WASHINGTON — The government is not only fighting persistent problems in the credit markets, but it is also battling unintended consequences of its previous rescue efforts.
The latest plan, announced Tuesday, is a case in point. The Federal Reserve Board unveiled a program to buy $100 billion of debt from the government-sponsored enterprises.
Though officials said it would help bring down mortgage rates, it was needed because the government had inadvertently made GSE debt more expensive by adding an explicit guarantee behind bank debt. Fannie Mae, Freddie Mac, and the Federal Home Loan banks, without such an explicit guarantee, had to pay more to raise funds.
The move highlights the challenges policymakers face as they try to respond to a crisis with many fronts.
"You put your finger in the hole in one part of the dam and another hole opens up elsewhere and you have to put your finger there," said Mark Zandi, the chief economist and a co-founder of Moody's Economy.com. "You can see that with guaranteeing bank debt; it raised the cost for Fannie and Freddie. When you guaranteed money market funds, you guaranteed problems for banks and people shifted deposits."
When the financial crisis began, the government responded by addressing individual problems as they arose. But by mid-September Treasury Secretary Henry Paulson was under pressure to come up with a plan to stabilize the entire system. He convinced Congress to give him authority to spend $700 billion pretty much any way he saw fit. In the six weeks since the law was enacted, Mr. Paulson has careened from one idea to another and contradicted himself so many times that critics claim he has lost credibility.
Observers said markets need a more consistent approach.
"There is a school of thought that says on one hand, you need to be flexible and nimble to address a major crisis," said V. Gerard Comizio, a partner at Paul, Hastings, Janofsky & Walker LLP. "On the other hand, where is the plan? The marketplace is going to perceive certainty in plans … and certainty brings confidence."
Even after publicly declaring a preference for systemic solutions, the government continues to minister to specific companies, as it did with Citigroup Inc. on Sunday. In fact, the problems enveloping Citigroup are at least in part connected to another government move. Mr. Paulson finally conceded on Nov. 12 that the Troubled Asset Relief Program would not be used to buy problem assets from financial companies — the program's original purpose. Instead, the agency used the bulk of the initial funding from Congress to inject capital into healthy banks.
That backtracking caused the value of assets to fall, and contributed to investor concerns about the viability of Citigroup.
"It's not unreasonable to think when Paulson reversed himself on the use of Tarp money, it may have precipitated the events that caused the bailout of Citi one week later," Mr. Zandi said. "It's important for policymakers to be aggressive and implement an unprecedented response to the crisis, but consistency is also important, and that has been lacking in the policy response."
Another example of unintended consequences is the Treasury's first program for money market mutual funds, announced in September. It aimed to reassure investors in such funds by providing them with a federal guarantee, but instead it prompted some consumers to withdraw funds from banks. That created liquidity pressures on financial institutions, and the Treasury was forced to respond by limiting the guarantee only to funds in place before the announcement.
"Every time you step in some place and the government provides a guarantee and shores it up, in addition to shoring it up, it's going to distort the competitive balance and other relationships," said Oliver Ireland, a partner at Morrison & Foerster LLP.
With GSE debt, investors had historically viewed it as very safe, particularly after Fannie and Freddie were seized by the government on Sept. 7. But that changed when the Federal Deposit Insurance Corp. announced a plan last month to guarantee bank debt.
Investors "prefer the explicit guarantee over the implicit guarantee of GSE debt," said Michael Barr, an economic adviser and assistant Treasury secretary during the Clinton administration who is now a senior fellow at the Center for American Progress. "It is due to … the nature of the guarantee."
In addition to buying GSE debt, the Fed said Tuesday that it would buy $500 billion of mortgage-backed securities guaranteed by Fannie, Freddie, and the Government National Mortgage Association.
The Fed, working with the Treasury, also announced a program to lend up to $200 billion to holders of certain triple-A asset-backed securities backed by new and recently originated consumer and small-business loans. Treasury plans to give the Fed $20 billion from Tarp to cover credit losses.
Time will tell if those steps, too, have unexpected ripple effects.
