Massive bailout plan won't work overnight

Image:U.S. Secretary of Treasury Paulson talks about financial markets at the Treasury Department in Washington
Secretary of Treasury Henry Paulson, left, and Federal Reserve Chairman Ben Bernanke explained the revamped bailout plan at a media briefing Tuesday. Larry Downing / Reuters
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When Treasury Secretary Henry Paulson asked Congress for authority to take over ailing mortgage lender Fannie Mae in July, he said the move would provide the government with a “bazooka” to fight the unraveling financial crisis. Today, government officials unveiled what amounts to an atom bomb.

Details are still being worked out. And it remains to be seen when, how — or if — the plan will work.

In a nutshell, the new "atom bomb" approach hopes to mainline a massive amount of capital into the nation's largest banks to jolt the ailing economy.

As a signal the government was using every weapon in its arsenal, the plan was announced in an extraordinary joint statement by Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke and Sheila Bair, the head of the Federal Deposit Insurance Corp. and a handful of other top economic advisers of President Bush. Bush spoke separately at a Rose Garden news conference.

The centerpiece of the plan is a move by the government to partially nationalize the banking system, buying up stock in some of the largest banks.

Treasury officials said that the first purchases of stock from the nine major banks will begin within days and will total $125 billion. The government expects to spend the entire $250 billion slated for the bank stock purchase program by the end of the year.

In addition to the stock purchases, the FDIC will temporarily provide insurance for loans between banks, charging the banks a premium for doing so.

The FDIC is also guaranteeing all bank deposits for businesses.

“We're seeing a lot small banks, frankly, lose their small business accounts to much larger competitors, because of public confidence issues,” Bair told CNBC after the announcement. “These smaller banks are quite viable, but this is creating a liquidity drain, losing these small business accounts.”

Deposit insurance limits for consumers have been increased to $250,000.

The government’s move to inject capital in the banking system follows months of efforts to get banks to borrow the money voluntarily from the Fed. Even in the best of times banks are reluctant to step forward asking for help, fearing such a move will be taken as a sign of weakness by shareholder, depositors and competitors. With the banking system in the grips of a full-blown global panic, there was an even greater stigma attached to stepping up to the borrowing window.

To break the logjam, Paulson summoned top executives of the nation's biggest banks to a historic meeting Monday and essentially told them they had to go along.

By force-feeding money into the biggest banks, the Treasury is hoping to overcome several  obstacles to its effort to battle the financial crisis. Paulson's original plan — which is still ongoing — was to buy up bad loans from any bank that came forward. But under that scenario it is likely that the first takers will be the banks in the weakest position — so weak they may be beyond saving.

The weakening economy means there is likely to be less demand for lending, forcing the weakest banks to find stronger banks to merge with or buy them out. The massive injection of capital into the biggest banks may help jump-start that process, allowing the banking industry, rather than the government, to undertake the process of saving faltering banks.

Injecting money directly into banks through stock purchases will produce a more immediate impact. Each new dollar dropped on a bank’s books gives it the financial reserves to lend out $10. By forcing money into the banking system, the government is hoping to break the lending logjam that has cut off borrowing to many businesses and consumers and it threatening to tip the economy into a deep recession.

The move is also designed to save otherwise healthy banks. Bair said the “overwhelming majority” of banks are still in good shape.

“What we’re trying to prevent now really is liquidity failures — failures of banks that are otherwise quite healthy, have plenty of capital, plenty of loan loss reserves to deal with the challenges that lies ahead, but because of uncertainty their liquidity is draining and we don't want to close those institutions,” she said. “That’s what these guarantees are about — to prevent unnecessary failures.”

Bernanke also underscored the need for massive intervention before the panic inflicts more damage on the financial system and the economy.

“History teaches us that government engagement in times of severe financial crisis often arrives very late, usually at a point at which most financial institutions are insolvent or nearly so,” Bernanke said. “Waiting too long to act has usually led to much greater direct costs of the intervention itself and, more importantly, magnified the painful effects of financial turmoil on households and businesses. That is not the situation we face today.”

While officials stressed the speed with which they had acted, the U.S. response followed similar moves by European authorities over the past week. On Sunday, the Bank of England moved to partially nationalize British banks. Several European countries already had pledged to back all bank deposits.

Those moves may have had a hand in prompting the U.S. action. Some bankers feared that if European banks were perceived as safer, U.S. depositors might shift assets to those banks.

A major component of the plan is its international scope. Though the crisis has galvanized U.S. and European countries in a coordinated effort, financial markets will be watching closely to see how well that cooperation holds up.

Opposition to direct government intervention in the United States has come from both sides of the aisle. In the debate over the $700 billion bailout plan, House Republicans attacked it as socialist interference in free markets. Democrats complained that it was bailing out rich bankers who made bad bets.

In announcing the plan, President Bush stressed that the plan doesn’t signal a long-term role for the government.

“The government’s role will be limited and temporary,” Bush said. “These measures are not intended to take over the free market but to preserve it.”

It’s far from clear what the government’s exit strategy will be. The history of financial panics shows that they are rarely resolved in a single moment by a single measure. The loss of confidence that underlies the current panic took years to develop; it will be months at least before some measure of confidence is restored.

But the hope is that the massive global response to the panic will prevent the kind of economic damage that has followed shocks when government was slow to act, like the prolonged downturn in the Japanese economy after that country’s stock and real estate markets collapsed in 1989.

“You’re getting a reaction way before you got the reaction in Japan,” said Mohamed El-Erian, co-CEO of bond fund Pimco. “Therefore, there is a hope that you can save the country from 10 years of stagnant growth.”