Economics correspondent John Ydstie helps explain what government officials are planning to do:
Treasury Secretary Henry Paulson has sketched out the sweeping outlines of what could be the biggest bailout in United States history. He said Friday that the Treasury Department would present a plan to Congress over the weekend that would relieve banks of their bad debts and breathe new life into ailing credit markets.
U.S. stocks rallied on the news. The Dow Jones industrials closed up 369 points to 11,388, an increase of more than 3 percent on the day.
In broad terms, Paulson said the plan could involve hundreds of billions of taxpayer dollars so the government can buy up the bad mortgages and other illiquid assets clogging up the financial system. The program, he said, would have to be "big enough to make a real difference" and while he knew it put a lot of taxpayer money at risk, he said this plan was the only option.
"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," he said.
Paulson said that when the financial system is working properly, money and capital flows freely, allowing business and households to pay for and get home loans, school loans and other investments. Right now, that isn't happening the way it should. He said that irresponsible lending practices put too many families into mortgages they couldn't afford and now that is coming home to roost. What began as a subprime lending problem has now spread to other, less risky mortgages, and the spillover is now affecting responsible homeowners.
"We have acted on a case-by-case basis in recent weeks," Paulson said, referring to the bailout of Fannie Mae and Freddie Mac and AIG. "Despite these steps, more is needed. We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses."
Paulson said Fannie and Freddie will start increasing their purchases of mortgage-backed securities to support the mortgage market. The Treasury will also expand a mortgage-backed security purchase program that it announced earlier this month to free up capital and make it easier for banks to issue new mortgages to qualified buyers. To prevent the economy from being further affected, he said, the federal government has to step in, even if that means using hundreds of billions of taxpayer dollars to do so.
Bush: 'This Action Does Entail Risk'
President Bush, speaking from the Rose Garden, admitted that "this action does entail risk but we expect this money will be paid back." He said that the program would help bolster investor confidence, which has been shaken in recent weeks.
As Paulson and the Congress work out a plan, the Securities and Exchange Commission and the Treasury have already started to try to smooth out the volatility in the financial markets. The SEC approved a proposal last night that would temporarily ban the practice of short selling in financial companies. Then, in the second of a one-two punch, the Treasury said it would move to guarantee the value of money market funds that had been socked as investors panicked and rushed to the safety of government securities.
'A Serious Moment'
Those announcements came after Thursday's high-level, closed-door meetings on how to stem the economic crisis. Congress will be asked to support legislation that will give the government authority to buy distressed mortgages.
"What we are working on now is an approach to deal with systematic risks and stresses in our capital markets," Paulson told reporters Thursday night. "And we talked about a comprehensive approach that would require legislation to deal with the illiquid assets on financial institutions' balance sheets."
One of many models under consideration is something like the Resolution Trust Corp., which was set up to bail out troubled savings and loans in the 1980s. The RTC was a government entity that bought and eventually sold hundreds of billions of dollars' worth of real estate from failed S&Ls.
This time, the rescue operation would be a little different because the underlying idea here is to save financial institutions, not just strip assets away from dead ones.
"We're waiting to receive something from them," Chris Dodd, the Democrat who heads the Senate Banking Committee, told reporters after Thursday night's meeting, referring to the Bush administration's financial team. "I have no idea what it will look like at this point. I can't tell you numbers, volume ... this is a serious moment."
In fact, Dodd emphasized that in more than 30 years as a member of the House and then the Senate he had never seen a moment "as serious" as this one.
The SEC And Short Selling
The SEC made good on its announcement Thursday that it would rein in short selling on financial companies. Short selling is a practice in which investors make a bet that a share price will decline to a certain level by a certain date. Essentially they sell the stock without really owning it. They hope to buy the stock later, at a lower price, and pocket the difference. Some observers said it was short selling that led to the demise of investment bank Lehman Brothers. As short sellers kept bidding down Lehman's share price, it shook confidence. Lehman ended up filing for bankruptcy on Monday.
The SEC said it had joined forces with the U.K.'s Financial Services Authority and decided to take the temporary emergency action and stop aggressive short selling. The SEC will also temporarily require institutional money managers to report their new short sales in particular securities. The SEC has already stiffened the rules against so-called naked short selling, a practice in which traders never actually borrow the shares they should hold when betting against a company.
Guaranteeing Money Market Funds
The Treasury said money market funds would be guaranteed by a $50 billion fund. The Treasury said it will be tapping into a stabilization fund that was created in 1934, during the Depression, to provide support for the dollar. News of the Treasury's support of money market funds was felt almost immediately. U.S. equity index futures soared and U.S. Treasury bill rates shot up. They had fallen to near zero earlier this week as investors rushed for the safety of government securities.
President Bush had hinted at all this activity Thursday when he came out and said he would do whatever was necessary to stabilize the markets. He didn't offer any policy prescriptions, and left that to his Treasury secretary and the Fed to work out.
The government has already provided some massive bailouts to individual financial companies. On Sept. 7, the Treasury announced that it was taking control of Freddie Mac and Fannie Mae to prevent them from slipping into bankruptcy. It provided a $100 billion line of credit for both companies in return for control of them. Then, earlier this week, the Federal Reserve surprised investors by saying it would take a nearly 80 percent interest in the insurer American International Group in exchange for a two-year, $85 billion loan.
Central Banks Move To Ease Credit Crunch
News of those bailouts roiled financial markets around the world. Banks started hoarding dollars, and the interbank lending rate, the interest rate at which banks lend each other money, skyrocketed to its highest level in almost a decade. To ease that credit crunch, the Federal Reserve pumped $55 billion into the nation's financial system.
A credit crisis can be more perilous than a market fall. The whole global financial system depends on banks lending each other money. Cash flow is the grease that keeps the financial system functioning, and without it, like a car engine without oil, the system seizes up. Proof of that "ongoing pressure" was the spike in the cost of borrowing money: London's intrabank lending rate, or LIBOR, rose to 3.02 percent. Banks have not had to pay this much to borrow dollars since 1999.
On Thursday, central banks around the world provided their own boost to the credit system. The Federal Reserve almost quadrupled the amount of dollars central banks can auction, to $247 billion. Then it authorized increases in what are called swap lines, which are temporary reciprocal currency arrangements that allow banks to borrow dollars at lower rates. It doubled the European Central Bank's swap line to $110 billion. The Swiss National Bank's line is now $27 billion, up from $15 billion. The Fed also established new swap lines for the Bank of Japan, the Bank of England and the Bank of Canada.