What is Paulson's Plan B?

It looks as if ungumming world credit markets is going to take more than the US Treasury Secretary's $700bn bailout. Stephen Foley looks at the options
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The Independent Online

Monday, 29 September, the US financial bail-out is rejected by the House of Representatives and the stock market plunges. A week later, after the Bill has passed, the stock market plunges again. What's to conclude from these apparently inconsistent responses?

The answer is that the so-called Paulson Plan – the bailout's central idea, as set out by US Treasury Secretary, Hank Paulson, for the government to buy the toxic mortgage assets that have gummed up bank balance sheets – is necessary, but not sufficient to restore order to the credit markets.

Such is the contagion that there are now numerous problems afflicting the credit markets, all threatening to quickly cause very serious problems for companies in the real economy. It has required a blizzard of creative thinking on the part of policymakers at the Treasury and the Federal Reserve, and traders and economists are not shy of making suggestions either.

Buying commercial paper

Commercial paper is a kind of corporate IOU and the market is a lifeline for many American companies who use it to fund their short-term cash needs, often using it to cover wages and to pay suppliers. The market has been shrinking because of problems at money market funds (which are normally the biggest buyers of commercial paper) and because of concern that many financial companies could default on their IOUs.

In a dramatic move yesterday, the Fed said it would start purchasing commercial paper directly, signing an open-ended commitment that it hopes will restore confidence. It is dramatic for the Fed, because it means it is offering unsecured loans for the first time, where normally it requires collateral. It is dramatic for the economy, too, since it means the Fed is now a lender of last resort to companies far beyond the banking industry that it regulates.

"Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper," the Fed said. "An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households."

Equity investment in distressed banks

As the Paulson Plan hung in the balance in Congress, a cadre of economists put forward an alternative suggestion, namely that instead of buying dodgy mortgage assets from banks, the government should recapitalise the banks directly, handing them cash in return for shares (or warrants). The simplicity of the plan attracted many politicians, who also noted that it gives American taxpayers something concrete for their money. Although Mr Paulson was not especially keen – how does one decide which banks to recapitalise, and by how much, and do we really want the government owning the banks anyway? – the Bill that was passed last week does give the Treasury the power to pursue this option if it wants.

George Soros, the billionaire financier, is among those most vociferously arguing for this plan. Under this alternative, the government "stabilises weakened banks and profits from the economy's eventual improvement," Mr Soros has argued. "The capital infusion approach will cost taxpayers less in future years, and may even make money for them."

In addition, Mr Soros and others have argued, private investors are likely to follow the government and invest in banks on similar terms, finally recapitalising a sector that has lost so much money it can no longer safely lend the quantities of credit on which the economy relies.

More short-term lending

Since the very beginning of the credit crisis in August 2007, the Fed has progressively increased the size and loosened the conditions of its activities as lender of last resort. It has invented numerous new ways to flood the financial system with extra liquidity, in the hope that banks will pass on the money in new lending to each other and – ultimately – to businesses. It has been an uphill battle, requiring ever larger actions. It has invented new auction processes for issuing loans, from overnight loans to three-month loans and everything in between. Meanwhile, it has widened the types of collateral it will take in return, from its original rule of taking only highly rated credit instruments a year ago, to a dizzying array of collateral now that includes mortgage-backed securities and even equities.

At the start of this week, the Fed scaled up three of its forthcoming auctions, promising to inject a total of $900bn by the end of the year, twice the sum it had previously planned. It has also shuttled tens of billions of dollars to European central banks to help them make similar injections into their markets for banks who sitting on dollar-denominated assets. All these programmes can be expanded indefinitely.

Central counter-party for CDS market

When Lehman Brothers was allowed to fail, the vast but opaque market for credit default swaps went into spasm. CDSs have been one of the most explosively growing areas of the derivatives market in recent years, allowing traders to bet on the creditworthiness of everything from giant corporations to obscure mortgage derivatives. There are now an estimated $60 trillion of these bets outstanding, but there is no real way to tell because they are contracts negotiated privately between banks, and there is no central exchange. Because of that opacity, no bank is confident that their counter-party will be able to pay them what they are owed, and the market has ground to a halt, with knock-on consequences throughout the interconnected banking industry.

There have been growing calls from fund managers, such as Pimco's Bill Gross, for the Fed to step in as a central counter-party for the CDS market, so that traders can be confident of being paid what they are owed, even if the bank at the other end of the trade is in trouble.

In the knowledge that the restoration of confidence is crucial to ungumming this market, the Chicago Mercantile Exchange said yesterday that it would set up a formal exchange for CDSs, in a joint venture with the hedge fund Citadel.

Co-ordinated interest rate cuts

In the aftermath of the terror attacks of 11 September 2001, central banks around the world co-ordinated cuts in interest rates in an attempt to stimulate the economy. Times are such that economists are calling for them to get together and do something similar to head off a global recession now. Any single government cutting interest rates could ease a little of the pressure in their local credit markets, since it can help to mitigate the sudden sharp rises in interest rates that many players in the markets have suffered in recent weeks. Co-ordinated action has the added advantage of sending markets a signal that central bankers believe the crisis is serious and global in nature – something that has become clearer and clearer with the collapse of a series of European banks over the past week.

Talk of joint action was at its peak at the start of this week, and the Bank of Japan, for one, was playing it down yesterday. Opponents say that rate cuts have much less effect on the logjams than more targeted intervention in particular areas of the credit markets, and there is more need for deep cuts in Europe than there is in the United States.

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