Spare the rod, spoil the child.
These Washington follies exposed two big weaknesses in the governmental underpinnings of the American financial system. First, the government's backing of Freddie and Fannie puts them in a box. The chaos around the GSEs indicated to the markets that the authorities would have to offer some kind of bailout. So, on Saturday, when Paulson called around to various investment banks urging them to buy debt that was going to be issued by Freddie Mac on Monday, he was met with a very cool response. Why should private institutions put their money at risk if the government already believed that it would have to be the investor of last resort? If the nation's finance minister was reduced to playing bond salesman for a private company, moreover, it would stand to reason that things must be pretty bad.
Second, the Schumer-inspired collapse of IndyMac will, over the coming few weeks, remind people that not all deposits in banks are insured; in fact, roughly one third are not. The FDIC only insures deposits up to $100,000 in each account. IndyMac had a fairly wealthy clientele, and, when they find that they may not get all their money back, it will become national news. This is how bank runs start. People with large accounts tend to be quite sophisticated and will rapidly move their deposits to Treasury bills or other investments. In the last banking crisis in the late 1980s, FDIC chairman Bill Seidman was able to protect nearly all of these uninsured depositors by merging institutions. But in 1991, Congress in its infinite wisdom, made this far more difficult to do the next time--i.e. this time. (This is a story that will unfold in coming weeks.)
