Will This Gigantic Bailout Work?
The truth is that simply buying the banks' worthless securities has been an option, if an unpalatable one, for the authorities since the credit crunch began a year ago. All the plans to lend against these assets, such as the Bank of England's Special Liquidity Scheme, and other "injections of liquidity", were temporary solutions, born out of a hope, if not an expectation, that the crisis would not be prolonged.
We know better now. What the American authorities have done is the only sure way to protect the banking system against further destabilisation. Short-selling or not, left to their own devices, the markets would sooner or later force more banks into the arms of the taxpayer anyhow. It is a sad day when hard-pressed citizens find themselves subsidising private banks for their stupid mistakes. But that is what's happening in the US, and it will surely be done here. The Bank of England hates the notion; but Gordon Brown may well feel that he has no choice.
So for the banks and their shareholders and staff, the US rescue plan is already working, and it will save the wider economy from yet more damage. It is less clear whether it will end the credit crisis or preserve America's fast disappearing economic hegemony.
Even taking a trillion dollars of crud out of the equation can't save the financial system from damage already done. Despite the Fed's efforts, many banks in America and around the world have severely enfeebled balance sheets. They cannot lend, even if they wanted to. With the developed world in recession – Japan, Britain, Germany and Spain are leading the way – the banks will soon be losing money on their conventional lines of business, as mortgages suffer defaults and companies go out of business. We will then see a vicious cycle of bad debts leading to less lending, more job losses, more defaults and so on.
The turning point in all this will be the moment when the US real estate market recovers, and the whole sorry cycle of decline starts to right itself. Sooner or later American homes will look cheap enough to attract even the most nervous buyer. That could take another year or two.
The other legacy of the rescue plan will be another huge debt burden loaded on to the shoulder of the American taxpayer (and the British one, if the precedent is copied).
The good news is that the great vitality of American enterprise has survived such traumas before. Franklin Roosevelt's Federal Reconstruction Corporation used $1.2trillion (at today's prices) of federal funds to fix the banking system and get the economy moving in the 1930s. The rescue of America's savings and loans associations at the end of the 1980s cost $125bn. Yet now we have a different dynamic. Behind all of this is an irreversible shift of income, wealth and power eastwards; from America and Europe to China.
The oil price was another tool in this redistribution – they bid the price higher and made us poorer. The Chinese also, in effect, lent us the money to buy all those overpriced houses. How? Because they had the savings to lend to us to do so, funded, in turn, from the huge trade surpluses – trillions of dollars – they built up with the US and Europe, earned from selling us all of those cheap DVD players, dog food and toys. All that money looking for a home pushed interest rates down to very low levels (aided by their cheap electronic goods, which reduced inflation as well). Now China is lending us the cash to get ourselves out of trouble again, by buying yet more US Treasury bills and shares in the likes of Barclays and Citigroup. For now, they seem content to do so; but we cannot be sure that they, and the Gulf states, the Russians and the others holding dollar assets, will do so for ever. The savers' run on Northern Rock, the institutional runs on Bear Sterns and Lehman Brothers, and every other run in this crisis will be as nothing to a global run on the dollar itself.
Could the US itself soon suffer a crisis of liquidity?
Will This Gigantic Bailout Work?
By Sean O’Grady
20 September, 2008
Q&A on cleaning up the financial crisis mess
WASHINGTON (AP) — The government on Friday began to assemble what could be the biggest-ever U.S. bailout, sketching out plans to ask Congress for broad authority to restore confidence in financial markets by rescuing banks from bad debts and taking over worthless mortgages and other distressed debt and assets.
Details remained to be worked out over the weekend between the administration and congressional leaders of both parties. But parts of the pattern were beginning to emerge.
Here are answers to some questions about the plans and earlier financial bailouts.
Q. How would it work?
A. Absent details, it's hard to say exactly. It still wasn't clear whether the government would be buying just the bad mortgages or actually taking possession of foreclosed properties and banks themselves. Treasury Secretary Henry Paulson indicated that there would be some government entity to oversee the process.
In the late 1980s, the government set up the Resolution Trust Corp. to help clean up the savings and loan crisis. It acquired defaulted mortgages, foreclosed real estate and other assets of nearly a thousand failed S&Ls and slowly sold them off, restoring order and stability to the system.
It followed the Reconstruction Finance Corporation, a Depression-era relief program formed in 1932 by President Hoover that tried to inject liquidity into the market by giving loans to banks and other businesses.
Q. Who would pay?
A. Both Paulson and President Bush indicated there would be significant exposure to taxpayers. Paulson said the program would cost "hundreds of billions" of dollars. The exact cost would depend on how many companies are "rescued" or taken over, and how far home prices fall. Resolving the S&L crisis took six years and $125 billion in taxpayer money — roughly equal to $200 billion in today's dollars.
Some economists have suggested cleaning up the present mess could cost more than that. But the proposal is designed to identify problems before failures occur.
"The risk ... of not acting would be far higher," Bush said. "The vast majority of assets the government is planning to purchase have good value over time because the vast majority of homeowners continue to pay their mortgages," he added.
Q. Who is supporting such an approach?
A. Such an approach seemed to be gaining bipartisan support on Capitol Hill. On the campaign trail, Democratic presidential nominee Barack Obama said it was critical that leaders in both parties work in concert. "Truly, we are all in this together," he said. GOP presidential candidate John McCain said leaders should put aside partisan differences and "any action should be designed to keep people in their homes and safeguard the life savings of all Americans."
McCain has also proposed a separate plan to set up a new agency that would work with troubled financial companies and, in extreme cases, could take control of the companies and their assets.
Q. What has the government done so far to try to stabilize the worst financial turmoil since the Great Depression?
A. The U.S. government has already taken actions that required more than $600 billion of taxpayers' money: Up to $200 billion overall was made available to mortgage giants Fannie Mae and Freddie Mac when the government seized them earlier this month; insurer American International Group Inc. was given an $85 billion, two-year loan, in exchange for giving the government right to a nearly 80 percent stake in AIG.
Also, as part of JPMorgan Chase & Co.'s takeover of Bear Stearns Cos. in March, the Federal Reserve provided a $29 billion loan. And in a new "Hope for Homeowners" program starting Oct. 1, the Federal Housing Administration can insure up to $300 billion in refinanced mortgages for troubled borrowers — if the existing investor voluntarily agrees to take a loss on the loan.
Q. How does any of this affect money deposited in savings and checking accounts, certificates of deposit and money-market accounts.
A. Through the 75-year-old Federal Deposit Insurance Corporation, every savings account, checking account and certificate of deposit is insured by the federal government for up to $100,000. The government on Friday agreed to extend similar protection, at least temporarily, to money-market mutual funds.
By TOM RAUM