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A Bailout. For Everyone.

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Wednesday, March 12, 2008; Page D01

Last week, it was a $200 billion cash-for-bond swap for the banks.

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This week, it was a $200 billion bond-for-bond swap for the big investment houses.

If they keep this up, pretty soon you'll be able to walk into any Federal Reserve bank and hock that diamond brooch you inherited from Aunt Mildred.

Forget all that nonsense about the Bernanke Fed being too timid or behind the curve. In the face of what is turning into the most serious financial market crisis since the Great Depression, the Fed has been more aggressive and more creative in using its limitless balance sheet -- in effect, its ability to print money -- than at any time in history.

We can argue till the cows come home about whether this is a bailout for Wall Street. It is -- but only to the extent that it is also a bailout for all of us, meant to prevent a financial and economic meltdown that drags everyone down with it. In broad strokes, we're going through a massive "de-leveraging" of the economy, wringing out trillions of dollars of debt that had artificially driven up the price of real estate and financial assets, and, more generally, allowed Americans to live beyond their means. The Fed's goal has not been to impede that process, simply to make sure that it proceeds in an orderly fashion. But even that has required central bank intervention that is unprecedented in scale and scope. And despite yesterday's huge rally in the stock market, Fed officials warn that this de-leveraging is nowhere near finished.

The real action is on the credit markets, where, for the third time since last summer, the price of bonds and other complex securities fell and interest rates rose on everything but U.S. Treasury bonds.

Over the previous month, there had been fresh signs that the economy was sinking into recession: a slowing of the growth in corporate sales and profits, a decline in payroll employment and further deterioration in a housing market already in deep distress. Deeper cracks began to appear in the commercial real estate market. And out of the blue, municipalities and nonprofit institutions found that they could no longer roll over their short-term debt on the auction-rate market.

But the real problem began in late February, as several of Wall Street's biggest investment banks prepared to close their books for the quarter and realized they were looking not only at big declines in profit from issuance of new stocks and bonds and fees from mergers and acquisitions, but also another round of write-offs in the value of their holdings. In response, the banks began to hunker down, instructing their trading desks to raise margin requirements for hedge funds and other customers, requiring them, in effect, to post more collateral on their heavy borrowings.

Thus began a chain reaction in which hedge funds began selling what they could -- largely mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae -- to raise the cash to meet their new margin calls. That wave of forced selling drove down the price of those bonds, which prompted more margin calls and more forced selling. By the end of last week, the interest rate spread on those securities -- the difference between their yield and that of risk-free U.S. Treasury bonds -- had jumped four, five, even 10 times the normal rate.

Among those caught up in the vicious cycle were hedge funds run by such blue-chip names as KKR and Carlyle Group, along with Thornburg Mortgage, a big mortgage lender. News of their troubles swept through Wall Street, heightening the sense of panic, as did rumors that Goldman Sachs was about to post big losses and Bear Stearns was about to run out of cash. Meanwhile, Lehman Brothers announced that it would lay off 5 percent of its staff in what was viewed by many as a first installment of a consolidation that would eventually eliminate 20 percent of the jobs on Wall Street. Analysts began to warn that financial-sector losses from mortgages, commercial real estate, failed takeover loans and other bad gets could reach as high as $1 trillion.

It was against this backdrop that the Fed announced Friday that it would auction $200 billion in additional loans to banks looking for cash to lend or use as reserve capital. By accepting AAA-rated mortgage-backed securities as collateral for the loans, the Fed aimed to restore confidence and trading in that beleaguered market and begin to put a floor under prices.

Then yesterday, the Fed announced that it would swap $200 billion worth of Treasury bills for $200 billion worth of mortgage-backed securities held by the major investment banks that are members of its "prime broker" network on Wall Street. The aim is to take some pressure off the investment banks to raise their margin requirements even more and put a halt to the vicious cycle of selling that begets more selling.

While all this may seem rather remote to most Americans, it has already had a profound effect on the real economy. It has reduced the value of the homes and stock portfolios of millions of American investors, led to a pullback in consumer spending and caused U.S. businesses to cut back on hiring and new investment.

The Fed hopes that by injecting $400 billion of liquidity, it can help restore the more normal functioning of credit markets and encourage banks to lend again rather than hoard their cash. For it is only when bank lending and credit markets have returned to more normal operations, say Fed officials, that the beneficial impact of their interest rate cuts can be transmitted to the economy. And they leave little doubt that, despite a heavy dose of monetary medicine already in the pipeline, they intend to add another dose at their meeting next week.

It's anyone's guess how long this credit crunch will last, but the chances are that we'll have several more market meltdowns and Fed rescues before it's over, probably in the fall. Until then, the dollar will continue to get hammered and stocks will continue their fitful decline. And if the last two financially induced recessions are any guide, it will be well into 2009 before the economy hits bottom, followed a couple of years of slow growth and "jobless" recovery.


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