Congress abandons Wall Street: Kohler

The financial system is now walking the liquidity tightrope without a safety net. Treasury Secretary Henry Paulson’s idea of allowing the banks to sell their bad loans to taxpayers has fallen victim to an historic split between America’s financial and pol

The financial system is now walking the liquidity tightrope without a safety net. Treasury Secretary Henry Paulson’s idea of allowing the banks to sell their bad loans to taxpayers has fallen victim to an historic split between America’s financial and political classes. And it was the Republicans who baulked most; the market intervention proposed was simply a step too far.

Wall Street stocks were already tumbling when the House of Representatives rejected the Paulson bailout bill. When the stunning news came out that House Republicans had voted the bill down, there was panic.

Regional banks were especially hard hit, with most of them falling by double figure percentages immediately. Cleveland-based National City Corp was the hardest hit because investors think it will be the next to face the music. By the time the bill failed in the House, there had already been four bank nationalisations or bailouts in Europe over the past 48 hours and the Federal Reserve had announced an unprecedented liquidity injection by central banks.

But with term funding markets now effectively frozen and with financial markets in a state of alarm, we are now in an extraordinarily dangerous situation. The Bush Administration has no choice now but to focus on the Federal Deposit Insurance Corporation as a last line of defence against bank runs. The Paulson plan was an attempt to preserve equity in financial firms while the Federal Reserve and the FDIC defend depositors.

As noted here yesterday, it is largely about the end-of-quarter audited accounts in which there will now be a new wave of loan loss write-downs against equity capital. Unless another version of the bailout can be cobbled together quickly, the shareholders will now have to be left to their fate as the authorities attempt to preserve depositors’ funds. At least another $US500 billion will have to be provided in funding for the FDIC to insure deposits in face of impending bank runs.

Then the Federal Treasury will need to find another way to recapitalise or nationalise banks that are worth saving – one way might be to buy convertible preferred shares as Warren Buffett has done with Goldman Sachs, which is now a retail commercial bank.

Meanwhile the Federal Reserve is orchestrating an extraordinary $US630 billion in extra liquidity into the global financial system – increasing its existing currency swaps with other central banks from $US290 billion to $US630 billion and expanding its Term Auction Facility by $US300-$US450 billion.

With US Treasury being declared off limits by the House of Representatives, the Fed’s balance sheet is likely to explode. Essentially Congress has ensured that for the moment at least the crisis will be treated by money printing instead of bond issuance – by inflation instead of debt. The end result is likely to be the same.

This article first appeared on Business Spectator