5 key questions about the US bailout

Currencies, Economic growth, Financial Events, Futures trading, Leverage

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The proposal now before Congress to authorise the spending of $700bn to bail out Wall Street contains just 849 words. It avoids the need to go into further detail via its suggestion that the Treasury Secretary should simply have unlimited authority to act as he ‘deems necessary’. But 5 key questions are bound to be asked over the next few days:

What is the likely total cost? The headline number is currently $700bn, plus the $50bn spent on Friday to insure money market funds. But, of course, there is also the estimated $200bn cost for bailing out mortgage giants Fannie and Freddie, in addition to the costs of the earlier Bear Stearns bailout and of the $100bn tax rebate in May/June. So already the sums involved are more than S Korea’s total GDP ($939bn).
Is this a ‘done deal’? No. The Wall Street Journal (WSJ) notes that House Speaker Nancy Pelosi has already said ‘the Democrats will insist on adding measures to protect taxpayers and tighten regulation of the industry’. They also want more help for homeowners threatened with foreclosure. So the cost is bound to rise – the Savings and Loans bailout took 10 years (1989-99), and cost more than double the original $50bn estimate.
How will the money be spent? One suggestion is that the Treasury will purchase the assets via reverse auctions. This leads the WSJ to comment that ‘the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets.’
Who will pay the bill? The proposal calls for US national debt to rise by a further $700bn, to $11.3 trillion. There is no suggestion that taxes will rise – instead, the government will borrow more. Global interest rates will therefore end up being higher than would otherwise have been the case. And as the blog noted in September, financial institutions are already deleveraging thier balance sheets. So this new government borrowing will ‘crowd out’ borrowing by companies and consumers, forcing them to cut back, and further slowing the economy.
Will it solve the crisis? The WSJ notes that the proposal only deals with one-half of the current problem. ‘A revival of the credit markets and a bottoming of the housing market are keys to a revival’ it comments. ‘The government’s debt plan may reduce the level of fear in the market, enabling the credit markets to operate properly. But such a plan wouldn’t do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits.’

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