This is getting out of hand: New law extends legal mandate for intervention By Krishna Guha in Washington Published: October 5 2008 21:02 | Last updated: October 5 2008 21:02 The US authorities intend to use new powers contained in the $700bn bail-out legislation signed into law on Friday to prevent the disorderly failure of any more systemically important financial institutions. As well as creating a large-scale asset purchase programme, the new law provides what had been a missing framework for dealing with failing financial institutions that supplements the existing regime for banks. EDITOR’S CHOICE US Treasury to take first step in bail-out - Oct-05European leaders offer united front on crisis - Oct-04Full coverage: Global financial crisis - Sep-30Editorial comment: Get the lights back on - Oct-03Comment: Fear and loathing after the credit crisis - Oct-03Outside Edge: No other word for it but a bail-out - Oct-03Through rescues and possibly through additional actions to strengthen viable but weakened banks as well, the scheme is likely to evolve in a way that ultimately involves significant direct recapitalisation of the financial sector. The Treasury now has the financial resources and the clear legal mandate to recapitalise failing financial institutions, subsidise rescue takeover deals, or guarantee the systemically important parts of a collapsing firm. People familiar with the programme say the Treasury will use these powers aggressively to ensure there are no more collapses like that of Lehman Brothers, the investment bank. In principle the Treasury could use these authorities to establish an implicit government guarantee for all banking system liabilities – similar to the explicit guarantee announced by the Irish government last week. The US government may not go quite this far. But it may declare its intention to stand behind the stability of the financial system as a whole, which would be code for not allowing any more disorderly collapses. Officials are reluctant to adopt a fully standardised approach to dealing with all financial institutions. They believe there will always be marginal cases when it may not make sense to commit a lot of public capital to contain a modest degree of systemic risk. But they recognise the need to provide the markets with a more predictable pattern of intervention so investors can develop a clearer sense of when the authorities will step in and how different classes of creditors will be treated. Market participants say the ad hoc and apparently unpredictable pattern of rescues in recent weeks – as the crisis enveloped Lehman Brothers, AIG, Washington Mutual, Wachovia and others – has contributed to the extreme aversion to risk in financial markets. Officials argue that one reason for the apparent unpredictability was the limited set of tools and resources at their disposal. For instance, the Federal Reserve did not believe it had the legal authority to bridge a rescue takeover of Lehman Brothers by financing its toxic asset portfolio because it cannot make loans that are not properly collateralised. The new powers in the bail-out legislation give the US authorities carte blanche to intervene. But the authorities recognise that the global financial system is in a fragile state, so they are likely to exercise their new powers in an expansive way, potentially including a large set of institutions and many if not all creditors. Stepping in to prevent the failure of a number of financial institutions – or in the case of banks, subsidising rescue takeovers along the model of the Wachovia/Citigroup deal – may involve injecting capital. This is one way in which the new government programme is likely to involve a sizeable amount of direct financial sector recapitalisation. But the legal authorities in the new law would allow much more widespread recapitalisation of viable but weakened banks in return for preference shares or equity warrants. Some influential US officials, as well as many experts outside the government, believe this would be the most effective way to deploy public capital – strengthening banks so they can resume lending activity. Hank Paulson, Treasury secretary, could end up pursuing recapitalisation as vigorously as the asset purchase side of the scheme. In effect the US government would do for mainstream financial institutions what Warren Buffett has done for Goldman Sachs and General Electric – provide an insurance policy against capital erosion in return for a suitable fee, either as preferred shares or warrants. But if he does not, there will be a new administration in four months’ time. The next Treasury secretary may well chose to do so, particularly if the asset purchase programme has only modest effects on the market.