Bank rescue plan to test capitalism

The government's plan to take stakes in financial institutions could backfire, some analysts say. Proponents say it's an efficient solution.

By Michael A. Hiltzik and Ken Bensinger

Los Angeles Times

October 12, 2008

http://www.latimes.com/business/la-fi-capitalism12-2008oct12,0,402445.story

Are we witnessing the erosion of capitalism, or its salvation?

That question is swirling around the federal government's latest proposed intervention in the private financial markets since Treasury Secretary Henry M. Paulson announced Friday a plan to take equity stakes in banks as a quick and efficient way to pump them with new capital.

Combined with the government's takeover last month of the mortgage companies Fannie Mae and Freddie Mac and its huge ownership stake in the crippled insurance company American International Group, the bank plan represents perhaps the largest federal intervention in private enterprise since President Truman's attempt to nationalize the steel industry to avert a strike in 1952 -- a move blocked by the Supreme Court.

The idea of taking direct stakes in financial institutions was adopted last week by Britain, which will in effect partly nationalize banks with as much as $87 billion in capital infusions and an additional $350 billion available for short-term loans. Some of the country's biggest banks have signed up, including Barclays and the Royal Bank of Scotland.

The Italian government has also authorized a recapitalization package to be enacted if the need arises. Germany, with Europe's biggest economy, has resisted such plans, but there were reports Saturday that Chancellor Angela Merkel might unveil a recapitalization plan as early as today.

A consensus seemed to be emerging among leaders of the world's top economies meeting Saturday in Washington that whatever economic or political differences existed among them, all countries must act aggressively and in concert in guaranteeing deposits in their banks and pumping government capital into faltering institutions to help ease the global crisis.

A stubborn seize-up of bank lending to businesses, individuals and each other has sharply heightened the prospects of a deep and lengthy recession in the U.S. and abroad.

The fact that devoted supporters of laissez-faire economics are falling in line to bless the aggressive foray into free enterprise by the U.S. government is a sign of the seriousness of the crisis.

"I'm against the government owning anything . . . ," Stanford University finance professor Jonathan Berk said. "That said, buying an equity stake may be the cheapest way" to achieve a banking recovery.

But others believe that scrapping free-market principles in a crisis atmosphere may doom the banking industry to a future of inefficiency.

"It's a move in the wrong direction, both economically and ideologically," said Casey B. Mulligan, a conservative economist at the University of Chicago who believes that predictions of an economic meltdown are overblown. "Government enterprises don't do well, because public management doesn't pay attention to the bottom line."

Paulson said the Treasury's investments would be in nonvoting stock, an important concession to conservatives and others who might be uneasy about giving government officials more direct sway over management of private institutions.

Whether the Treasury will stay out of management decisions -- or even whether it should leave the institutions in the hands of the executives who turned them into beggars for a federal lifeline -- is one of the greatest uncertainties of the program.

"I've got big reservations about the government deciding which banks need help and how they should be administered," said Bert Ely, an Alexandria, Va.-based banking consultant. "We haven't heard about the strings tied to this program. This is not going to be free capital."

Proponents contend that the new plan is sure to be a more efficient and cheaper solution to the banks' ills than the main proposal of the economic rescue package passed by Congress less than two weeks ago. That arrangement granted Treasury's request to spend as much as $700 billion to take soured assets, especially mortgages and mortgage-backed securities, off the banks' hands.

A little-noticed provision of that plan authorized direct investments in financial institutions of the sort Paulson now plans to pursue. As the rescue unfolds, the pace of the new program may well outstrip that of the original asset-purchase approach. Paulson said the government could begin these equity purchases within weeks; the mortgage securities acquisitions might not begin for a month or more.

Details of the government's bank intervention are unclear. But the Treasury may try to link its investments with parallel capital infusions by private investors, offering to contribute a stake equal to the private capital a bank raises on its own.

In a fundamental way, the Treasury plan contradicts two centuries of American economic orthodoxy. Americans have always been wary of giving the government a direct role in the banking sector. These concerns date to the first Treasury secretary, Alexander Hamilton, who founded the nation's central bank, the Bank of the United States, in 1791, but ensured that the government would be a minority stakeholder by contributing only one-fifth of its $10 million in capital.

As president, Andrew Jackson, who yielded to no one in his suspicion of bankers, essentially abolished the bank's successor in 1832. The U.S. went without any central bank until 1913, when Congress established the Federal Reserve System. The new institution, however, was a regulatory weakling, rendering it all but powerless to address the Great Depression. It was a complete overhaul during the New Deal that gave the Fed the almost unlimited monetary and regulatory authority it has been aggressively deploying in the current crisis.

By then the perils of a loss of confidence in the banking system had become all too clear. The most vivid example was the failure of another Bank of the U.S., this one a small Depression-era institution with a grandiose name that served mostly Jewish merchants in Lower Manhattan. When J.P. Morgan rebuffed regulators' pleas for a rescue, it collapsed, shattering trust in the nation's banks. The loss of faith helped trigger the Depression.

Similarly, a determination to instill confidence in banks so that they will keep credit flowing underlies the Treasury's extraordinary new steps.

"Nobody . . . believes in the rule of the 'free market' in a financial crisis," UC Berkeley economics professor J. Bradford DeLong wrote on his blog Friday.

DeLong points to the example of Sweden, which nationalized its banks during its financial crisis in 1992. After the government disposed of their troubled assets, it refloated them as public companies.

The Treasury's plan does not look quite as drastic as Sweden's. Instead, it is designed to conform more to the traditional American aversion to outright ownership. To many economists and business experts, the key is the nonvoting nature of the equity that Paulson proposes to acquire.

"It's not nationalizing the banks," said Peter Morici, a business professor at the University of Maryland and former chief economist for the U.S. International Trade Commission. "It would only be nationalizing the banks if we bought warrants, converted them into common stock and started voting the shares."

James Barth, senior fellow at the Milken Institute and former chief economist at the Office of Thrift Supervision, contended that the government should take further steps to remain a silent partner in any investment.

"There's no need for the government to change a company's directors or vote on anything," he said, "because you have a great backstop: prompt corrective action with federal regulators taking control should things get too bad."

Clearly, economic ideologies have taken a back seat to calls for quick action.

"Many countries have nationalized their banking systems over the years, then reprivatized them and become very strong," said Lawrence E. Harris, a finance professor at USC and former chief economist at the Securities and Exchange Commission. "The government will undoubtedly want to get out of the business as quickly as it can. This is certainly not the end of capitalism. Extraordinary problems require extraordinary solutions."