Thursday, September 25, 2008

The Last Federal Bailout

The Bush Administration's proposed $700 billion bailout of Wall Street, if it occurs, will be the last government bailout during the current financial crisis. That doesn't mean it will work, although it may. However, the $700 billion estimated price tag, which may be low, would pretty much tap out the federal government. We're already looking at a $400 billion plus budget deficit. The $700 billion would have to be raised and spent quickly--within a year or so--in order to be of any help. Thus, the federal government would probably have to come up with $700 billion or more in cash in the next year in order to implement the bailout. The fact that the assets the government purchases may, years from now, be sold for prices higher than the government pays, is irrelevant to the government's immediate cash flow problem. Where will the federal government get an extra $700 billion or more within the next year?

Raising taxes may be in the cards for the next president, regardless of who is elected and regardless of their current campaign sloganeering. But getting an additional $700 billion could require increasing federal taxes by 50% or more. That won't happen. So most of the money will have to be borrowed. Given how the dollar and the world economy are slumping, how eager will foreign investors be to throw more money at the most profligate of borrowers in the world? Maybe, with the help of major foreign central banks (which have substantial dollar reserves and can lean on the large banks in their countries), the U.S. government can one more time scare up enough money to make ends meet. But there won't be any more loans after this one. Foreign banks are sitting on top of hundreds of billions of dollars of mortgage-related losses themselves, and are running low on capital, too. No one, not even the U.S. government, can borrow an unlimited amount of money. This will be the last federal bailout of Wall Street.

It's unclear as of tonight (Thursday, Sept. 25, 2008) whether the bailout will be enacted. Today's negotiations between Congress and the White House collapsed amidst a Republican revolt against the Bush Administration. (Conservative sentiment against the bailout runs strong.) However, the financial markets are frigid--short term U.S. Treasury bills are priced close to zero percent interest while large financial institutions can't borrow nary a nickel. There's a lot of political pressure to do a bailout, so it's more likely than not that something will be enacted by the end of this weekend.

Since this will be the last bailout, the Bush Administration and Congress had better get it right. Recent history does not inspire confidence. Within the last year, the Fed has significantly increased the types of financial firms to which it will lend, and dramatically expanded the scope of the collateral it will accept. It engineered a bailout of Bear Stearns. Next, the Treasury nationalized Fannie Mae and Freddie Mac, effectively taking over the secondary mortgage market. Then, the Fed agreed to lend AIG $85 billion in order to protect the credit default market. It's loaned many billions more to foreign central banks in order to keep credit flowing overseas. None of these measures made a difference for long. It is unclear whether the proposed big bailout will save the day. The Congressional Budget Office has noted that federal acquisition of toxic assets would set clear prices for those puppies, which could force reticent banks to own up to losses that they've quietly been keeping in closets. More financial firms could fail and things could really unravel.

If there is no bailout, or if the bailout fails, what should we expect? Short term, financial institutions will borrow very heavily from the Federal Reserve and the Treasury. No one else will fund them. At the same time, credit availability will enter a new Ice Age. Longer term, it's impossible to predict what will happen. It's unclear that we'll have a disaster. Asset prices will come under increased pressure, but if banks don't lend, alternative sources of financing will evolve, as they always have. This process won't come easily or quickly, but it will occur. Look at immigrant communities in America. Immigrants often have a difficult time getting credit from established financial institutions. What do they do? Band together and finance themselves. For example, within the Korean community, a half-dozen or so members may pool their savings and make loans to each other in order to finance new businesses. Each borrower repays the pool, and the pool makes a loan to another member to start his or her own business. (Credit unions and mutual savings and loan associations work the same way on a larger scale.) Angel investors for high tech startups are another example of capital bypassing the banking system. Internet based lending sites, where lenders directly interact with borrowers, are the latest example of this phenomenon. If the banking system fails to serve people, people will be resourceful. You may lose hope in the banking system, but don't lose hope in yourself.

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