Financial turmoil intensifies; broader solutions are sought

Over the past week, the US Treasury, the Federal Reserve, and Securities and Exchange Commission have all taken extraordinary steps to alleviate the pressure on financial firms. This pressure has remained intense despite the seizure of Fannie Mae and Freddie Mac and the bailout of AIG. Led by financial firms' shares, equities plummeted in value on Monday and Wednesday. By the close on Wednesday, the S&P 500 index had lost 7.6% from the previous week's close. Additional financial institutions were coming under pressure, and investors were even withdrawing funds from money market accounts, the safest investments other than federally insured bank deposits. Clearly, the case-by-case approach to solving the crisis was not working, and a broader approach was needed.

On Thursday, the Fed pumped $180 billion into the system, much of it through other central banks. And the SEC announced an extension of the temporary ban on short selling of financial firms' shares, a practice that has been blamed for some of the pressure. But it was not until there was word that the Administration was conferring with the financial authorities and congressional leaders on the possible creation of a federal agency to purchase and hold the mortgage-backed securities at the heart of the turmoil that the equity market turned around. In the last hour or so of trading, another significant decline was reversed, and the S&P closed up 3.3% nearly recouping all of the previous day's loss. Financial stocks saw the largest increases.

On Friday, additional measures were undertaken. The Treasury announced a new program to insure the holdings of money market funds. Eligible funds will pay a fee to participate in the program, but initial funding ($50 billion) will come from the Exchange Stabilization Fund, which was created in 1934. In addition, the Fed announced that it would lend up to $230 billion to money-market funds, accepting asset-backed commercial paper as collateral.

The Treasury also announced that Freddie Mac and Fannie Mae will increase their purchases of mortgage-backed securities and that the Treasury would step up its own mortgage-backed securities purchases. All of these measures could be put into place without Congressional action, and therefore without delay.

In addition, Treasury Secretary Henry Paulson announced plans to ask Congress for the authority to absorb non-performing and/or illiquid mortgage-backed assets from financial institutions. The markets received the news of all of these steps very enthusiastically - the S&P index climbed another 3.4% on Friday, ending the week slightly above its starting point.

But it remains unclear whether these actions will actually resolve the crisis. In theory, removing the bad assets from financial institutions balance sheets should restore confidence, and allow banks to once again lend to each other and to the private sector. But a badly shaken financial sector may take some time to recover its footing. And confidence among nonfinancial businesses and consumers has also probably been adversely affected.

And there will be costs. On Saturday, the Treasury sent its request for legislation conferring the authority it seeks to Congress. It asked for the authority to acquire mortgages and mortgage-related assets from any financial institution headquartered in the United States, up to a total of $700 billion. The language is extremely broad and only requires semi-annual reports to Congress. It would also require an increase in the Federal debt limit, which has already been increased this year to accommodate the seizure of Fannie Mae and Freddie Mac, to $11.3 trillion. Congress is scheduled to recess for the elections on September 25, and congressional Democrats have already indicated that they want to 'strengthen' the bill by adding help for struggling homeowners and possibly other stimulus measures, such as additional unemployment support. However, passage of a package this week is a virtual certainty - neither side will be willing to appear as the roadblock on such vital legislation so close to the election.

It is impossible to put a total price tag on the bailout. The federal government is acquiring assets as well as additional debt, and much depends on how the housing market recovers and what happens to the foreclosure rate. Still while it is theoretically possible for the government to come out ahead, that is extremely unlikely.

Credit Crunch Watch

Financial stress indicator

The financial stress indicator is a composite index of a number of indicators including risk spreads, mortgage spreads, equity volatility, commercial paper and commercial loans outstanding and the spread of LIBOR rates over T-bill rates. The indicator spiked dramatically to fresh all-time highs over the last week in the wake of the dramatic events on financial markets-the collapse of Lehman Brothers, the hasty merger of Merrill Lynch and Bank of America and the rescue of giant insurer AIG. Equity volatility rose sharply, while credit spreads and the LIBOR-T-BiII spread gapped wider. The yield on short-term US Treasury bills approached zero, indicating the massive degree of risk aversion and the extreme demand for liquidity and safety.