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Treasury, Fed Low on Rescue Options

By Neil Irwin and David Cho
Washington Post Staff Writers
Tuesday, September 30, 2008

The failure of the $700 billion bailout bill leaves Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Chairman Ben S. Bernanke with few options to continue their urgent campaign to rescue the financial system.

The top economic policymakers geared up yesterday to try to salvage the package, concluding that the existing powers they have would not be enough to restore confidence in financial markets wracked by bank failures.

"Our toolkit is substantial, but insufficient," a grim-faced Paulson said yesterday, speaking outside the White House.

Yesterday afternoon, as the votes on the House floor were tallied, Treasury and Fed officials gathered around televisions in their offices, stunned that a package that had bipartisan support from congressional leaders was soundly rejected. As the vote progressed, the stock market plummeted and world credit markets went haywire, events that Paulson had privately predicted would result if Congress rejected the measure.

"The problem is, all the eggs were in one basket," said Hans R. Stoll, director of the Financial Markets Research Center at Vanderbilt University. "The economic leaders have worked hard on this particular program, and its failure puts everything into question."

Indeed, if a version of the bill doesn't ultimately pass, the Fed and Treasury would have little choice but to return to their strategy of the past 14 months: making case-by-case decisions about the fates of individual firms, on the fly, using existing powers to try to contain the crisis.

But Paulson and independent economists have warned that this ad-hoc approach has its limitations. It sends a mixed signal to the markets, since investors cannot be sure which firms the government will save and which will be allowed to fail. And it does not relieve the financial system of its vast holdings of toxic mortgage-related assets.

"We know what they can and cannot do because they have tried all of these things over the last three months," said Tim Ryan, chief executive of the Securities Industry and Financial Markets Association. "Unfortunately, they solved the individual problems they were trying to address but did not solve the confidence problem."

The Federal Deposit Insurance Corp. has nearly unlimited power to save depository banks that it deems fundamentally important to the financial system, based on an emergency authority granted by Congress in 1991. The agency invoked the provision this week to make sure that Wachovia, which was teetering, would be sold. In the deal, the FDIC promised to cover any losses for the buyer, Citigroup, above $4 billion a year for the next three years for Wachovia's most troubled loans.

The Fed has been extremely creative about using its existing legal authority and massive pool of resources to try to stabilize the financial system during the past 14 months. Just yesterday, it announced it would triple the size of a special program through which it injects cash into banks. It also vastly expanded a lending program for foreign central banks to make $620 billion available to pump into the financial systems in other large countries.

The central bank has already used Depression-era legal authority to lend money to any "individual, partnership, or corporation" in "unusual and exigent circumstances" as grounds for the interventions involving Bear Stearns and insurance firm American International Group. In theory, the Fed could use that same latitude to do what the bailout bill was trying to accomplish: take on some of the troubled mortgage securities that are weighing down bank lending.

But there are two problems. First, Bernanke has resisted using Fed powers that way because he views that decision as more appropriately left to political authorities, hence his support for the bailout bill. It would be doubly hard to take such action after the House has specifically rejected the idea.

Second, the Fed has finite resources, and has already used vast portions of its financial capacity to combat the crisis on other fronts. As of last Wednesday, the Fed had $1.2 trillion in assets on its balance sheet, but $150 billion of that was extended in special loans to banks, $262 billion was in various emergency lending facilities (including to the investment banks and to AIG), and $29 billion was tied up on Bear Stearns assets that the Fed holds. The Fed has to keep a certain amount of assets on hand for its day-to-day task of managing the money supply; that and the measures announced yesterday leave it with a dwindling capacity for big interventions in the financial markets.

A provision in the failed bill would have given the Fed leeway to use more resources for such measures, which would have left the central bank with more flexibility to intervene.

"These are desperate times, and you're going to pull out some desperate measures," said Richard Yamarone, chief economist at Argus Research. "They're going to try to stretch every imaginable solution and initiative they have to right this sinking ship. But I don't know what they have left. They've already exceeded anything I believed that they could do."

Speaking outside the White House yesterday, Paulson stepped up his rhetoric about the risks that the deepening credit crunch poses to ordinary Americans, trying to deflect the idea that the package only helps Wall Street. A major reason the bill failed, some in Congress said, was that Paulson and Bernanke did not lay out an easily understandable case for how it would affect ordinary consumers and businesses if the bill wasn't passed.

Paulson spoke of companies having a hard time paying for inventory or making payroll, and consumers not being able to get a car loan or student loan.

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