In banking crisis, U.S. steps up

Actions this week by federal regulators open a new phase in America's banking crisis – with the government stepping toward its most interventionist financial-market role in nearly 15 years.

The latest moves are intended to restore confidence in Fannie Mae and Freddie Mac, enterprises that play a central role in the home-loan market. Also, the faltering bank IndyMac reopened Monday with a new owner, the Federal Deposit Insurance Corp.

Since the subprime lending problem emerged in earnest a year ago, financial institutions and regulators have scrambled to contain the damage. They have made some progress, but this new phase signals that the private sector probably is not capable of resolving the crisis on its own.

Among the reasons: Some banks are having trouble raising new capital from investors, a key step to maintaining solvency when loan losses are rising. Also, a weak economy is adding to loan defaults that were already high because of imprudent mortgage lending during the housing boom.

"There's no question in my mind that this crisis will be much worse than the S&L [savings and loan] crisis" of the late 1980s in its cost to government, says Kenneth Thomas, a finance expert at the University of Pennsylvania's Wharton School in Philadelphia. Government "will have to play a bigger role."

America and other nations have been down this road before. Banking crises have emerged periodically, often after an era of good times when financial firms lent too freely and inflows of foreign money were large.

In the early 1990s, the government spent about $150 billion to dispose of failed savings-and-loan institutions.

The latest government moves include:

•Treasury Secretary Henry Paulson said Sunday he is seeking congressional approval for the US Treasury to temporarily buy and hold stock in Fannie and Freddie, which operate in the private sector but with government-chartered missions.

•Also on Sunday, the Federal Reserve said it will lend to Fannie Mae and Freddie Mac, should that prove necessary. Separately, Secretary Paulson is seeking approval to expand a Treasury line of credit to the two firms.

•IndyMac, a large mortgage lender, reopened Monday under the control of the Federal Deposit Insurance Corp. The FDIC seized the bank Friday after a run by depositors threatened its survival. The agency plans to operate the bank until it can be sold.

•The FDIC, in a statement related to the IndyMac takeover, sought to clarify the insurance coverage it provides, which covers bank accounts up to $100,000.

In recent months, the Federal Reserve has taken many actions designed to help banks avoid collapse. It has been extending credit through various lending operations – including the unusual step of lending to securities firms as well as traditional banks. It has also reduced short-term interest rates, which reduces banks' borrowing costs.

In March, it provided a $30 billion loan that enabled JPMorgan Chase to buy Bear Stearns when that investment bank was on the verge of bankruptcy.

But the Fed can do only so much, given the scale of losses in the banking industry.

Analysts see the central bank's efforts as a prelude to more involvement by bank regulators in the Treasury Department. The FDIC, for example, has been adding staff to the division that deals with bank failures.

"We're entering a new phase, but it's a new phase of a typical crisis progression," says Joseph Mason, a financial industry consultant affiliated with Louisiana State University in Baton Rouge.

What remains to be seen, he says, is how fast government regulators will ramp up their role.

One role of bank regulators now, given high levels of fear and uncertainty in the financial markets, is to compel better disclosure of where problem assets lie, says Mr. Mason.

"It's a matter of choosing your poison," he says. "Revealing those exposures will have to result in a substantial hit to many banks."

But delay in revealing the extent of the trouble may only make the credit problems longer and deeper – and worse for economic growth. Eventually, in addition to closing failed banks and selling problem loans, what's needed is a "recapitalization" of the industry – by investors or by the US government – so it can return to health.

"We need that [new] capital to restore economic growth," Mason says.

One risk is if people with accounts larger than the $100,000 that are federally insured start pulling money out of banks, further weakening the banks' position.

"Americans have $6.9 trillion in deposit institutions, but only $4.2 trillion of those deposits are insured, according to the latest FDIC year-end statement," economist Ed Yardeni writes in a note to clients.

A crucial issue for the economy is not just the health of banks, but also the ability to keep credit flowing into the troubled housing market. That's why government officials are rushing to ensure that Fannie and Freddie have the liquidity they need.

"Ultimately, we do not view these measures, dramatic as they look, as either a turning point for the US housing market or as a sign that the downturn will be much worse than previously believed," economists at the global investment firm Goldman Sachs wrote Monday. "They simply reaffirm … that the government will do everything it can to avert a meltdown in the conforming [loan] mortgage market."

Still, the magnitude of potential losses on subprime mortgages and other loans is sizable. Some estimates put the total at about $1 trillion.

The Bear Stearns case has raised the question of whether US regulators now consider the largest investment banks – firms that originate securities such as stocks and bonds – to be "too big to fail." That is, the government will bail them out rather than risk a collapse that would ripple through the entire financial system.

Responding to a direct question at a House hearing July 10 about the four largest investment banks, Fed Chairman Ben Bernanke declined to call them too big to fail. But they play a larger role in the financial system than they used to – issuing securities that package mortgage and credit-card loans, for example.

Taxpayer dollars may or may not be needed before the crisis is over. The Fed has been loaning banks money with the expectation of repayment, taking collateral as a backstop. The FDIC's costs are typically covered by deposit-insurance fees – paid in effect by depositors themselves.