Monday, December 01, 2008
U.S. policy makers “have finally recognized the enormity of the problem” afflicting the financial system and are sparing no effort to address it, Pacific Investment Management Co.’s Paul McCulley said.

Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson will do to “whatever it takes to prevent a debt deflation scenario” from taking root in the U.S. economy and to revive lending, McCulley said in an interview on Bloomberg Television.

So far, that has included expanding the Fed’s assets to $2.2 trillion, promising to buy $600 billion in mortgage securities related to government-sponsored enterprises and injecting $270 billion of capital into what McCulley called “punchbowl banks.”

The government’s efforts to aid financial firms in effect are reversing a well-known quip by William McChesney Martin, the Fed’s chairman from 1951 through 1970. Martin said his job as central-bank chief was “to take away the punchbowl just as the party gets going” to keep the economy from overheating.

“Now they are actually creating ‘punchbowl banks’ where you have the equity coming in from the Treasury,” McCulley said. “They are de facto banks owned by the Treasury and funded by the Fed.”

Shielding Citigroup

The government said Nov. 24 it will invest $20 billion in the preferred stock of Citigroup Inc. and shield the firm against “unusually large losses” on $306 billion of troubled home loans. The Fed said yesterday it will set up a $200 billion program to support consumer and small-business loans, as well as buying debt issued or backed by government-chartered housing- finance companies such as Fannie Mae and Freddie Mac.

Paulson has committed $270 billion of a $700 billion financial-system rescue package to inject capital directly into banks. The Fed has more than doubled the amount of assets available to support financial markets, from $924 billion before the Sept. 15 bankruptcy filing by Lehman Brothers Holdings Inc.

The government’s financial commitment to the banking sector and to buying mortgage-backed securities is a model investors may want to mimic, McCulley said.

If the U.S. is putting its “full faith and credit behind the liabilities of the various financial institutions, then I want to be a co-investor with Uncle Sam, which is another way of saying I want to invest with the American taxpayer,” McCulley said. “It sounds a little like socialism only because it is.”

‘Shadow’ System

The government’s attempts to revive lending have led policy makers to use taxpayer money to recreate “the shadow banking system,” he said. Before the start of the financial crisis in August 2007, that comprised institutions which lacked access to the Fed’s discount window and whose customer accounts were not insured by the Federal Deposit Insurance Corp.

While the government is unlikely to extend the use of bailouts far beyond the financial sector, the automobile industry may present “a unique case,” McCulley said. Car companies are laboring under “a broken business model, and it needs to be very seriously revamped all the way to the core.”

Pimco’s Total Return Fund, the world’s largest bond fund with $129.6 billion in assets, had 79 percent of its holdings in mortgage securities, according to the Newport Beach, California- based company’s Web site.

Source: http://www.bloomberg.com/apps/news?