The Bush administration is expected to take stakes in the nation’s top financial institutions as part of a wide-ranging effort to restore confidence to the battered banking system, following similar moves by European governments that sent global stock markets soaring.

As part of its new plan, the government is set to buy preferred equity stakes in nine top financial institutions, according to people familiar with the situation. It’s unclear how much would be invested in each institution. The move is designed to remove any stigma that might come with a government investment.

Banks receiving government funds include Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Bank of New York Mellon.

Not all of the banks involved are happy with the move, but agreed under pressure from the government.

Read it all. Also, note that Nouriel Roubini is still concerned.

The government’s plan to buy equity in financial institutions, announced Friday by Treasury Secretary Henry Paulson, is an idea that many academic economists have championed from the start of the crisis.

Many economists believed that the heart of the government’s initial plan to pay $700 billion for toxic assets was aimed at the wrong target. Purchasing mortgage securities from banks wouldn’t do anything to kick-start lending and get credit flowing again, they said. Rather, banks would use the proceeds they got from the Treasury to pay off debtors, and those debtors would use the proceeds to buy safe assets.

They said a wiser course — the one the Treasury now seems to have come around to — was for government to rebuild the badly depleted cash levels on bank balance sheets. That would cushion institutions against future losses, giving them the wherewithal to lend again. Other hitches in the original plan include coming up with a price for mortgage securities that is above the “fire sale” level they would draw on the open market, but not so high that taxpayers end up getting taken for a ride.

Read it all.

Remember the Rule of Holes: When you find yourself in one, the first thing to do is to stop digging.

Right now we’re in one of the deepest economic holes anyone has ever seen. And what we need to do is to stop making things worse by continuing to over-rely on financial markets and financial institutions that have proven to be incapable of performing their core missions: getting capital to where it needs to go and pricing that capital in a way that reflects the risks and underlying economic values. We have to stop digging. Another week like this one, and there won’t be much left to rescue.

Read it all.

Conservative U.S. Christians say the culture has gone to hell and it has taken the economy and Wall Street down with it.

It is a view which outsiders may find puzzling but has wide resonance in the U.S. heartland: the notion that moral decay and a lost sense of responsibility has brought on the worst banking and credit crisis since the Great Depression.

Such a view helps explain the unpopularity in conservative Christian circles — which have a big influence on the Republican Party — of a $700 billion bailout plan which the U.S. House of Representatives rejected on Monday, rocking financial markets.

Read it all.

Having tried without success to unlock frozen credit markets, the Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system, according to government officials.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks.

The proposal resembles one announced on Wednesday in Britain. Under that plan, the British government would offer banks like the Royal Bank of Scotland, Barclays and HSBC Holdings up to $87 billion to shore up their capital in exchange for preference shares. It also would provide a guarantee of about $430 billion to help banks refinance debt.

Read it all.

If you think this bailout is expensive, just wait until you see the next one.

The $700 billion rescue plan approved by the U.S. Senate won’t fix the core problem with the nation’s ailing financial institutions. And it almost guarantees that you and I will have to pony up for an even costlier bailout someday….

Treasury Secretary Hank Paulson has correctly identified the quandary: Lots of shaky banks and insurance companies are showing strangely high values for assets that aren’t worth squat in the market. Many need more capital and can’t raise it. And he’s right in saying the outlook is grim if we don’t get this fixed.

What’s stunning is how little the taxpayers would get in return for their money under Paulson’s package, and how illusory much of the banks’ newly minted capital would be.

Read it all.

Obviously, next year’s deficit is a problem. And if you assume the credit crisis isn’t about to lift ”” which seems smart at this point ”” the ultimate cost of the bailouts could conceivably go higher. Whatever the final figure, it should still be put in some context.

Despite everything, the biggest fiscal problem remains, far and away, health care. Based on the rate that medical spending has been rising, the Congressional Budget Office forecasts that Medicare and Medicaid will take up 10 percent of G.D.P. within two decades, up from about 4 percent now. In today’s terms, that would be the equivalent of adding at least $900 billion to the deficit every single year, in perpetuity. It makes the cost of the bailouts look like a rounding error.

When it comes to health care, we have a situation that is blatantly unsustainable. With the right choices, we can prevent that. But so far, we instead seem to be hoping that the situation will magically resolve itself, which is a recipe for big problems and perhaps even a crisis.

Let’s see. That doesn’t sound familiar, does it?

Read it all.

By and large, 70% to 90% of you wanted something to be done to calm the economy, but you didn’t want $700 billion in new debt to bail out Wall Street. The stock market has had record declines since then. What’s going on?

You need to remember that you need to take control of your life. It’s disturbing that people in government totally disregard what the people tell them to do. It’s disturbing that the market goes down and the media panics about this. It’s disturbing that greedy banks made loans to people who couldn’t afford to repay, and people signed up for the trip when they couldn’t afford it. It’s disturbing that Washington ignores its constituents and takes huge strides toward socialism.

All of these things are disturbing, but none will cause this great nation to cease to function. They are not the beginning of the end. But the most disturbing thing is some people’s reactions. Don’t react based on fear or panic. Another negative reaction is that you are looking to Washington to fix your problems. They have never fixed your problems, and you want Obama or McCain to fix things. There has never been a president who can fix your problems. They always say they can and they never can.

Read it all.

Less than a week after the federal government offered an $85 billion bailout to insurance giant AIG, the company held a week-long retreat for its executives at the luxury St. Regis Resort in Monarch Beach, Calif., running up a tab of $440,000, Rep. Henry Waxman (D-Calif.) said today at the the opening of a House committee hearing about the near-failure of the insurance giant.

Showing a photograph of the resort, Waxman said the executives spent $200,000 for rooms, $150,000 for meals and $23,000 for the spa.

“Less than a week after the taxpayers rescued AIG, company executives could be found wining and dining at one of the most exclusive resorts in the nation,” Waxman said. “We will ask whether any of this makes sense. ”

What on earth were they thinking? Makes the heart sick–read it all.

“I told him, ‘You have to do this,’ ” [Charlie] Rose recalled in an interview on Saturday. ” ‘No one has your credibility, and people want to hear what you have to say.’ ”

Buffett agreed to do it, and Rose flew to San Diego, where Buffett would be on Wednesday. The hourlong interview on Wednesday night was vintage Warren Buffett: calm, plain-spoken and wry.

He called the current crisis an economic Pearl Harbor, requiring immediate action. Its biggest single cause, he explained, was the real estate bubble. “Three hundred million Americans, their lending institutions, their government, their media, all believed that house prices were going to go up consistently,” he said. “Lending was done based on it, and everybody did a lot of foolish things.”

As far back as 2003, Buffett had warned that the complex securities at the center of today’s troubles– once so profitable, but now toxic– were “financial weapons of mass destruction.” These securities were engineered by the math quants on Wall Street, and in the interview Buffett expressed his disdain: “Beware of geeks bearing formulas.”

Read it all.

What’s occurring now is a frantic effort to prevent a modern financial disintegration that deepens the economic downturn. It’s said that the $700 billion bailout will rescue banks and other financial institutions by having the Treasury buy their suspect mortgage-backed securities. In reality, the Treasury is also bailing out the Fed, which has already — through various actions — lent financial institutions roughly $1 trillion against myriad securities. The increase in federal deposit insurance from $100,000 to $250,000 aims to discourage panicky bank withdrawals. In Europe, governments have taken similar steps; Ireland and Germany have guaranteed their banks’ deposits.

The cause of the Fed’s timidity in the 1930s remains a matter of dispute. Some scholars suggest a futile defense of the gold standard; others blame the flawed “real bills” doctrine that limited Fed lending to besieged banks. Either way, Fed Chairman Ben Bernanke, a scholar of the Depression, understands the error. The Fed’s lending and the bailout aim to avoid a ruinous credit contraction.

The economy will get worse. The housing glut endures. Cautious consumers have curbed spending. Banks and other financial institutions will suffer more losses. But these are all normal symptoms of recession. Our real vulnerability is a highly complex and global financial system that might resist rescue and revival. The Great Depression resulted from the mix of a weak economy and perverse government policies. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.

Read it all.

Check it out.

Two September shocks will define the presidency of George W. Bush. Stunningly enough, it already seems clear that the second — the financial crisis that has only begun to unfold — may well have far greater and more lasting ramifications than the terrorist attacks of Sept. 11, 2001.

That’s because while 9/11 changed the way we view the world, the current financial crisis has changed the way the world views us. And it will also change, in some very fundamental ways, the way the world works….

The current economic debacle is far more likely to be seen by historians as a true global watershed: the end of one period and the beginning of another. The financial chaos has brought down the curtain on a wide range of basic and enduring tenets also closely linked with the Reagan era, those associated with neoliberal economics, the system that the Nobel Prize-winning economist Joseph Stiglitz has called “that grab-bag of ideas based on the fundamentalist notion that markets are self-correcting, allocate resources efficiently and serve the public interest well.” Already this crisis has seen not just our enemies but even some of our closest allies wondering whether we are at the beginning of the end of both American-style capitalism and of American supremacy.

Read the whole piece.

PLENTY of people can be blamed for the calamity on Capitol Hill on September 29th. Two-hundred and twenty-eight congressmen decided they were ready to risk another Great Depression. Nancy Pelosi made an idiotic speech damning the Republicans. Sheriff McCain claimed that he was going to ride into town to sort out the mess””and promptly fell off his horse. But there is no doubt where the lion’s share of the blame belongs: with George Bush. The dismal handling of the financial crisis over the past fortnight is not only a comment on Mr Bush’s personal shortcomings as a leader. It is a comment on the failure of his leadership style over the past eight years.

The convenient excuse for Mr Bush’s performance is that he is at the fag-end of his presidency. Public attention has shifted to the presidential candidates, and the members of the House face the electorate in a month. But this rings hollow: there is nothing about the political cycle that dictates that an outgoing president should have an approval rating of 27% and an army of enemies on Capitol Hill. Bill Clinton ended his two terms with ratings of close to 70%.

The crisis underlined Mr Bush’s two biggest personal weaknesses””his leaden tongue and his indecisiveness.

Read it all.

In the case of households, debt rose from about 50% of GDP in 1980 to a peak of 100% in 2006. In other words, households now owe as much as the entire U.S. economy can produce in a year. Much of the increase in debt was used to invest in real estate. The result was a bubble; at its peak, average U.S. house prices were rising at 20% a year. Then ”” as bubbles always do ”” it burst. The S&P Case-Shiller index of house prices in 20 cities has been falling since February 2007. And the decline is accelerating. In June prices were down 16% compared with a year earlier. In some cities ”” like Phoenix and Miami ”” they have fallen by as much as a third from their peaks. The U.S. real estate market hasn’t faced anything like this since the Depression. And the pain is not over. Credit Suisse predicts that 13% of U.S. homeowners with mortgages could end up losing their homes.

Banks and other financial institutions are in an even worse position: their debts are accumulating even faster. By 2007 the financial sector’s debt was equivalent to 116% of GDP, compared with a mere 21% in 1980. And the assets the banks loaded up on have fallen even further in value than the average home ”” by as much as 55% in the case of BBB-rated mortgage-backed securities.

To date, U.S. banks have admitted to $334 billion in losses and write-downs, and the final total will almost certainly be much higher. To compensate, they have managed to raise $235 billion in new capital. The trouble is that the net loss of $99 billion implies that they will need to shrink their balance sheets by 10 times that figure ”” almost a trillion dollars ”” to maintain a constant ratio between their assets and capital. That suggests a drastic reduction of credit, since a bank’s assets are its loans. Fewer loans mean tighter business conditions on Main Street. Your local car dealer won’t be able to get the credit he needs to maintain his inventory of automobiles. To survive, he’ll have to lay off some of his employees. Expect higher unemployment nationwide.

Anyone who doubts that the U.S. is heading for recession is living in denial. On an annualized basis, real retail sales and industrial production are both declining. Unemployment is already at its highest level in five years. The question is whether we’re headed for a short, relatively mild recession like that of 2001 ”” or a latter-day version of what the world went through in the 1930s: Depression 2.0.

Read it all.

I’ve been frightened for my country only a few times in my life: In 1962, when, even as a boy of 9, I followed the tension of the Cuban missile crisis; in 1963, with the assassination of J.F.K.; on Sept. 11, 2001; and on [this past] Monday, when the House Republicans brought down the bipartisan rescue package.

–Thomas Friedman, in Rescuing the Rescue

Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors ”” not small investors ”” were panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a credit crisis looks like. It’s not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can’t see. It’s banks refusing to lend to other banks ”” even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman ”” both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps ”” a financial insurance policy against potential bankruptcy ”” at prices 30 times what they normally would pay.

It was this 36-hour period two weeks ago ”” from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 ”” that spooked policy makers by opening fissures in the worldwide financial system.

Read it all.

The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years.

This parallel banking system financed vast amounts of real estate lending and consumer borrowing. The system (which included the likes of Thornburg Mortgage, Bear Stearns and Lehman Brothers) made loans but had no deposit base. Instead, it relied on roll-over funding obtained through money markets. Additionally, it operated with little capital and extremely high leverage ratios, which was critical to its tremendous profitability. Finally, loans were usually securitized and traded among financial firms.

This business model has now proven extremely fragile. First, the model created a fundamental maturity mismatch, whereby loans were of a long term nature but funding was short-term. That left firms vulnerable to disruptions of money market funding, as has now occurred.

Second, securitization converted loans into financial instruments that could be priced according to market conditions. That was fine when prices were rising, but when they started falling firms had to take large mark-to-market losses. Given their low capital ratios, those losses quickly wiped out firms’ capital bases, thereby freezing roll-over funding.

In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.

Read it all.

A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.

The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.

Because of the 20% fall in the price of homes since the bursting of the house-price bubble, there are now some 10 million homes with mortgages that exceed the value of the house. Residential mortgages are generally “no recourse” loans, meaning that if the homeowner stops making payments, the creditor can take the property but cannot take other assets or attach income. Individuals with loan-to-value ratios greater than 100% therefore have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. When individuals default and creditors foreclose, the property is added to the stock of unsold homes. That depresses prices further, increasing the number and magnitude of negative equity houses.

The prospect of a downward spiral of house prices depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions. Experts say that an additional 10% to 15% decline in house prices is needed to get back to the prebubble level. That decline would double the number of homes with negative equity, raising the total to 40% of all homes with mortgages. The mortgages of five million homeowners would then exceed the value of their homes by 30% or more, which could prompt millions of defaults.

Read it all.

“There is one thing necessary to understanding what is happening and it is this: no one at U.S. banks, no one at the Federal Reserve, and no one in politics can accept the reality that real estate assets in this country remain oversupplied, overpriced and overleveraged.”

“It is that simple.”

—Kevin Depew, Five Things You Need to Know: Will the Bailout Succeed

The House of Representatives gave final approval on Friday to the $700 billion bailout for the financial system, reversing course to authorize what may be the most expensive government intervention in history.

At 1:21 p.m., applause and cheers echoed through the House chamber as the number of “aye” votes crossed the threshold needed for passage with just seconds remaining in the official 15-minute voting period. The vote was 263 to 171.

And in a sign of the urgency surrounding the package, Congressional staff rushed the newly printed legislation into a news conference where Democratic leaders gathered after the vote and Speaker Nancy Pelosi, Democrat of California, signed it, at exactly 2 p.m.

Within an hour, the legislation had been conveyed to the White House and signed by President Bush. Standing in the Rose Garden shortly before signing the document, the president thanked Congressional leaders of both parties by name and said they had achieved something “essential to helping America’s economy weather the financial crisis.”

Read it all.

Desperate to avoid another market-crushing defeat, House leaders won key converts Thursday to the $700 billion financial industry bailout on the eve of a make-or-break second vote.

President Bush and congressional leaders lobbied furiously for the dozen or so supporters they’d need to reverse Monday’s stunning setback and approve a massive rescue plan designed to stave off national economic disaster.

Read it all.

Update: I see over on Intrade this morning that the chances of the bill passing by October 31th are up to 94.

The world economy is on edge as it awaits the next round of American roulette. The US Senate has voted to create a $US700 billion ($880 billion) rescue vehicle for distressed debt. But the bill now goes to the House of Representatives, which has already rejected the idea once.

What will happen if the House says yes? And if it says no? What is the prize for winning this high-stakes game of chance? And the consequences of losing?

If you strip away the jargon, the core problem is pretty simple. There is an estimated $US2 trillion in dubious debt instruments, tied to the subprime mortgage market, outstanding at the moment. The US banks and institutions that hold them need to do one of two things – either sell them, or put a value on them in their financial statements.

At the moment, they can do neither. Why not? Because there is no functioning market. It’s not like the American sharemarket, where there are dedicated market-making firms that are charged with the job of standing in the market to buy shares, come what may.

Read it all.

This is dangerous. We have House members, many of whom I suspect can’t balance their own checkbooks, rejecting a complex rescue package because some voters, whom I fear also don’t understand, swamped them with phone calls. I appreciate the popular anger against Wall Street, but you can’t deal with this crisis this way.

This is a credit crisis. It’s all about confidence. What you can’t see is how bank A will no longer lend to good company B or mortgage company C. Because no one is sure the other guy’s assets and collateral are worth anything, which is why the government needs to come in and put a floor under them. Otherwise, the system will be choked of credit, like a body being choked of oxygen and turning blue.

Well, you say, “I don’t own any stocks ”” let those greedy monsters on Wall Street suffer.” You may not own any stocks, but your pension fund owned some Lehman Brothers commercial paper and your regional bank held subprime mortgage bonds, which is why you were able refinance your house two years ago. And your local airport was insured by A.I.G., and your local municipality sold municipal bonds on Wall Street to finance your street’s new sewer system, and your local car company depended on the credit markets to finance your auto loan ”” and now that the credit market has dried up, Wachovia bank went bust and your neighbor lost her secretarial job there.

We’re all connected. As others have pointed out, you can’t save Main Street and punish Wall Street anymore than you can be in a rowboat with someone you hate and think that the leak in the bottom of the boat at his end is not going to sink you, too. The world really is flat. We’re all connected. “Decoupling” is pure fantasy.

Read it all.

Take a look. Of interest at a local level, the two Senators from South Carolina voted opposite to each other.

After one spectacular failure, the $700 billion financial industry bailout found a second life Wednesday, winning lopsided passage in the Senate and gaining ground in the House, where Republicans opposition softened.

Senators loaded the economic rescue bill with tax breaks and other sweeteners before passing it by a wide margin, 74-25, a month before the presidential and congressional elections.

In the House, leaders were working feverishly to convert enough opponents of the bill to push it through by Friday, just days after lawmakers there stunningly rejected an earlier version and sent markets plunging around the globe.

Read it all.

After one spectacular failure, the $700 billion financial industry bailout found a second life Wednesday, speeding toward passage in the Senate and gaining ground in the House where conservative opposition seemed to soften.

Senators loaded the economic rescue bill with tax breaks and other sweeteners for the right and left, hoping to secure approval in the House by Friday, just days after lawmakers there stunningly rejected an earlier version and sent markets plunging around the globe.

The measure has not caused the same uproar in the Senate, where both parties’ presidential candidates, Republican John McCain and Democrat Barack Obama, were making rare appearances to vote their support. That would send the package back to the House, where passage would require a turnaround of 12 votes from Monday’s 228-205 defeat.

Read it all.

The ongoing turmoil in the financial markets has diverted me from my usual tax academic pursuits, including this blog, for which I apologize. This post explores the causes of that turmoil. My next post will explore solutions currently under consideration, including aspects of the so-called “$700 billion bailout.”

The current financial crisis has many causes, some long-term and structural. I focus here, however, on three immediate aspects of the crisis: the trigger, how problems generated by that trigger spread through the markets, and how this produced the liquidity freeze that persuaded Mr. Paulson and Mr. Bush to act (unsuccessfully thus far).

Read it all. This is a pretty good basic analysis. It is missing some important pieces, especially the 1999 decision to expand Fannie Mae and Freddie Mac’s purview and the role that had in encouraging more risky mortgages. Also, I disagree with him about Lehman, he is way too kind– it was a big mistake by the Fed. More about credit default swaps would have helped too.

Anyway, you take a look and see what you think–KSH.

“We don’t have a lot of leeway on time,” [Harry] Reid told reporters in the Capitol. “One of the individuals in the caucus today talked about a major insurance company — a major insurance company — one with a name that everyone knows that’s on the verge of going bankrupt. That’s what this is all about.”

—As quoted in the Louisville, Kentucky, Courier-Journal political blog

Check it out if you are so inclined. Is there some symbolism in the fact that what was originally three pages became 110 pages in the House version and has now become 451 pages? Just asking–KSH.