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FinalCall.com News
Business & Money
America’s Bailout Prescription, Part 2
By Cedric Muhammad
(Part 2 of a 3 part series)
Updated Oct 31, 2008 - 10:51:00 AM
Can It Heal A Global Economy and Prevent Another Great Depression?
Falling Housing Prices
President Bush, on October 3 said of the bailout package, “A major problem in our financial system is that banks have restricted the flow of credit to businesses and consumers; many of the assets these banks are holding have lost value. The legislation Congress passed today addresses this problem head on by providing a variety of new tools to the government—such as allowing us to purchase some of the troubled assets, and creating a new government insurance program that will guarantee the value of others.”
Will the bailout package really do what President Bush states?
Mr. Martin Feldstein, Harvard professor and chairman of the Council of Economic Advisers under President Reagan does not think so. In a recent Wall St. Journal op-ed, “The Problem Is Still Falling Houses,” he explains, “A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities. The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.”
Showing the Bush administration’s continued blind spot and the bailout’s inattention to the dangerous derivatives market, Mr. Feldstein writes, “The impaired assets are not just mortgages but the complex derivatives based on those mortgages: the collateralized debt obligations, the various risk slices of those CDOs that, even if rated AAA, often have market prices close to 50 percent of their ... value. In addition, hundreds of billions of dollars of credit default swaps ‘guarantee’ the value of mortgage-backed securities.”
A triple A rating—AAA—signifies the highest quality. The fact that derivatives with AAA ratings have lost so much value, and the bailout plan fails to address the underlying problem associated with derivatives, is revealing, and suggests an ignorance of the new world of high finance among America’s political leadership.
Mr. Feldstein explains the complicated relationship, “Even if the government could purchase every troubled mortgage, the prospect of future price declines would contaminate the mortgage portfolios. As house prices fall, the value of mortgage-backed securities would fall further.”
No Economic Growth
In order to measure the ability of the bailout package to deliver on its promises, it is helpful to look at the crises from the lens of the capital to labor ratio—an unofficial gauge of economic health.
Capital—the wealth available to produce goods and services—was accumulated as never before in America as a result of the dramatic rise in home and stock ownership.
But in one year things have dramatically changed.
Nationally, U.S. home prices have fallen by over 15 percent.
The Dow Jones Industrial Average is down 40.3 percent since reaching a record high close of 14,164.53 a year ago, on Oct. 9, 2007. In the week of Oct. 6, investors lost $2.4 trillion, and over the past year, the losses equal $8.4 trillion.
Americans’ retirement plans have lost as much as $2 trillion in the past 15 months, 20 percent of their value, according to Peter Orszag, the head of the Congressional Budget Office.
Black homeownership, according to the U.S. Census Bureau went from 44.8 percent in 1997 to a peak of 49.1 percent in 2004, before settling at 47.2 percent in 2007. Experts predict it will drop to 42 percent by 2009. According to the Ariel-Schwab Survey, Black stock ownership spiked from 57 percent, in 1998, the first year of the survey, to 74 percent in 2002. By 2007 it was already back at 1998 levels—57 percent.
Labor—the amount of human effort available to produce goods and services—has also experienced a roller coaster ride over the past 10 years. The Black unemployment rate, which was 7.6 percent in December of 2000, now stands at 11.6 percent, as of September 2008, according to official Department of Labor statistics.
When capital is plentiful and labor scarce, the seeds for economic growth are in place.
More Black men are employed, able to assume their responsibilities as fathers and productive members of society; crime is down; entrepreneurship and risk-taking flourishes; and small businesses survive and grow.
We are now moving away from that vision of stability and the $700 billion bailout plan does little to address it.
“The Bush administration pushed the bailout package with an urgency that really prevented a growth solution from being applied, which could have alleviated the concerns over the growing bad debt problem. Any lender understands that if a borrower increases his income, his ability to honor existing debt obligations automatically improves. Including some pro-growth items into the legislation, such as eliminating the capital gains tax, indexing capital gains for inflation, or even raising the capital gains exemptions on the sale of houses, it would have been a critical plus in any rescue plan. And it would have been a positive example for the rest of the world on how to counter the problem of bad debts. Instead, it pushed through this $700 billion redistribution package that ignores the obvious: even as the Treasury sets up agencies to detoxify bad debts on one end of the economy, more job losses, more delinquencies, more foreclosures in a slowing economy will create more bad debts. As you can see, the only solution that will deliver us from the problem of rising bad debts is more economic growth,” said Vlad Signorelli, Chief Economist, Bretton Woods Research (http://brettonwoodsresearch.com/).
Interestingly, on October 10, Democratic Party Presidential Nominee Barack Obama unveiled an Emergency Small Business Platform which included capital gains tax elimination. “Small businesses employ half of the workers in the private sector in this country, and account for the majority of the job growth. But we also know that a credit crunch has dried up capital and put these jobs at risk—shops can’t finance their inventories, and small firms can’t make payroll,” Obama said at a rally in Chillicothe, Ohio. “If we don’t act, we’ll be looking at scaled back operations, shuttered shops, and laid-off workers.”
A Crisis Of Confidence—And No Mention Of ‘LIBOR’
We would be well served to look deep into the root meaning of such words as “trust,” “security,” “credit,” and “bond”—terms used every day in global finance and economics. The dominating idea of all of these words—at their root—is confidence, belief, faith, or reliability. It is these concepts and principles that are the foundation of an economy. It is helpful to keep this in mind when considering the financial panic and whether or not the banking industry can be healed by the $700 billion bailout as advertised (or even the announced global coordination underway of the G-7). Not many of us realize that when we deposit money in a bank we are in effect making a loan to that institution. Some of us—with only tens of dollars, are loaning money, in a sense, to a billion-dollar corporation. As odd as it may seem, this is the case because no bank—however large or small—simply watches over our bank deposits, like a security guard, making sure no one touches the cash. In fact it is quite the opposite, a bank takes your deposit and loans or invests it, in an attempt to earn more money—until you need to make a withdrawal.
“Banks’ viability depends on getting deposits and then offering loans to consumers and businesses, many of whom, in a crisis, may default. Banks have $100 in loans for a few dollars of equity, which means that what is backing these institutions is mainly trust of them being properly managed and trust that the government and the central bank manage the economy properly, too, to avoid crises,” writes Reuven Brenner in a Sept. 17 Forbes magazine article, “Back To Basics.”
America, and most of the world (with the largest exception of the Islamic World and ‘barter’ economies that don’t use money) operates on a fractional reserve banking system, in which only a fraction of the total deposits managed by a bank must be kept in reserve and not lent out. In such a system only a limited amount of deposits are available for withdrawal at any single time. If everyone with a savings or checking account were to come to the bank at once, the bank would most likely be able to give only 10 percent of those present their money back (the other 90 percent has been lent out or invested). This is what is known as a “run on the bank.” During the Great Depression many U.S. banks were forced to shut down because so many peopleattempted to withdrawdeposits at the same time.
Due to the fractional reserve lending system, the loss of mortgage-related assets, and the increase in unemployment, banks are refusing to make loans to each other, or to corporations, businesses and individuals. Wall St. firms will not honor or complete trades with one another, many corporations cannot make payroll, entrepreneurs can’t get business loans (or must pay much higher interest rates on the loans they do receive), and individuals—even with excellent credit, are not qualifying for auto and home loans.
As a result, of this credit freeze and lack of liquidity to supplement the $700 billion bailout package, the privately owned Federal Reserve announced on October 9 that it will buy “commercial paper,” a short-term financing instrument that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls. The Associated Press notes: “The market for this crucial financing, which relies on investors rather than banks, has virtually dried up.”
The commercial paper market of $2.2 trillion in the summer of 2007 shrunk to $1.6 trillion this summer.
In the biggest move since the $700 bailout package became law, Treasury Secretary Paulson, announced on October 10 that the federal government will buy actual ownership stakes in banks, in order to inject liquidity directly into them.
Neither this decision nor the original bailout plan deals with the biggest problem in the credit market—the lack of interbank lending—the amount of loans that banks make to one another. Interbank lending is necessary because as Investopedia.com describes, “Banks are required to hold an adequate amount of liquid assets, such as cash, to manage any potential withdrawals from clients. If a bank can’t meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets.”
Banks aren’t loaning money to each other through this market because they don’t trust one another or because they don’t believe they will receive their money back. Banks continue to charge one another extremely high borrowing rates—a bad sign for the larger credit market. Banks that won’t loan to one another at low interest rates, overnight, are very likely to not loan money to businesses or individuals—in the short or long term.
This is known as counterparty risk.
Banks, for instance are concerned that the banks they may lend to, while in reasonably good shape themselves, may have money in some other bank or hedge fund, for instance that might go out of business suddenly.
A hedge fund is a private investment partnershipopen to a limited number of investors and requires a very largeinitial investment.Investments inhedge funds are considered to beilliquid because they often require investors to keep their money in the fund for at least one year.
Banks don’t want to lend to one another until they know if the borrowing bank has its money in an illiquid investment—one that ties much of its money up for a period longer than it would take them (the borrowing bank) to repay the loan.
Possibly the most important interbank rate in the world—in addition to the Federal Reserve’s Fed Funds rate—is The London Interbank Offered Rate, or LIBOR, launched in 1986.
LIBOR is also important because it is directly tied to many consumer loans, including adjustable-rate mortgages.
LIBOR reached its highest rate in ten months on October 9.
If those rates rise—as a result to their being tied to LIBOR—that means more mortgage defaults and foreclosures.
Yet, this reality was not addressed or prepared for in the $700 billion bailout package.
As of press time, Secretary Paulson and President Bush still would not commit to government backing of interbank lending which could lower LIBOR, and in the process defaults and foreclosures.
Apparently this bold move may have to come from abroad or in coordination with the G-7 nations.
(Final Call readers of this series are urged to listen to the October 9, 2008 edition of The Diane Rehm Show, “The International Response to the Financial Credit Freeze” and “The Future of American Capitalism.” Available online at: http://wamu.org/programs/dr/08/10/09.php#21985)
(Cedric Muhammad is a business and political economist who advises entrepreneurs and small businesses through his company, CM Cap. His weekly “Cedric Muhammad and Black Coffee Program” can be viewed every Wednesday from 12 p.m. to 4 p.m. EST at The Black Coffee Channel, http://www.blackcoffeechannel.com.)
