Massive Bailout Planned For Banks

Image: James Victore

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Since the onset of the subprime crisis last summer, the White House has repeatedly rejected the notion of a government bailout, either for homeowners facing foreclosure or for the banks and mortgage companies that made the now souring loans. "There's no bailout with government money, none whatsoever," Treasury Secretary Hank Paulson emphasized. But even as the administration has stuck to its laissez-faire stance in public, behind the scenes a covert bailout has been under way, with a number of public and quasi-public agencies quietly dispensing vast sums to financial institutions saddled with worthless or near worthless mortgage securities. All the while, homeowners at the heart of the problem have been left largely to their own woes. The rescue operation brings to mind John Kenneth Galbraith's dictum that in the United States, the only respectable form of socialism is socialism for the rich. (Read about some former government bailouts.)

Let's start with the Federal Reserve. In addition to bringing down the federal funds rate from 5.25 percent last August to 3 percent—including a dramatic three-quarter-point cut one day in late January—the central bank recently introduced a new auction process that makes it easier (and cheaper) for cash-strapped financial institutions to borrow from the government. Through four auctions in December and January, the Fed lent dozens of financial firms $100 billion at rates well below the discount rate, the rate at which distressed lenders formerly had to borrow. Crucially, the Fed also expanded the range of collateral it accepts to include triple-A-rated asset-backed securities, the same toxic paper that institutions like Citigroup and Merrill Lynch have been unable to sell or even value because the market for it has dried up. In effect, the Fed has been acting as a benevolent pawnbroker, extending cash for illiquid goods and charging low interest rates.

Then there is the Federal Home Loan Bank system, an obscure institution that President Herbert Hoover set up in 1932 to stimulate mortgage lending. The F.H.L.B., actually 12 government-chartered but privately owned regional banks, exploits its semiofficial status to raise money cheaply in the bond market and lends the proceeds to its membership, including most of the nation's big banks and investment firms. Since last summer, the F.H.L.B. has been extending low-cost credit at an unprecedented rate—$184 billion in the third quarter alone. Recipients include Citigroup, which owed the F.H.L.B. $98.7 billion at the end of September; Countrywide Financial, which owed $51.1 billion; and Washington Mutual, owing $43.7 billion.

Finally, there are Fannie Mae and Freddie Mac, which are also government-chartered but privately owned institutions. Fannie and Freddie do two things: They encourage other lenders to issue home loans to low- and middle-income families, and they raise money in the bond market to buy mortgage-backed securities. Despite losing money during the third quarter of 2007, the two mortgage giants stepped up their issuing and buying, often in tandem with the very Wall Street players that are now suffering. In fact, while many companies were drastically downsizing their mortgage divisions, Fannie and Freddie still did great business.

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