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A bailout for the banks only

November 2, 2007 | Page 3

PETRINO DiLEO explains what the big banks want out of a bailout fund.

GEORGE BUSH'S Treasury Secretary Henry Paulson has been racing around the globe and begging CEOs at many of the world's largest banks to commit billions of dollars to a massive bailout fund that the U.S. political and business elite hopes will contain the financial damage from the mortgage meltdown.

But the bailout is designed entirely to save banks from damaging investments in problem mortgage loans--while offering nothing to the millions of Americans faced with losing their homes.

The fund--which bears the incomprehensible name Master Liquidity Enhancement Conduit (M-LEC)--will be worth somewhere between $80 billion and $100 billion, making it one of the largest financial bailouts in history, not to mention the largest-ever organized financing, dwarfing previous packages put together by banks for any corporate merger or acquisition.

The banks involved--Citigroup, J.P. Morgan Chase and Bank of America, for starters--are among the biggest names in the financial world. And Treasury officials admit the federal government has never played so prominent a role in pushing private financial firms to do something like this.

All of which shows how concerned the U.S. ruling establishment is about the bursting of the housing bubble and the mortgage crisis.

As the bailout plan was unveiled, new statistics showed the extent to which the bottom has fallen out of the housing market.

In the month of September, sales of existing homes dropped 8 percent, according to the National Association of Realtors, to the slowest pace in nearly a decade. New housing starts fell by more than 10 percent in September, according to federal statistics. From the year before, new construction on homes was down by nearly one-third.

The impact of the plummeting housing market is working its way through the economy. "If you build one-third fewer homes, you're going to sell one-third fewer washers and dryers into the new construction market," Steven Wieting, an economist at Citigroup Global Markets, told the New York Times.

In other words, even if the M-LEC bailout fund heads off any catastrophic bankruptcies or financial implosions, the damage of the mortgage crisis will continue to be felt--and the price will be paid not by the banks, but by millions of ordinary people.

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WHAT CONVINCED government officials and bankers to agree on the bailout plan?

The simple answer is fear. Though they've gone to great lengths to obscure it, major banks have hundreds of billions of dollars tied up in investments based on problem mortgages--and little hope of getting out from under in the current circumstances.

At the heart of the problem are little-known investment programs--usually run by banks and involving only the very biggest players in the financial world--called "structured investment vehicles" (SIVs).

Basically, SIVs take in money through short-term borrowing (via the commercial bond, or paper, market) and invest in long-term securities. The profit comes in the difference between the lower cost of the short-term borrowing and the higher yield of the long-term securities.

But what has emerged is that almost all of the SIVs' long-term investments--roughly $350 billion of the $400 billion estimated total value of the SIV market--were in mortgage-backed securities.

These securities come from banks rolling together thousands of mortgage loans and selling them as giant bonds that pay out at different rates, depending on the risk. The highest-yielding bonds--and those most in demand while the housing market was booming--were those with the largest component of risky loans, so-called "sub-prime" mortgages.

Banks and investment firms, eager to package the riskier and more lucrative loans, pressured mortgage companies and brokers to push people into sub-prime loans--made at higher-than-normal and adjustable interest rates to borrowers with poor credit history or scant evidence of the means to make payments.

When the housing bubble burst, defaults on sub-prime loans--particularly adjustable interest rate mortgages that reset to unaffordable levels--shot up. So the mortgage-backed securities bought by the SIVs are now worth quite a bit less. Meanwhile, due in large part to the mortgage meltdown, short-term borrowing in the commercial paper market dried up.

The formerly high-flying SIVs are stuck. They have to pay an estimated $100 billion on previous short-term loans. They can't arrange more short-term borrowing because there's no market for it. And they can't sell the longer-term mortgage-backed securities without incurring huge losses.

Like other shadowy corners of the financial world, the SIVs are unregulated, so banks have kept them "off balance sheet," meaning they don't show up as a profit or a loss in any accounting or financial reporting--reminiscent of the sorts of antics that Enron made notorious a few years ago. But if and when the losses are reported, they could take down some of the biggest names in the financial world and bruise any investor confidence rebuilt since the scale of the mortgage crisis emerged this summer.

The M-LEC fund is supposed to be a solution to the problem. According to its backers, the fund would cover the $100 billion worth of SIV debt that has to be paid off in the next six to nine months.

To see how seriously the fund is being taken by Wall Street, look at the roster of banks that have signed on and promised to commit between $2 billion and $10 billion each. Citigroup, which was heavily involved in SIVs, is a chief sponsor. But other banks that weren't involved in the SIV market at all are joining up. They're doing it to bail out their competitors and save confidence in the system.

The bailout plan shows the problems with the financial system extend far beyond the standard tools--such as cutting interest rates and managing the money supply--available to the policy makers.

Instead, the government is making a move reminiscent of what the Federal Reserve did in 1998 when it engineered a bailout after Long-Term Capital Management--an obscure investment firm, known as a hedge fund--went under and threatened to cause international financial turmoil. Only this time, the Treasury Department itself is taking the lead in promoting the deal, and the bailout is many times larger.

But what stands out starkly is who won't get a bailout--the countless homeowners conned into signing up for toxic mortgages. The M-LEC funds will be used to offload securities from banks that no one wants, and save major firms from embarrassing write-offs. But the mortgages themselves won't change.

It's an abject lesson in the priorities of the system: Henry Paulson is scrambling to save investors. But he hasn't lifted a finger to raise a fund that offers affordable refinancing options and saves people's homes.

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