Is US response to financial crisis strong enough?

In the history of financial crises, one lesson stands out: It’s important to match the scale of the remedy to the scale of the problem – and to do so quickly.

That doesn’t mean every corporate bailout is a good idea. But what’s needed is a forceful approach, whether the costs fall on investors or taxpayers. Governments that try to cut corners or take a wait-and-see approach often end up making recessions deeper and taxpayer costs higher, say financial historians.

The Obama administration is well aware of that trap, yet many economists see a high risk that the United States will go down that path in 2009.

Some signs that efforts to date haven’t been adequate to the task:

• Insurance giant AIG, now largely government-owned and supported, is expected to report the largest quarterly loss in corporate history Monday – plus a newly restructured bailout that will amount to the third rescue of a company that has already tapped $150 billion in federal funding.

• The Treasury on Friday announced its third rescue in six months of the bank Citigroup, which has received $45 billion in capital infusions plus billions more to insure against losses.

• The overall economy has declined more sharply than economists expected, with gross domestic product shrinking at a 6.2 percent annual pace in the final quarter of 2008.

“As long as they don’t fix the banking system, the economy is going to get worse,” says Pete Kyle, a professor of finance at the University of Maryland. “Death by a thousand cuts is not going to work.”

He notes that the Treasury has just taken its “cut No. 3” at Citigroup, and that it’s possible more rescues will be needed at that company alone.

As the woes of AIG suggest, the financial crisis goes well beyond the borders of the banking industry itself. The Obama administration and the Federal Reserve are working on several fronts to break a downward spiral in which consumer spending, jobs, and the value of financial assets have been declining in tandem. Their programs are designed to restore health to banks, to repair damage to the economy’s nonbank channels of credit, and to stimulate economic activity.

But the costs keep rising, and a key question is whether tax dollars are being used in the most effective way to meet the challenge.

In his new budget for next year, President Obama allocates $750 billion for corporate rescues. That amount is just a best estimate of what the administration may seek after it runs through the second half of the government’s current $700 billion rescue fund.

For policymakers, choosing a course of action hinges on a couple of questions: How bad are the financial-system losses, and who should bear them?

On the first question, uncertainty reigns, but the estimates of losses have been trending up. Where the International Monetary Fund was estimating $1 trillion a year ago, it has more recently put a $2 trillion estimate on US credit losses in the current crisis.

This fits with the history of past crises around the globe, in which nations often find that cost estimates keep rising, partly because banking problems get worse when unaddressed or partly addressed.

One reason: When a banking system is under stress, real economic activity typically suffers. That, in turn, affects the value of bank collateral such as real estate and the performance of bank loans, and the crisis deepens.

As to who bears the losses, the choices boil down mainly to investors, taxpayers, or some mix.

In his annual letter to shareholders of Berkshire Hathaway, released over the weekend, billionaire Warren Buffett said rescues have been necessary, but he warned of the rising federal tab.

“Major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests,” he said.

A skeptical US public

The public shares this concern about the toll of rising federal deficits and is skeptical of aiding troubled corporations. In a USA Today/Gallup survey late last month, 39 percent of Americans supported aiding financial firms that are in danger of failing and 59 percent were opposed.

That may be one reason Timothy Geithner, Mr. Obama’s Treasury secretary, is not moving yet to ask for extra money beyond the initial $700 billion fund Congress created last fall.

But Mr. Geithner also appears reluctant to impose high costs on investors who own the bonds or stocks issued by the banks. He has said he hopes to avoid outright nationalization of troubled banks by wiping out shareholders, for example.

He has proposed an alternative plan, but it’s not clear how successful it will be.

The Treasury’s planned course is to assess how healthy the major banks are – and then inject new capital as needed. It would come in the form of preferred shares that may be converted to common shares in the future, if needed by the banks themselves.

The banks would pay dividends back to the Treasury on the preferred shares. By trying to avoid taking common shares, the government hopes to sidestep the need to acquire a large ownership stake in the banks.

Geithner and other officials worry that the more entangled in banks the government becomes, the harder it will be to restore them to normal functioning.

Taxpayers versus investors

Critics respond that government ownership, though difficult, is the logical way out for the most troubled banks – and that to avoid it is to subsidize investors at taxpayers’ expense.

It’s possible the government is headed that way with Citigroup. The rescue announced Friday involves swapping $25 billion in preferred stock for common shares. The deal, which depends on other preferred shareholders agreeing to do the same, could make the Treasury a 36 percent owner of Citi – by far the largest shareholder.

The deal confirms that the government will be in a position to call many shots as the bank moves forward. The restructured federal aid puts Citi in a stronger position, because the amount of total common stock is now viewed by investors as the litmus test of a bank’s health. The new common shares give the bank a larger buffer against potential losses. Its existing shareholders take a large loss, because their stake is diluted in the deal.