Analysis: Banks' high rolling leaves huge hangover

To understand the nation's financial calamity and where it might go next, imagine you own a $200,000 house.

Using financial gimmicks, all legal, you put up the house to borrow $8 million. You go to an Atlantic City casino, play the high roller, and party like wild. Then suddenly you lose it all.

Oh, and by the way, the value of your house crashed while you were away.

In the last few weeks, the Bush administration has acted like a rich uncle bailing out you and a few of the other - many other - people who did the same thing.

But it didn't save everyone, nor will it save all those houses still at the heart of the scheme. It didn't outlaw or rein in the gimmicks. At least not yet. The problem is not solved. Not by a long shot.

That, essentially, was the scene after a historic week when financial titans fell and central banks worldwide pumped billions into the global financial system to prevent it from sputtering to a halt.

Now, the foreclosure epidemic still needs to end, house prices have to stop falling, and the economy has to get off its knees.

Confidence in the economy - the most elusive ingredient - must be restored before the crisis can be resolved. A homeowner who lacks confidence might forgo spending $7,000 to repair stone walls. A factory owner might not spend $150,000 on a new equipment. And giant banks, such as Citigroup and JPMorgan, might not lend to each other, fearing they won't get the money back.

In the longer term, expect a post-9/11-type concentration of regulatory authority in Washington in an attempt to prevent the excess risk-taking that is forcing a bailout bill of untold billions on taxpayers. And expect people to go after those gargantuan banks as being way too big.

The prospect of bailing out people who borrowed too much and banks that lent too much has Herbert E. Balian, a retiree who lives near West Chester, feeling bitter.

"Those people should be hung out to dry," Balian said. "Why should it hurt me?"

Treasury Secretary Henry M. Paulson Jr. argued that the bailout "will cost American families far less than the alternative - a continuing series of financial-institution failures and frozen credit markets unable to fund economic expansion."

"We are days away from the collapse of a good part of the financial system if we don't act. The stakes are as high as we have seen them in a generation," Paulson told Sen. Bob Casey (D., Pa.) and other officials Friday, according to the senator.

Perhaps, but it also means that families whose budgets are already stretched by higher food and energy costs will find that the federal government has less to spend on such things as education, medical research, or grants to help build libraries.

City agencies relying on federal tax dollars will have to curtail neighborhood anticrime programs. A small retailer may find it harder to get a loan to expand its showroom. And millions of Americans with 401(k) accounts could see their pensions evaporate if the market keeps sinking.

In the meantime, house prices - central to the financial crisis because so many investments held by troubled companies are tied to mortgages - keep falling, with no signs of a recovery.

Five million homeowners are behind on their mortgage payments or in foreclosure, Paulson said.

That needs to be dealt with more aggressively, because the "uncertainties there underlie all that has happened in the last month," said David Skeel, a professor at the University of Pennsylvania Law School.

Skeel favors a change in bankruptcy law that would allow judges to slash what debtors owe on their mortgages to the value of the property. "This proposal is political dynamite. It's a tough sell," he said.

Robert Dye, a senior economist with PNC Financial Services Group Inc. in Pittsburgh, said this month's nationalization of mortgage-finance giants Fannie Mae and Freddie Mac, combined with the plan to take over bad debt, would help solve the problem of house prices by bringing mortgage rates down and freeing money for new loans. That could make it possible for more people to buy.

Until now, most Treasury and Federal Reserve actions have not increased lending by the banks "because of the extreme lack of confidence that the various players have with each other," said Dye, who offered the casino scenario to explain the crisis.

It is tough for people to feel confident when they see federal finance officials scrambling the way they have been this year to prevent a complete failure of the financial system.

"I think they are literally trying to put their fingers into the holes in the dike until they can build a stronger dike," said Michael E. Bleier, a partner in ReedSmith L.P.'s Pittsburgh office and a former general counsel at Mellon Financial Corp.

Bleier and other financial experts are overflowing with ideas about what that stronger dike, a new world order of financial regulation, could look like.

To start with, some government unit, probably the Federal Reserve, would be handed the job of keeping tabs on risk in the overall financial system and given the information it needs on the esoteric financial instruments that enabled risk-taking to run amok.

"If you have a better sense of where the risk is and what the amount of risk is in the system, then regulators would have a better sense of when they might have intervened earlier," said Robert W. Helm, who leads Philadelphia law firm Dechert L.P.'s financial-services practice.

Specifically with regard to price bubbles, like the one in housing that started forming in the 1990s, the Federal Reserve and regulators at the Treasury should accept responsibility for pricking them, said Morris Goldstein, a senior fellow at the Peterson Institute for International Economics in Washington.

There might be restrictions on how reckless the bets can be in the capital-markets casino.

And maybe - down the road, when survival of the financial system is no longer in question - attention might turn to the size of the banks that are being formed.

Bank of America Corp. was already huge before its purchase of mortgage lender Countrywide Financial Corp. and brokerage Merrill Lynch & Co. Inc. Bidders were reported last week to be circling Washington Mutual Inc., one of the country's biggest banks.

"It's downright scary, to tell you the truth," said Joel Naroff, chief economist for Commerce Bank. "The concentration of power in the financial sector has become enormous."