Left Flank

The White House is now the legislator of last resort for Republican members of Congress too scared to face the consequences of their votes, in this episode, the auto bailout. It's a shame. Even with their Toyota and Hyundai keepers, I would have at least supported them as a serviceable route supporting others' more principled vote for bankruptcy.

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I generally agree about the experience argument. But, as for Lawrence Summers, Treasury is a high-profile appointment even more scrutinized because of the global financial crisis. Summers has demonstrated a talent for notoriety and he, and Tim Geithner, did not perform well during the 1997 Asian currency crisis and during the 1998 Russian crisis. Humility might be an asset, but not in such quantity.

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Oddly, instead of prepping myself for a dive off my roof, I'm taking cathartic relief from a consensus among smart talking heads and pundits, that humility is coursing through the media like a vaccination. No one knows if there is any precedent for this financial market crunch, and if so - or more likely, if not - what do we do? The big guy prayer - calling on the «leaders» to save us - took a swan dive now that consensus has it that allowing Lehman Brothers to tank was a bad plan.

That's because now - and blogging is a form of archiving - the plan is recapitalization.

American officials unveiled a three-part rescue programme on Tuesday October 14th. Under the first part, the Treasury will inject as much as $250 billion into American banks, with roughly half initially going to nine big institutions. The capital would come in the form of non-voting preferred stock. Under the second part, the Federal Deposit Insurance Corporation (FDIC) would guarantee unsecured borrowing by banks for maturities of up to three-and-a-half years, at a relatively modest cost of 75 basis points. That would include interbank loans. Under the third part, the FDIC would guarantee without limit small-business bank deposits that do not pay interest. Also on Tuesday the Federal Reserve gave more details of its previously-announced commercial paper backstop programme, which should ease borrowing for big nonbanks, such as GE Capital.

The plan is undoubtedly bold: it marks perhaps the largest foray by the American government into ownership of private enterprise since the second world war. But it would have looked much bolder a month ago. As it is, America has only caught up to where Germany, France and especially Britain (in that case, last week) had already reached. To a great extent, Hank Paulson, the treasury secretary and Ben Bernanke, the Federal Reserve chairman, are making up for what were, in retrospect, miscalculations in their earlier efforts.

The early evidence is reassuring. The historic stockmarket rally on Monday, though it petered out on Tuesday, will impress the retail audience of small investors and politicians. But the more important verdict is from the wholesale audience in the credit markets, which has been encouraging. Borrowing costs for big financial institutions plunged on Tuesday, as measured by credit-default swap spreads. Libor, the rate at which banks lend to each other, also dropped, although it remains stratospheric. «This is definitely the end as far as the systemic aspect to the credit system goes,» said Gregory Peters, head of fixed income at Morgan Stanley.

Even if true, that will not alleviate the downward pressure on the economy. Bank lending is still constrained by a lack of balance-sheet capacity: banks have been forced to boost loans to companies that are shut out of the commercial-paper market while setting aside more capital for future loan losses.

The new capital injections should help. In theory $250 billion of new capital leveraged by ten-to-one could support $2.5 trillion of assets in banking system, serious money when total loans to non-financial corporations, households and state and local governments in America stood at $27 trillion on June 30th. But it is unlikely to spur a big expansion in new loans. Much of the credit restraint comes from nonbanks such as the captive finance-arms of carmakers. Moreover, fewer householders can meet the stricter underwriting standards that now prevail because they have lost the equity in their home, or their jobs. «The combination of declining wealth and a sharp tightening of credit availability is likely to induce a substantial recession in consumer spending,» said Peter Hooper and Thomas Mayer of Deutsche Bank on Tuesday. They project zero growth for America in 2009 and outright contraction for every other G7 country apart from Canada.

The programme should overcome the errors that, with hindsight, hampered earlier efforts to tackle the crisis. The most prominent was the decision to let Lehman Brothers fail. That sparked a run on money-market funds which held Lehman paper, and forced deleveraging by customers and counterparties who had trading positions with Lehman. It dramatically raised in investors' minds the odds that other big banks could also fail, and those fears risked becoming self-fulfilling as their stock prices plunged, credit spreads exploded and lenders and depositors fled. The bank-loan guarantee and expanded deposit-insurance limits should eliminate that risk.

The authorities' second mistake was to treat the crisis as one principally of liquidity rather than solvency and thus to focus on solutions that did not directly rebuild capital in banks. The focus was understandable: in aggregate American banks are well capitalised and it is not clear how many would have voluntarily accepted public injections of equity. Fed officials had discussed ways the government could inject preferred equity into banks that also issued common stock as far back as June. But Mr Paulson worried that Congress would say no and in the process alarm markets more, according to some officials. A person close to the Treasury says that Mr Paulson and Mr Bernanke were in agreement on how to proceed. In any event, Mr Paulson made sure the bail-out law impliclity allowed such injections. But not until the law passed and panic ensued did he conclude it was necessary, and Britain's dramatic recapitalisation plan last week all but forced his hand.

Thirdly, the plan marks a move away from ad hoc interventions towards a comprehensive solution. In contrast to earlier rescues for AIG, Bear Stearns, Fannie Mae and Freddie Mac, the recapitalisations announced on Tuesday are designed to encourage new private capital infusions, rather than punish shareholders. Under the terms announced on Tuesday, the Treasury will receive preferred stock on the same terms as other preferred shareholders and warrants for common stock equal to 15% of the preferred stock, convertible at the trailing 20-day average stock price when the preferred stock is issued. The preferred stock will pay a 5% dividend for the first five years, and 9% thereafter. Those are hardly onerous: they are less than the 10% yield Morgan Stanley will pay Mitsubishi UFJ Financial Group and that Goldman Sachs will pay Warren Buffett for their preferred-stock investments. The banks can buy back the Treasury's stake after three years, sooner if they issue sufficient stock of their own.

Yet, even for all its customary optimism, The Economist is not immune to the bogeyman.

Aggressive as these actions are, they may not be the last. As the world falls into recession, loan losses will mount and banks may need yet more capital. Some emerging markets may be on the brink of another crisis on the scale of 1997-98. After 14 months, the defining characteristic of this financial crisis has been its tendency to change shape and return in ever more virulent form. But if the corner really has been turned, then attention in America will turn to the consequences of the bail-out, in particular: how will future administrations handle the responsibilities and temptations that come with being a big financial stakeholder?

Comparing the Japanese debacle in the 90s with the 2007-8 mutation, Joshua Kurlantzick rains further on the recapitalization prayer.

Koizumi's strategies were actually based on lessons learned after America's savings and loan crisis, when nearly half of the country's S&Ls went out of business and the rest were forced to adapt their business models. «A central lesson to remember from the U.S. [S&L] experience is that ... in the end, the principal use of public funds was to put institutions out of business,» notes economist Benjamin Friedman in a study comparing the S&L crisis to Japan in the '90s. Today, public funds are being used to do the opposite--to keep companies in business regardless of whether they change their practices, meaning that, as in Japan, the government might have to intervene again in a few years. Japan was able to afford repeated infusions of state cash in part because it was an export powerhouse. But, in the United States, which already boasts $10 trillion in public debt and regular trade deficits, another round of bailouts would be truly catastrophic. It could doom the entire U.S. economy throughout the next president's term. A «lost decade,» you might say.

Finally, Megan McArdle and Dan Drezner agree to remain skeptical and embrace their utter dearth of fortune-telling skills.

So, is there clear answer? Yes, according to Michael E. Lewitt, the dismal science is our savior.

...the stock market has the patience of a flea. The government's Herculean intervention into the markets will do what they are supposed to do--lead U.S. banks to start making loans again and reignite economic growth. But U.S. stock markets continue to be driven by «hot money»--failing to see money market rates plunge immediately, they conclude that these key lending rates won't drop at all. This is short-sighted and self-defeating. The government's actions will take some time to work, but they will work. The laws of economics were not repealed on the upside--that is why the markets crashed. But these laws were also not repealed on the downside, which is why these radical steps will work sooner rather than later.

Do less, but be firm and forceful when you do DO it? I'm very glad now I studied more political science than economics: it's axiomatic that the worst will happen, not, as the dismal science has it, that we can approach perfect equilibrium. At least I didn't waste my tuition money.

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Hank Greenberg, AIG's former and controversial Chairman and CEO, disagrees with the US Treasury Department's decision - as well as AIG's current leadership - for the Feds to rescue AIG and end its independence. The Economist explains why Greenberg might just be right, and what he doesn't know that might prove him wrong.

AIG posed a systemic risk because of its investment bank, tucked away behind the dull business of writing insurance contracts, which has lost it both a fortune—and now its independence.

At one stage, this unit contributed over a quarter of profits. It has played the role of schmuck in one of finance's most dangerous games by writing credit-default swaps (CDSs), a type of guarantee against default, with a giant notional exposure of $441 billion as of June. Of this, $58 billion is exposed to subprime securities which have already generated huge mark-to-market losses. For regulators, the real horror story may be the $307 billion of contracts written on instruments owned by banks in America and Europe and designed to guarantee the banks' asset quality, thereby helping their regulatory capital levels.

How much pain taxpayers will ultimately bear is an open question. The official line is that AIG only suffered a liquidity crisis. As subprime losses mounted, it had to put up more collateral with its counterparties, in turn prompting credit-rating downgrades, which in turn triggered more margin calls. It is probable that operating cashflow was drying up too as big risk-sensitive commercial customers stopped doing business with the insurer. On September 16th the Federal Reserve extended a two-year, $85 billion credit facility at a penal rate. The government will get a 79.9% stake in the company in return. The idea is that this buys time for AIG to improve its liquidity in an orderly way. The bail-out's structure should also avoid a technical bankruptcy, which could force the unwinding of many of those CDS contracts.

Yet might the government be taking over a company that is insolvent as well as illiquid? Extrapolating from AIG's own test, but adjusting fully for mark-to-market losses and stripping out goodwill and hybrid capital, even at the end of June AIG might have had about $24 billion less book equity than it needed to be safely capitalised. And some of its equity may be «trapped» within its insurance subsidiaries, whose capital positions are ringfenced by insurance regulators. That might leave the holding company that taxpayers have backed in a far worse state. On September 17th Eric Dinallo, New York's insurance regulator, vouched for the solvency of AIG's insurance subsidiaries but was more circumspect on the company overall.

Ultimately, though, AIG may turn out be worth something after all: in June it had $67 billion of tangible equity, a much bigger buffer relative to assets than existed at Lehman or Bear Stearns. And, says Andrew Rear of Oliver Wyman, a consultancy, AIG's insurance assets will attract a lot of interest. That raises the chances of their being sold at a premium, raising cash for the holding company. If the government holds on long enough, perhaps even AIG's CDS contracts might make money.

Also, if you're wondering about Hank Greenberg's career, and his relationships with the Chinese sovereign-wealth funds he suggests could have helped to rescue AIG's core of insurance companies, start with Richard Komaiko's and China Stewart's biographical sketch. From that angle, is it plausible to assume that the US Treasury Secretary, Henry Paulson, might not have been looking at AIG when he considered a takeover, but rather at the prospect of sovereign wealth funds covering the cracks in AIG's liquidity? Paulson and Greenberg represent the two poles of business leadership, nationalistic and market. As with oil companies, AIG's downfall has solidified a nationalistic center among Democrats, like Senators Chuck Schumer and Chris Dodd, and Republicans, like Paulson.

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