Treasury Secretary Henry Paulson is meeting this weekend with members of Congress, in hopes of crafting the most dramatic response yet to the challenges facing the nation's financial system. The Bush administration now wants the federal government to take responsibility for the risky mortgage assets weighing on the nation's financial institutions.
Bush says the economy is facing "unprecedented challenges," and the government is responding with "unprecedented action."
The government has already seized control of mortgage giants Fannie Mae and Freddie Mac. It offered an $85 billion loan to prop up the insurance company AIG, and on Friday, it began extending temporary insurance to money market mutual funds, in hopes of discouraging a run on nearly $3.5 trillion in savings.
Like a financial firefighter whose defensive lines keep getting overrun, Treasury Secretary Henry Paulson says these case-by-case responses are not enough.
"We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses," he said.
Paulson says the federal government needs to "remove" the high-risk mortgages and other bad debt that's clogging up the financial system and preventing banks and other lenders from extending credit where it's needed. The effort would involve hundreds of billions of dollars worth of taxpayers' money. But Paulson says it's worth the risk.
"I am convinced that this bold approach will cost American families far less than the alternative — a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion."
It's not yet clear how the government would go about taking over the troubled mortgages and mortgage-backed securities now held by banks and others. Back in the late 1980s, the government used the Resolution Trust Corp. to dispose of bad loans from the savings and loan debacle. But economist David Malpass, who was with the Treasury Department at the time, notes that back then, the government already had control of the loans from failed S&Ls it had taken over.
"In the current situation, we don't have that. The government doesn't control the bad assets or the troubled loans within individual banks, Bank of America, Wachovia and so on. And it's unclear how they could get a hold of them," he said. "Are they going to make the banks turn them over? And at what price?"
Finding a price that satisfies both the bank and the taxpayer could be difficult. The value of mortgage-backed securities has fallen, as more and more homeowners default on their mortgages. And that's forced huge write-offs for financial institutions. But Malpass believes most homeowners will continue to make their monthly payments. So over the long term, the mortgage-backed securities may turn out to be worth more than their current market prices would suggest.
"I think there's been a pendulum swing from people being blind to risk and now people seeing risk under every bush," he said.
Malpass should know. He was chief economist at Bear Stearns until its collapse, and now runs his own consulting firm, Encima Global. Despite the challenges of carrying out a rescue plan, Malpass says he's encouraged by the growing consensus in Washington that some kind of action is needed to prevent an even bigger financial meltdown.
"I think it must have been clear to both parties that it was hurting their incumbents," Malpass said. "Meaning if you were sitting in Washington while this was all happening, it was going to hurt your re-election chances. So they seem to have come together in a bipartisan way to do something about it. I think that's a plus for the outlook."
The stock market seems to agree. After a stomach-churning, 800-point plunge in the first half of the week, the Dow Jones Industrial Average bounced back to end the day Friday within 34 points of where it was a week ago.