[Vision2020] Financial Rescues Can Set Off New Problems

[Art Deco]

Financial Rescues Can Set Off New Problems

By Peter Whoriskey and Zachary A. Goldfarb
Washington Post Staff Writers
Sunday, October 19, 2008; A01



If there was one thing policymakers could agree on during the recent economic turbulence, it was that interest rates on U.S. home mortgages ought to come down, and fast. But as the government stepped in recently to shore up the nation's banks, those rates went up.

Chalk up another case of unintended consequences.

Since the beginning of the crisis that has upended financial markets and stunned the world economy, the well-intentioned actions of governments and officials have often created new problems that require nearly equally urgent solutions.

The complexity and linkages in the world financial system are to blame.

"Every action the government takes has cascading effects on the market, and they're not always easy to predict," said Jim Vogel, an analyst at FTN Financial. "The government has to have time to catch up."

When authorities in Ireland and Greece guaranteed deposits, banks across the rest of Europe feared a stampede out of their own countries, forcing many governments to take the same precaution. The race to guarantee deposits spread as far as Hong Kong and Singapore, where banks are considered relatively stable.

When the U.S. Treasury announced it was guaranteeing money market accounts, it fanned fears of a run on bank accounts.

And by not protecting preferred stockholders when the government seized mortgage-finance firms Fannie Mae and Freddie Mac, it sunk investor confidence in preferred shares in other financial institutions, too, making it harder for them to raise money that way.

"It's like a chess game," said William Poole, who was president and chief executive of the Federal Reserve Bank of St. Louis from 1998 to this March. "You might be able to anticipate the next couple of moves. But after that, it gets very complicated, very quickly."

Virtually every emergency measure over the past few weeks has had secondary and sometimes unpredicted effects, according to economists, and this is one of the key dangers in the weeks ahead, as the government issues more short-term loans to corporations, buys toxic securities and invests in banks.

One of the first examples of unintended consequences came as Lehman Brothers filed for bankruptcy protection. The bank's fall spurred investors to pull out of money-market mutual funds, many of which were tied to Lehman debt. Fearing a run on money-market funds, the Treasury on Sept. 19 announced it would guarantee these funds.

That made money-market investors feel better. But in turn, it led community bankers to erupt in protest as they saw investors pulling out of their bank accounts to invest in money-market funds -- which always paid more and now were just as safe.

"The unintended consequence would have been a run on the banks," said Ken Guenther, former chief executive of the Independent Community Bankers of America.

Eventually, the Treasury quelled the protests by agreeing to protect only existing money-market deposits.

Much of the uncertainty about government intervention comes because it reorders in sometimes unforeseen ways how investors value their investments.

For example, many investors had considered preferred shares in Fannie Mae and Freddie Mac as near-sacred. But by allowing those shares to collapse as the government took over the institutions in early September, officials created skepticism about the value of preferred shares from financial institutions and made it harder -- and more expensive -- for other financial institutions to raise money by issuing them.

For example, the government this month had to privately assure a Japanese bank, Mitsubishi, that preferred shares in Morgan Stanley would be protected if federal money was invested in the Wall Street firm, according to a person familiar with the discussions who spoke on condition of anonymity. The assurance helped clear the way for Mitsubishi to buy a 21 percent stake in Morgan Stanley.

"With the whipsawing failures of Fannie and Freddie, the private-sector capital option to support the financial industry was ripped off the table," said Karen Petrou, an analyst at Federal Financial Analytics.

Similarly, by propping up banks with capital infusions and guaranteeing more of their deposits as part of the Treasury Department's massive rescue package for financial markets, the government may be elevating banks over other institutions, accelerating the longstanding rush of money out of hedge funds.

"To the extent that banks are perceived as more stable, investors may be motivated to move to banks," said Kenneth Heinz, president of Hedge Fund Research. He noted, however, that many hedge fund investors have already pulled out in favor of cash. According to the firm's latest data, third-quarter hedge fund redemptions hit a record-high $210 billion.

But the most perverse of the unintended consequences could be how the government's bank rescue appears to be boosting mortgage rates, contrary to a key government goal.

When the government took over Fannie Mae and Freddie Mac last month, Treasury Secretary Henry M. Paulson Jr. said "the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance."

It worked -- at first.

Before the takeover, the average 30-year, fixed-rate mortgage was hovering at 6.35 percent.

Immediately after the takeover, rates on mortgages fell. Investors had new faith in Fannie Mae and Freddie Mac, which allowed them to borrow money more cheaply, and that kept rates down.

But rates have soared beyond their pre-seizure levels. They now hover around 6.46 percent.

The reason, according to several analysts, is that the government's backing of Fannie Mae and Freddie Mac lowered their cost of borrowing money. That, in turn, allowed them to buy mortgages that carried lower rates, lowering rates for everyone because of their dominant market position.

Since then, however, the government has begun guaranteeing an array of other investments. It has announced plans to invest in nine major banks, it guaranteed new bank debt and raised the insurance limits on bank accounts to $250,000. Investors now have other places to go to get the U.S. government's full faith and credit. Fannie Mae and Freddie Mac were not uniquely attractive to investors and could no longer borrow money so cheaply. That pushed rates upward.

"A month ago, Fannie and Freddie were the unique beneficiaries of government support -- so the mortgage costs fell in response, which is exactly what you would anticipate," Vogel said. "Since that time, mortgage securities no longer have the special position."

Although there have been other forces on mortgage rates -- for example, many foreign governments have been selling Fannie and Freddie debt -- analysts agree that the government's new programs have had some role in boosting mortgage rates.

"This is, of course, bad news for the mortgage market -- a critical factor in taking the U.S. out of the market panic and into a long-term recovery that puts a floor under residential prices," Federal Financial Analytics, a Washington research firm, said in a report this week.

Further into the future, some economists predict even more profound consequences from today's interventions.

By fostering the belief the government will rush to the rescue whenever a major financial institution begins to falter, federal officials may be creating what many economists call a "moral hazard." That is, those institutions may be more willing to undertake risky investments.

"It's all very Rube Goldberg-esque," said William O'Donnell, the head of U.S. interest rate strategy at UBS, referring to the cartoonist famed for devices that work in indirect and convoluted means. "You're never quite sure what any one action will do."
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