Government Fear Itself

Potential bank investors don’t want to be ‘AIG-ed.’

Amid economic fear and uncertainty, many Americans naturally look to government for reassurance. But with its vast power and potential to harm, government can itself become a source of panic. This has happened too often in recent days as Americans and the world have finally awakened to the scale of the losses in the banking system.

[Review & Outlook] AP

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson.

The Federal Reserve and Treasury have both taken extraordinary actions in the last year to prevent large-scale financial damage. Some of that we have supported, including the recent Treasury authority to spend as much as $700 billion to shore up financial institutions. But how these proposals are presented and executed also matters if they’re going to reassure people and markets. This week’s stock market carnage is evidence of the danger when they frighten instead.

One problem is reckless news leaks of potential policy actions, some of them far-reaching, without adequate thought or public explanation. Take Friday morning’s reports, presumably leaked by Treasury, that the federal government might insure all bank deposits. This would be no small matter. Until recently the feds insured deposits only up to $100,000 per account, and last month it raised that to $250,000. Ensuring all deposits would add another $1.9 trillion in taxpayer guarantees.

It isn’t clear, however, that insuring all deposits would do much more to reassure most retail savers, who have largely stayed calm. There have been runs on individual banks but so far not runs across the system. Yet leaking the possibility of such a policy change is the kind of thoughtless action that could well incite such a run.

There’s also the problem of what such a policy could mean for deposits held outside the banking system. What about the danger of flight from General Electric’s credit subsidiaries if money rushes to the relative safety of bank deposits? It might also cause problems for money-market funds, whose deposits are only insured if they were made before September 19. Treasury decided to insure money-market deposits precisely to prevent a run on those funds that in turn had caused damaging redemptions in the commercial paper market. Media trial balloons are a Washington pastime, but in a global financial panic they may only compound the fear.

Recapitalization Recap

A similar lack of transparency has marred the execution of the Troubled Asset Relief Program, or Tarp. Secretary Hank Paulson first sold the proposal as a way to buy troubled bank securities via an auction, though it quickly became clear that Treasury hadn’t thought about it very deeply. We supported Tarp nonetheless as a fund that could be deployed in many ways to shore up the financial system, and sure enough this week Mr. Paulson floated the idea of injecting public capital directly into financial institutions.

In contrast to the British, however, Treasury couldn’t explain how this would work, who would be eligible, or even when it would take place. Amid this policy vacuum, rumors quickly spread that Treasury might “nationalize” the banks. This isn’t what anyone we know in government has in mind, and it would be disastrous if it happened. But it’s unsurprising if people believe it in a panic, especially absent any details and in the wake of the government’s recent “bailout” of AIG.

In retrospect, the AIG seizure has also undermined confidence by looking both arbitrary and punitive. The loan terms were so onerous — requiring the company to pay more than 10% interest even on money it doesn’t borrow but might in the future — that this week the New York Fed had to bail out the bailout. It extended another $38 billion on top of the original $85 billion, while AIG now must sell its healthy insurance assets at firesale prices. No one wants to put private capital into a bank if it might be “AIG-ed.”

Using the Tarp to help recapitalize the banks still has much to recommend it, and the idea has been endorsed in some form on these pages by financier John Paulson, Nobel economic laureates Vernon Smith and Edmund Phelps — and by us. This has to be done carefully without savaging current (and especially) future shareholders. But doing this quickly in specific cases would have a salutary effect on confidence as it becomes clear that sound banks can’t be run out of business merely by a stampede of fear.

Such a capital stand might be especially useful now as a way to shore up Morgan Stanley, which is under siege as investors worry over the fate of its planned $9 billion capital injection by Mitsubishi UFJ Financial Group. A successful stand would also go a long way to unlocking the interbank lending market.

Our point here isn’t to play Saturday morning second-guesser. Mr. Paulson and the staff at Treasury and the Fed are working night and day, and they must make decisions in real time while dodging real bullets. But they also now have all of the tools they need to stabilize the banking system, if they use them well. Most Americans have only recently discovered how serious this threat to the economy is. No wonder they’re scared. Mr. Paulson or Fed Chairman Ben Bernanke need to explain what they are doing, and why it will lead to a better, more stable financial system.

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