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Peter Crabb: The new bailout program just might work — but it's heavy-handed

The bond markets say the end may be near. Recent bond market activity suggests a growing confidence that banks will survive this crisis.

Interest rates on interbank loans eased slightly Wednesday, and the yield on safe, short-term U.S. Treasuries moved higher. The higher rate on U.S. Treasuries shows investors have their risk appetite back – taking money out of this cash position and putting it where it can really earn something.

Corporate bonds issued by banks jumped in value, and their yields fell sharply.

The risk that financial bailout programs from Washington would cause inflation also subsided. Prices fell in the commodity markets over the past few days as the prospect of falling demand from the very likely global recession rose. Crude-oil prices dropped under $75 a barrel on Wednesday.

So what is there to like in the new plan where our government holds stock in banks? As Floyd Norris reported Wednesday in The New York Times, the government is guaranteeing new loans and planning to invest $250 billion in preferred stock from banks. The stock will come with warrants that give the government a chance to earn big profits if share prices recover.

Warrants are options attached to the preferred stocks, allowing the government to buy more shares at prices set now, when and if the future price rises. This lets the government share substantially in any gains from its investment. The new program has a similar ”carrot” for banks, allowing them to cut the government ownership if they raise private stock by the end of 2009. This way out for the banks may keep the program temporary.

Investors and economists alike are showing more optimism for this program than for the previous plan whereby so-called troubled assets are bought off the books at most U.S. banks. In a Wall Street Journal interview, Markus Brunnermeier, an economist at Princeton, said this new program is “way better than starting a complicated reverse auction” for troubled bank loans. He pointed out that no one was sure how the reverse auction would correctly price all these bad loans. In a reverse auction you have one buyer (the government in this case) and many sellers, as opposed to traditional auctions with one seller and many buyers. Under the new program, we know exactly where the money is going and how it can be used for new lending.

While still within the letter of this law, the original $700 billion buy-bad-mortgages plan has morphed into something much more. The current program is officially volunteer-only, but reportedly Treasury Secretary Henry Paulson forced nine major U.S. banks to agree to take $125 billion from the government. The CEOs of these large banks were each handed a one-page document that said they agreed to sell shares to the government, and told they must sign before leaving the meeting.

From market reaction, it looks as if the program will work well enough to stop the bank panic. There are plenty of reasons, however, to fear such a heavy-handed, government-run banking system. China has one now.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.

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