Originally published October 8th, 2008 in The Campus Issue
The latest financial turmoil in the U.S. has seen many companies bailed-out by the American government. The trend has been criticized as an ever growing threat to so-called free-market policies. The $700bn bail-out could be the beginning of a long tumble down the rabbit hole.
When the housing bubble started to collapse, companies like Fannie Mae and Freddie Mac suffered greatly. They had backed money to “high risk” clients and many of these high risk loans went into foreclosure. Deemed too-big-to-fail, they were bailed out by the government, fearing their collapse could bring down the whole economy.
Fannie and Freddie were not the only institutions involved in this risky lending, many other institutions were involved. For example, Lehman Brothers closed the sub-prime lender, BNC Mortgage, in August 2007. But their involvement in the sub prime and lower rated mortgages lending continued. They were underwriting these mortgages with mortgage backed securities and collateralized debt obligations (CDOs.)
Mortgage backed securities and CDOs, in short, bundle the mortgages from the lenders into bonds. They are sold out on the bond market the same way government bonds are.
As more and more mortgages went into foreclosure, these underwritten assets started to loose value and Lehman Brothers could no longer sell them. Since Underwriting entails Lehman taking on the risk of distributing the assets, they suffered billions of dollars in losses. What followed was the failure of many deals to save Lehman Brothers and finally their bankruptcy.
The real danger of this crisis is not the housing bubble but credit default swaps (CDS), a kind of derivative. CDSs are insurance on financial instruments, in this case on CDOs and mortgage backed securities, that guarantees the debt.
When an insurance company insures cars, they calculate that only a few will have accidents and pay out a smaller amount than the money received from the insurance contracts.
The bond market is different. One big failure can scare off investors of all the other bonds preventing borrowers from finding capital to stay solvent. It creates a domino effect.
As these companies fail, so do their bonds and the CDS contracts have to be fulfilled. This is what happened to AIG Insurance when Lehman Brothers failed. They had to cover the failing bonds they had insured.
What is truly scary about CDSs is how complicated they are. Few people really understand them and it is unclear who has them and where they come from. The scariest figure is that the derivative market is estimated to be somewhere north of $500tn dollars. No one really knows what would happen if it collapsed and this is why Warren Buffet calls CDSs the “weapon of financial mass destruction.”
As the U.S. financial credit crisis plays out, many offer different views and opinions on how to rectify the issue. The traditional Keynesian response calls for government intervention, free-market advocates conversely support laissez-faire solutions but most have no idea what to do.
The plan that the house of representatives passed on Friday, was designed largely by the U.S. treasury secretary, Hank Paulson, and the Federal Reserve chairman, Ben Bernanke.
The plan, which is backed by the Bush administration, offers a $700bn dollar bail-out of the fragile financial system. The plan gives Paulson the power to buy risky assets from the financial institutions in an attempt to stabilize the system.
There are major problems with this plan. First, the government does not have $700bn available with which it can purchase those risky assets. The money will come fresh off the printing press of the Federal Reserve. Paulson will then buy the precarious asset with the new treasury bills. Bernanke and Paulson both argue that the purchase of these assets will allow the bank to begin loaning money at an increasing rate and help support housing prices.
By stabilizing the housing market, they will keep housing prices, already at record lows, from slipping further and minimize foreclosure. At the same time, keeping further situations like Lehman brothers and other government bail-outs to a minimum.
$700bn is a breath taking number, just to offer some comparisons: It is more the $2000 per person in the United States. It is approximately equal to was has been declared to have been spent on the Iraq War. It is more than the pentagon’s yearly budget.
The time frame surrounding the design, ratification and implementation of this legislation is even more impressive. This legislation was written and presented to Congress for a vote within two weeks of the initial realisation of the crisis. The breakneck pace of its design reaffirms the urgent call for action.
Throughout history, when governments have printed money, they have devalued their currency, decreasing how many goods money can buy. The Romans did it near the end of their empire, the Germans did it in the 1920’s and many other governments have done it in the past to finance their state endeavours at the expense of their populations.
A question that some in the financial sector are asking is: “should an increase in liquidity be the solution?”
Many argue that easy credit got us into this situation and that this solution would simply act as a band aid for a bullet wound, temporary gain and long term pain.
What will happen in the next couple weeks will probably seal the fate of the American economy and in turn, at least temporarily, the world economy. Unfortunately, the results of the bail-out will only become evident after the crisis has run it’s course.
Originally publisher in The Campus, student newspaper at Bishop's University
Available on-line at
www.thebucampus.ca/
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