Too Big to Bail Thomas Ferguson and Robert Johnson, TOO BIG TO BAIL: THE “PAULSON PUT,” PRESIDENTIAL POLITICS, AND THE GLOBAL FINACIAL MELTDOWWN. PART II: FATAL REVERSAL – SINGLE PAYER AND BACK By: Kyli Letang

Showdown Bailout: Freddie and Fannie Representative Barney Frank, Chair of the House Financial Services Committee, talked up a plan to let bankruptcy judges modify mortgages. Democrats settled on a plan for mortgage relief originally promoted by Credit Suisse, Bank of America, and other financial institutions. The plan did not include the bankruptcy language. They also embraced a proposal supported by the Mortgage Bankers Association that expanded the size of the mortgagees the two GSEs could purchase. – This jumbo provision aided primarily affluent neighborhoods. Both choices limited mortgage relief because few banks saw any reason to make concessions.

Once foreign central banks began buying large amounts of their bonds, Fannie and Freddie evolved into American originals: semipublic institutions to big and complicated to fail without international ramifications. Fannie Mae had to serve the public interest and also make profits, not because of any ‘‘duel mandate,” but because the top management would then become fabulously rich and share the wealth with friendly members of congress and allied community groups. Bush and Greenspan concluded that the game of reforming the GSEs was not worth playing. With mortgagee market booming, they left House Republican leader Michael Oxley of Ohio in the lurch after he had promised reforms at their urgings. Critics continued to complain that the firms were undercapitalized, taking on too much debt, and were extravagantly rewarding top managers while lining the pockets of politicians and lobbyists.

The End of the Showdown Bailout Abandonment of Paulson’s superfund proposal left the toxic waste in place, with more showing up every day. The announcement by the Fed on March 11, 2008, of another special facility, the $40 billion Term Securities Lending Facilities, was widely taken by markets as a signal that the Fed suspected one or more large investment banks were in trouble. Primary mortgage market would soon lock up, bringing housing sales across the United States to a screeching halt. Housing prices, already falling like a runaway elevator, would go into a steeper tailspin, pulling national income and the dollar down with it.

Republicans went ballistic, with the combination of the big bailouts for two more giant financial institutions and even modest government help for ordinary Americans with bad mortgages was too much The bailout became inevitable when central banks in Asia and Russia began to curtail their purchases of the GSEs’ debt, pushing up mortgage rates and deepening the economic downturn. At a stroke, the federal government was in charge of financial intuitions with gross holding of securities equivalent to 40 percent of the gross domestic product.

Fatal Reversal The venerable investment banking firm of Lehman Brothers was on the edge of bankruptcy. In the end, Paulson and Bernanke decided to do what free markets conservative had been demanding since the beginning of the crisis: let a giant financial institution fail. They thereby turned a desperate situation into a world disaster of historic proportions.

The Put is dead; long live the Put Suddenly unable to refinance by issuing commercial paper, banks became fearful both for themselves and their counterparties. They frantically hoarded reserves at central banks instead of lending them out. In the five days after Lehman collapsed, bank reserves held at the Fed more than doubled while bank borrowing from the Fed surged. Merrill Lynch consented to a shot gun wedding with Bank of America just hours before Lehman became history.

In the meantime, a wave of bankruptcies and defensive mergers rippled through the commercial banking system. The message seemed clear; neither bank debt nor preferred stock in financial institutions was safe. At the time when no one else in the market was getting a hundred cents on the dollar, fortunate financial corporations were having their credit default swaps paid off at par by the people of the United States. Short sellers were still having a field day with Goldman and Morgan Stanly, while Citigroup was turning into the incredible hulk.

Then the government sweeps all the toxic waste into a “bad bank” and gets it out of circulation. The delay arising from the showdown bailout was fatal: there was way too much junk out there. After the Lehman bankruptcy, all TARP’s $700 billion could buy was relief for a few lucky financial houses, not a serious bailout for the U.S. banking system

Path to Disaster That even if TARP worked perfectly, it could at best only unclog the arteries of the financial system, but getting blood flowing through the patient’s arteries again would not make her healthy; it would just keep her form dying. The TARP, in short, was a failure that taxpayers were in effect financing bonuses for the people who had created the mess. Treasury also issued a ruling giving massive tax breaks to banks perhaps as much as $140 billion worth.

The FDIC also guaranteed new bank debt, allowing banks to raise funds when almost no one else could. The Fed cut rates to virtually zero and proliferated special facilities for lending. It lent directly to large corporations. The Fed no longer was supporting private financial markets. It was extensively replacing them.