Next step: U.S. to bankroll banks

In an extraordinary response to the escalating financial crisis, Treasury Secretary Henry M. Paulson said Friday that the government would buy direct stakes in banks and other financial institutions for the first time since the Great Depression.

Paulson had initially dismissed the idea of taking equity stakes in crippled banks, and his change of heart may reflect a growing conviction that the severity of the credit crisis warrants a more direct approach. The Treasury plan aims to help banks rapidly shore up their dwindling capital so that they are more willing to lend to businesses, individuals and one another.

The announcement followed Wall Street’s most tumultuous week ever, including a volatile session Friday that saw the Dow Jones industrial average whipsaw over a range of 1,000 points. The Dow fell for an eighth straight day and posted the biggest weekly loss in its 112-year history.

“We’re in this together and we’ll come through this together,” a somber President Bush said in a Rose Garden statement. He warned that “anxiety can feed on anxiety” -- echoing President Franklin D. Roosevelt’s Depression-era declaration that “the only thing we have to fear is fear itself.”

Paulson said the Treasury Department was working on a plan to buy equity in “a broad array of financial institutions,” using some of the $700 billion in the financial rescue package approved by Congress last week.

The equity would be in the form of nonvoting shares, a move that might temper the government’s ability to meddle with management.

Paulson made the announcement after emerging from a meeting of finance ministers and central bankers of the world’s leading industrial democracies. After the meeting, the so-called Group of 7 issued a five-point plan, promising “urgent and exceptional action” to address the crisis.

Although the finance ministers pledged to work cooperatively on the same goals, they did not commit to a specific plan. That poses the possibility that disappointment over the limited scope of the communique will drive stock markets lower again on Monday.

Many economists and investment professionals had been hoping that the G-7 meeting would produce a concrete, coordinated international plan to address the spreading global credit crunch. Paulson dismissed that suggestion.

“Some in the press and some in the markets are naive if they think that different countries with different financial systems, economies in different stages of development . . . and different political systems, different laws are going to come up with precisely the same policy to deal with the issues,” he said.

But Paulson added that all participants at the meeting agreed that strong steps were necessary. “This is a period like none of us has ever seen before,” he said. “What came out of the meeting is there weren’t differences in what we need to do.”

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Favored by economists

The Treasury’s equity-purchase program was widely favored by economists, who contended that it would be preferable to the approach of buying bad mortgage securities from banks, the centerpiece of the financial bailout bill.

“Buying mortgage assets is plagued with problems,” said R. Glenn Hubbard, dean of the Columbia Business School and former chairman of President Bush’s Council of Economic Advisors.

Hubbard made his comment shortly before the Paulson announcement but after it became clear that the Treasury secretary was leaning toward the new approach.

“It’s very helpful that Treasury is pivoting in this direction,” Hubbard said. “This is a crisis that policy can fix -- it’s not beyond our ability.”

Paulson offered few details about the equity program, declining to say how much of the $700 billion would go to such purchases. He said U.S. officials were “working around the clock” to develop the program.

In recent weeks, the Treasury and Federal Reserve have taken unprecedented steps to protect the economy from the effects of the global credit crisis. And much more aggressive steps are looming, government and economic observers say.

The Fed, for example, has moved to thaw out the commercial paper market -- the provider of short-term loans for companies including massive conglomerates and provincial manufacturing firms. The central bank’s announcement this week that it would create a “backstop facility” -- essentially a form of guarantee -- for commercial paper began to lower interest rates on the debt for some borrowers within a day or so.

Many economists and finance experts say the latest round of initiatives, along with those that are being telegraphed by government officials, suggest that policymakers are pulling out all the stops in attempting to unlock the credit crunch.

Some also suggest that the current approach still has several gaps -- including more direct efforts to shore up home prices and reduce foreclosures, and more coordinated international initiatives to restore confidence in the global banking system, largely by providing banks with capital and insuring deposits.

Many of the steps already taken involved authority that existed but was seldom used. Some, such as the Treasury’s ability to take direct equity stakes in banks, involve new powers.

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Financial emergency

Other steps require explicit findings of an impending financial emergency. The Fed’s ability to provide capital to some corporations or partnerships may rest on a vote by its board that “unusual and exigent circumstances” exist in the credit system, according to the Federal Reserve Act.

A plan to allow the Federal Deposit Insurance Corp. to insure all bank deposits -- beyond the limit of $250,000 per depositor written into the economic stabilization bill this month -- would require a multi-agency finding that “systemic risk” threatens the economy.

But financial experts believe that it would go far toward shoring up public confidence in the banking system, as well as giving banks more comfort about lending to one another.

In any event, obtaining the necessary findings from the Treasury, Fed and FDIC may not be much of an obstacle, given the urgent atmosphere in the financial markets.

Many experts praise Paulson and Fed Chairman Ben S. Bernanke for their creativity in addressing the crisis.

“They’ve been creating and refashioning tools on a daily basis,” said Cornelius Hurley, a banking and financial law professor at Boston University. “It’s been breathtaking to see them reach into their tool kit.”

Few policymakers are as familiar with the size of that tool kit as Bernanke, a longtime student of Fed policy. Addressing an audience of economists in 2002, when he was a Fed governor but not yet chairman, Bernanke outlined the almost unlimited authority of the Federal Reserve to protect the U.S. economy from harm.

The central bank could inject money into the economy by purchasing almost any asset -- government bonds, corporate bonds, foreign debt or other assets -- to manipulate interest rates and capital flows, Bernanke said. Even in the most extreme circumstances, he said, a determined central bank would “most definitely not run out of ammunition” to maintain economic activity even in harsh recessionary conditions.

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Homeowner relief

But many observers say that, far-reaching as they are, the steps taken thus far don’t adequately address the root cause of the credit crisis -- rising defaults and foreclosures on mortgages issued to overextended borrowers who are now financially strapped and unable to keep their homes under their existing loan terms.

Although some homeowner relief has been enacted by Congress, the economy appears to be slowing sharply and job losses are mounting. That has triggered calls for a bailout for Main Street, especially in light of a lingering public perception that the $700-billion rescue plan is a bailout for Wall Street.

Indeed, Democratic leaders in Congress are discussing a new economic stimulus plan, possibly to be considered after the Nov. 4 election.

Among the initiatives that can also be taken by the federal government are programs to convert some mortgages on homes with values that have fallen below their mortgage balances from adjustable to fixed-rate loans. That change, which might make the mortgages more affordable for certain owners, could be undertaken by Fannie Mae and Freddie Mac, the mortgage giants taken over by the Treasury last month.

“You should be using the expertise of Fannie and Freddie to go out to people in trouble,” said William Donaldson, former chairman of the Securities and Exchange Commission and a former Wall Street executive. “You could really analyze their creditworthiness and their ability to carry low-interest 30-year mortgages.”

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jim.puzzanghera@latimes.com

richard.simon@latimes.com

michael.hiltzik@latimes.com

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Daily developments

* In a somber Rose Garden address, President Bush says of his administration’s financial rescue initiative: “The plan we are executing is aggressive. It is the right plan. It will take time to have its full impact. It is flexible enough to adapt as the situation changes. And it is big enough to work.”

* The Dow Jones industrial average sinks almost 700 points in the opening minutes and sets a new volatility record before closing down for an eighth consecutive session.

* Finance ministers and central bankers of the leading industrial democracies meet in Washington and issue a five-point plan, promising “urgent and exceptional action” to aid the global financial crisis but providing few specifics.

* Treasury Secretary Henry M. Paulson announces that the government will buy stakes in banks and other financial institutions for the first time since the Great Depression using a portion of the $700-billion bailout package.