As the financial crisis threatens to spiral out of control, U.S. Treasury Secretary Henry Paulson is taking extraordinary steps through the extensive authority granted to him under emergency rescue legislation.
With the legislation’s main mechanism—an auction system to purchase bad mortgage-based securities—still weeks away from implementation, Paulson now plans to make big capital injections into large financial institutions and get equity in return.
In a news conference Friday evening, following the Group of Seven meeting in Washington, Paulson said the plan is to offer a term sheet for needy banks. The government will not get voting rights status for its injection in most cases. Paulson said the government's efforts were focusing on "liquidity" needs and "systemic risk."
Paulson said recapitalization was now "necessary" and would let "taxpayer dollars go further," because it is a "more efficient" use of capital than the auction process, which is meant to deal with illiquid assets.
"This a plan I am quite confident will work," Paulson said.
Still, not all economists heard all the details they wanted from Paulson's statement Friday night.
"There are few specifics," said economist Robert Brusca of FAO Economics. "Too many key words are vague and not well-specified."
Details of the plan were first reported by CNBC earlier Friday.
Even before details of the latest measures began to trickle out, there was heightened concern about the health of big institutions and the need for direct government support.
“I don't wish to spread alarm on the line people but the big issue confronting the market is I'm afraid the health and sustainability of Morgan Stanleyand Goldman Sachs," Hugh Hendry, Partner and CIO at Eclectica, told CNBCearly Friday. "It is unimaginable that they can be allowed to go, I suspect that they will be nationalized at some point today or over the weekend," he add.
The Emergency Economic Stabilization Act of 2008’s vague language gives Paulson almost unlimited power to intervene and leaves much up to interpretation.
In that context, some say cash injections could wind up being made to non-depository institutuons like investment banks, insurers and hedge funds. That issue was not addressed in Paulson's news conference Friday in either his remarks or the question-and-answer period, but at this point it is understood that the plan is meant for banks, savings and loans and credit unions.
“He’s free to just strike deals, to do special deals,” says Lawrence White, a former White House economist and savings and loan regulator, who adds Congress was aware of the powers being given to Paulson and thus pressed hard for an oversight board.
Like the auction process, however, that board has yet to be set up, and with developments in the financial markets moving much faster than the Washington bureaucracy it might not be long before Paulson takes action.
Indeed, on Thursday, the Treasury indicated it would take action by the end of the month, but it now appears action may come sooner, based on comments by the Treasury Secretary and President Bush Friday. The President said the department would move quickly.
Independent bank analyst Bert Ely, who says he’s read the new law closely, sees no such specific authority for the Treasury in the EEA. "Presumably they have the authority some place—in this legislation or otherwise," he adds.
A staffer in the House Financial Services Committee says Congress was aware that the EEA would authorize the Treasury Secretary to make cash injections separate to the auction process.
When asked, if that authority also applied to non-depository institutions, the staffer was non-committal. It's unclear if those injections would have to yield an equity stake.
(Calls Thursday to the office of Sen. Christopher Dodd, who chairs the Senate Finance Committee, and that of Sen. Charles Schumer, a vocal member of the panel, were either not answered or failed to yield comment. Sen. Richard Shelby, the Ranking Republican on the committee, who opposed the bill, had no comment.)
“I've got to think they have that figured out, to interpret the legislation broadly enough that they can do it," says Ely.
A government move to prop up an investment bank-turned bank-holding company, such as Morgan or Goldman is all the more likely given the growing consensus that says Paulson and Federal Reserve Chairman Ben Bernanke erred in not rescuing Lehman Brothers three weeks ago, a date which happens to coincide with the beginning of the market’s deep descent.
Pressure has been mounting on Morgan Stanley for days now, amid growing speculation Japan's Mitsubishi UFJ will not proceed with plans to purchase a major stake. Goldman shares, in contrast, have held up relatively well compared to the broader market.
For the first time Thursday, the Treasury publically acknowledged that it was "seriously considering" capital injections. In doing so, the government was recognizing it “might have to do something different,” says Dean Baker, co-director of the Center for Economic And Policy Research.
“In a sense, they are also following the markets,” adds Baker. “There was no burst of relief last week when the bill was passed. People were not impressed. He's [Paulson] got to take that seriously.”
In a news conference Wednesday, Paulson said the “primary motivation” of the government’s efforts was to lead to the “recapitalization” of the financial services industry, but he avoided outlining what circumstances would determine whether institutions would be allowed to fail or the government would step in to save them. He also declined to comment on whether he would consider a bank nationalization plan, such as the $77-billion one announced by the UK.
The decision not to seek voting rights is an important one. Banks are considered reluctant to give the government that sort of power as a shareholder. By avoiding the issue, the government is increasing its chance of obtaining broad industry acceptance, analysts say.
Bank nationalization would be a more extraordinary move for the US, but in a recent interview former FDIC Chairman William Isaac provided some rare insight into the matter. He said that during the Latin American debt crisis of the 1980s when major money center banks were facing possible loan payment defaults by sovereign governments, the US “had a contingency plan in place to nationalize [the banks].”
“That's always going to be the answer," Isaac explained.
Paulson diid not acknowledge that the recap plan might be considered a change of policy, maintaining that the problem has always been about a recapitaization of the industry.
Though deatils of the Treasury's term-sheet plan are just beginning to emerge, it is by no means a simple undertaking. There are some 8,400 banks and savings and loans in the country with government-insured deposits.
There’s also a sense that the concept of moral hazard may have become something of a luxury item in the current meltdown. The Fed and Treasury have already taken a number of unusual steps, from paying interest on bank deposits to backing up the commercial paper market to providing more than $100 billion in loans to the insurance giant American International Group. On top of that, there’s a growing chorus calling for governments to guarantee banks’ liabilities, which essentially separates credit risk from funding, and may encourage more lending among banks.
"They're prepared to do almost everything,” says Ely.
(Editor's Note: CNBC Senior Economics Reporter Steve Liesman provided exclusive and critical information to this story.)