Who should get bailed out? Who should not? Prior to the proposed comprehensive $700 billion rescue, the government followed a piecemeal approach to deal with the ailing institutions. This is a leak-patching approach that allows institutions to fall through the leaks. Lehman BrothersLehman Brothers fell through one of those leaks. Under this approach, institutions are not treated equally. The chance that an institution will be bailed out depends on several factors including size, connectedness and sophistication of investors. If you have the size like Bear Stearns, Fannie Mae, or Freddie Mac, then you will get support from the government to dodge the crisis. What if you are the fourth largest investment bank like Lehman BrothersLehman Brothers? You will let go to bankruptcy! But if you are Merrill LynchMerrill Lynch, the leak will be a fire-sell to a very large commercial bank like Bank of America. If you are well-connected with other giant enterprises and you are also the world’s largest insurer like AIGAIG, you will be bailed out. Letting AIGAIG go is likely to have ripple effect on the world’s corporate debt and money markets. If your investors are foreign entities and are not sophisticated enough such as the SWFs, you will have a greater opportunity to be supported as foreign pressure mounts. These factors do not form standards. It is likely that under the piecemeal the total cost will exceed the cost of the comprehensive approach, whether it is $700 billion or more, as leaks widen to big holes. More institutions, national and regional, will fall and FDIC will have to take custody of their assets. The 1980s and 1990s history will repeat itself.

What lessons have we learned from the worst financial crisis since the Great Depression? The piecemeal approach is suboptimal and a comprehensive plan that rises to the gravity of the crisis and has the support of both the executive and legislative branches is by far the better solution. Under the comprehensive approach there will be common standards and all eligible institutions will be treated equally. The government and the financial institutions will be pro-active and act in a timely manner.

Timing is important in this crisis. Lehman BrothersLehman Brothers had the opportunity to borrow from the discount window, but it squandered this opportunity. Two weeks may have made a difference for the survival of this investment bank. In contrast, AIGAIG sought and received help and it is still with us. If the government had embarked promptly on a more comprehensive solution, the automatic standards would have been activated in both cases. We would have a different landscape now.

A financial world of giant institutions such as Bear Stearns, Lehman BrothersLehman Brothers, WaMu and AIGAIG has been transformed into a world of super giants such as Bank of America and J. P. Morgan, as Merrill LynchMerrill Lynch was rushed to the arms of Bank of America to avoid the fate of Lehman BrothersLehman Brothers and WaMu failed and was acquired by J.P. MorganJ.P. Morgan. This new world will be characterized by greater thrift, less leverage and more diversification and more regulations. The dwarfs and the midgets will always feel vulnerable and find it risky to stay on their own feet. Investment banks will find it safer to link up with commercial banks to survive the current crisis and to succeed in the new financial world. Commercial banks have more stable loans and less cyclical balance sheets than investment banks. Some super giant investment bank will transform them selves into banking holdings to be able to establish banking subsidiaries. In this world, the government will also have a strong shadow over Wall Street.

Under the piecemeal approach, the Federal Reserves’ balance sheet can run out of ammunition hindering its ability to put out new financial fires. The Fed had $800 billion on its balance sheet last year. Now it has about $450 billion which will be less than $200 billion if we account for the $200 pledged to the new lending facility created earlier this year to loan money to investment banks. Recent events may have been favorable to auctioning off government debt to enlarge the Fed’s dwindling balance sheet. However, although the Fed is well equipped to provide short term-money to banks, it is ill equipped to provide long-term capital to fix investment banks’ balance sheets. This will also undermine its credibility on the dollar. History has taught us that the Fed will need to work with an emergency government agency as part of a comprehensive rescue plan to quarantine the investment banks’ toxic assets and oversee the troubled institutions. Such an entity was created during the Great Depression, the 1980s saving and loan crisis, and the 1997 Asian crisis. The current crisis is no different. In the Great Depression era, this entity was the Reconstruction Finance Corporation, and in the saving and loan crisis it was the Resolution Trust Corporation. In both situations, the government agency’s mandate entailed ownership of failed institutions. RFC was also charged with creating jobs. In the current situation, the major task of this proposed entity is to primarily articulate a price-setting process for troubled assets. In contrast, RTC acquired the assets of already failed institutions and did not face this task. Are open auctions in which the government and the private sector bid securities prices a good process for the current crisis? We think so. This process should create a market for those securities. The auction should start with a price that is higher than the fire-sale price and hopefully end up at a price near the value on an institution’s book. The implementation process will not be easy, will create controversies and will initially have arbitrary valuations and pricing because of the complexity of the troubled assets. The institution will first sell their worst assets to the proposed agency. The agency can also learn few lessons from the experience of RTC. Bill Seidman, the RTC chairman, can testify to that.

There are other questions that the government should figure out in implementing a comprehensive solution to the crisis. Should the government just buy the troubled assets or should it have equity interests in the institutions? The Democrats are pushing for the equity stake as a supplementary option, while bankers and their lobbyists are opposing it, describing it as a black mark on their financial statements which may restrict the banks’ ability to lend. This should be a restricted option and the focus should be on buying the assets. Should the plan cover troubled and untroubled assets domestically and overseas? Should homeowners be helped in order to stabilize housing prices which are at the root cause of the crisis? Should the institutions be given the option to buy insurance from the government to insure some of their bad home loans rather than buy them as demanded by the Republicans? This option would limit the amount of federal funds used in the rescue. These questions should be open and be addressed over time, depending on the progress of the plan. Since Congress will share oversight, fine-tuning may be required down the road to keep the plan on track.

Taxpayers should get used to the fact that politicians will use a big chunk of their money to de facto nationalize ailing private institution during major crises such as the current one. The stakes and challenges in this crisis are tremendous. Socialism can come up to the rescue of capitalism. The socialization of a private giant such as AIGAIG is startling but it is needed to prevent further collapse in the system. If a comprehensive plan is not adopted, taxpayers’ losses will mount. Their portfolios of stocks, bonds and real estate will be ravaged. The $700 billion plan is dwarfed by the $1.2 trillion loss that was realized on Wall Street on Monday September 29, 2009. The taxpayers will find it hard to locate jobs and buy and sell goods and services. Taxpayers should have the right to question the wisdom of making them bear the losses of solvent institutions on behalf of those institutions’ stakeholders. However, they should be cognizant of the fact that rescue plans that entail buying assets do not add all the value of the plan as an expense to the government budget deficit. Budget rules allow the government to treat asset purchases as a means of financing. Only the interest cost on the Treasurys that will be issued to finance the plan and the investment losses that will be realized from reselling the assets are considered as an expense to the budget deficit. How much the government will recover, how much it will lose and when those expenses will appear in the budget is not clear now. However, the deficit should not increase by $700 billions and a $1 trillion budget deficit (or 7% of GDP) in 2009, as some say, is unlikely.

How would the regulators act on those hard-learned lessons? Regulators do not fully understand the rapidly changing instruments floating in the system. The regulators who will deal with the current crisis should be well familiar with the various risk- management instruments and their interconnectedness. Today’s debt assets are complex securities. They are strands of instruments several steps away from the actual collateral, which makes it difficult for regulators to unravel those strands to reach the actual collateral. Regulators should be able to make a decisive decision on regulating the infamous credit-default swaps (CDS) on loans and corporate bonds. As much as $1 trillion of contacts need to be settled in the new and unregulated CDS market. The New York Insurance Department has moved to regulate CDS. These supposedly risk-hedging instruments have been identified as one of the culprits that generated stress in the markets. CDS played a role in the collapse of Lehman Brothers and pushed AIGAIG into government custody. Not all the existing financial instruments or accounting rules are needed or desirable now. Regulators should examine the mark-to–market accounting rule which forces financial institutions to mark their assets to market prices even though the net present values of their cash flows are above those prices and the institutions are not selling assets. The institution will be forced to have a loss on its capital account. This rule has contributed to sharp downspins in asset prices. The assets of WaMu were marked down to fire-sale values and this institution was bought by J.P. MorganJ.P. Morgan. This contributed to marking down the assets of Wachovia which was then sold to CitibankCitibank. This rule may impair the pricing prices when assets are auctioned. But we should also keep in mind that abolishing this rule now will not make the distressed assets go away. One way to modify this rule is to apply it for short term assets and not for assets that institutions will hold for the long haul. Solvent institutions should have a say in marking their assets. However, with sound supervision, it should help asset prices recover as they do not have to face the downward spinning that was generated by the rule. This rule and the CDS, when work together, reinforce risk and a vicious downward spiral in asset prices.

Regulators should prohibit naked shorting for good and favor short selling at uptick. Short sellers have their own demands and supplies of stocks in response to up and down movements in the markets. But they react asymmetrically more when the market is heading down than when is moving up. The uptick rule, which was abolished recently by SEC, is akin to circuit breaker rules. It calms the markets by halting trading during highly volatile times and abates some of the relentless downward pressure on stocks. There will also and should be new regulations to deal with the crisis. Some of these regulations should be temporary such as raising the federal deposit insurance limit, which is now $100,000 per account. But at the end a new financial system will finally emerge.

The comprehensive $700 billion rescue plan is necessary but may not be sufficient and more may be needed. But it should help Wall Street, reduce some collective pain and hopefully and eventually help Main Street. However, the White House and Congress should be flexible and timely and taxpayers should swallow the bullet for the sake of all of us. But trickling economics does not work very well. Further economic measures such as monetary easing and fiscal stimulus with an eye on housing prices are likely to be needed down the road to connect Wall Street with Main Street in order to avoid another Great Depression. We need a Swedish recovery not a Japanese one.

Shawkat Hammoudeh is Professor of Economics and International Business at Drexel University, and Mark Thompson is Cree-Walker Chair of Business Administration at Augusta State University. The authors can be reached at hammousm@drexel.edu and mthompson@aug.edu, respectively. The original version of this expanded version was published in Middle East Economic Survey (MEES), VOL. LI No 40, 6-Oct-2008.