Saturday, September 13, 2008

Take this weekend off, Hank

By John Gapper

Published: September 10 2008 19:15 | Last updated: September 10 2008 19:15

Ingram Pinn illustration

I do not know what plans Hank Paulson, the US Treasury secretary, has for the weekend. Bird-watching, perhaps. Whatever they are, may I suggest that he sticks to them?

Mr Paulson is a keen ornithologist but he is also an energetic intervener in financial markets and, when he has worked on weekends recently, the US taxpayer has paid dearly.

In March, it was a line of funding to steer Bear Stearns, the investment bank, into the hands ofJPMorgan Chase. On Sunday, it was the bail-out of Fannie Mae and Freddie Mac, the quasi-public mortgage lenders, which could cost the US government $200bn (€143bn, £114bn) or more.

It is only Thursday and, already, others seem to be preparing to interrupt his days of rest again.

The first is Lehman Brothers, whose shares fell sharply after the failure of its talks with Korea Development Bank aimed at gaining a capital injection to offset its mortgage-related losses. It disclosed on Wednesday a $3.9bn loss and plans to sell a stake in its fund management arm.

Then there are the US regional banks that hold preferred shares in Fannie and Freddie, which Mr Paulson caused to plunge in value. They face their own financial crises and Tony James, president of Blackstone, the private equity group, this week predicted “massive defaults”.

Apart from banks, there are the Detroit carmakers, which have persuaded Congress to give them $25bn in soft loans. That is far more than the 1980 Chrysler bail-out but they want to double the hand-out, and both presidential candidates, Barack Obama and John McCain, have meekly fallen in line.

In an election year, neither party dares to place fiscal discipline above politics and the urge to placate US voters and foreign investors.

The US government has talked tough about moral hazard and its not wanting to bail out failed institutions but has been a soft touch. Eventually, someone must say “no” to the line of those angling to pile their own losses on to the budget deficit, which could reach $440bn next year. Mr Paulson, who headed Goldman Sachs before what Mr James called “the meltdown years”, needs to be that man.

It was not exactly comforting that credit ratings agencies had to declare to investors that the Fannie and Freddie bail-out would not affect the country’s triple-A sovereign rating. When people are assured that nothing is wrong, it makes them wonder. The rating has supported the dollar’s reserve currency status for most of the past century. Yet, on Tuesday, the cost of insuring Treasury bonds against a US government default spiked to a record level.

It is true that the Fannie and Freddie intervention does not, in itself, pose grave financial risks to the US. Standard & Poor’s estimates the worst case loss at $325bn, or 2.5 per cent of US gross domestic product, less than a third of the bill for Japan’s banking crisis in the 1990s. “It is one of the largest financial interventions not only in US history but in any country’s history. But the cost to the government is manageable,” says John Chambers, an S&P analyst.

The bigger problem is the precedent that it, once again, sets. Mr Paulson emphasised on Sunday that Fannie and Freddie were “unique” bodies that deserved special treatment. One analyst describes this as a “dog whistle” to Lehman not to expect capital from Capitol Hill.

If it was a signal, then good, and I trust Mr Paulson will stick to his warning. Lehman, like other big investment banks, can get short-term funding from the Federal Reserve if all else fails, a guarantee put in place after Bear Stearns’ takeover.

That should prevent a run on the bank and it is the only money the Fed or the Treasury should offer. Mr Paulson or Tim Geithner, president of the New York Fed, can put pressure on banks or investors with deep pockets to give Lehman capital but must not do so themselves.

The reality is that Lehman, like General Motors and Ford, got itself into this mess and ought to address it itself. Dick Fuld, Lehman’s prickly and obstinate chairman and chief executive, has turned down offers valuing it at less than book value. His pride has led to Lehman’s fall.

Similarly, no one forced US regional banks to invest in Fannie and Freddie preferred shares. It should have occurred to them that their dividends were high because of the risk of losing their money if the two entities got into trouble. I thought bankers knew that kind of thing.

In normal times, no one would entertain the notion that such supposedly sophisticated financial institutions should get a handout from the taxpayers. But these are not normal times and Mr Paulson’s fear of allowing financial chaos has pushed him on to the defensive.

It is time to push back. The Fed and the government had to stand behind Bear Stearns and prevent a run on the dollar by making good the promises that Fannie and Freddie issued to foreign investors. But there is a cost to playing with the government’s balance sheet.

It sounds outlandish that the US could lose its triple-A status, which it has held since before Standard merged with Poor’s in 1941. But stuff happens. A full-blown recession and bail-out of the banking system would put public finances under severe strain.

Japan lost triple-A status for a time, as did Denmark, Finland and Sweden during the Scandinavian banking crisis. Mr Paulson has tried to keep the dollar strong and confidence intact but endless intervention will have the opposite effect.

If he takes the weekend off and allows events to unfold, it will show that Fannie and Freddie were indeed unique and that the government has not lost its nerve. Inaction speaks louder than words.

john.gapper@ft.com

More columns at www.ft.com/johngapper

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