Massive Bailout Planned For Banks

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Such an initiative has historical precedents, and it wouldn't necessarily break the federal budget. In 1933, President Franklin D. Roosevelt founded the Home Owners' Loan Corp., which refinanced about a million troubled mortgages during the Depression. In 1989, Congress set up the Resolution Trust Corp. to take over more than 700 bankrupt savings and loans. Some experts predicted that the R.T.C. would end up spending $100 million or more, but by holding on to some of the S&Ls' assets until the economy and property values rebounded, it was able to keep its net spending to $87.9 billion. Adding in other expenses, such as those incurred by the R.T.C.'s predecessor, the Federal Savings and Loan Insurance Corp., the total cost to taxpayers of resolving the S&L crisis was $132 billion—in today's money, about $180 billion.

At this stage, the subprime crisis is still smaller than the S&L debacle: About 150 mortgage companies have been sold or gone under. Benn Steil, an economist at the Council on Foreign Relations, and Mark Fisch, a managing partner at Continental Properties, guesstimate that an R.T.C.-style subprime rescue could cost up to $75 billion. As part of the $3 trillion federal budget, this would be a perfectly manageable sum. There isn't much political support for such a dramatic move, however, so Wall Street is hobbling along on a combination of gradual write-offs and capital injections from foreign governments.

But one big financial collapse or near-collapse could change the climate overnight. How likely is such a catastrophe? Consider Merrill Lynch, one of the worst offenders in the subprime mess but an instructive example nonetheless. Last summer, before the credit crunch began, Merrill had total assets of roughly $1.1 trillion perched on top of equity capital of roughly $40 billion. With a leverage ratio of 25.3, it was in a situation where a mere 4 percent fall in the value of its assets would wipe out all of its capital. Such thinly capitalized financial firms are at the mercy of their lenders. If a crisis of confidence develops, funding can dry up and the firms can unravel with stunning rapidity.

Fortunately for Merrill, the full scale of its exposure to the subprime problem emerged gradually, and so far it has been able to secure fresh capital and stabilize its finances. The next casualty might not be so lucky. Much depends on the degree to which credit problems extend from subprime to other areas in which securitization was popular, such as home-equity loans, commercial real estate, corporate loans, credit-card receivables, and auto loans. If these sectors deteriorate—and recent reports from American Express, Citigroup, and other firms indicate some disturbing trends—more big financial firms will find themselves with holes in their balance sheets, and persuading others to bail the firms out may be difficult. (Presumably, even the governments of Dubai and Abu Dhabi have limits on their largesse.)

Since letting a major bank or Wall Street firm fail in the current environment could easily lead to contagion, the federal government would have little option but to launch a formal rescue. This is what happened in May 1984 when Continental Illinois, which was stuffed full of bad loans that had been extended to the oil patch, found itself shut out of its usual funding markets. The Federal Deposit Insurance Corp. injected $4.5 billion into Continental, removed the senior management, and took an equity stake of 80 percent. The bank continued to do business, albeit in a scaled-back manner; eventually it was sold to Bank of America.

GaveKal, a Hong Kong economics consultancy, says that this financial crisis, like those that preceded it, began with government at arm's length. But as in past rescues, that government resistance eventually begins to soften. "In each of these cases, the interventions were undertaken by doctrinaire free-market governments—and in each case, they worked," GaveKal's report states. Evidently, in order to save capitalism, it is sometimes necessary to administer a stiff dose of socialism.

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