Having savaged the U.S. financial sector since it surfaced in the summer of 2007, the credit crisis evolved into a crisis of confidence - which has manifested itself as a liquidity crisis. And that liquidity crisis is no longer confined to the financial sector. It’s spilled over into the energy sector, as well.

With that, two government officials stepped up with competing plans to help ease the domestic economy through this difficult time. Sen. Schumer and U.S. Rep. Barney Frank, D-Mass., head of the House Financial Services Committee, have called for the creation of entities similar to the Resolution Trust Corp. that was created by federal government in the 1980s as part of its S&L bailout plan.

A government-run asset-management operation, the RTC took assets that had been held by insolvent S&Ls, and found ways to repackage them and sell them off. The RTC was widely heralded as a bold and innovative creation, and its success was one reason the S&L debacle was put to rest much sooner than experts predicted, and cost the taxpayers much less than many had feared.

Ex-Treasury Secretary Lawrence H. Summers and former Federal Reserve chairmen Alan Greenspan and Paul A. Volcker are all in favor of the plan.

But current U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. remains admantly opposed to an RTC-like entity, according to BusinessWeek, and is proposing his own plan.

Reports of a government intervention raced across the newswires late yesterday afternoon - just in time to give the stock market a last-chance boost for the day - but details of the plans remain sketchy as news operations provided conflicting descriptions.

Fears Roil Commercial Paper Market

The U.S. commercial paper market - consisting of short-term corporate borrowing - recorded its biggest-percentage-point decline in more than a quarter century yesterday as the bankruptcy of brokerage giant Lehman Brothers Holdings Inc. (LEH) and the takeover of insurance heavyweight American International Group Inc. (AIG) sent a stampede of investors into government securities, Bloomberg News reported.

Commercial paper is a short-term debt obligation with a maturity ranging from two days to 270 days. It is issued by corporations, banks and other institutions to investors with surplus cash, which companies can use to finance their day-to-day operations. But a crisis of confidence among investors who fear they may not get their money back has made it impossible for firms to raise cash, creating a liquidity crisis big enough to shove otherwise solid firms into bankruptcy.

These investor liquidity fears had a major side-effect recently: By literally pouring cash into Treasuries, investors yesterday sent investment yields on the three-month T-bill to their lowest levels in at least 54 years, Bloomberg stated.

Thanks to this “flight to quality,” the U.S. commercial paper market actually declined by 2.9%, or $52.1 billion, to a seasonally adjusted $1.76 trillion for the week ended Sept. 17, the U.S. Federal Reserve said yesterday. Without the seasonal adjustments, the market declined 4.2%, or $74.1 billion, to reach $1.68 trillion.

That was the biggest-percentage-point decline in at least 26 years. It was also the biggest slump in corporate short-term borrowing since December, Bloomberg reported.

“There’s a loss of confidence in the market. You don’t know if one of the banks you’re trading with is next,” Ina Steinke, a money-market trader for Norddeutsche Landesbank Girozentrale AG, Germany’s fourth-biggest state-owned bank.

But this is one example of how a catastrophe on Wall Street can lead to major problems on Main Street since money-market funds are among the biggest buyers of corporate commercial paper.

Investors pulled $80.7 billion from taxable money-market funds in the week ended Sept. 16, including $39.6 billion of withdrawals from the Reserve Primary Fund. Total assets in U.S. money-market mutual funds fell 2.5% to $3.45 trillion, according to Money Fund Report, a Westborough, Massachusetts-based newsletter.

The Reserve Primary Fund and the Reserve International Liquidity Fund Ltd. became the first two money-market funds since 1994 to “break the buck,” meaning that their net asset values (NAV) fell below the $1-a-share price paid by investors. [For an in-depth look at the money-market-fund mess, check out a related story elsewhere in today’s issue of Money Morning].

The list of firms facing liquidity shortfalls after spooked investors and short-sellers sent their stocks diving over the past week continues to grow as Morgan Stanley (MS), Washington Mutual Inc. (WM) and Constellation Energy Group Inc. (CEG) all scrambled to restore investor confidence.

By Jennifer Yousfi, William Patalon III and Jason Simpkins
Money Morning Editors

Source: The Government’s Financial Crisis Fix-it Plan Sends Stocks Soaring, Though Some Argue There’s no Quick Fix for this Disaster

(Part 2)