Federal government wants a few more hammers

The failure of the $700 billion bailout bill leaves Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke with few options to continue their urgent campaign to rescue the financial system.

The top economic policymakers geared up Monday to try to salvage the package, concluding that the existing powers they have would not be enough to restore confidence in financial markets wracked by bank failures.

“Our toolkit is substantial, but insufficient,” Paulson said Monday.

If a version of the bill doesn't ultimately pass, the Fed and Treasury would have little choice but to keep making case-by-case decisions about the fates of individual firms, on the fly, using existing powers to try to contain the crisis.

But Paulson and others have warned that this ad-hoc approach has its limitations. It sends a mixed signal to the markets, since investors cannot be sure which firms the government will save. And it does not relieve the financial system of its vast holdings of toxic mortgage-related assets.

The Federal Deposit Insurance Corp. has nearly unlimited power to save depository banks that it deems fundamentally important to the financial system, based on an emergency authority granted by Congress in 1991. The agency invoked the provision this week to make sure that Wachovia would be sold.

The Fed has already used Depression-era legal authority to lend money to any “individual, partnership, or corporation” in “unusual and exigent circumstances” as grounds for the interventions involving Bear Stearns and insurance firm American International Group. In theory, the Fed could use that same latitude to do what the bailout bill was trying to accomplish: take on some of the troubled mortgage securities that are weighing down bank lending.

But there are two problems. First, Bernanke has resisted using Fed powers that way because he views that decision as more appropriately left to political authorities, hence his support for the bailout bill. It would be doubly hard to take such action after the House has specifically rejected the idea.

Second, the Fed has finite resources and has already used vast portions of its financial capacity to combat the crisis on other fronts. As of Wednesday, the Fed had $1.2 trillion in assets on its balance sheet, but $150 billion of that was extended in special loans to banks, $262 billion was in various emergency lending facilities (including to the investment banks and AIG), and $29 billion was in Bear Stearns assets that the Fed holds.

A provision in the failed bill would have given the Fed leeway to use more resources for such measures, which would have left the central bank with more flexibility to intervene.

“These are desperate times, and you're going to pull out some desperate measures,” said Richard Yamarone, chief economist at Argus Research. “They're going to try to stretch every imaginable solution and initiative they have to right this sinking ship. But I don't know what they have left. They've already exceeded anything I believed that they could do.”