First, a little background. The traditional tool of monetary policy is an open market purchase, in which the Fed purchased U.S. Treasury securities that had previously been held by someone in the private sector. The Fed would pay for those securities by crediting deposits in an account that the selling bank had with the Federal Reserve. These reserve deposits of banks represent claims that the bank could use, if it wished, to withdraw green currency from the Federal Reserve. The volume of reserve deposits historically was extremely important in determining the interest rate at which banks would lend the deposits to one another overnight. The traditional understanding of monetary policy was that the Fed would use open market purchases to achieve its desired objectives for the overnight interest rate and the money supply.

If the Fed wished to implement a purely temporary increase in the volume of reserve deposits, historically the tool of choice was a repurchase agreement, in which the Fed would buy a particular security with a promise to return it at a specified future date. The purchase was again implemented by creation of reserve deposits, and when the security was returned, those deposits came back into the Fed.

The Fed began to see a new potential use for these repos after the initial banking difficulties in August 2007. Although repos were traditionally used as a device for temporarily injecting reserves, their structure amounts to a collateralized loan from the Fed to the counterparty. The Fed's objective subsequent to August 2007 was to increase the volume of its lending and support the market for certain securities that it could accept as collateral for repos. Thus the Fed utilized an expansion of repurchase agreements as one of the initial tools for responding to the crisis, simply rolling them over to create a de facto expanded lending facility.

The graph below tracks the various assets held by the Federal Reserve since the beginning of 2007. The height of the graph represents the total asset holdings at the end of each week, with the colors indicating the contribution of each category. Repos are represented by the turquoise band. This traditionally had been small and highly variable, but grew significantly in the early phases of the financial crisis. Later the Fed came to use direct loans through its Term Auction Facility in preference to repos. Since January, the Fed has been directly buying up mortgage backed securities and agency debt in the way it used to purchase Treasury securities.

Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

A separate question is what happens to all the reserve deposits created through this process. The Fed has never wanted to see the huge volume of reserves it created end up as currency held by the public, for fear this would be inflationary. It has relied on several devices to keep that from happening. One was use of the Treasury's account with the Fed, another traditional feature of Fed operations that ballooned as it became adapted to new purposes. The Fed asked the Treasury to borrow funds that it simply left in deposit in its account with the Fed. These idle reserves held by the Treasury absorbed some of the vast increase in new reserves created by the Fed.

A more important tool was that the Fed started paying interest on reserves in October 2008, and by November had increased that rate to the target fed funds rate itself. This created a very strong incentive for banks to simply hold reserves idle at the end of each day rather than lend them out on the overnight fed funds market. In effect, by paying interest on reserves, the Fed is borrowing directly from banks and using the proceeds for the various asset expansions detailed above.

The graph below shows the Fed's liabilities at the end of each week. The height of the graph is, by definition, exactly equal to the height of the previous graph at every date. The first graph tracks what assets the Fed acquired with its operations, while the second graph shows where the funds it created ended up. The surge in the Treasury account (in yellow) and excess reserves of member banks (green) explain why the huge expansion in the Fed's balance sheet has not translated so far into a massive increase in the quantity of currency held by the public (blue).

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

The question under discussion at the moment is the extent to which the Fed could continue to rely on these two devices-- Treasury borrowing on its behalf and banks' willingness to simply hold the ballooning reserves-- to contain the monetary consequences of its expansion. The traditional political gamesmanship over the debt ceiling could well induce the Treasury to want to discontinue its facilitation of the expansion of the Fed's balance sheet, in which case the Fed must either reduce some of its lending or count on banks to hold even more excess reserves. Some in the Fed are assuming that they could always ensure the latter outcome, if needed, by raising the interest rate the Fed pays on reserves. But clearly the Fed has no desire at the moment to raise interest rates, so it's difficult for me to imagine them taking that step any time soon.

Where else could the Fed get the funds? Fed Chairman Ben Bernanke described his contingency thinking last July:

the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Just as the Fed converted the use of repos, which had historically been used on a small scale to temporarily add reserves, into a much larger operation with which it could lend broadly on a long-term basis, it is now contemplating using the reverse repo, which had historically been used on a small scale to temporarily drain reserves, into a much larger operation with which it could borrow broadly on a long-term basis. Thus we saw the following report from Bloomberg last week:

The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.

Central bank officials are discussing plans to use so-called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That's where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.

There's no sense that policy makers intend to withdraw funds anytime soon, said the people. The central bank's challenge is to decrease the cash without stunting the economy's recovery and before it sparks inflation. Fed Chairman Ben S. Bernanke said in a July Wall Street Journal opinion article that reverse repos are one tool to accomplish that goal without raising interest rates.

"One thing the Fed has to figure out is if they can launch pilot programs without spooking the market and creating the perception that they are about to tighten," said Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance. "They are discussing things like accounting issues, and updating the governing documents to the volume of reverse repos the dealer community could absorb."

Is this a feasible interim plan for handling the liability side without increasing either the money supply or interest rates? In a mechanical sense I believe the answer is yes. But the nature of inflationary pressures that we should be watching at the moment would arise from a depreciation of the dollar relative to other currencies and increase in the dollar price of internationally traded commodities. A modest move toward a weaker dollar and slightly higher inflation would be welcome. But the concern in my mind is whether a flight from the dollar could become more precipitous and destabilizing. It may not be the most likely scenario, but it is one for which I hope there has been some contingency planning.

And if the Treasury and the Fed think they could prevent that simply by borrowing even more without raising interest rates, they are mistaken.

With a diverse portfolio of Class A office and industrial/flex properties, Mack-Cali is a leading real estate investment trust (REIT) in the US. As of Mar 31, 2009, its portfolio included 294 properties, spanning 33.8 million square feet with over 2,100 tenants.

Strategically, the company concentrates on a few select high-barrier geographic markets and derives most of its annualized base rents from New Jersey (NJ). Its major markets are Newark, NJ (20.0% of annualized base rents as of the first quarter of 2009); Jersey City, NJ (19.6%); Westchester Rockland, NY (15.6%), Bergen-Passaic, NJ (15.2%), and Philadelphia, NJ (9.2%).

While reaffirming Mack-Cali's credit rating, Fitch considered its strong liquidity, adequate debt service coverage, manageable debt maturity schedule, and ability to access capital from varied sources. At quarter end, debt to market cap was 58.1%, while interest coverage ratio was 3.1x and fixed charge coverage ratio was 2.7x.

In order to conserve cash, the company has drastically cut its dividend from 64 cents per share to 45 cents. With the dividend cut, Mack-Cali anticipates saving approximately $62 million on an annualized basis.

The company has manageable near-term debt maturities with only $6.9 million of unsecured debt maturing in 2009 and about $340.3 million maturing in 2010. Mack-Cali currently has $410 million available on its $750 million line of credit, and $60 million cash in hand.

Subsequent to the end of the quarter, the company issued 11.5 million common shares at $25 each, raising net proceeds of $275 million. The bulk of the proceeds was utilized to repay debt and increase liquidity. With the increased liquidity, the company is now in a position to take advantage of strategic acquisition and development opportunities.

While the company's valuation at current price levels is attractive, we see no near-term growth catalyst. The company's office markets are weakening, and earnings will be flat in 2009. In general, we would stay away from most suburban office REITs in the current economic environment. We reiterate our Sell rating of Mack-Cali.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.