Bailout's Flaw of Large Numbers

By PETER EAVIS and DAVID REILLY

Berkshire Hathaway's investment in Goldman Sachs Group provides a template for how to get the financial system back on its feet.

The problem is, the Bush administration's $700 billion bailout plan ignores some of the key lessons of Warren Buffett's deal. Most notably: Capital, or lack of it, is at the heart of the crisis.

The proposed bailout only goes a certain distance in addressing that, so it mightn't spark the sort of quick confidence rebound its proponents are hoping for. That explains Wednesday's renewed stress in debt markets.

The realism of the Goldman/Buffett deal is instructive. The market was getting nervous about funding Goldman's highly leveraged balance sheet. The bank had to adjust and raise expensive capital quickly.

First, Goldman agreed to become a bank-holding company Sunday, giving it greater access to Federal Reserve credit. Then it reduced leverage markedly by raising $10 billion in fresh capital from Berkshire and other investors. It did so even though it meant diluting shareholders by as much as 20%.

In contrast, the government's bailout plan contains no explicit demands that banks raise capital. If Goldman needed to, others surely do.

Instead, the government plan aims to repair balance sheets just by taking large amounts of distressed assets from the banks. True, this could allow banks to reverse losses, depending on the price at which the government buys them. That would boost capital to an extent. But, on its own, not by enough to soothe credit markets, which want to see balance sheets cleaned up more definitively.

Indeed, Mr. Buffett likely made a bet on Goldman because he felt comfortable with the valuations on its balance sheet. Investors looking at the U.S. financial system overall need to feel the same level of comfort before things return to anything like normal.

The bailout plan might not achieve that if the government buys bad assets at prices higher than they would fetch in the market. This would allow banks to maintain inflated valuations for the assets they retain. The possible result: continued mistrust of banks' balance sheets.

The alternative -- buying at conservative mark-to-market levels -- could trigger further financial losses in the system, exacerbating the need for capital.

A multipronged approach could address that dilemma. Like Mr. Buffett, the government needs to focus its resources on shoring up institutions that can survive the crisis. This could take the form of asset purchases, equity investments or a combination.

Meanwhile, it should leave the weakest to be euthanized by the Federal Deposit Insurance Corp., beefed up by a portion of the bailout funding.

A big number, by itself, won't restore confidence. Any solution that doesn't directly address the capital shortfall is likely to fail.