AIG rescue fails to boost investor confidence

One strong indication that the credit crunch continues to weigh on the financial system was the announcement Wednesday that the Treasury Department plans to issue fresh bonds to help shore up the capital base of the Federal Reserve system.

It’s not clear how the government will respond to future financial meltdowns. The refusal by Fed and Treasury officials last weekend to backstop the failed investment bank Lehman Bros.  was seen by many as a “line in the sand” — a signal that the government would not put taxpayer dollars at risk to rescue companies that made bad financial decisions and took on too much risk. Just days later, the government has apparently reversed course in its rescue of AIG.

The ad hoc nature of the government’s approach has prompted calls for a broader government response to the crisis in the financial sector. Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, has called a hearing to consider setting up a separate government agency to oversee the bailout of failed financial institutions.

"The issue is are we now in a situation where there's so much bad paper out there, at least temporarily devalued, that it's clogging the system and somebody has to step in and take it off (the books)," Frank told CNBC.

Proponents of a new agency to deal with the crisis say it would go a long way to restoring confidence in the financial system.

“Right now we're dealing with it on an ad hoc basis -- but only during times of crisis,” said Bernard McSherry, senior vice president with institutional brokerage Cuttone & Co. “If we can set up a vehicle to take some of those assets off the books of banks that are not in crisis earlier in the process, we might get a more orderly disposition of some of those assets.”

Much of the uncertainty over the value of assets in the financial system is due to the declining value of housing — the asset backing much of the most problematic debt. The housing market continues to grind through its biggest downturn since the Great Depression. Fresh evidence came Wednesday with data showing that housing construction hit a 17-year low last month.

While home sales have begun to show signs of stabilizing, prices are still falling in many areas of the country. That suggests that a larger portion of those sales may be coming from foreclosures, according to John Ryding, chief economist at RDQ Economics.

“With a large overhang of unsold homes in relation to sales, and prices continuing to decline, it is too soon to look for stabilization in housing construction,” he said.

There are also concerns that the credit crisis in the financial system is spilling over to the broader economy. While the economy continues to post growth, the rising pace of job losses is a troubling sign that growth may be faltering. The slowdown in the global economy and the rising value of the dollar will likely dampen the recent demand for U.S. exports. Despite low interest rates, credit is harder to come by as lenders have tightened their standards, and consumer spending is slowing.

"Major downside risks to the economy, with diminishing inflation risks, are plain for anyone who has eyes to see," said Brian Bethune, an economist with Global Insight.

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