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How to Spend That $700 Billion

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke testify before the House Financial Services Committee on Wednesday.
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke testify before the House Financial Services Committee on Wednesday. (By Nikki Kahn -- The Washington Post)
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By Sebastian Mallaby
Friday, September 26, 2008

Even if congressional leaders can close a deal on the bank rescue, the real debate is just beginning. The key questions about the plan are not the ones that Congress debated: how much it would cost and whether it would impose symbolic pay caps for bosses whose wealth has already been hammered. Rather, the key question lies in the execution of the bailout.

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Start with the sobering fact that even a $700 billion rescue fund would be small relative to financial markets. Private lenders (not counting Fannie Mae and Freddie Mac) own $6.5 trillion of mortgage-related loans plus $2.5 trillion in consumer loans and yet more trillions in corporate loans. By themselves, federally insured deposit-taking banks hold loans totaling $14 trillion.

Given these astronomical numbers, the government's plan will fare best if markets respond favorably to it. The bailout is often seen as a commando operation, in which you take out the bad-loan enemy and imprison him in a government vault. But it is also a hearts-and-minds operation, in which you persuade wary financiers whose territory you have invaded to trust you and work with you.

The key question is whether Treasury purchases of bad loans will encourage hedge funds and other investors to dive in themselves. If the government starts a buying trend, its plan will work brilliantly. If it triggers a selling reaction, those trillions of dollars in private hands could swamp its efforts.

How can the Treasury encourage private players to back up its purchases? The short answer is: Buy cheaply. If the government pays, say, 30 percent of what the loans were originally worth, any hedge fund that thinks they are really worth 40 percent will dive into the market. If the government pays 50 percent of what the loans were originally worth, that same hedge fund will stay on the sidelines -- or may even figure out a way of betting against the government.

In their congressional testimony this week, Hank Paulson and Ben Bernanke have sent mixed signals on this crucial issue. They say they want to create a liquid market for bad loans -- which means they want to encourage private buying. Yet they also say they don't want banks to have to unload assets at "fire-sale" prices, which suggests they may want to pay some higher price -- which would discourage private buying.

Some Wall Streeters believe that Paulson and Bernanke can have it both ways. If the government buys large quantities of debt at 50 cents on the dollar, the turnover in that debt could make it more attractive to buyers: Investors like to own stuff that's actively traded and can be unloaded. So perhaps the government could pay 50 cents on the dollar and still persuade the hedge funds to pile in. What was worth 40 cents before the rescue operation could soon be worth 50 cents-plus because it is being traded.

Unfortunately, this is probably too optimistic. If the government buys a mountain of loans and then goes home, it will not have created the ongoing turnover that investors find attractive. If it buys loans in monthly installments, it will create some continuing action, but the purchases may be too small to persuade hedge funds that they can unload their paper if they need to. Besides, the hedge funds would have to believe that next month's government purchases would be targeted at the particular type of loans they own. Faced with these uncertainties, the funds would probably hold back unless the loans are a real bargain.

Paulson and Bernanke constitute a dream team -- a top market practitioner and a top economist. But they shrink from buying loans cheaply because doing so would force banks that currently value loans at high prices to recognize big losses, leaving them with too little capital. Buying loans cheaply would solve the liquidity problem in the loan market, but it would also reveal banks' capital shortage.

In the face of this dilemma, the dream team's instinct seems to be to split the difference -- pick a price that's low but not too low, so that you get some liquidity without vaporizing bank capital. But there is a better way: Tackle the capital shortage directly. Paulson has already urged banks to cut their dividends in order to preserve capital. When his key lieutenant, Robert Steel, left Treasury to run a troubled bank, its dividend was cut immediately. Now, Paulson needs to move more forcefully. He should use every power to block dividend payments, and he should overcome his squeamishness about using part of the bailout fund to bolster banks' capital.

Paulson may not like the idea of the government owning chunks of the financial system. But after the nationalization of Fannie, Freddie and AIG, it's too late to worry about that. Besides, if the U.S. government refuses to recapitalize the banking system, foreign governments may eventually do so. Sovereign wealth funds have already bought $35 billion worth of stakes in U.S. financial institutions.

smallaby@cfr.org

Read more from Sebastian Mallaby at washingtonpost.com's new opinion blog, PostPartisan.


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