The Big Bank Bailout: Are You Next?

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For weeks, Paulson had held off on direct investment, preferring instead to use the $700 billion Troubled Asset Relief Program (TARP), passed by Congress on its second go-round, to buy toxic mortgage-related assets from the banks. The bank bailout will be funded out of that budget, and the Treasury still plans to start buying troubled assets in the next month or so. But that wasn't soon enough for worried investors or for Fed Chairman Ben Bernanke, who according to inside reports had been advocating for a recapitalization for months. Money flowed out of the stock market, including that of many large hedge funds. Some $2 trillion in market value disappeared in a week. "It was tunnel vision," says Republican Congressman Spencer Bachus, ranking member of the House Committee on Financial Services. At a meeting at the White House on Sept. 25, Bachus says, he and others brought up the need for alternative approaches. "The President said, 'Paulson wants to do it. He's the guy. Whatever he says, we do.'"

So what finally forced Paulson's hand? Pressure mounted from abroad when Ireland, the U.K., France and Germany moved almost sequentially to insure deposits and recapitalize banks--nearly $3 trillion worth. For the Treasury to fail to match that offer would have risked a capital flight by institutional depositors that could have started emptying U.S. banks.

The move to recapitalize the banks got an endorsement in global stock markets, which momentarily roared back, in many cases with record one-day gains. "[They] have headed off a full-blown collapse of the economy," says Anil Kashyap, an economist at the University of Chicago Graduate School of Business. "There's a 0% chance of 1930s-type depression."

The new government guarantees should insure that interbank loan rates retreat to the point where money is moving again. With the first capital injections a few days away, loans should begin flowing easily in a matter of weeks, says Scott Talbott, chief lobbyist for Financial Services Roundtable, representing major U.S. banks. "This will open up credit immediately, and the benefit will begin to flow to small businesses shortly thereafter," he says. Every $1 of equity creates $10 in lending power. Half of the $250 billion set aside for capitalization is targeted at smaller banks. Some banks are wary of the strings attached--including a halt to dividend increases--but they may have no choice.

The Demand-Side Problem

While the banking bailout may address the supply side of credit, it doesn't necessarily stimulate the demand side--where we all live. Across America, there is growing evidence that demand for credit--and everything else--is shrinking, with recessionary consequences. Two days after the Washington drama, the Fed's Beige Book report revealed that business was weakening everywhere, prompting the Dow to regurgitate 700 points. GM is shutting plants earlier than anticipated, idling 2,800 workers; PepsiCo, which reported falling sales in the U.S., is chopping 3,300 jobs worldwide. Demand for Samsung's DRAM chips is dropping. The retailer Linens'n Things is closing its remaining 371 stores, eliminating 17,000 jobs. The NBA is laying off 80 people, citing slower ticket sales.