Finally here is something that looks like light at the end of the tunnel. US treasury secretary and former Goldman Sachs chief Hank Paulson and Fed Chairman Ben Bernanke, an expert in the economics of the Great Depression, have together put together a plan that, by early indications, US Congress cannot wait to approve?the mother of all bailouts to combat the mother of all crises. Add the proposed $700 billion to the sums paid to keep AIG afloat and the still unclear costs of nationalising Fannie Mae and Freddie Mac, and the bill to taxpayers quickly crosses the trillion dollar mark, well over a third of the US federal budget. The proposed $700 billion package itself is larger than the social security obligations as well as Medicare and Medicaid and only marginally less than the expenditure on national security. It necessitates an enhancement of the federal public debt limit by $800 billion. By all measures, this is one gargantuan deal.
Few need convincing that something of this scale was absolutely the need of the hour. The Fed had earlier helped the Bear Sterns rescue as well as provided a $85 billion bridge loan to the insurance giant AIG, but after the fall of Lehman Brothers and the takeover of Merrill Lynch and with Morgan Stanley tottering, it was clear that case-by-case support was not reaching the heart of the epidemic and the cancer had already reached across an unexpectedly wide swath of the financial terrain. During the Asian crisis a decade ago, we had witnessed massive cross-country contagion. This time, the contagion is cross-institutions and cross-instruments. Through the ingenious use of financial engineering, bad subprime loans have layers and layers of financial derivatives built on them and it is not clear where the ripple effect of subprime write-offs would end. Highly leveraged financial institutions are trying to simultaneously offload debt leading to a ?fire-sale? situation in the private debt market. Government debt seems to be the only instrument in which people have any faith any more. The seizing of inter-bank credit can well trigger off a Japan-style long and painful recession?an outcome that policy makers should avoid at all costs.
How is the bailout supposed to work? The Treasury is seeking unfettered authority to buy, hold, manage and sell mortgage loans for the next two years up to the funding limit of $700 billion and after that total freedom in managing the portfolio of these loans. Thus the Fed would be a ?buyer of last resort? of the tainted loans, essentially swapping the ?toxic? debt with treasuries, shoring up public confidence in the system and reducing counterparty risk to unfreeze lending.
While this dialysis of the financial system provides a way out of an ever-widening malaise by flushing out the offending cells themselves, there are many things that can still go wrong. First, it is not clear if the disease has already caused organ failure. In other words, would the institutions be sufficiently capitalised even after the ?toxic? debt has been taken out? Many have argued that the real problem is that of under-capitalisation of financial institutions, something that this package would not directly address. Next, a lot depends on the price at which Fed purchase of the tainted debt happens. If it is at the current distress-sale levels, that may not be much of a help to most players?many systemically large ones included. On the other hand, if there is a significant premium, it will have uncomfortable implications about the fairness of use of public funds. On the flip side, again depending upon the price paid and the future recovery of this sector, the agency created to manage this debt swap can potentially turn a nice profit for US taxpayers in a few years. Finally, the Congress may well have issues about the complete freedom from supervision sought by the Treasury, particularly given the uncertainties about the next regime.
Any government bailout of the private sector is fraught with what is known as ?moral hazard?. In essence, it sets wrong incentives. Private players can now be reckless in their risk taking, enjoy the upside and expect to be bailed out if the bets go wrong. Given the systemic nature of the current crisis however, this is not the paramount concern now. Also, letting Lehman fail sent out a signal, that even in a crisis, no player is large enough to have a guaranteed rescue at public expense.
This is certainly not just an internal matter of the US. Globally, markets today are hoping the proposed package sails through Congress, and praying that the treatment works. A US meltdown of this scale would spell disaster for the international economy. There are reasons to thank the current US administration for the courage and pragmatism it has shown to move away from its much-touted ?small government? rhetoric, and the American taxpayers for shouldering the burden?willingly or otherwise.
?Rajesh Chakrabarti teaches finance at the Indian School of Business, Hyderabad