09/19/2008 04:27 PM

Dealing with the Credit Crisis

Massive Government Intervention to Bail Out Banks

By in New York

The US Treasury Department and the Federal Reserve stepped in on Thursday to help calm down Wall Street. The government is to take on stricken banks' bad debts to the tune of hundreds of billions of dollars in the biggest state intervention since the Depression.

Federal Reserve Chairman Ben Bernanke (C) speaks next to Treasury Secretary Henry Paulson (L), and House Speaker Nancy Pelosi on Thursday.

Federal Reserve Chairman Ben Bernanke (C) speaks next to Treasury Secretary Henry Paulson (L), and House Speaker Nancy Pelosi on Thursday.

US President George W. Bush has had a tough week.

He entertained his counterpart from Ghana, President John Kufuor, at the White House, serving him Maine lobster, ginger lamb and a medley from "The Lion King."

He inspected Hurricane Ike's aftermath in Texas.

He met with former US Commander in Iraq General David Petraeus and the president of Panama, Martín Torrijos.

He made a proclamation to mark Constitution Day and he made a statement commenting on the passage of the Second Amendment Enforcement Act, which allows "law-abiding individual Americans living in the District of Columbia to keep and bear arms."

As for the financial crisis, Bush addressed that, too -- on Thursday, for the first time all week. For exactly two minutes he stood in the Rose Garden and read comforting platitudes from a piece of paper, only to disappear without further comment. No questions, please.

Bush's invisibility during the recent Wall Street turmoil is telling. Many blame his laissez-faire policies for contributing to the collapse of several big, famed investment banks and to what seems to be the beginning of the end of the current banking system in the US -- a dramatic turn of events which until recently would have been unthinkable and which has shaken stock markets to their core.

Instead of Bush, two others have taken the reigns these days: Treasury Secretary Henry Paulson and Ben Bernanke, the chairman of the Federal Reserve. The markets know who to trust. It was only after a new round of massive interventions by Paulson and Bernanke that Wall Street calmed down again on Thursday.

The Dow Jones index, which had lost about 900 points since Monday, recovered, even managed to squeeze out a fine rally just before the bell to end up 410 points -- the biggest daily gain in six years, after the biggest daily loss in seven years.

The cause of the dizzying turnaround provides yet further proof that the current system cannot right itself on its own merits. The jump came after rumors about yet another unprecedented attempt to rescue the US financial sector -- this time a government mechanism to take bad assets off the balance sheets of banks and institutions.

Hours after the bell, those rumors, fanned in particular by the TV cable channel CNBC, turned indeed out to be true.

Relieving Wall Street of Its Toxic Debt

On Thursday night Paulson and Bernanke held an emergency meeting with congressional leaders and members from both parties. Afterwards they all vowed to find a "comprehensive solution" to remove "illiquid assets" from banks' balance sheets.

In other words: Washington wants to relieve Wall Street of its toxic debt. The size of the rescue plan could reach hundreds of billions of dollars, Paulson said at a press conference on Friday. "This needs to be big enough to make a real difference and get to the heart of the problem," he told reporters. This would be the most massive government intervention since the Depression, giving "the US financial system its biggest makeover since the 1930s," wrote the Wall Street Journal, with uncharacteristic excitement.

On Thursday night it was still unclear exactly how this biggest bailout in US history would be structured. Paulson plans to work with Congress over the weekend to get legislation in place next week and he has said that "all options" will be on the table.

The highly dramatic step -- which comes after yet another multi-billion-dollar Fed infusion for the banks -- shows how dicey things have become on Wall Street. The historic bailout is supposed to shield Main Street from Wall Street's losses, said House Speaker Nancy Pelosi.

This week has wreaked catastrophic havoc already. "What we are witnessing may be the greatest destruction of financial wealth that the world has ever seen -- paper losses measured in the trillions of dollars," wrote columnist Steven Pearlstein in Thursday's Washington Post.

The pressure on Paulson & Co. to go beyond the previous billions increased almost by the hour on Thursday. "This is about restoring confidence in America," said former President Bill Clinton in an interview with CNBC. "You're trying to save the American financial system. And the savings of hundreds of millions of Americans."

Most Americans rely on the stock market for their pensions and so they are directly affected by this crisis: "There is no American that has not been potentially damaged by what's happened the last two days," said Clinton.

According to US media reports, the government's plan to buy distressed debt from banks and other institutions could be structured in a similar way to the so-called Resolution Trust Corporation (RTC). That was a federal asset-management company that took over and liquidated assets of more than 1,000 failed savings and loan associations after the Savings and Loan crisis of the 1980s.

This time around, the banks asking for help haven't collapsed -- yet. The details of how exactly this gigantic bailout would be engineered was the focus of wild speculation on Thursday. Democratic Senator Chuck Schumer suggested that the government could invest in those companies "to give them a stronger capital base."

Which leads to the question: How much money does the Federal Reserve -- which has never before so actively interfered in the market --have left for such enormous commitments? How far can it stretch financially?

At the beginning of the year, the Fed's reserves were estimated at $800 billion. Since then, they are said to have shrunk to less than $300 billion. "This is unique," said Allan Meltzer, a professor of economics at Carnegie-Mellon University, to the New York Times. "The Fed has never done something like this before."

The bailout wasn't the only measure taken on Thursday to prevent a meltdown. There were attempts to plug leaks on all fronts.

The Securities and Exchange Commission (SEC) now wants to follow the example of the British Financial Services Authority and ban certain kinds of so-called short sales -- where stocks are borrowed in anticipation that the price will fall, allowing the stock to be bought back more cheaply. On Friday the SEC issued an emergency order to temporarily halt the short selling of 799 financial stocks.

Critics and the battered US investment banks have complained that short sales have only aggravated their problems, if not even caused them by creating a vicious cycle downward -- from which only short sellers profit. In March, when Wall Street went through a similar upheaval, the SEC prohibited naked short selling, an especially controversial, unsecured form of short sales.

Meanwhile, New York's Attorney General Andrew Cuomo started a "wide-ranging investigation into short selling in the financial market." The probe will focus on stock sales of companies which have come under heavy pressure this week, among them Lehman Brothers, AIG and Morgan Stanley.

These are breathtaking, cataclysmal times on Wall Street: Without the state, it seems, nothing works anymore. "Nothing will be the way it was," a trader said yesterday. Even though the market has caught its breath for now -- the New York Times sees enough reason to ask the big, uncomfortable question: "Is the United States no longer the global beacon of unfettered, free-market capitalism?"


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