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Will UK rescue banks too?

• Robert Peston
• 19 Sep 08, 06:05 PM

It's a bit early for definitive judgements about Hank Paulson's plan to rescue Goldman Sachs and Morgan Stanley - sorry I meant the US economy - because today's statement from the US Treasury Secretary is short on detail and elaborates very little on what I published in my note early this morning.

Which is a bit uncharacteristic of this former banker who learned his trade at meticulous Goldman Sachs (that name again) and ended up as chairman of the bulgiest bulge bracket firm.

For us here in the UK the big question is whether what Paulson's proposing makes it more or less likely that our Government will have to launch a similar rescue scheme for our banks.

As of this moment, the thinking in Government is that Paulson's bail out should improve confidence throughout the global banking system, and thus reduce the likelihood that British taxpayers' money will have to be deployed on buying out stinky assets from British banks, or guaranteeing mortgage-backed bonds issued by them, or the other ways in which our banking system could be partly nationalised.

But ministers are taking nothing for granted. The Treasury is working on a contingency bail-out plan, just in case.

Because there is a risk that if Paulson succeeds in shoring up confidence in US banks, the doomsayers could turn their poisonous speculative attention on the economy perceived to be the next most vulnerable - in the way that the investment bank Lehman Bros became the target after Bear Stearns had to be rescued from collapse.

In that sense, the UK would be Lehman, in that the weakness of our housing market looks rather too much like the weakness of the US housing market - or at least it does in the eyes of the money managers who sit in air-conditioned offices all over the world and decide which banks receive their trillions of loose cash.

And if they withdrew more of their cash from the UK banking system than they did during the wholesale run on Northern Rock last autumn, well let's hope it doesn't come to that.

So what more is there to say about the Paulson plan?

Well it is extraordinary how beneficial for Morgan Stanley and Goldman Sachs the rescue package has turned out to be - especially the provision of insurance for investments at money market mutual funds, which should stem the withdrawals of cash from these funds, and reduces the risk that these funds will cease financing the last two bulge bracket firms left standing.

Or at least it helps Goldman and Morgan Stanley in the short term. Though as I implied earlier today, their originate-to-distribute business models - which helped to pump up the credit bubble that has been pricked with such devastating consequences - doesn't look so gleaming right now.

And their once-ginormous profits from servicing private equity and hedge funds, and also managing their own private-equity and hedge money, is likely to wither to something not so pretty: there's a strong likelihood that the hedge-fund and private-equity industries will be crushed under the combined weight of new legislation and the losses that some funds are incurring.

Perhaps Goldman and Morgan Stanley will become smaller simpler firms, suffering from fewer conflicts of interests, acting a bit less hubristically.

Which, you might say, wouldn't be such a bad thing.

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The American way to fail

• Robert Peston
• 19 Sep 08, 09:16 AM

The breathtaking rises in the price of bank shares this morning are symptomatic of a stock market that is bereft of reason and is being driven almost purely by hysteria and momentum.

They are surging in part because of the crackdown on short-sellers but mostly because of the overnight news that the US Treasury Secretary, Hank Paulson, and the Chairman of the , Ben Bernanke, are preparing a bold - or possibly impetuous - plan to tackle what can now be classified as the most severe and intractable malfunction of the banking system since the late 1920s.

As I put it on the , yesterday's co-ordinated intervention by central banks, led by the US Federal Reserve, to pump an additional $180bn of short-term loans into the banking system treats only a symptom, not the cause, of banks' reluctance to lend to each other and to us.

It's a stopgap, while Paulson prepares to absolve many of the world's biggest banks of their idiocy during the boom years, by nationalising their bad debts.

To understand the pros and cons of what's being considered by Paulson, it's worth reminding ourselves of what created the latest terrifying phase of the credit crunch.

The ultimate cause is the chronic downturn in the US housing market. The proximate causes are the rotten loans to US homeowners sitting on banks' and other financial institutions' balance sheets that has mullered their capacity to make new loans.

The recent trigger has been the crises at , and so on, which have created a climate of fear, in which bankers and managers of money appear to believe that almost any bank could collapse.

One important new stress has been a significant withdrawal of investors' cash from US money-market funds, because of the perception that the funds aren't as safe as was widely thought - which has in turn deprived banks of an important source of wholesale deposits (this sudden rise in the perceived riskiness of these funds was sparked by the announcement of a loss at the Reserve Primary Fund).

The drying-up of liquidity from money-market funds is in part what drove to acknowledge that the game was up, and that a rescue takeover by was the best form of protection for its savers and shareholders.

To reiterate, the big point is that Paulson is working with Congress on a package of measures that - he hopes - will attack the roots of the crisis.

It would involve buying many hundreds of billions of the banks' bad loans to overstretched US homeowners.

And it would also attempt to re-establish confidence in money-market funds by insuring them, in the way that retail bank deposits are insured against loss.

This would be the mother of all bailouts. It would certainly involve the deployment of hundreds of billions of US taxpayers' money, possibly more than a trillion dollars.

And it comes on top of the $300bn commitment of public money already made by Paulson to the rescue of Fannie, Freddie and AIG.

It all represents a massive humiliation for Wall Street, the giant US financial services industry and bankers supposed to be the canniest on the planet.

Paulson, himself, was one of their ilk, as the former boss of .

There will be serious long-term damage to the ability of the US to export its way of doing business to the rest of the world.

The American way of capitalism doesn't seem all that brilliant right now.

In that sense, a degree of moral authority - as well as financial clout - will shift east.

It'll also damage the robustness of the US public finances.

Possibly the biggest risk for the US is that in bailing out the finances of the private sector, Paulson would dent international investors' confidence in the American government's balance sheet - which could ultimately undermine the dollar, push up inflation even more and raise the cost of servicing debt for the US authorities.

Maybe the US is still big enough and powerful enough to persuade the rest of the world to pay for the mistakes of its financial sector - which is broadly what's being proposed.

But, as I mentioned here yesterday, surely it would be more rational for the Chinese to own the American financial system itself, rather than lend to the US Government (and in that context, it's resonant that Morgan Stanley may well be close to selling almost half of itself to CIC, China's state investment fund).

In this game of Wall Street Monopoly, there's no "get-out-of-jail-free" card.

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