Pushing Back from the Abyss

Monday saw the continuation of frantic efforts to prevent the collapse of the U.S. financial system as the Federal Reserve converted Goldman Sachs and Morgan Stanley to bank holding companies. The move transformed both companies from investment banks into depository banking institutions, brought them under the Fed’s regulatory control and marked an end to a Wall Street era. Unlike investment banks, depository banks may borrow at the Fed’s discount window. They also have access to funds held for depositors, which are insured by the Federal Depository Insurance Corp. (FDIC). In return, however, depository banks must submit to Fed regulations, including strict capital requirements. As an investment bank, Goldman Sachs held $1 in capital for every $22 in assets (or loans). Morgan Stanley held $1 in capital for every $30 in assets. Fed regulations require commercial depository institutions to lend no more than $11 for every $1 of capital. The change will lower profits substantially, while boosting stability. Commercial banks like Bank of America and Citi appear to have survived the subprime mortgage tsunami because of their more conservative lending postures. Meanwhile, Congress and the financial community began discussions of Treasury Secretary Henry Paulson’s bailout plan. Over the weekend, Paulson (pictured) called for quick action on the plan, which would purchase up to $700 billion in bad mortgage loans from institutions in an attempt to inject liquidity into the nation’s drought-stricken financial arteries. The financial community suggested that continued deterioration of assets at Fannie Mae and Freddie Mac may add another $100 billion to the $700 billion price tag. While pricing remained an issue, a proposal for reverse auctions with banks bidding against each other to get to the lowest prices seemed to be gaining traction throughout the day.In addition, Congress raised questions regarding the sweeping authority given the executive branch and Paulson, who, under the administration plan, would have a free hand to do whatever he believes necessary. In control of both houses of Congress, Democrats submitted their own bailout proposals on Monday morning. With an eye on oversight, Senator Christopher Dodd, Democrat from Connecticut and the Senate Banking Committee Chairman, has released a plan that requires that the government receive shares of stock in the companies from which the government buys distressed mortgages. Treasury’s plan carries no such requirement. Dodd’s proposal would also limit executive compensation at firms making sales to the government and creates an inspector general and an oversight board. Representative Barney Frank, a Democrat and Chairman of the House Financial Services Committee, was also preparing a House version of the plan. As negotiations progressed on Monday, according to a report in the Wall Street Journal, the administration agreed to the proposal to create an oversight board and to provide more relief for homeowners threatened with foreclosure. The administration also agreed to the Democrat’s equity proposal, allowing that the government would receive warrants for equity stakes in firms selling their bad mortgages. Frank told the Journal, “We also made it clear that if you take that equity, it has to be with warrants so if a company becomes profitable, we get a little bit more than the general share for taking these risks.” The Democratic proposals bear some resemblance to the Resolution Trust Corp. (RTC) plan created to work out the savings and loan crisis of the late 1980s and early 1990s. The RTC took over failing institutions and sold distressed assets to investors for as little as 10 cents on the dollar. While tossing barbs at each other, both presidential candidates resisted the move to give Paulson unfettered authority and called for oversight. “We cannot give a blank check with no oversight,” said Barack Obama, the Democratic nominee. John McCain said: “When we’re talking about nearly $1 trillion of taxpayer money, ‘trust me’ is not good enough.” By the end of Monday’s trading session, the stock market’s judgment of the day’s events had driven the Dow Jones Industrial index down by 373 points.