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Will the financial markets judge Geithner’s plan to be in conflict with the Fed’s action?

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Fed Votes ‘No Confidence’ in Obama

Will the financial markets judge Geithner’s plan to be in conflict with the Fed’s action?

Despite the trillions of dollars pouring out of the federal government, neither Wall Street nor the Federal Reserve has confidence in President Obama or Treasury Secretary Tim Geithner.  

In an unprecedented action last week, the Federal Reserve decided to purchase $1 trillion in toxic mortgage-backed securities in order to take them off the books of banks whose assets were so tied up in them that they could no longer lend.  The Fed’s decision put into action a version of the plan that was first demanded by then-Treasury Secretary Hank Paulson, then legislated quickly only to have Paulson change his mind and not purchase the securities.  And the Fed’s action apparently was taken after two months of dithering by the Obama administration. 

 It was a direct repudiation of the Obama administration’s failure to act to solve the credit crisis: the clearest vote of “no confidence” in the White House since the financial crisis erupted last fall.

Republican Study Committee Chairman Rep. Tom Price (R-Ga.) characterized the Fed’s action just that way. Price told me, “The Fed just cast a $1 trillion dollar vote of no confidence on the Treasury Secretary. Months into the administration, we would have hoped Geithner would at least formulate a workable plan to stabilize the economy. Hopefully they will learn there is a positive solution out there before future generations lose another trillion dollars.”

Price’s comment cuts to the heart of the problem. Wall Street’s panic continues because the Obama administration has spent trillions of dollars without aiming any of them at the causes of the financial market crisis. When the Obama administration was slamming Geithner’s confirmation through the Senate, he was portrayed as indispensable to inspire confidence in the market and solve its problems quickly. But no confidence has been gained.  

The long-awaited Geithner plan to solve the banking crisis comes out today and will reportedly be based on government purchase of the same kind of toxic mortgage-backed securities which the Fed announced it was buying.

This is essentially the “bad bank” concept — one of the two possible solutions to the crisis — that was supposed to be the plan for the “Toxic Asset Recovery Plan” put in place and then abandoned too quickly by the Bush administration last fall.  The idea was to have the government buy up the securities, freeing banks and other financial institutions to lend again.   Because they have to carry the unmarketable — and possibly valueless — securities on their books as debt, they lack sufficient other assets on which to base lending.  Buying up the toxic assets would free up the credit markets.  

The Geithner plan will fail to inspire confidence if it appears too indefinite, too complex, or if it conflicts with the Fed’s action last week.  There is considerable danger here:  if Geithner decides to buy the securities on terms that are more stringent or slower than the Fed’s purchase, the two may be seen to conflict, making both fail. 

The Bush administration backed away from the direct purchase of the toxic securities because then-Treasury Secretary Hank Paulson changed his mind at the moment he was given the authority to purchase them.  Paulson saw the administrative challenges as too great. 

Paulson’s reversal was wrong: previous government bank support plans involving “bad banks” to buy up troubled assets have worked, and one can probably work now.  The problem is how to make the government’s purchase of toxic assets work in a bank crisis that is magnitudes larger and more complex than any before it.

Just how large no one really knows.  Which brings us to AIG, the famously failing insurance company which was judged “too big to fail.”

According to the latest Rasmussen poll, 59% of Americans would rather AIG fail than to continue government support of the insurance giant.  But it’s not that simple.  AIG has already received about $170 billion in federal aid, but that may not be nearly enough.

AIG is one of the principal holders of “credit-default swaps,” one of the biggest classes of mortgage-backed securities that are tying up the financial markets.  The Fed’s action — injecting $1 trillion into the money supply — has to be judged against the size of the credit-default swap problem.

The entire world’s gross domestic product is about $62 trillion.  There may be as much as $40 trillion in unmarketable credit-default swaps clogging the banking system worldwide, and a large part of them (again, no one knows how much) are held by AIG.  

A credit-default swap is like an insurance policy against the loss of value in a security.   The financial system for home mortgages cobbles together hundreds or thousands of mortgages and resells them in the form of securities that resemble shares of stock.  When those securities can’t be sold — because the underlying mortgages are worth less than their face value — credit-default swaps are supposed to cover the loss.  

But when no one knows how much the underlying securities are worth, they can’t be sold, and the credit-default swaps bring the flow of credit to a halt.  

According to the Congressional Budget Office, the Obama budget would swell the federal deficit to $1.8 trillion this year, about 13% of the nation’s gross domestic product.  As Senate Minority Leader Mitch McConnell said, “If there was ever any doubt that the administration’s budget spends too much, taxes too much and borrows too much, it’s gone.”

The magnitude of any solution to the banking crisis, coupled with Obama’s budget plan, make the phrase “runaway government spending” seem entirely inadequate.  Republicans in Congress — as well as a few Democrats — are trying to bring the budget back to reality.  Unless they succeed in imposing severe cuts on Obama’s plan, the burden of this spending will be too much for our economy to sustain the toxic asset purchase plan Geithner proposes.

Some state governors, led by South Carolina’s Mark Sanford, are trying to find a way for their states’ budgets to survive the Obama-imposed spending.  Obama refused Sanford’s request for permission to use stimulus money to pay down the state’s debt.  Obama is determined to impose on the states the future spending liabilities of the increased unemployment benefits and other spending required by the “stimulus” legislation.

Sanford told me, “This level of federal deficit spending is unconscionable for the way it puts future generations on the hook for spending they’ll never have a say over, and for the way it will over time devalue the American dollar. We’re doing whatever we can on the state level to pay down debt rather than increase spending so that tomorrow’s taxpayers won’t be footing as large of a bill."

The Obama administration’s actions to date — the “stimulus” legislation that can’t stimulate, the failure to come up with a plan to solve the credit crisis and now the bloated budget — combine to burden the economy with enormous debt without solving any of the problems that brought the economy down.  

There is nothing the administration has done that builds the markets’ confidence in the economy.  The Geithner plan is probably its last opportunity to reverse the trend, but there’s no reason to be hopeful.  Obama’s team is spending too much too fast, and Geithner’s plan will spend much more, even faster.

If the markets judge Geithner’s plan to be in conflict with the Fed’s action, it will certainly fail, and may drag the Fed’s action down with it.

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Written By

Mr. Babbin is the former editor of Human Events and HumanEvents.com (Jan 2007-Mar 2010) and served as a deputy undersecretary of defense in President George H.W. Bush's administration. He is the author of "In the Words of our Enemies"(Regnery,2007) and (with Edward Timperlake) of "Showdown: Why China Wants War with the United States" (Regnery, 2006) and "Inside the Asylum: Why the UN and Old Europe are Worse than You Think" (Regnery, 2004).

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