President Paulson and VP Bernanke

President Bush didn’t announce it, nor did Congressional leaders. Rather, it was US Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, his intellectual backer, who proposed a vast bailout of financial institutions in the US, requesting unfettered authority to purchase up to $700 billion in distressed mortgage-related assets from private firms, after which it will try to resell them to investors. Given the experience of these two, it is preferable that they run the show amid the escalating financial crisis and become the shadow president and VP of the US economy.

On Friday, Paulson first announced a structural solution for the problem of toxic financial assets in the system. At that time, the concept being floated was along the lines of the Resolution Trust Corp., a key tool to liquidating holdings of failed savings and loans in the late 1980s and early 1990s. The news helped calm investors and pushed stocks to essentially unchanged on the week.

It’s hard to believe that it was just one week ago that we were wrestling with the failure of Lehman Brothers, purchase of Merrill Lynch by Bank of America and the near-implosion of AIG. On Thursday, it was clear that the case-by-case, reactive approach to the crisis was not enough to prevent widespread panic across financial markets. To help stabilize the broader economic and structural problems plaguing the market, Paulson and Bernanke, himself a student of the Great Depression, gathered Congressional leaders and scared them straight. The lawmakers emerged from the meeting visibly shaken, but ready to swallow the bitter pill that Paulson and Bernanke prescribed. By yesterday, it appeared that the US was entering unchartered territory of the credit and housing crisis that would require a new regulatory structure.

Paulson noted that “lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing” and that cancerous mortgage-backed securities had become “frozen on the balance sheet of banks of banks and financial institutions…the inability to determine their net worth has fostered uncertainty about mortgage assets and even about the financial conditions of the institutions that own them.” As Joe Nocera pointed out in the New York Times, “Nobody understands who owes what to whom — or whether they have the ability to pay. Counterparties have become afraid to trade with each other. Sovereign wealth funds are no longer willing to supply badly needed capital because they no longer know what they are investing in. The crisis continues because nobody knows what anything is worth. You simply cannot have a functioning market under such circumstances.”

There are hoots and hollers that we have morphed from capitalism to socialism over the course of a week. To that, one has to wonder whether such free-market adherents were willing to see the entire system seize up and watch idly as the global economy entered what could have been another Great Depression. With a number of terrible choices, Hank Paulson and Ben Bernanke chose the one that seemed the least odious. As Bernanke told colleagues last week, “There are no atheists in foxholes and no ideologues in financial crises.”

The plan is a proactive, systematic approach that attempts to stabilize confidence, which should temper the severe price action and prevent a seizing-up of market liquidity. The action demonstrates that US authorities were unwilling to sit idly and watch the economy slide into a Japanese-like, decade-long malaise. The results of the exceptional government intervention will be written about in history books, but for now, investors are hopeful that with time and this powerful policy response, confidence will be restored and markets and the economy will eventually recover.