The US governmental plan to perform bail-outs of failed banks, which were “too big to fail”, failed itself. It encouraged investors to start duck shooting. As Raghuram Rajan, economist at University of Chicago and former chief economist at the International Monetary Fund stated on Bloomberg: “Bailouts are creating weird incentives, When you point out the guys you are going to back, you point out the next sitting duck.”
That is the reason why finally the US Government intents to bail out the financial market instruments which fail, itself. During this crisis this has been attempted several times, without getting into effect.
Last year the banking industry tried to save the itself by generating a super SIV, backing up all the illiquid assets. An attempt which gave hope to the stock markets but was never realized. Then the Fed basically tried earlier this year to rescue the industry with its “Trash for Treasury program”.They further opened access to the Fed’s term auction facility and Discount Window for investment banks. These measures should have effectively stopped the failures of investment banks, because now it was the Fed holding the risk.
But then in September 2008 the crisis stroke back and the government had to bailout companies which have had already an implicit guarantee from the government. Hank Paulson made us believe that Fannie Mae and Freddie Mac needed more than that implicit guarantee, and that we needed Fannie and Freddie. The conclusion we have to draw from this is that the size of the problem is too big. Investors do not trust in the US government’s capabilities to deal with the problem.
The government now tries to build up a plan which builds on the experience from the Resolution Trust Corporation (RTC) from 1989. The RTC was a successful help when mortgage banks got into problems. Its cost is estimated to $156.4 billion of which the tax payer stemmed 82%.
Hank Paulson pointed out that plan before the starting off into the weekend, without having even worked out the details. We need to keep in mind that even $200billion will not be enough to cover for the crisis this time. It might be much more than one, up to two trillions, which are required. In 1989 it was anticipated to take 45 days to get the required laws approved, and it took six months. Will a trillion dollars bail out take more or less time to get approval, we don’t know, yet.
This is the “crisis of greed and denial” as it was named by bloggers. It is though the crisis based on loss of trust. Trust is not easy to recover, once you lost it. Recovery from a loss of trust takes time, rebuilding of confidence and stopping of in-transparency and lies. But actions by the financial industry supported by the main stream media have not proven to be trustful. That is the reason why uncertainty might remain, even though the government might buy trillions of assets under pressure.
Another reason to distrust the plans to bail out the financial system, are the following:
We have a global system and the US is the largest, but not the only counterparty, with trillions of dollars on the line. A year ago I stated that other even small economies are so interconnected that they can further destabilize the system as such.
A potential financial decoupling from the global financial system might happen. That would change the rules to the financial industry and put the global system under more pressure than expected. Policy makers in Europe, Asia and the Middle-Eastern world might consider their own needs at a higher priority than the needs of the US financial system. A potential decoupling is already taking place in Russia and other parts of the world.
A mortgage market recovery in the US might not be in sight, even though mortgage assets might be bought by the US government. The administrative overhead to bail out and manage each single mortgage contract is just too high, so an individual bail-out of those troubled mortgage borrowers will not happen. The result is that complex, non-transparent mortgage debt instruments (securities) will remain in the form which caused the problem. A necessary rapid recession and clean-up in the financial system will not take place. This will lead to prolongation the process of clean up.
The consumer and the real-economy is hurt. The largest problem in the US economy is NOT the mortgage market. It is a troubled GDP based on 25% consumer credit which fuels 70% of the GDP by consumer spending. The plan of the US government will bring itself closer to failure with taking more debt onto its balance sheet. At a certain point of time, global investors will start to worry about the US capability to repay its debt. By bailingout troubled assets directly the government unnecessarily increases this specific risk. It becomes a game changer for the US acting as a lender and borrower of last resort.
The most crucial point here is that former governmental attempts failed. That leads to the conclusion that there is more risk hidden in the system than anticipated. Some parts of this risk can be found in the size of the derivative market and the resulting exposure to systemic risk, inflation risk and the real economy growth. We can anticipate that the GDP will show signs of slow down. Due to the turmoil in the last months, we can anticipate that consumers remain careful and we can anticipate that inflation finds its way to the consumers in Q4 2008. All of that will be negative on exchange rates and earnings, driving the troubled banking industry further into problems.
The investment banking business model is broken. With the absence of those great complex non-transparent tools banks and investment banks will not make the same profits as before. Combined with the hundred’s of thousands of lay-offs in this sector, so far, this part of the society is unable to contribute to consumption. Common sense tells us that this might have been a significant part of consumption in the economies around the globe. Already on Friday, after Paulson’s plan was announced, the FDIC reported by CNBC, said that it expects further bank failures to come. The very next day another bank failure occurred.