THE SUB-PRIME MESS CONTINUED

BAIL OUT DEVELOPMENTS

1. The Treasury will use $250 billion of the $700 billion congressionally authorized bail out fund to buy preferred stock of commercial banking institutions. Initially, it will take stakes in 8 of the largest banks and Merrill Lynch. Some of these banks do not need financial help from the Treasury but all were pressured to join the plan lest the public perceive banks participating as weak precipitating deposit withdrawals. The other $125 billion will be invested in perhaps hundreds to thousands of healthy banks thru November. The remaining $450 billion of the bail out fund will be used to purchase bad assets from financial institutions as originally conceived. The Treasury retreated from using all of the funds to purchase bad assets because:

a. The Treasury wanted to join a globally more unified front in attacking what clearly had become a world-wide economic crisis. If countries take ad hoc action offering more security, such measures cause unanticipated flights of bank deposits and capital to the perceived to be safer investment locations.

b. Congress took too long to pass the bail out measure and it became clear that it would take even longer to fully implement the complex reverse auction process of buying the bad assets. Market reaction, however, moved at a faster speed.

c. The Treasury came to realize that buying bad assets at current market values would reduce banks’ loan assets more than the cash received thus negatively impacting the seller’s balance sheet and requiring an infusion of capital to meet required capital reserves and collateralized loan requirements (the banks had pledged the bad loans as collateral on lines of credit and bonds). That capital would be next to impossible to procure in this risk-adverse environment. The direct infusion of cash before the bad asset buy-out avoids that potentially exacerbating domino effect.

2. Lowering the Federal Funds rate and Discount rate alone did not unfreeze credit. These measures that normally add dollars to the economy did not address the current problem - risk-aversion that has caused the illiquidity. Banks and investors are hoarding cash. Reducing the cost of borrowing did not help because no one will lend and the economy is thought to be contracting. The Federal Reserve has now stated that as of October 27, it will take the unprecedented step of opening the discount window for loans directly to commercial enterprises on collateral backed commercial paper. This move is a milestone because borrowers such as GE and AT&T are not banks under its regulatory jurisdiction.

3. In another highly unusual step, the FDIC announced it will begin a 3 year program of insuring interbank short term loans that have been frozen by an unwillingness to assume risk that cannot be adequately assessed.

4. Also, the FDIC will begin insuring non-interest bearing bank accounts above the $250,000 increased normal insurance limit. This novel move is aimed at helping small businesses with checking accounts.

WILL THE NEW STEPS WORK?

The world economy was precipitously close to going over the cliff as negative factors began to form a critical mass. The more cohesive and unified steps implemented in Europe and here stave off the worst case scenario. But, questions remain and there will undoubtedly be additional unforeseen ripple effects to be felt. Some unanswered issues:

1. The U.S. economy is in a recession regardless of the plan:

a. Corporate earnings are under pressure from not being able to expand due the lack of available funding.

b. Unemployment is rising as consumer spending which accounts for over 70% of the U.S. economy has slowed noticeably.

c. Home prices have continued to fall putting more mortgage borrows under water. It remains to be seen whether banks will use the capital infusion to increase mortgage lending to new buyers. Next month home mortgages keyed to the LIBOR rate will adjust upward dramatically. Absent principal reductions these loans will go into foreclosure adversely affecting an already oversupplied housing market.

d. The impact of anticipated credit card and auto loan defaults has yet to be reflected in the market place.

2. The stock market on Wednesday October 15 reflected the anxiety over news of slowing retail sales by taking back the gains of the day before. I would expect to see the stock market continue its roller coaster ride until investor confidence is restored. That will take some time.

3. What will banks do with the new capital? If banks merely use the capital to retire debt costing more than the 5% dividend to be paid the U.S. Treasury, no positive impact to the economy will be felt.

4. Unanticipated effects – Financial markets are incredibly more complex today than in 1929. For example, increasing the FDIC insurance protecting on bank accounts to $250,000 had the unanticipated effect of causing money market funds to hoard cash fearing large redemptions. Thus, the money market funds were not investing in corporate commercial paper which the Fed was trying to encourage.

5. Summary – the steps should unfreeze lending. The question remains will banks lend. The institutional level steps, however, do not directly address the housing market decline. That problem must be addressed at the borrower level. It remains to be seen how the government programs to renegotiate loans will navigate the fact that most of these defaulting loans are not individually owned but have been incorporated into widely held mortgage backed securities. And regardless, none of these steps changes the undeniable fact that the economy is in a recession that may be much deeper than originally feared. Economist.com on October 9, 2008 stated that:

“The average downturn after recent banking crises in rich countries lasted four years as banks retrenched and debt-laden households and firms were forced t save more. This time firms are in relatively good shape, but households, particularly in Britain and America, have piled up unprecedented debts. And because the asset and credit bubbles formed in many countries simultaneously, the hangover this time may well be worse.”

NOTE: The tax provisions of the bail out legislation will be discussed in a subsequent issue. See also, Volume 2, No. 3, “Primer on the Sub-Prime Mess.”