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No Silver Bullets Here

By Steven Pearlstein
Thursday, October 2, 2008

To hear it from critics on the left and right, the Bush administration and legislative leaders were in such a rush to pass a "$700 billion bailout for Wall Street" that they failed to consider much simpler, cheaper, common sense approaches.

In fact, all of their ideas were considered as part of a contingency planning process over the past year at the Treasury and the Federal Reserve, and given voice during the bipartisan congressional negotiations. Some of the ideas were incorporated in various forms in the bill voted down by the House on Monday, while none is likely to be the silver bullet that proponents suggest.

· Raise the limit on deposit insurance. The government had to rescue three large banks in recent weeks after large depositors -- businesses and investment funds -- began withdrawing money, raising fears of runs on other banks. One idea, now supported by the two presidential candidates as well as by the Federal Deposit Insurance Corp., is to raise the limit on deposits covered by the government's insurance program from $100,000 per individual account to $250,000.

Here's the problem: Increasing the insurance limit will encourage the weakest banks to lure "hot money" with high interest rates. They would then use the deposits to take big lending risks in the hope of earning big profits and returning to financial health -- "gambling for redemption," as it is known among bankers. That happened in the later stages of the savings and loan crisis of the late 1980s, and could happen again if regulators don't take steps to prevent it.

· Suspend mark-to-market accounting. This idea has a big following among conservatives, who always see overzealous regulation as the cause of almost any market failure.

"Fair value" accounting rules require banks to value certain loans and securities on their books -- those that they don't intend to hold forever -- at the price that they are currently trading at on secondary loan markets. That's generally a sound idea when those markets are working well. But now that those markets have virtually collapsed because there aren't enough buyers, prices have plummeted well below what their economic value would be if held until maturity. Requiring banks to use artificially depressed values is making a bad situation even worse.

Given the market situation, banks want to be able to ignore market prices and use their own models to guess at the economic value of the securities. That might make the banks' financial statements look stronger, but might not do much to restore investor confidence. Financial institutions have dragged their feet in acknowledging the extent of their losses in real estate and other lending, and many investors and regulators now believe they can't be trusted to come up with credible alternatives to market prices, as imperfect as they may be. Moreover, without credible financial statements, it would only get harder for the banking system to attract new capital.

The bill defeated by the House did not ignore the accounting issue. It ordered the Securities and Exchange Commission to move quickly to study the issue and granted the agency the power to immediately suspend the mark-to-market rule.

There is an easy compromise here: Require banks to disclose market prices right alongside their own estimates of "fair value." Let the investors decide which to rely on.

· Provide relief to homeowners, not Wall Street. This is the favored approach of liberals, who argue that dealing with the root problem-- families that can't make their loan payments -- is the fastest, surest, cheapest and most humane way to solve the financial crisis.

In fact, earlier this year Congress appropriated $300 billion to do just that, authorizing the Federal Housing Administration to refinance troubled mortgages if lenders agree to reduce the amount of outstanding principal and homeowners agree to share some of their future home-price appreciation with the government. In addition, the bill defeated by the House would have required the government to pursue a variety of loan-restructuring options to avoid foreclosure on any of the mortgages it acquired after it purchased troubled assets from banks.

Some have suggested that the government go further by providing direct subsidies to homeowners facing foreclosure. While that may sound like a politically attractive "trickle-up" strategy, it would be every bit as much a bailout for lenders as for homeowners. (Who do you think would end up with the money?) Moreover, one can only imagine the political backlash once those who kept up on their mortgage payments every month saw that their tax dollars were going to neighbors who had not.

· Recapitalize the banks, don't buy their lousy loans. Many academic economists argue that if taxpayers are going to rescue the financial system, their money should be used to recapitalize the banks in exchange for preferred stock or stock warrants, just as Warren Buffett did with Goldman Sachs and General Electric.

In fact, the much-maligned House bill would have given the Treasury secretary wide latitude to use any portion of the $700 billion to recapitalize financial institutions before they failed, in exchange for stock or stock warrants, just as the government did when it took control of Fannie Mae, Freddie Mac and AIG.

But recapitalizing the banking system would require much more than $700 billion, and involve the government in the ownership of hundreds of institutions. It would also be much less cost-effective than the Treasury strategy of jump-starting the market in mortgage-backed securities, which would bolster the finances of almost every bank, whether or not they wound up selling into the government-funded auctions for those securities.

Given the widespread fear of lending to or investing in banks until the full extent of their lousy lending becomes clear, there's a good chance that injecting large amounts of government capital wouldn't do much to attract additional private capital, or even get banks to begin lending again.

What we've got on our hands is a big, hairy, complicated mess. Beware of smooth-talking salesmen with hidden agendas peddling magic potions.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

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