The financial crisis, September 17th

[Guy Berger]

1) An op-ed in which economist Ken Rogoff argues that the cost to US taxpayers of cleaning up this mess will be upward of $1 Trillion.

2) An op-ed from Nicholas Brady and Paul Volcker calling for a resurrection of the Resolution Trust Corporation

3) A review of today's historic events

4) A more general article on the crisisi

Edited September 18, 2008 by Guy

[Guy Berger]

America will need a $1,000bn bail-out

By Kenneth Rogoff

Published: September 17 2008 19:06 | Last updated: September 17 2008 19:06

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America's flagship financial sector, the public and private sector's massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan's debt levels. It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, yesterday's $85bn bail-out of the insurance giant AIG.

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.

True, the US Treasury and the Federal Reserve have done an admirable job over the past week in forcing the private sector to bear a share of the burden. By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury's most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.

It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.

Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.

It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.

Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America's ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.

The writer is professor of economics at Harvard University and former chief economist of the International Monetary Fund

Copyright The Financial Times Limited 2008

Edited September 18, 2008 by Guy

[Guy Berger]

SEPTEMBER 17, 2008

Resurrect the Resolution Trust Corp.

By NICHOLAS F. BRADY, EUGENE A. LUDWIG and PAUL A. VOLCKER

We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse.

Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis.

Fannie Mae and Freddie Mac, the giants in the mortgage market, are overextended and now under new government protection. They are not in sufficiently robust shape to meet all the market's needs.

The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms. This paper, in turn, is unable to support huge quantities of structured financial instruments, levered as much as 30 times.

Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy that so far has held up reasonably well.

There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. There are precedents -- such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.

Such a stabilizing mechanism would accomplish four much-needed tasks:

- First, by buying paper that otherwise is effectively not trading, it would help restore liquidity to the marketplace and help markets to function more fluidly again.

- Second, by warehousing the troubled paper for a longer period than, for instance, the Fed's discount window typically should or could, it would allow for a more orderly liquidation of this paper, and the chance for much of it to recover a portion of its value.

- Third, by giving the agency the ability to manage mortgages with flexibility to keep people in their homes and businesses running, it should lessen the number of foreclosures. This, in turn, would help moderate the decline in real estate values and the deterioration of neighborhoods, thus supporting house prices that in fact lie at the heart of the crisis.

- Fourth, where necessary, like the RTC of the 1980s, this new mechanism can assist the Federal Deposit Insurance Corporation in resolving sick institutions that are so clogged with the troubled paper they cannot continue as independent entities. However, we would hope that purchasing the mortgage-related paper will minimize the need to provide emergency, short-term assistance to solvent banking institutions.

It is certainly the case that the new institution we are proposing will in the short run require serious money. That will involve a risk to the taxpayer; but the institution, administered by professionals, means that ultimate gains to the taxpayer are also possible.

Moreover, a failure to act boldly in the fashion we are suggesting would cost the taxpayer and the country far more. The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link. A deteriorating financial system, diminished economic activity, loss of jobs and loss of revenues to the government is enormously costly. And the cost to our citizens' well-being is incalculable.

Crisis times require stern measures. America has done well in the past to face up to economic turmoil, take strong measures, and put our problems behind us. RTC-like mechanisms have worked well in past crises. Now is the time to take a similarly forceful step.

The American economy still has enormous underlying strengths. What we need, and in part are proposing, is a road map to financial stability.

Mr. Brady was U.S. Treasury secretary from 1988-1993. Mr. Ludwig was U.S. comptroller of the currency from 1993 to 1998. Mr. Volcker was chairman of the Federal Reserve from 1979-1987.

Edited September 18, 2008 by Guy

[Guy Berger]

SEPTEMBER 18, 2008 <H1 class="dateStamp first">Mounting Fears Shake World Markets

As Banking Giants Rush to Find Buyers </H1><H3 class=byline>By TOM LAURICELLA, LIZ RAPPAPORT and ANNELENA LOBB</H3>Fear coursed through the U.S. financial system on Wednesday, as hope for a resolution to the year-old credit crisis faded.

Stocks tumbled, concern grew about which financial firm would fall next, and investors rushed toward the safe haven of government bonds in the wake of the collapse of Lehman Brothers Holdings Inc. and the crisis at insurer American International Group.

Associated Press

A trader rubs his eyes as he works on the floor of the New York Stock Exchange. Wall Street stumbled again Wednesday, with anxieties about the financial system still running high even after the government bailed out insurer AIG.

The market turmoil is doing more than inflicting losses on investors. Borrowing costs for U.S. companies have skyrocketed, and the debt markets have become nearly inaccessible to all but the most creditworthy borrowers.

The desperation was especially striking in the market for U.S. government debt, long considered the safest of investments. At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured. Some investors, in essence, had decided that a small but known loss was better than the uncertainty connected to any other type of investment.

That's never happened before. In a special government auction on Wednesday, demand ran so high that the Treasury Department sold $40 billion in bills, far beyond what it needed to cover the government's obligations.

"We've seen crisis. We've seen recession. But we've not seen the core of the financial system shaken like this," says Joseph Balestrino, a portfolio manager at Federated Investors. "It's just crazy."

A 449-point selloff took the Dow Jones Industrial Average to its lowest level in almost three years, leaving it 23% below where it stood a year ago. Volume on the New York Stock Exchange was the second highest in history, falling just shy of the record set on Tuesday. The VIX, a widely watched measure of market volatility that is often referred to as the "fear index," shot up to its highest level since late 2002.

In Europe, stock markets lost roughly 2% of their value. In Russia, the scene of recent massive declines, trading on the country's major exchanges was halted for the second day in a row, this time only an hour and a half into the session. Gold prices rose 9% to $846.60 an ounce amid the global turmoil.

"Forget about retail investors, all the pros are scared," says one broker. "People have no idea where to put their money."

For now, "if you have cash, you're going to put it in the short-term, most liquid stuff you can," says Steve Van Order, fixed-income strategist for Calvert Asset Management.

Adding to the fear was a loss in a prominent money-market fund, the Reserve Primary Fund, which held Lehman Brothers debt. It was the first time since 1994 that such a fund, which is supposed to be as safe as a bank account, had lost money. The loss was made worse by a run on the fund. Over two days, investors pulled more than half of their assets from the fund, once valued at $64 billion.

"This is a panic situation" in the bond markets, says Charles Comiskey, head of U.S. government-bond trading in New York at HSBC Securities USA Inc.

Riskier assets were sold off. Yields on bonds issued by financial companies hit a record high of about six percentage points above U.S. Treasurys. In the market for credit-default swaps -- essentially insurance against default on assets tied to corporate debt and mortgage securities -- fears increased on Wednesday about whether counterparties would be able to honor their agreements. Investors tried to reduce their exposures to two more big players in the market, Goldman Sachs and Morgan Stanley. That sent the cost of protection on both Wall Street firms soaring to new highs.

In the stock market, the pressure on financial firms continued, with Morgan Stanley stock dropping 26% and Goldman Sachs shares losing 19%.

Investors say the government takeover of AIG and Lehman's bankruptcy are evidence that the situation is grimmer than all but the most pessimistic had expected. Problems have spread from complex debt markets tied directly to the housing market into plain-vanilla corporate bonds.

<H3 class=first>More on the Crisis</H3>

• Morgan Stanley in Talks With Wachovia
  
• Worst Crisis Since '30s, No End in Sight
  
• Bad Bets and Cash Crunch Hurt AIG
  
• Complete Coverage: Wall Street in Crisis
  

"Another front is opening," says Ajay Rajadhyaksha, head of fixed-income research at Barclays Capital.

Some fear that the dwindling ranks of investment banks, coming at a time when commercial banks are pulling back on their own use of capital, will prolong the credit crunch.

"It's unclear who is going to be a credit provider going forward, and if having fewer credit providers means higher costs of borrowing going forward," says Basil Williams, chief executive of hedge-fund managers Concordia Advisors.

Ordinarily, bondholders are better protected from losses than stock investors. But the events of the past two weeks have shown that they are vulnerable, too. The Federal Reserve's rescue of AIG doesn't protect the company's bondholders. That's because the deal, which consists of a high-priced loan to the company from the government, requires AIG to pay the Treasury before current bondholders. If AIG can't raise enough cash by selling assets, bondholders won't be fully repaid.

As a result, despite the Fed lifeline, some AIG debt is changing hands at just 40 cents on the dollar, less than half of the price one week ago. Now that Lehman has defaulted on its debt, its senior bonds are worth as little as 17 cents on the dollar, traders say.

That's spilled over to other financial names seen as under stress. Bonds of Morgan Stanley are trading at around 60 cents on the dollar. Goldman Sachs's bonds are trading at prices in the range of 70 cents on the dollar.

As the bond prices dropped, their yields rose. The spread between yields on corporate bonds and safe U.S. Treasurys have blown out to the widest levels traders have seen in years. On Wednesday, yields on investment-grade corporate bonds were more than four percentage points higher than comparable Treasury bonds, according to Merrill Lynch. Junk bonds ended the day more than nine percentage points over Treasurys, approaching the 2002 high of 10.6 percentage points, according to Merrill.

Short-term debt markets, where companies borrow overnight or in periods up to one year, have dried up. The money-market fund managers who normally buy such short-term debt have suffered losses on their holdings of debt in Lehman Brothers and other financial institutions.

If companies can't borrow in the short-term debt markets, they may be forced to draw down on their revolving credit lines, yet another drain on banks' dwindling capital.

The Lehman bankruptcy also pressured the market for leveraged loans, which are used by private-equity firms to finance buyouts. When the firm attempted to sell some of its loan holdings earlier this week, prices dropped toward 85 cents on the dollar, according to Standard & Poor's Leveraged Commentary & Data.

The damage has gone beyond banks and brokerages. Ford Motor Credit Co., the finance arm of Ford Motor Co., paid 7.5% for overnight borrowings on Wednesday, says one trader. Typically, the rate for such debt would be about one-quarter percentage point over the federal-funds rate, which is currently 2%, he says. Even for companies considered of the safest credit quality, the cost of overnight debt is soaring. General Electric Co. was forced to pay 3.5% for overnight borrowing on Wednesday, the trader says. In normal times, GE, which has the highest debt rating, would have to pay the equivalent of the federal funds rate.

"There's no evident catalyst for ending the pain," says Guy Lebas, chief fixed-income strategist at Janney Montgomery in Philadelphia.

—Emily Barrett and Min Zeng contributed to this article. Write to Tom Lauricella at tom.lauricella@wsj.com, Liz Rappaport at liz.rappaport@wsj.com and Annelena Lobb at annelena.lobb@wsj.com

[BruceH]

1) An op-ed in which economist Ken Rogoff argues that the cost to US taxpayers of cleaning up this mess will be upward of $1 Trillion.

That's all?