In a remarkable week that began with the fall of investment bank Lehman Brothers and the rescue of insurance giant AIG, the federal government threw aside concerns about long-term precedent and crafted a massive bailout for the ailing financial industry.
Aimed at restoring confidence and liquidity, the moves greatly broaden an already expanding role for the government in financial markets and potentially put $1 trillion or more of taxpayer money at risk.
Events transpired so quickly during the week that there was little time to analyze historic decisions made by U.S. Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and others.
The government denied Lehman the funding that it had extended to another investment bank, Bear Stearns, in March, and to mortgage lenders Freddie Mac and Fannie Mae earlier this month. It encouraged Merrill Lynch, Morgan Stanley and Washington Mutual to seek buyers. It initially spurned AIG but then threw it an $85 billion lifeline because its survival was seen as crucial to financial market stability.
Meanwhile, the Treasury moved to shore up the Fed’s balance sheet with $200 billion financed by T-bill auctions. The Fed injected hundreds of millions of dollars in short-term loans into money markets, and regulators put a temporary ban on short-selling.
On Friday, the White House began discussing with congressional leaders a proposal to buy, hold and later sell distressed mortgage assets that are at the heart of financial institutions’ problems. The program, akin to the Resolution Trust Corp. created in the late 1980s to clean up the savings-and-loan mess, could spend $1 trillion or more on the assets.
“This is not a time for ideologues. It’s an emergency,” said Raymond Horton, a professor of political economy at the Columbia Business School in New York. “They’re solving problems as they go along, but they’re creating new problems. . . . There will be consequences for the dollar, for tax policy, for military spending and for other federal programs.”
Roots in subprime mortgage crisis
The roots of the problem lie in the subprime mortgage crisis that took hold last summer. Investment banks, including Lehman and Bear Stearns, bought massive quantities of residential home loans in recent years as low interest rates and easy credit fueled a housing boom.
Among those mortgages are millions of high-interest-rate subprime loans made to borrowers with poor credit. As the recent housing boom turned, subprime delinquencies and foreclosures rose to unprecedented levels, causing the value of the investment banks’ assets to plummet. That spawned the current crisis, in which lenders are unwilling to extend credit.
Early last week as the crisis spiraled downward, it appeared the Bush administration had no plan in place and was making momentous choices on the fly. Later, it emerged that the Treasury and Fed had quietly developed outlines of the broader intervention.
The stunning developments put Republicans and Democrats in unusual positions regarding government interventions and free-market policies.
Paulson and Bernanke drew fire from House Speaker Nancy Pelosi, D-Calif., for lending AIG $85 billion “without the scrutiny and transparency the American people deserve.”
The AIG bailout came just one day after Lehman filed for bankruptcy protection.
Last-ditch efforts to line up private funding for Lehman had failed over the weekend. Suitors had required government help similar to the $29 billion the Fed lent JP Morgan in its purchase of failing Bear Stearns in March.
Lehman the loser
In the Bear Stearns bailout, the Fed took the investment bank’s most distressed assets onto its own books as collateral for the loan.
In Lehman’s case, observers said Paulson and Bernanke did not want to save another investment bank. Bear Stearns’ failure came abruptly and relatively early in the crisis; the Fed hoped to avert deeper problems by cushioning its fall.
“If Bear and Lehman had been reversed, Lehman would have been bailed out and Bear would have gone bankrupt. It was unfortunate for Lehman that it was second,” said Maclyn Clouse, a finance professor at the University of Denver’s Daniels School of Business.
“I think the Fed was trying to establish that they can not be bailing out every investment bank that engages in risky investments,” he said.
Investment banks differ from commercial banks in that they do not take deposits. They issue and sell securities for clients and provide advice on transactions. They are less regulated than commercial banks and are not federally insured, though many are now calling for closer oversight.
Lehman’s problems had built up over months, giving it time to adjust and find private backers. Ultimately, money spent on Lehman wouldn’t have saved the venerable firm, said Ronald Melicher, chair of the finance division of the University of Colorado’s Leeds School of Business.
AIG’s tentacles widespread
AIG was a different story. The nation’s largest insurer was No. 13 on the 2007 Fortune 500 list of largest U.S. companies, with revenues of $110 billion. Its operations directly affect 80 percent of the U.S. population, and the company also operates in 130 countries, Melicher said.
A critical issue for AIG is its deep involvement in insuring bank loans, including hundreds of billions of dollars’ worth of home mortgages. An AIG bankruptcy could wipe out those insurance contracts, causing the value of the insured mortgages to fall and bringing more distress to the financial industry.
“There was concern that many U.S. banks would fail if AIG did not keep operating,” Melicher said. “AIG is just monstrous.”
Finally, AIG bonds are widely held by money-market funds, which came under tremendous stress last week with the Lehman bankruptcy and other developments.
The AIG bailout has been called a bridge loan by some and a nationalization by others. The $85 billion loan has a two-year term and an interest rate of just under 12 percent — terms the government said will encourage AIG to move quickly to sell assets to repay the loan. The government replaced AIG’s chief executive and took warrants that give it the right to nearly 80 percent ownership of AIG.
Fannie, Freddie a bigger deal
The AIG deal is exceeded in scale only by the $200 billion Fannie Mae and Freddie Mac government takeover less than two weeks earlier. Less controversial because the entities are already closely connected to the government, the move was viewed by many as essential to alleviating the housing and credit crisis.
Together, the companies own or guarantee about $5 trillion in home loans, about half the nation’s total. They lost a combined $14 billion in the past year.
The government placed Fannie and Freddie in a conservatorship and said it is prepared to put as much as $100 billion in each to keep them in business, in exchange for senior preferred stock.
Critics of the companies have called for long-term solutions ranging from privatizing them to breaking them into smaller, regional independent banks that aren’t “too big to fail.”
The government’s seizure of Fannie and Freddie is expected to put downward pressure on mortgage rates. They have remained high this year, even as other interest rates have plunged, due to tight credit for mortgage lenders.
Major government interventions invariably spark controversy over “moral hazard,” the notion that bailouts reward irresponsible behavior and encourage excessive risk-taking.
So far the debate has been somewhat muted by the scale of the problems facing the financial markets.
“The moral-hazard argument doesn’t carry very far when you’re standing on the precipice,” said Columbia’s Ray Horton.
Greg Griffin: 303-954-1241 or ggriffin@denverpost.com
