Rescue Package May Not Fully Thaw Credit Markets

By Steven Mufson
Washington Post Staff Writer
Friday, October 3, 2008

As hopes rise for congressional passage today of a massive rescue plan for the U.S. financial system, many financial experts are already wondering: What is being left out and what will have to be done next?

The rescue package may be missing measures intended to offset shrinking bank balance sheets, free up capital for non-financial companies squeezed by the credit crisis, or prevent the possible collapse of a $58 trillion unregulated market in loan insurance policies -- known as credit default swaps -- written by a variety of firms, say financial experts.

Most urgently, the short-term lending system remains largely frozen, endangering the ability of everyone from small businesses to universities to General Electric to finance day-to-day operations. The financial rescue package will not fully thaw it.

"The market for commercial paper issued by a large number of corporations has essentially shut down," said Mohamed A. El-Erian, co-chief executive of Pimco, an investment firm with about $800 billion under management.

The market for commercial paper, which companies use to borrow money, shriveled by $94.9 billion, or 5.6 percent, to a seasonally adjusted three-year low of $1.6 trillion for the week ended Oct. 1, the Federal Reserve said yesterday. With banks, insurers and other investors shying away from corporate loans, the amount of outstanding commercial paper has dropped by more than $600 billion since hitting a peak of $2.223 trillion in July 2007.

Peter R. Fisher, a former Treasury undersecretary and former senior New York Federal Reserve official, said that in buying troubled loans, the new agency created by the legislation would attack the credit crisis "indirectly . . . by trying to lighten the load on the balance sheets of the banks, but it is unlikely to do enough to change the propensity of banks to shrink their balance sheets from here to year-end."

That means less lending by banks and tight times for Americans who need to borrow money. Fisher pointed to the generous terms of the deal Warren E. Buffett's Berkshire Hathaway got from General Electric in return for providing GE with $3 billion. Fisher, now a managing director at BlackRock investment firm, said that the deal wasn't so much a tribute to the acumen of Buffett as it was to the desperation of GE, a company with the top credit rating. Buffett is a director of The Washington Post Co.

For other companies that need to borrow money on a short-term basis, the Buffett deal was an ominous sign. "One of America's premier companies couldn't roll over commercial paper without selling a big chunk of equity," Fisher said. "That means the cost of short-term borrowing for every company in America went way up."

Steven Rattner, managing principal of the Quadrangle Group, an investment firm, thinks that the rescue plan should have taken a different approach. It should have invested in troubled banks by buying preferred shares or other kinds of equity, as the Swedish government did during an earlier banking crisis there. In other words, Rattner said, "Why isn't the government doing what Warren Buffett is doing?"

Even if Congress approves the plan, Fisher said, the Federal Reserve may need to take steps to stabilize the commercial paper market that companies use for short-term credit.

John Ryding, chief economist and founding partner of RDQ Economics, a research firm, said that the world's central banks should guarantee the repayment of loans between banks, a move that the Irish government took this week. Currently banks are reluctant to even lend to one another, making normal transactions difficult.

"We can stand behind these banks collectively, or we can end up bailing them out one at a time," he said.

Ryding said the Treasury should use the money Congress gives it to help private investors who want to buy distressed mortgages that are a drag on bank balance sheets. Under Ryding's proposal, Treasury would provide half the money for such purchases, thus attracting new capital, boosting the value of troubled securities, and doubling the impact of the $700 billion rescue plan. In cases of defaults, private investors would absorb losses first, making the odds of taxpayer losses remote.

Rattner says ideas he believes are dangerous could still be proposed even if the House ratifies the rescue plan. One bad idea, he says, would be changing the rule that requires banks to account for troubled loans at market value on the theory that the market for such loans is temporarily depressed.

"That would be s aying 'if you don't like the numbers, change them,' " Rattner said. Tough accounting rules, he said, are "like democracy, not perfect but better than any other system."

Experts say the government should review regulations written for an industry that looked completely different just a month ago. "Over the longer term, a fundamental retooling of financial regulation and supervision is required, including reconciling the many new facts created on the ground as a result of crisis management responses as opposed to a coherent master plan," El-Erian said.

© 2008 The Washington Post Company