Fanning the Flames


Ever since Treasury Secretary Henry Paulson announced his plan to buy ownership shares in the nation’s banks, three words should be haunting conservatives: government-directed lending.

In many ways, government-directed lending brought us to this point. Yes, Wall Street was buying subprime mortgages before Fannie Mae and Freddie Mac plunged into the market. But between 2005 and 2007, Fannie and Freddie financed $1 trillion of these risky loans in pursuit of affordable-housing goals at the behest of their patrons in Congress, most of whom were Democrats. The subprime conflagration never would have grown this large and ungovernable without Fannie and Freddie fanning the flames.

This summer, Fannie and Freddie collapsed under the weight of all their bad debt, leaving taxpayers with a bill for $200 billion. This would have been a perfect time to wind them down and privatize them. Instead, their regulator put them into a government conservatorship, with the goal of returning them to fiscal health. Democrats in Congress wouldn’t have it any other way: The sooner Fannie and Freddie are back on their feet, the sooner guys like Barney Frank can put them back to work financing home loans for  high-risk borrowers.

Now that the government is buying an ownership share in the banks, we are left to contemplate the prospect of hundreds of Fannies and Freddies roaming the countryside, making loans based on politics instead of commercial merit. This would wreak havoc on the economy, to say nothing of the wisdom of letting the government pick winners and losers in the market.

How likely is this scenario? More specific: Has Paulson put the right safeguards in place? For now, the answer appears to be yes. Under the terms laid out by the Treasury Department last week, the government’s power is limited. It does not get voting rights or board representation. Participating banks can buy back the government’s shares at any time by raising private capital.

The strings attached are few. Participating banks must accept limits on executive compensation, and they must pay dividends to the government before they pay other shareholders. Paulson can pressure the banks to start lending the money, but he cannot make the banks make loans.

So far, Paulson has convinced nine major financial institutions representing half of all U.S. bank deposits to participate in the plan (he didn’t give them much choice). The U.S. government now owns $125 billion in preferred stock in these nine banks. Paulson has announced that he will make another $125 billion available for hundreds of smaller regional and community banks, should they choose to take part. They have until November 14 to decide.

Any bank that is thinking about accepting Paulson’s offer must keep in mind that his last day in office is three months away. An Obama administration would be less concerned with restoring the banks to private ownership and more concerned with putting them to work — think the Community Reinvestment Act on a grander scale. In point of fact, Obama has proposed legislation requiring banks participating in the Treasury plan to put a 90-day moratorium on home foreclosures. One can only imagine what else he has in mind.

There is also a high likelihood that, no matter who succeeds George W. Bush, the Democrat-controlled Congress will browbeat participating banks into making the “correct” lending decisions. Institutions that don’t play along will be dragged before Congress and accused of putting profits ahead of patriotism. The taxpayers’ stake in the banks will be used to justify regulation above and beyond what is necessary to prevent another crisis.

House Speaker Nancy Pelosi is already chomping at the bit. Last Friday, she sent Paulson a letter urging him to put more pressure on the banks to serve the governments’ ends. She wrote that while she recognized “the need to strike a balance between encouraging participation in the Capital Purchase Program and respecting financial institutions’ business decisions,” Paulson should “send a clear message to participating financial institutions” — start making loans, or face the consequences.

There should be no illusions about the dangers involved in letting the government take an ownership share in the banks. Paulson’s plan includes adequate safeguards, but the government can always change the rules. We would encourage every bank that takes the government’s money to have an exit strategy — one that gets banks back to private ownership as soon as possible.


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