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New confidence -- at a big price

Updated: May 3, 2013 12:14PM

Suddenly on Friday, the markets turned around. What did the government really do?

It took unprecedented steps to confront a $1 trillion problem that threatened to bring down not only the entire U.S. financial system, but destroy the interconnected global markets ranging from England to Japan, and from Russia to Canada. It's a very small financial world, after all.

Over the weekend, President Bush asked Congress for $700 billion to buy up troubled mortgage securities. That appears to be in addition to the $200 billion pledged to rescue Fannie Mae and Freddie Mac, and the $85 billion to be lent to AIG. The moves will require an increase in our national debt ceiling to $11.315 trillion -- a number that boggles the mind.

Meanwhile, Democrats on Capitol Hill pledged to add more aid for troubled homeowners, and are even raising the issue of a salary cap for CEOs, reacting to the contractual payouts to many failed bankers that put millions in their pockets in spite of their mismanagement. There's even talk of a second economic stimulus plan that would add to the deficit.

The Friday announcement succeeded in buying time -- time for markets to return to a rational state of mind, time to revalue the mortgage-backed securities and all the derivatives contracts based on those packages of mortgages, and time for the dollars that are sloshing around in the central banks of the world to find a home in our financial institutions, which desperately need capital.

Congress is being asked to create a new federal agency that resembles a giant waste landfill. Into it, they will dump all of the toxic securities now being held on the books of banks and financial services companies -- holding them until they either mature or can be sold in calmer times.

Getting the bad loans off the books will give the banks the freedom to move forward with their regular business of lending and financing their good customers, helping the economy.

Fannie and Freddie, now controlled by the government, will increase their purchases of healthy mortgage-backed securities, and the Treasury will also support the mortgage market.

What's behind this part of the plan? Once the housing market gets going again, the economy will improve, pushing home prices higher, helping to solve the problem that started it all.

In addition, the Fed will give very low interest (2.25 percent) loans to the banks to buy commercial paper -- short-term corporate IOUs -- now sitting in money market funds, along with using $50 billion to temporarily protect investors in money-market funds.

To calm bank depositors worrying about which bank is "safest," the FDIC reserve fund was given a big boost.

Still unknown

All of that concentrated attention from the Fed, the Treasury, the president and Congress gave the market a ray of hope. But questions remain.

Valuing the junk: No one knows how the government will value the bad assets they put into this new agency, or when and if they'll be able to sell these securities. If they price them low enough, maybe eventually they'll sell at a profit!

Whose junk is included: In addition to the banks, there are pension funds, hedge funds and foreign banks that own these questionable mortgage securities. Will those be purchased, too?

Where to get the money: The federal government will have to borrow this money, with the entire situation, including Fannie, Freddie, Bear Stearns and AIG plus these promises, now totaling nearly $1 trillion. Will foreigners lend us this money -- at the current low rates? Will all that borrowing push rates higher, or will new credit creation cause inflation down the road?

The market wasn't quibbling about the details Friday because the plan does one thing that can't be valued in dollars and cents: It instills confidence in the financial markets -- confidence that the entire weight of the United States is standing behind the banking system and financial markets.

But as Congress adds spending plans, and dithers over details, the markets could conclude that this rescue plan will cause more financial problems than it solves. That's what the markets will weigh when they open Monday. And that's the Savage Truth.

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