the government in the position of deciding which enterprises to save and which to sacrifice. But it's a solution that's particularly attractive to Wall Street.

Once the mission is nailed down, there's still a question of how to structure the agency and how much money to give it.

The simplest approach would be to create a new office within the Treasury, reporting directly to the secretary of the Treasury. Or you could create a new independent agency with its own director and an independent board. That's the way its been done in the past.

But the more modern variation would be to create a public-private entity and require that half the capital come from elsewhere -- private equity funds, hedge funds, pension funds, even sovereign wealth funds. These investors would get the same deal as the taxpayers, participating equally in all the risks and the rewards. The government would need to borrow less money and reduce its risk.

As for funding levels, you can figure it could be anywhere from $200 billion to $500 billion, on top of the money already committed for Fannie Mae, Freddie Mac, AIG and Bear Stearns. That's a pretty good indication of how serious a problem we have on our hands.

On a less serious note, finding someone with experience to run this new agency ought to be a piece of cake, given the large number of unemployed Masters of the Universe who now spend their days perfecting their golf swings. On Wall Street, losing $30 billion of your shareholders' money is never a disqualification for the next job -- hey, it could happen to anyone, right? But getting Stan O'Neal or Jimmy Cayne through confirmation hearings might be a problem. Maybe now that Hank Paulson has gotten used to working nights and weekends cleaning up after his former colleagues on Wall Street, he'd be willing to re-up for another tour of duty here in Washington.

Finally there is the all-important question of what to call this new agency. Democrats like Schumer like the ring of the old New Deal agency, the Reconstruction Finance Corp., while Republicans take their model from the Resolution Trust Corp. set up by President George H.W. Bush to dispose of assets taken over from failed savings and loan institutions.

Then again, given our great success with government-sponsored enterprises, maybe we could call it something catchy, like Rescue Ray or Vulture Mac.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

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