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U.S. taps piggy bank, borrows to aid market

Where does Uncle Sam come up with huge sums of money during a financial emergency? Like the rest of us, the government taps its reserves and borrows if it needs more.
/ Source: The Associated Press

Where does Uncle Sam come up with huge sums of money during a financial emergency? Like the rest of us, the government taps its reserves and borrows if it needs more.

The federal government has pledged eye-popping amounts — more than $600 billion in the past year — to bail out, or help bail out, some of the biggest names in American finance. The latest was American International Group Inc.

Now the credit crisis is starting to tax even the Federal Reserve's deep resources.

On Wednesday, the central bank took the unprecedented step of asking the Treasury Department to sell debt on behalf of the Fed. The first of those auctions raised $40 billion, and two more to raise an additional $60 billion are scheduled for Thursday.

Analysts said these auctions don't mean that the Fed, the bank that backs up the U.S. banking system, is strapped for money. Instead, they said it represented an effort to better manage its own holdings of Treasury securities.

It uses those securities to control interest rates by buying or selling the securities to banks, thus raising and lowering the amount of money banks have to loan out and influencing the price of that money.

While the Fed has access to its fat piggy bank to support its effort to prop up financial companies, the Treasury Department will have to whip out the credit card for the support it is pledging to mortgage finance companies Fannie Mae and Freddie Mac.

Treasury will have to borrow the money because it doesn't have the deep reserves that the Fed does. The country is running a huge budget deficit this year and is projected to run an even bigger one next year.

Those deficits will present a major challenge for the next president. Both Republican John McCain and Democrat Barack Obama have a list of their own spending priorities that they want to enact, not to mention their promises to provide tax cuts.

The Tax Policy Center, a nonpartisan think tank, estimates those will cost $4.2 trillion over the next decade in the case of McCain and $2.9 trillion in the case of Obama.

Those campaign promises, on top of all that the current administration has done to contain the current fiscal crisis, could really put a strain on the government's balance sheet.

Ten days ago, the government took control of Fannie and Freddie, pledging to provide up to $200 billion to cover losses at the two companies.

On Tuesday, the Federal Reserve employed powers granted during the Great Depression to extend an emergency loan worth up to $85 billion to AIG, the nation's biggest insurance company.

That assistance is on top of billions of dollars in help the government had already put on the table as it battles the worst housing slump in decades.

The Fed extended a $29 billion loan to facilitate the forced-sale last March of Bear Stearns, at the time the nation's fifth-largest investment bank, and in the housing bill that Congress passed last summer the Federal Housing Administration was given the power to insure up to $300 billion in refinanced mortgages.

And that doesn't count the billions of dollars the Fed has pumped into commercial banks and investment banks over the past year as it has struggled to make sure they have the resources needed to keep loans, the lifeblood of the economy, flowing.

Federal Reserve Chairman Ben Bernanke and his colleagues met on Tuesday and voted to hold the target for the federal funds rate, the interest that it influences through its buying and selling of Treasury securities, at 2 percent.

Analysts said if the Fed had not gotten help from the Treasury to auction off more debt that it could use, it ran the risk of pushing the funds rate lower than it wants it to go and thus increasing the threat of inflation down the road.

For the Treasury's $200 billion pledge for Fannie and Freddie plus its support for FHA-backed mortgage loans, the borrowing needed will send the deficit soaring even higher.

Stimulus checks totaling $168 billion, sent to Americans earlier this year to bolster the economy, will have an impact on the budget deficit. For the budget year ending Sept. 30, it's expected to hit $400 billion, the second highest on record and more than double last year's deficit of $161.5 billion.

The Bush administration is projecting that the deficit for the new budget year, which begins Oct. 1, will surge to an all-time high of $482 billion. And that estimate doesn't include any costs for bailing out Fannie and Freddie.

So far investors, including those overseas, have shown no reluctance to buy Treasury debt. In fact, all the financial turmoil of recent days has driven Treasury's borrowing costs lower as investors have flocked to the safety of Treasury securities.

But the combination of Bush's efforts to contain the current financial crisis plus the campaign promises of the next president offer the daunting prospect of serious deficit problems over the next four years.