Critics Forced Financial Officials To Rework Plans

In Depth

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In moves largely unnoticed by the general public, the federal government put two emergency measures in place last week to help stabilize the economy.

As Congress and federal regulators began debating a $700 billion bailout for Wall Street, the U.S. Treasury also had an eye on nervous investors in money market mutual funds. On Friday, the Treasury announced that it would extend government insurance to money market mutual funds — a step it took in an effort to stop a potential panic.

The change drew immediate criticism from bankers. "My initial thought was I wasn't hearing correctly," says Wayne Abernathe of the American Bankers Association.

His group represents commercial banks, which worried that the government insurance would drive people to pull their money out of banks and put it instead into mutual funds. After all, the funds pay higher interest rates, and would now be just as safe. "It is a breathtaking step to instantaneously provide insurance for $2 trillion worth of investment," he said.

Abernathe says that in trying to prevent one crisis, the Treasury had set the stage for another. If people pulled their money out of banks, he argues, then the banks wouldn't have that money to lend out. Imagine this scenario, he says: "You've got a small businessman who comes in and says, 'I need a loan to expand my business.' The bank says, 'I'd love to lend it to you, but I don't have the money to do it.'"

The American Bankers Association wrote a letter to the Treasury Department within an hour of the announcement. Abernathe says the group got a call from Assistant Secretary David Nayson, who invited them in for a conversation. As Abernathe reports it, the bankers told the government they need a fix immediately, or else risk watching billions of dollars move out of banks and into money market accounts when the markets opened on Monday.

On Sunday, the Treasury issued a statement saying that the government guarantee would only cover money that was already in a money market fund. Treasury signaled to investors that they shouldn't move their money, because it wouldn't be protected by insurance.

Abernathe calls the episode a reminder that for even the smartest minds, it can be hard to think through consequences. "The financial system in the United States is very complex," he says. "You can't poke at one part of the balloon without pushing something out the other side of it."

A second emergency measure taken by the government also drew fire. This one had to do with a temporary ban on short-selling of financial stocks. Short selling is a way of betting that a stock will go down. The Securities and Exchange Commission worried that short selling might actually drive a stock price down, dooming an otherwise sound institution.

James Angel, a professor of finance at Georgetown University, says it's unclear whether that was indeed taking place. "As a matter of fact, I personally believe was not enough short selling in Lehman," Angel says. "A couple weeks ago I thought, 'Ah, ha, the worst is over. I think they're going to make it.' And I actually bought some [stock]."

Angel chuckles to himself. "Lo and behold, I was wrong and the shorts were right," he says. "So if there had been more short sellers, that would have brought down to true value sooner I would not have made that mistake.

Just as the Treasury had to back track on the extension of insurance, the SEC had to amend its ban on short selling. The SEC more clearly defined which types of short selling were allowed and which wouldn't. It sent out the amended version of its order at at 12:30 a.m. on Monday — before the markets opened.

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