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<DIV style="MARGIN-RIGHT: 165px"></DIV><FONT size=+2><B>Financial Rescues Can
Set Off New Problems</B></FONT><BR>
<P><FONT size=-1>By Peter Whoriskey and Zachary A. Goldfarb<BR>Washington Post
Staff Writers<BR>Sunday, October 19, 2008; A01<BR></FONT></P>
<P></P>
<P>If there was one thing policymakers could agree on during the recent economic
turbulence, it was that interest rates on U.S. home mortgages ought to come
down, and fast. But as the government stepped in recently to shore up the
nation's banks, those rates went up.</P>
<P>Chalk up another case of unintended consequences.</P>
<P>Since the beginning of the crisis that has upended financial markets and
stunned the world economy, the well-intentioned actions of governments and
officials have often created new problems that require nearly equally urgent
solutions.</P>
<P>The complexity and linkages in the world financial system are to blame.</P>
<P>"Every action the government takes has cascading effects on the market, and
they're not always easy to predict," said Jim Vogel, an analyst at <A
href="http://www.washingtonpost.com/ac2/related/topic/First+Horizon+National+Corporation?tid=informline"
target="">FTN Financial</A>. "The government has to have time to catch up."</P>
<P>When authorities in Ireland and Greece guaranteed deposits, banks across the
rest of Europe feared a stampede out of their own countries, forcing many
governments to take the same precaution. The race to guarantee deposits spread
as far as Hong Kong and Singapore, where banks are considered relatively
stable.</P>
<P>When the <A
href="http://www.washingtonpost.com/ac2/related/topic/U.S.+Department+of+the+Treasury?tid=informline"
target="">U.S. Treasury</A> announced it was guaranteeing money market accounts,
it fanned fears of a run on bank accounts.</P>
<P>And by not protecting preferred stockholders when the government seized
mortgage-finance firms <A
href="http://projects.washingtonpost.com/post200/2007/FNM/" target="">Fannie
Mae</A> and <A href="http://projects.washingtonpost.com/post200/2007/FRE/"
target="">Freddie Mac</A>, it sunk investor confidence in preferred shares in
other financial institutions, too, making it harder for them to raise money that
way.</P>
<P>"It's like a chess game," said <A
href="http://www.washingtonpost.com/ac2/related/topic/William+Poole?tid=informline"
target="">William Poole</A>, who was president and chief executive of the
Federal Reserve Bank of St. Louis from 1998 to this March. "You might be able to
anticipate the next couple of moves. But after that, it gets very complicated,
very quickly."</P>
<P>Virtually every emergency measure over the past few weeks has had secondary
and sometimes unpredicted effects, according to economists, and this is one of
the key dangers in the weeks ahead, as the government issues more short-term
loans to corporations, buys toxic securities and invests in banks.</P>
<P>One of the first examples of unintended consequences came as <A
href="http://financial.washingtonpost.com/custom/wpost/html-qcn.asp?dispnav=business&mwpage=qcn&symb=LEH&nav=el"
target="">Lehman Brothers</A> filed for bankruptcy protection. The bank's fall
spurred investors to pull out of money-market mutual funds, many of which were
tied to Lehman debt. Fearing a run on money-market funds, the Treasury on Sept.
19 announced it would guarantee these funds.</P>
<P>That made money-market investors feel better. But in turn, it led community
bankers to erupt in protest as they saw investors pulling out of their bank
accounts to invest in money-market funds -- which always paid more and now were
just as safe.</P>
<P>"The unintended consequence would have been a run on the banks," said Ken
Guenther, former chief executive of the Independent Community Bankers of
America.</P>
<P>Eventually, the Treasury quelled the protests by agreeing to protect only
existing money-market deposits.</P>
<P>Much of the uncertainty about government intervention comes because it
reorders in sometimes unforeseen ways how investors value their investments.</P>
<P>For example, many investors had considered preferred shares in Fannie Mae and
Freddie Mac as near-sacred. But by allowing those shares to collapse as the
government took over the institutions in early September, officials created
skepticism about the value of preferred shares from financial institutions and
made it harder -- and more expensive -- for other financial institutions to
raise money by issuing them.</P>
<P>For example, the government this month had to privately assure a Japanese
bank, <A
href="http://financial.washingtonpost.com/custom/wpost/html-qcn.asp?dispnav=business&mwpage=qcn&symb=MSBHF&nav=el"
target="">Mitsubishi</A>, that preferred shares in <A
href="http://www.washingtonpost.com/ac2/related/topic/Morgan+Stanley?tid=informline"
target="">Morgan Stanley</A> would be protected if federal money was invested in
the <A
href="http://www.washingtonpost.com/ac2/related/topic/Wall+Street?tid=informline"
target="">Wall Street</A> firm, according to a person familiar with the
discussions who spoke on condition of anonymity. The assurance helped clear the
way for Mitsubishi to buy a 21 percent stake in Morgan Stanley.</P>
<P>"With the whipsawing failures of Fannie and Freddie, the private-sector
capital option to support the financial industry was ripped off the table," said
Karen Petrou, an analyst at Federal Financial Analytics.</P>
<P>Similarly, by propping up banks with capital infusions and guaranteeing more
of their deposits as part of the Treasury Department's massive rescue package
for financial markets, the government may be elevating banks over other
institutions, accelerating the longstanding rush of money out of hedge
funds.</P>
<P>"To the extent that banks are perceived as more stable, investors may be
motivated to move to banks," said Kenneth Heinz, president of Hedge Fund
Research. He noted, however, that many hedge fund investors have already pulled
out in favor of cash. According to the firm's latest data, third-quarter hedge
fund redemptions hit a record-high $210 billion.</P>
<P>But the most perverse of the unintended consequences could be how the
government's bank rescue appears to be boosting mortgage rates, contrary to a
key government goal.</P>
<P>When the government took over Fannie Mae and Freddie Mac last month, Treasury
Secretary <A
href="http://www.washingtonpost.com/ac2/related/topic/Henry+M.+Paulson?tid=informline"
target="">Henry M. Paulson</A> Jr. said "the primary mission of these
enterprises now will be to proactively work to increase the availability of
mortgage finance."</P>
<P>It worked -- at first.</P>
<P>Before the takeover, the average 30-year, fixed-rate mortgage was hovering at
6.35 percent.</P>
<P>Immediately after the takeover, rates on mortgages fell. Investors had new
faith in Fannie Mae and Freddie Mac, which allowed them to borrow money more
cheaply, and that kept rates down.</P>
<P>But rates have soared beyond their pre-seizure levels. They now hover around
6.46 percent.</P>
<P>The reason, according to several analysts, is that the government's backing
of Fannie Mae and Freddie Mac lowered their cost of borrowing money. That, in
turn, allowed them to buy mortgages that carried lower rates, lowering rates for
everyone because of their dominant market position.</P>
<P>Since then, however, the government has begun guaranteeing an array of other
investments. It has announced plans to invest in nine major banks, it guaranteed
new bank debt and raised the insurance limits on bank accounts to $250,000.
Investors now have other places to go to get the U.S. government's full faith
and credit. Fannie Mae and Freddie Mac were not uniquely attractive to investors
and could no longer borrow money so cheaply. That pushed rates upward.</P>
<P>"A month ago, Fannie and Freddie were the unique beneficiaries of government
support -- so the mortgage costs fell in response, which is exactly what you
would anticipate," Vogel said. "Since that time, mortgage securities no longer
have the special position."</P>
<P>Although there have been other forces on mortgage rates -- for example, many
foreign governments have been selling Fannie and Freddie debt -- analysts agree
that the government's new programs have had some role in boosting mortgage
rates.</P>
<P>"This is, of course, bad news for the mortgage market -- a critical factor in
taking the U.S. out of the market panic and into a long-term recovery that puts
a floor under residential prices," Federal Financial Analytics, a Washington
research firm, said in a report this week.</P>
<P>Further into the future, some economists predict even more profound
consequences from today's interventions.</P>
<P>By fostering the belief the government will rush to the rescue whenever a
major financial institution begins to falter, federal officials may be creating
what many economists call a "moral hazard." That is, those institutions may be
more willing to undertake risky investments.</P>
<P>"It's all very <A
href="http://www.washingtonpost.com/ac2/related/topic/Rube+Goldberg?tid=informline"
target="">Rube Goldberg</A>-esque," said William O'Donnell, the head of U.S.
interest rate strategy at UBS, referring to the cartoonist famed for devices
that work in indirect and convoluted means. "You're never quite sure what any
one action will do."</P></DIV></FONT></DIV></BODY></HTML>