By John Berry
Cleaning up the mess of the US financial markets disaster will cause a mess of another kind.
Dealing with the disaster in US financial markets requires extreme measures, and cleaning up the mess will cause a mess of another kind.
Treasury secretary Henry Paulson and Federal Reserve chairman Ben S Bernanke sent Congress a plan to stabilise the financial system by having the government buy the bad mortgage-backed assets that are dragging down banks and investment firms.
Since stop-gap measures haven't done the job, Paulson and Bernanke had no choice. What they envision, though, is going to be a political and administrative nightmare.
The problem is there's no market for the securities and derivatives linked to subprime mortgages. Judging from the outlines of the plan, the government will offer to buy the assets and hold them until the US housing market finds its feet again.
With no trading in the assets, no one knows what they are worth now or might be worth in the future. They are being carried on institutions' books with values based on indexes that themselves are little more than guesses. And as those indexes have gone down, the institutions have recorded huge losses.
Furthermore, some of the instruments are opaque derivatives tied to slices of other derivatives and financed by the sale of credit-default swaps to hedge funds. How do you price something like that?
And what happens if the government "starts setting prices for tradable, albeit illiquid, securities?'' as economist John Higgins of Capital Economics in London asked in a memo to clients on September 19. "Set prices too low and it could trigger a fresh round of panic as other financial institutions are obliged to mark down their holdings of the same illiquid assets.''
The rescue will be very costly. The administration's request is for $700bn, which would be appropriated automatically.
With next year's budget deficit already estimated by the Congressional Budget Office at more than $400bn, that expenditure would be hard for many members of Congress to swallow - particularly since they are going to be asked to approve a sketchy plan within a matter of days.
Some conservative members of the House were already complaining about the cost of bailouts for American International Group, Fannie Mae and Freddie Mac.
Representative Barney Frank, the Massachusetts Democrat and chairman of the House Financial Services Committee, said officials have told him that the Treasury "will buy selectively.''
Just what does that mean? Would Treasury buy first from institutions, such as Morgan Stanley or Wachovia Corp, whose stocks have been hammered amid concerns they might fail?
Or would the purchases be more across the board, since a large number of institutions hold the bad paper? And would assets be bought only from banks, or would hedge funds, pension funds and other investors be eligible?
No legal challenges to any of the Treasury secretary's decisions regarding purchases or later sale of mortgage-related securities could be challenged in any court, according to one provision of the plan.
Those pushing for a broad rescue effort have been saying another Resolution Trust Corp, or RTC, is needed. That was the agency that cleaned up the mammoth mess caused by the failure of 747 thrift institutions in the 80s and early 90s. In the process, the RTC disposed of about $450bn worth of assets, mostly real estate scattered all over the country.
Unfortunately, the RTC's task was a snap compared with dealing with today's financial mess. The RTC wasn't trying to save troubled institutions; it was dealing with those that had failed. The government stepped in because it had insured the thrifts' deposits. To cover part of the losses, collateral taken over when borrowers couldn't repay their loans was sold for whatever bidders would pay.
In a September 17 op-ed article in the Wall Street Journal, former Federal Reserve chairman Paul A Volcker, former Treasury secretary Nicholas F Brady and former Comptroller of the Currency Eugene A Ludwig argued for just such a rescue.
"The financial system is clogged with enormous amounts of toxic real estate paper that will not repay according to its terms,'' they said.
"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.''
The trio also endorsed the notion of direct help to beleaguered homeowners. "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,'' they wrote.
That's a really bad idea, given the urgency of the situation. There's no time to create a bureaucracy to deal with millions of mortgages at thousands of institutions.
Some politicians, including Frank, said they will seek to expand the programme in that fashion. Attempts to add such a provision might hold up passage of the legislation.
No one likes bailouts. Unfortunately, it looks like there's no other choice, as costly and as messy as it's likely to be.
John M Berry is a Bloomberg News columnist. The opinions expressed are his own.