Why the bailout may not be enough

After much ado, the government appears ready to toss a lifeline to Wall Street. But with policymakers frantically battling to keep the economy out of a deep slump, it won't be the only one needed.

The House of Representatives is expected to approve a $700 billion rescue package Friday. The so-called Troubled Asset Relief Program would allow Treasury Secretary Henry Paulson to buy bad mortgage assets, in hopes of getting bank loans flowing through the economy again.

But using TARP to slim the bloated balance sheets of U.S. financial institutions may not be enough to restore the investor confidence that began ebbing last year - confidence that's necessary if banks are going to be able to raise the capital they need to stand behind their loans, and engage in the borrowing they need to keep their operations running on a daily basis.

The key is to vanquish the fear that has left banks hoarding cash - and potentially strangling growth by withholding the credit consumers and businesses need. That means recapitalizing troubled banks via purchases of preferred stock, and guaranteeing the senior debt of financial companies.

"Nationalization works because it creates confidence," said John Hempton, an investor and financial analyst based in Australia. Investors around the globe lost faith in American finance when it became clear that Wall Street had spent the boom years earlier this decade peddling bad debt, Hempton says.

But for the banks, restoring trust isn't merely a matter of saving face. Financial institutions borrow to finance their operations. Because Americans have been loath to save money in recent years, banks in the United States tend to have much smaller deposit bases than those in, say, Japan, where a high savings rate has given banks a surplus of deposits.

In America, by contrast, deposit-light financial firms have funded themselves in the short-term debt markets. That was a profitable strategy for years, because the wholesale funding markets generally offered low rates and abundant liquidity.

But since Wall Street's perfidy came to light in August of 2007, short-term lending rates have risen, squeezing firms that depended on market funding. The squeeze continued even as the Fed and other central banks created all sorts of new methods to lend to financial institutions.

And the vise has tightened in earnest in the past month, with the failure of Lehman Brothers and Washington Mutual and the forced sale or nationalization of five other firms.

The collapse of short-term funding markets recently forced two blue-chip U.S. companies, Goldman Sachs (GS, Fortune 500) and General Electric (GE, Fortune 500), to sell some $8 billion in preferred stock to billionaire investor Warren Buffett's Berkshire Hathaway (BRKB). Those sales will cost the companies dearly: the terms call for Berkshire to get a rich 10% dividend in each case.

But then, when credit isn't available, everyone pays, as policymakers are well aware.

Stop the bleeding
"A continued correction in credit supply, fiscal receipts, investment, employment and consumer balance sheets is inevitable," wrote Lena Komileva, an economist at Tullett Prebon in London, a broker that facilitates business between other brokers. "The question is about the slope and duration of the downturn, not about the direction of the economic cycle."

That's why Hempton says that however the next stage of the bailout unfolds, it's imperative that the government stand behind the senior debts of financial companies in a bid to restore the confidence of the lenders who supply the bulk of financing for U.S. banks.

Hempton cites last month's takeover of mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) as proof that a government backstop can work, even in a market as large as the one for mortgage-backed securities. By signaling that the Treasury would stand behind the debt the agencies have issued, the Fannie-Freddie takeover brought the foreign central banks that have been the big buyers of Fannie and Freddie securities back into the market, reducing U.S. mortgage rates.

By contrast, the failures of Lehman Brothers and Washington Mutual left senior creditors with substantial losses - potentially discouraging investors from putting their money into other financial firms that need funding as well.

The government may also need to take a more direct role in providing new capital. One question about the TARP is whether the government's purchases of illiquid mortgage-related assets would help banks boost their capital cushions, which have been depleted by mortgage-related losses.

Paulson and Federal Reserve chief Ben Bernanke have indicated a preference for paying prices above the fire sale values quoted in the markets - which could, by forestalling further writedowns, help the banks' capital positions.

Don't overpay
But overpaying for assets may leave taxpayers exposed to big losses and may simply drag out the time it will take for the real estate market to finish making the painful correction that comes when a bubble is popped.

Even TARP backers such as Buffett have suggested the plan is workable only if the purchases are made at market prices.

So why not have the government recapitalize firms directly by buying senior preferred shares? It's a more straightforward, honest approach and, says David Merkel, chief economist at broker-dealer FinaCorp Securities, it puts taxpayers first in line to reap the benefits of any recovery down the road.

Yes, a government stake will dilute the ownership stakes of existing shareholders. But combined with backstopping the banks' debt, it will send a clear message that the U.S. is serious about restoring banks' capital and creditors' confidence before economic conditions worsen.

"As the rapid deterioration of market conditions following Lehman's collapse revealed," Komileva wrote, "a government move today is worth two tomorrow."