Uncertainty surrounds rescue plan

Some fear US will use stake in banks for political ends

Analysts say government pressure is partly responsible for Fannie Mae's and Freddie Mac's lending practices. (Justin Sullivan/Getty Images)

The federal government's decision to buy ownership stakes in US banks has helped ease the flow of credit, but some analysts worry the massive intervention will inject politics into the financial system and sow the seeds of another crisis in the long run.

The danger comes if lawmakers and policy makers employ the government's ownership stake in banks to pursue social agendas, analysts said. Such interference from officials contributed to the federal takeover of mortgage giants Fannie Mae and Freddie Mac, private companies created by Congress to buy and guarantee mortgages as a way to expand credit and affordable housing.

Fannie and Freddie came under pressure from lawmakers and policy makers to lend widely to increase homeownership, analysts said. As a result, Freddie and Fannie bought and guaranteed risky mortgages, which generated huge losses, undermined their finances, and compelled the government to step in.

With the Treasury now taking ownership stakes in private banks, "you are potentially making more Freddies and Fannies," said Vincent Reinhart, resident scholar at the American Enterprise Institute, a Washington think tank. "The question is, will politicians refrain from using the new influences these actions have given them?"

Treasury Secretary Henry Paulson this month launched an initiative to shore up the financial system by investing $250 billion directly in US banks, providing the capital they need to weather the financial crisis. This partial nationalization of the banking system represents a major shift in the relations between government and private enterprise. The government has not intervened on such a scale since the Great Depression, when federal programs such as the Reconstruction Finance Corp. lent to and invested directly in banks and other companies.

In theory, the government will become a silent partner under Paulson's scheme, taking nonvoting preferred shares and letting bankers run their banks. Among the dangers of having government in the role of partner, silent or otherwise, are potential conflicts of interest, said analysts. In other words, would economic and regulatory policy decisions be unduly influenced by the government's interest in protecting its investment in private banks?

"Will there be times when macroeconomic policies are considered or reconsidered because they affect the investment portfolio?" said Reinhart.

Another big question is the exit strategy: How will the government get out of the banking business?

The design of the rescue program suggests banks would buy out the government within five years, before the dividends banks must pay to the government nearly double. In the first five years, banks pay the government a 5 percent dividend; after five years it jumps to 9 percent.

Both Paulson and President Bush have said these are short-term investments the government will sell as soon as the financial system returns to normal.

But again, the fear is that political considerations could override such intentions. Already, the mortgage industry has been essentially nationalized, with the Freddie and Fannie takeovers and the expanded role of federal housing agencies in making loans, said Mark Zandi, chief economist of Moody's Economy.com in West Chester, Pa. It might become difficult for the government to end its support of banks if higher interest rates for mortgages and other consumer loans would result, he said.

"The government is now so deeply into the financial system," said Zandi, "it's not clear how it's going to get out of the business."

At the least, it could take a long time. The Swedish government launched a similar bailout of its banking system in the early 1990s, and still holds a significant stake in one major bank. In the United States, the Depression-era Reconstruction Finance Corp. operated into the 1950s.

The government's intervention could also sow the seeds for future taxpayer bailouts, analysts said. Even before Congress approved the $700 billion plan to rescue financial companies, the government encouraged the consolidation of financial services, helping, for example, to broker the sale of Bear Stearns Cos. to JPMorgan Chase, and Merrill Lynch & Co. to Bank of America Corp.

The government investments could lead to further consolidation, providing low-cost capital for stronger banks to buy weaker ones. While that could further strengthen the financial system, analysts said, it could also lead to new dangers by creating institutions that are "too big to fail" because their failure would threaten the financial system.

That could compel the government to intervene again, much as it did to save insurance giant American International Group with an $85 billion loan. In addition, having the security of government backing could encourage banks to take unwise risks. Again, analysts cited Freddie and Fannie, which had implied government backing before the takeovers, as examples.

"If it becomes clear to banks that the government will come to their rescue," said Nariman Behravesh, chief economist of Waltham forecasting firm Global Insight, "they will behave as if there's no downside risk."

But Ricardo Caballero, an economics professor at MIT, said effective regulation could prevent such risky behavior. In the final analysis, Caballero said, the government had to prevent a collapse of the financial system, and probably should have launched the bailout sooner.

Over the long run, he added, the government will recoup most of its investment by selling off shares, and could even end up making money.

"This is a temporary intervention," he said. "It would be so much worse without it."

Robert Gavin can be reached at rgavin@globe.com.