Financial Crisis- US Government Steps In With Largest Bail Out Package

Thursday, 25 September, 2008

As western media chases words to describe the market crash in the West, people have begun to realize how close they had been to total crash and how near that prospect still is. The financial regime that had been in place for the last three decades took nearly two years to unravel totally but the final lap occurred in a matter of just a week.

The spiral down began with the takeover of Fannie Mae and Freddie Mac, the two companies that guarantee half of all housing mortgages in the US and then moved on to the crash of Lehman Brothers, takeover of Merrill Lynch and near collapse of AIG, the world's largest insurance company. It was also the principal insurer of the mortgages that have triggered the collapse. In the end as the break up of the entire banking system loomed rather large, the US administration had no option but to step in and buy up the entire lot of bad stocks that was causing the problem.

In effect, it bought up all the bad deeds of the sector because they were not left with any other options. It was that or the collapse of the economic system as the globalize world knows it. "But this is a humbling experience to see such fragility in capital markets and to ask how did we ever get here," US Secretary for Treasury Henry Paulson has said. For a tribe that is more famous for arrogance - he was the ex-CEO of a major Wall Street investment bank Goldman Sachs-- his words show how deep the trouble was.

Most are saying that the cause of this problem lay in bad debts or loans to people to buy houses through mortgages which they couldn't pay. In other words, it was the result of greed of the poor people who wanted to own a home/house and the greed of the rich who wanted to make money out of this lending process. To spread the risk of the bad loan which most lenders knew could default; they sold the loan to many others who were eager to buy this high risk and high yield 'debt packages'. That is how the infection of the bad loans became global and affected so many financial institutions in so many parts of the world. The globalize face of the banking sector can be seen from the fact that even Bangladesh Bank had invested several million dollars in the recently dead investment firm Lehman Bros.

Insuring greed

The insurance companies add an interesting twist to the issue. They also wanted a piece of the action and agreed to insure the debt packages which of course made them more attractive. They gambled that the situation would never get so bad and so they would never have to pay out so many claims in one go and it was worth the gamble. However, when the market began to slip and the big banks began to melt, the pressure fell on AIG insurance, the worlds biggest and other insurance companies shaking the world's financial system. With everyone caught in the web, it became a serious threat to the arrangement that keeps the world's financial and commercial highways alive. To avoid a devastating cardiac arrest of the global economic arteries especially of the US, the US government stepped in.

Media commentators are having a great time discussing the problem. Many are also saying loans to those unable to pay back must be stopped. It's a bit of a puzzle why bankers would give out such loans in the first place unless they greatly benefited. However, conservative critics know that what has been rubbished through the process is the fundamental weakness of the argument for totally unregulated markets.

Several critics have said that the pressure put by various predecessor governments, both Republican and Democrats, to loan money to black people who were economically backward was largely responsible for this disaster and future arrangements should forbid such loans. However, this is also worth considering that such loans constituted only 12% of the total housing loan sector. However, they constituted a full 50% of the defaults or unpaid loans.

While it means the poor fell through the cracks and crevices and now chasms, many of those who were not taking the unsecured loans also fell which isn't being discussed so much. It also means the US financial system can't handle 6% of bad debts in the sector, something which shows how notoriously fragile the financial system had become. However, instead of this aspect, more attention is being paid to the issue of unreliable borrowers.

The crash is also an ideological blow to those who advocate market operations without regulations. What Bush and Paulson have been forced to do is to plan to buy and hold all the so-called toxic debts by the government prompting some to say that the US has taken the socialism route.

The rescue package nobody wanted

Meanwhile, Henry Paulson has urged Congress to move quickly to pass a US$ 700bn package to tackle the worst financial crisis, possibly ever. The US Treasury Secretary plans to set up a fund to buy back much of the bad debt held by banks and financial institutions around the world.

Paulson has also said that other countries should act in the same way and act accordingly and regain investor confidence. "I wouldn't bet against the American people and I wouldn't bet against the long-term fundamentals of this country." Congressional and Treasury officials have been meeting to try to get the package signed into law within a matter of days.

Under the draft Treasury plans, financial institutions with "significant operations in the US" are eligible to sell or auction their bad debts to Treasury fund. The fund would aim to sell off these mortgage-related debts in the future. That would mean a number of banks including the hard-hit British ones could sell their soured assets to the Treasury-owned bank too.

Last week, US President George Bush defended the plan, saying the cost to taxpayers of shoring up markets was better than the alternative of job losses and diminished pensions. "I'm convinced that this bold approach will cost American families far less than the alternative." Bush added that anymore stress would lead to massive job losses, wipe out retirement accounts, reduce even more falling housing values, and dry up new loans for homes, cars and college tuitions.

And finally some regulations for the market

The Treasury has revealed little detail of its ambitious package, other than the estimated cost of buying these bad debts and who is eligible for the scheme. Mr. Paulson has asked for congressional approval to raise the amount the government can borrow to US$ 11.3 trillion (from US$ 10.6 trillion) to cover that cost.

How much the Treasury will pay for the banks' toxic assets is still not known. Some members of Congress are uneasy at the thought of the taxpayers taking on hundreds of billions of dollars of currently worthless debt but leaders have promised quick action.

Once this difficult period was over, Mr. Paulson said, the government's next task would be to overhaul bank regulations. UK's Prime Minister Gordon Brown has said that one of the lessons from the global financial crisis is the need for international regulation to be brought up to date. He told the BBC, "We're in a new economy, a global financial economy, the world is changing very fast, but the governance of the global financial system has not caught up with it and that's what's got to change."

While most in the US see it as an American problem, people in the financial world will echo Gordon Brown that the financial world has changed and the rules to govern global economies need updating and the US needs to realize that. The absolutist belief that the market can do no wrong is as untenable as the argument that the market is all bad. While for a while, the unbridled supremacy of the market fundamentalism reigned, it has been brought down by its own internal flaws just as socialist fundamentalism collapsed with the death of Soviet Union and the great leap forward of China to the market.

Perhaps leaders everywhere will recognize that even in finance, it's better to follow common sense than ideology that in the end can cause early demise.

Source: http://www.tradingmarkets.com/