There is no doubt that reforms in the financials sector are necessary going forward following this financial crisis. Stricter regulation of financial products and more transparency in the markets probably could have helped to prevent some of the problems that have recently rocked the markets, including the fall of Bear Stearns and Lehman Brothers and the turmoil surrounding American International Group (AIG) and their credit default swaps. In the beginning of October, when investor fear was spurring a dramatic and rapid drop in stock prices, accompanied by a changing landscape in the financial sector, a rising unemployment rate, and decreased consumer spending, the markets were begging the U.S. government to intervene.

Investors were so fearful that money market mutual funds, typically regarded as safe investments, saw massive outflows. They subsequently reduced their holdings of commercial paper, traditionally a source of financing for many companies' day to day operations. In order to address this liquidity problem, the Federal Reserve created a commercial paper lending facility and began talks with the Treasury Department. These talks, led by Henry Paulson and the FDIC, developed a plan that would restore investor confidence in the financial system. The major players worked together to devise an extensive $700 billion Troubled Asset Relief Program, or TARP, to provide banks with much needed capital. The rescue plan seeks to provide liquidity to the markets, spurring banks to lend more money to other banks, companies, and consumers.

From the Beginning

The bailout plan originated as legislation sent to the House of Representatives seeking permission for the Treasury to purchase troubled mortgage related assets from banks in a reverse auction process. However, Congress rejected the idea and a new plan was drafted entitling the U.S. government to use $250 billion of the approved $700 billion in order to purchase stakes in the nation's largest banks. The government began by taking preferred equity stakes in Goldman Sachs Group Inc. (GS), Morgan Stanley (MS), J.P. Morgan Chase & Co. (JPM), Bank of America Corp. (BAC), Citigroup Inc. (C), Wells Fargo & Co. (WFC), Bank of New York Mellon (BK) and State Street Corp (STT). The plan stipulates that the investments will carry a 5 % annual dividend that rises to 9% after five years. In addition, the government will receive warrants and the senior preferred shares will qualify as Tier 1 capital. The direct infusion makes more sense as it helps the Treasury to avoid the difficult task of pricing illiquid assets. If the government would have paid too much for the assets they would have received criticism while paying too little would have forced banks to take more writedowns.

The rescue plan was quickly opened up to an increasing amount of financial institutions and it seems like almost every one wants to jump on board. Just last week, the Treasury announced a revision of AIG's rescue and will now inject $40 billion into the giant insurer. Combined with the previous totals, the U.S. government will provide over $150 billion to the company. American Express (AXP) even made the transition into a bank holding company in order to gain access to the bailout plan. As a bank holding company, more of their assets will be under federal supervision and the bank will qualify for up to $3.6 billion, but customers are unlikely to notice a large change. CIT Group Inc (CIT) announced this week that they applied to become a bank-holding company as well, and the company is seeking up to $2.5 billion from the Treasury. There are some rules and regulations that these participants will be required to adhere to, including caps on executive salaries.

On Friday, the Treasury dished out over $33 billion more in capital to 21 more financial institutions. The capital injections have received some criticism, as people fear that the funds will not be effective in causing banks to increase lending activities and that many banks will only use the capital to make acquisitions and beef up their balance sheets. When PNC Financial Services Group Inc. (PNC) was allocated $7.7 billion from the Treasury, they quickly acquired National City Corp. (NCC) for just over $5 billion.

Funds are Limited and Competition is Heated

Requests for a bailout from Uncle Sam expanded beyond the financial sector quickly. As talks of a merger between General Motors Corp. (GM) and Chrysler LLC. began, the firms estimated that they would need at least $10 billion of capital from the government. U.S. auto makers, including Ford Motor Co. (F), continue to be downgraded, and many estimate that they could run short of money within the next year without government aid. Senate Democrats have introduced new legislation that would provide a bailout to the Big Three automakers by using a chunk of the $700 billion. However, the Bush administration recently stated that the auto makers should only receive funds from the $25 billion loan program, designed to emphasize an increase fuel efficiency, that already exists with the Department of Energy. White House officials announced this week that they do not want funds from TARP, which was designated to include solely financial companies, to be available to the auto companies. It will be interesting to see who wins the battle, but one thing is for certain; the government can only rescue so many firms. In my opinion, the auto makers do not deserve to be bailed out. Their business models are flawed and have been for years, their labor costs are high, and a bankruptcy would allow them to restructure and hopefully return to profitability in the future.

This week, the Treasury announced that $158.6 billion has been spent on 30 financial institutions thus far, including the first nine major banks; this means only just over $90 billion remains for capital injections. Now insurers, who have taken huge hits to their investment portfolios, are also trying to qualify for the government bailout funds by becoming savings-and-loans holding companies. Just this week, Genworth Financial Inc. (GNW) and Lincoln National Corp. (LNC) made plans to buy savings-and-loan institutions, following in Hartford Financial Services Group's (HIG) footsteps. The argument for aiding the insurers is that they provide capital to other companies; life insurers hold well over $1 trillion of corporate debt on their books.

One of the many problems that still has not been addressed, which the plan was originally designed to target, is that firms still have bad assets which will cause them to have writedowns and incur losses. Treasury Secretary, Henry Paulson, has noted that the next step to resolve the issue is some type of lending facility to aid investors in buying these assets. Another idea proposed in tandem with the bailout is a policy that will help homeowners to avoid foreclosure; the FDIC has been a huge advocate of the idea. In my opinion, this type of program will be complicated and difficult to enforce effectively. Most recently, Paulson has announced plans to take a break from dispersing capital, leaving the remainder of the funds for the future administration in case of emergencies or use for various programs.

A Potential Threat to Capitalism

The injection plan undoubtedly produces concerns over how far the government should extend itself in order to rescue the economy. If the total spent on the TARP reaches $1 trillion it would be the equivalent of 7% of U.S. GDP. Over-regulation poses a serious threat to capitalism, and while some government aid is necessary to keep the economy afloat, too much regulation will surely affect free markets and hinder future economic growth. Currently, many questions are raised as to how long the government can wait before selling the investments and what will happen with the profits. The success of free market capitalism has been proved throughout history, and it is vital that it be restored as quickly as possible. However, I think that some have been too critical of the government's approach to the financial crisis, and there are a few key points to remember.

The financial crisis we are experiencing is completely unprecedented due to the complexity of financial derivatives which were created by computer models and carried risk that was unfathomable to investment banks and other financial institutions. Secondly, regulators have had an extremely limited amount of time to develop a comprehensive plan that will benefit banks without decreasing shareholder value and costing taxpayers astronomical amounts of money. Historically, governments have waited much longer to respond until banks reached the point of insolvency. Finally, private sector solutions for the likes of Fannie Mae (FNM) and Freddie Mac (FRE) were infeasible, and failures of large, global financial institutions such as AIG would have broader implications for the economy, not just in the U.S. If there is one idea to take away from this whole plan to shore up the economy, it is that the plan may help going forward but cannot erase previous damage.

Disclosure: The mutual fund the author manages is long PNC, GS, JPM, and BK.