USA's bailout plan

Year 2008 has been dreadful for US financial markets. It has further led to the credit crisis and liquidity freeze. It is also affecting the main street now making the availability of credit very difficult. US government has come up with the bailout plan (Paulson-Bernanke bailout plan) and it has been very controversial so far.

The plan is too buy so called ‘toxic waste’ (MBS, CDOs) from the troubled banks and infuse some liquidity in the system. Question arises – why bailout the Wall Street which was the one to cause the problem? After all what good does it produce for economy? Aren’t these just the giant speculative firms? The Wall Street does facilitate the easy and more credit flow in the system, provides the economy with hedging and risk sharing opportunities. But in recent years, Wall Street firms were not creating the value; they were speculating massively, leveraging up the system and creating the systematic risks.

The greatest negative impact of the financial crisis is the demolition of trust amongst the banks. No bank is still sure how much subprime exposure the other banks have. Banks started to doubt each other, the cost of credit started growing and institutions started finding it more and more difficult to obtain funding. Most of the banks rely on low interest short term loan to finance their daily operations; but interest rates went up because of credit crisis and funding became more and more difficult. Banks are very leery about lending to other banks. Another issue is the domino effect – failure of the one bank can cause many other banks to fail. Now the main street is also suffering. Most of the businesses rely on short term loans for running their daily operation and even the average people are finding it difficult access credit – economic growth has stunted i.e. the main street too is in danger. According to US government, the bailout is a safety net for the main street via rescuing the Wall Street. Also we are no way near bottom in terms of the number of bankruptcies; asset deflation is massive. The government also needs to make sure that they pay enough to the troubled firms to avoid the bankruptcies -The bailout needed is massive.

But this bailout is unjust to the tax payers and blessing to the people who made the bad decisions i.e. lenders and shareholders of the failing banks. These people received the rewards on their excessive risks in earlier years and when the real risks hit, it is borne by the average people. It creates so called ‘Moral Hazard’ problem i.e. people taking excessive risks are assured that the government will rescue them in troubled times and they will continue their risk taking behavior. And many of these people include the owners and top officials of these speculative firms. Wall Street executives paid themselves huge bonuses in 2008– totaled billions of dollars – this is immorality.

Also, it is fundamentally impossible to value assets (MBS and CDOs) with so much uncertainty; mostly government will end up overpaying. Government’s plan is to auction these assets, but most of the assets are worth nothing. If they were worth anything – why did not other people come up to buy these assets in first place? There are enough people and firms who are sitting on huge pile of cash.

Fed needs to distinguish between the companies which are solvent and companies which are only facing the liquidity crisis. There is no point in bailing out companies with bad management – it is putting tax payer’s money at a huge risk. E.g. bailing out someone like GM/Ford makes a very little sense, these have been very badly run companies, and they will continue producing big gas guzzlers. It is better to let such companies let go bankrupt – it also provides the opportunity for new entrepreneurs who may run such companies much more efficiently.

I heard this brilliant idea on ‘The real news’ by Doug Henwood - solution – why not bailout the main street directly? Why not let these speculative monsters fail? Many of these failed banks will come up in few years but with the cleaner balance sheet and much better risk profile. Why not create the government sponsored banking institutions who can lend money to general businesses? Government can make these banks public organization and distribute the shares amongst American citizens. Surely it won’t be easy to implement it, but it looks a much better plan. It may be a good plan, but considering its conflict of interest with Wall Street and Wall Street’s clout in Washington and FED, it may not fructify.

USA is world’s largest debtor nation; it even depends on the debt from foreigners to run its government.
From where does the money come for the bailout? – It’s by printing more and more money. Which is again a sure fire way to cause more inflation, higher interest rates and the weakening of dollar in the long run.

Bailout is certainly the step in right direction, but the plan itself is quite flawed. Also the whole implementation of the plan itself is quite cumbersome. And this is just the solution to the short term liquidity issue; there are many more issues to be sorted out with the weakening American economy.

- Finance freak