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How to Spend That $700 Billion; Paulson and Bernanke Would Do Better to Put Capital Directly Into the Banks

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
September 26, 2008
Washington Post

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Even if congressional leaders can close a deal on the bank rescue, the real debate is just beginning. The key questions about the plan are not the ones that Congress debated: how much it would cost and whether it would impose symbolic pay caps for bosses whose wealth has already been hammered. Rather, the key question lies in the execution of the bailout.

Start with the sobering fact that even a $700 billion rescue fund would be small relative to financial markets. Private lenders (not counting Fannie Mae and Freddie Mac) own $6.5 trillion of mortgage-related loans plus $2.5 trillion in consumer loans and yet more trillions in corporate loans. By themselves, federally insured deposit-taking banks hold loans totaling $14 trillion.

Given these astronomical numbers, the government's plan will fare best if markets respond favorably to it. The bailout is often seen as a commando operation, in which you take out the bad-loan enemy and imprison him in a government vault. But it is also a hearts-and-minds operation, in which you persuade wary financiers whose territory you have invaded to trust you and work with you.

The key question is whether Treasury purchases of bad loans will encourage hedge funds and other investors to dive in themselves. If the government starts a buying trend, its plan will work brilliantly. If it triggers a selling reaction, those trillions of dollars in private hands could swamp its efforts.

How can the Treasury encourage private players to back up its purchases?

 

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