Credit Crisis Strains Government's Options

By Jon Hilsenrath, David Enrich and Deborah Solomon

A year into a credit crisis that started with troubled mortgages to sketchy borrowers, the financial system is reeling once again, casting a pall over a widening array of financial institutions just days after history-making efforts by policy makers to contain the problem.

The Federal Reserve has already slashed interest rates to counteract a deepening credit freeze and instituted its broadest expansion of lending facilities since the Great Depression to keep financial markets functioning. Over the weekend, the nation’s two main mortgage finance firms — Fannie Mae and Freddie Mac — were placed under government control.

Federal officials and market players are struggling with the same issues: Why haven’t the steps taken so far calmed the system? What can policy makers do next? Should the U.S. government let a big institution fail rather than stage another potentially costly bailout?

Henry Paulson

Lehman, one of Wall Street’s last big independent firms, saw its stock plunge 42% a day after the company unveiled a plan to shrink itself as a way to ride out the crisis. It is now in talks to be sold altogether, though it’s not clear there will be takers.

The Federal Reserve and Treasury Department have been working with Lehman to help resolve its troubles, including talking to potential buyers, according to people familiar with the matter. A rescue like those of Fannie, Freddie and Bear Stearns Cos. isn’t currently expected, but much can change in the days ahead.

Merrill Lynch shares were down 17% to $19.43 a share Thursday. Washington Mutual Inc., the nation’s largest savings and loan, which replaced its CEO this week, came under heavy selling pressure early in the day. After dipping below $2, the stock rallied to gain 51 cents to finish at $2.83 in 4 p.m. New York Stock Exchange Composite trading. The stock is still down 34% since Monday.

In some ways, broader financial markets are taking the latest drama in stride, a cause for some reassurance. The Dow Jones Industrial Average has traded in a range between 11200 and 11800 since July. Though the Dow is down for the year, stocks in Europe and Asia have performed much worse.

Among the reasons for optimism: Falling oil prices could eventually provide relief to consumers and a stronger dollar has taken pressure off inflation. U.S. officials hope that the rescue of Fannie and Freddie will help lower mortgage rates, and financial firms have already raised billions of dollars of fresh capital.

But other measures of financial conditions are as bad as they were back in March, when the Fed and Treasury arranged the abrupt takeover of Bear Stearns by J.P. Morgan Chase & Co. For instance, junk bonds now yield 8.55 percentage points more than safe Treasury bonds, a spread that is about as wide as it was in March. These spreads widen as investors become more fearful about risk.

Banks are also finding it more costly to fund themselves. Wells Fargo & Co. of San Francisco, which has weathered the crisis better than most peers, was forced this month to promise higher-than-expected yields on debt securities it issued in order to lure nervous investors. Last month, Citigroup Inc., American International Group Inc. and American Express Co. all faced weak demand for bond issuances that pushed up the yields they had to pay.

“The market has no tolerance for uncertainty,” says Laurence Fink, chief executive of money manager BlackRock Inc.

Three problems are behind the latest wave of trouble.

First, the economy shows signs of weakening as stimulus from federal tax rebates wears off. A survey of 51 economists for The Wall Street Journal projects that consumer spending will contract in the third quarter for the first time in 17 years. Lower energy prices are helping, but might not be enough to counter the heavyweights of the housing crunch and job cuts.

Second, households and financial institutions aren’t finished with a painful process known as deleveraging, in which they reduce their reliance on debt.

Home Prices

These two processes — deleveraging and soft consumer spending — can feed on each other, something economists call an adverse feedback loop. Deleveraging puts downward pressure on home prices. That, in turn, forces financial institutions to deleverage more. In the same way, falling home prices squeeze households, which forces them to cut back on spending and puts off a housing recovery, further weighing on home prices.

Federal Reserve Vice Chairman Donald Kohn made note of these feedback effects in comments on the housing market Thursday. Despite some signs that home prices were stabilizing recently, he noted that mortgage conditions were getting tighter, which could ultimately weigh on prices. “In my view, the jury is still out on whether housing prices are close to finding a bottom,” he said.

The government’s many interventions have been designed to break this feedback cycle. But such efforts increasingly show signs of running up against their limits. “There’s no trend of improvement. It’s not improving even slowly,” says Laurence Meyer, a former Fed governor and now vice chairman of Macroeconomic Advisers LLC, an economic-forecasting firm.

Raising Capital

A third wrinkle is that financial firms are having an increasingly hard time raising the capital they need to hasten the process of deleveraging. In the past year, sovereign-wealth funds and others have poured billions of dollars of fresh capital into Lehman, Merrill Lynch, Citigroup and others.

Stung by mammoth losses on those investments, many investors are now balking. Sovereign-wealth funds, many of them facing criticism at home over the investments, have stayed on the sideline as Lehman and other firms have struggled to raise capital.

In the Middle East, some sovereign-fund managers say their portfolios are now heavy on U.S. and European holdings after the recent buying spree. They’re scouting for opportunities elsewhere, such as India, Asia and closer to home.

Private-equity firms face different hurdles. If they own too much of an institution that accepts deposits, they would open themselves to federal regulation as bank-holding companies. The rules limit them to less than 25% of the voting stock of a regulated depository institution.

Since April’s large cash infusions into Washington Mutual Inc. and National City Corp., private-equity firms — with some $450 billion in untapped funds, according to London-based data provider Preqin — haven’t made any major investments in capital-starved banks.

Executives from such firms as Carlyle Group and Blackstone Group have been using the credit crunch to lobby the Office of Thrift Supervision and the Federal Reserve to allow them to own bigger stakes of financial firms without having to face regulation.

“At some point, that flow of capital to financial institutions will dry up, and we’ll still have most of the issues for regional banks, in terms of defaults and credit problems, still ahead of us,” Blackstone President Tony James said last month. “So maybe I’m giving an advertisement for our own business, but I think that the economy would be well suited to find ways to bring private-equity capital into the financial sector.”

The recent government rescues may have backfired by making investors more wary of investing in capital-hungry firms. In the cases of Bear Stearns, Fannie and Freddie, federal officials’ strategy was to protect debtholders. But their interventions were also clearly designed to not bail out stock investors.

Now stock investors are worried that they could be wiped out if they pump money into firms that could fail. “It seems unthinkable to intervene for the benefit of shareholders,” says Mr. Meyer of Macroeconomic Advisers.

Lehman provides the starkest recent example of the difficulty of raising capital. In early April it was able to raise $4 billion by issuing convertible preferred shares. Demand then was so strong that it increased the number of shares it issued. Since then, however, its share price has sunk more than 90%. After talks fell through for fresh capital from a Korean bank, Lehman announced plans to shed assets and slash its dividend. Its share prices have continued to sink.

Confronting the Crisis

U.S. officials are not powerless to confront the crisis. But they are far more constrained than they were a year ago, after taking a series of steps to bolster financial markets, including slashing interest rates.

The Fed now has facilities in place to provide short-term funding to firms such as Lehman if it runs into a liquidity crisis. As of Wednesday, no firms had used the Fed’s lending facility for investment since late July.

“A number of markets remain disrupted and illiquid,” the Fed’s Mr. Kohn said Thursday. “But I believe that they would have been even more illiquid and the risk of disruption runs even greater without our various facilities.”

Doing more could lead to other problems. Fed officials are wary of pushing short-term interest rates lower. At 2%, the federal-funds rate is 3.25 percentage points lower than it was a year ago, and looks likely to stay on hold because the Fed worries that more rate cuts would worsen inflation. What’s more, other interest rates, such as mortgage rates, remain elevated as previous rate cuts have been counteracted by the force of the credit crunch. It’s not clear that further cuts would have much effect in bringing down other rates.

Officials are also acutely aware of the problem of “moral hazard.” Bailing out too many firms, the reasoning goes, would encourage more risk taking in the future. That makes officials reluctant to be seen as rescuing another institution. The Fed made a $29 billion loan to help J.P. Morgan take over Bear Stearns. It’s not clear that it would be willing to do that for another firm.

Treasury Secretary Henry Paulson has said that institutions must be allowed to fail and that markets can’t expect the government to lend money or support every time there’s a crisis. “For market discipline to constrain risk effectively, financial institutions must be allowed to fail,” Mr. Paulson said in a speech in July.

Bound Together

But the government is in somewhat of a bind, one that Mr. Paulson himself has noted. Financial markets are now bound together by complex financial instruments like credit-default swaps and certain money-market instruments that firms and regulators have limited experience handling in a crisis. They worry that problems could spread more widely through the system through the use of these instruments. Regulators are working on addressing the clearing and settling of these instruments but aren’t finished, and worry that the failure of a firm could send ripple effects far and wide.

Moreover, Mr. Paulson, along with Federal Reserve Chairman Ben Bernanke, has called for a formal procedure for facilitating a disposition of assets when an investment bank fails. But no such procedure yet exists, complicating any decision by the government to let an institution fail. Efforts to modernize other markets, like the market for credit-default swaps and repurchase agreements, are also incomplete.

“Today, our tools are limited,” Mr. Paulson said in his July speech.

Policy makers could ultimately find themselves in a situation similar to one they faced a decade ago when a global financial crisis was sweeping from country to country.

Starting in mid 1997, the International Monetary Fund, pushed by the U.S. Treasury, mounted multibillion-dollar bailouts of Thailand, Indonesia and Korea. By August 1998, when Russia threatened to default on its bonds, the Treasury and Federal Reserve decided to pull the plug. Another rescue would have thrown good money after bad, they figured.

One of those opposing a prospective bailout was Timothy Geithner, then a senior Treasury official, now President of the Federal Reserve Bank of New York, which played a central role in the Bear Stearns rescue. Mr. Geithner now has to help decide whether Lehman will become the Russia of this financial crisis.

“Everyone thought Russia was too nuclear to fail,” says Ted Truman, who was a senior Federal Reserve official at the time and worked closely with the U.S. Treasury. “But we let it fail.”

Markets, shocked by the U.S. inaction, were battered by Russia’s default. A similar anxiety is weighing on investors now.

“You could argue that you should let Lehman go. Everyone knows it’s been on the ropes since May. It wouldn’t shock the market,” says Mr. Truman. “But the reason to [rescue it] is not to create more chaos” in the market, which could require yet more federal intervention later on.

–Carrick Mollenkamp, Peter Lattman, Tom Lauricella and Sudeep Reddy contributed to this article.