I was sent this letter from a very intelligent friend from Boston. I believe that it will help you understand the economic situation we are in at this moment in time.
Like much of America I followed the events of this past week on Wall Street with a sense disbelief and confusion. The following is one layman’s attempt to put it all in terms understandable to those of us, like me, who are not economists and who do not have a MBA.
In recent weeks we saw: (1) the federal seizure of mortgage giants Fannie Mae and Freddie Mac; (2) the bankruptcy of Lehman Brothers; (3) Merrill Lynch’s shotgun marriage to Bank of America; (4) the federal seizure of American International Group; (5) a fall in the stock prices of Morgan Stanley and Goldman Sachs of 24% and 14%, respectively; (6) the downgrading of Washington Mutual’s credit-rating to junk status; (7) the SEC issue new rules prohibiting the practice of short selling on financial shares; (8) the LIBOR rate jump from 3.33% to 6.44%; (9) Reserve Primary, the oldest money-market fund, post a loss; and (10) the Fed, in co-ordination with other central banks, pledge to inject $180 billion of short-term liquidity into the markets.
Wow, it’s no wonder that the Dow whipsawed up and down causing anyone who watched it to feel queasy. But why was the government saving some institutions last week, and letting others fail? There is a pattern in the government’s ad hoc response crafted and directed by Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke. Put simply:
Determine if the firm is so large or integral to the financial system that to let it fail would cause a catastrophe. If the answer is no, encourage a private sale, or let if file for bankruptcy.
If the answer is yes, then take it over and make sure that the taxpayers get first claim on the assets, and replace the current management.
Applying the above test the government took a hard look at the books of Fannie and Freddie and determined that they were woefully under-capitalized, which had been suspected, but not readily apparent due to the use of questionable accounting practices. Since these two giants buy up half of all US mortgages to allow them to fail would not only have been catastrophic to the housing market and the overall national economy, it would have had international political and economic ramifications. Now with the explicit backing of the government the hope is the market for mortgage backed securities will stabilize, allowing more loans to be made.
Unlike Bear Stearns, the government decided that Lehman Brothers was not so big or integral to the financial system, and thus could be allowed to fail if a buyer was not found. A buyer was not to be found without backing from the government, and so Lehman Brothers filed for bankruptcy and Barclays subsequently purchased some of its assets at fire sale prices.
But the fall out was horrific. As it turned out American International Group (AIG), an insurance company, had written a considerable amount of credit-default swaps (a type of guarantee against corporate defaults) against Lehman Brothers. The bankruptcy caused a liquidity crisis at AIG and the government had to step in and extend $85 billion in credit to AIG in exchange for a 79.9% stake in the company. The government could not allow it to fail as AIG has a $441 billion exposure in credit-default swaps.
The fall-out from the Lehman Brothers failure had further repercussions. Many Americans have money market accounts, thought to be the safest of investments. Money markets typically invest in short term corporate debt, the kind that banks and businesses float to fund their daily operations.
When Lehman Brothers filed bankruptcy it caused the Reserve Premier fund, which had invested in Lehman’s debt, to loose money. And because money markets are not insured, people started pulling their money out of the money market funds, causing a freeze up in the commercial paper market. Without this money many businesses and banks simply can not operate. It would be like you or me going to the ATM only to find there is no money in the account, and the bank has terminated our overdraft protection!
To cover anticipated withdrawals banks started hoarding their money and not lending to each other, sending the LIBOR rate through the roof. To quell fear, the government decided it would extend federal insurance to money market accounts, and in conjunction with other central banks, inject $180 billion of short-term liquidity into the markets (i.e., lend the banks the money).
Despite these extraordinary efforts to calm the markets, they continued to roil. Partly in response to the brutal pummeling the stocks of Morgan Stanley and Goldman Sachs were taking (despite better than expected earnings results) the SEC halted short sales against financial companies. Panic and, not reason, was thought to be the cause of such dramatic drops in share prices which were destroying confidence in the market.
This morning, Morgan Stanley and Goldman Sachs announced they were each filing for a change in their charters that will allow them to act more like commercial banks. They will now be able to increase their capital reserves by accepting federally insured deposits. In exchange they will be subject to federal oversight. This will certainly lead to more conservative lending practices, and lower future profits. There are now no stand-alone investment banks left on Wall Street.
Realizing that the ad hoc responses to the unfolding crisis were proving insufficient, Secretary Paulson and Chairman Bernanke determined it was necessary take the boldest step yet to avoid a collapse of the entire financial system. Over the weekend they have been working with Congress on a bill that would allow the Treasury to buy $700 billion of mortgage backed securities of questionable value from financial institutions.
The hope is that when financial institutions sell the debt to the government (at a discounted price) the government can hold the debt for a period of time until the markets stabilize, and then resell it at a profit. Another possibility is that once the government owns the debt, it can work out easier terms with homeowners that may allow them to stay in their homes and avoid foreclosure. This would have a positive effect on declining home values, the root cause of the mess we find ourselves in today. It would also increase the value of these securities, to the taxpayers’ benefit, when they are resold.
Sometimes an analogy is helpful to understand complex problems. Let’s say your heart is like Wall Street in that it pumps blood (credit) throughout your body (the economy) where it is needed. You go to your doctors Ben and Henry because you have some chest pain (call it AIG). Henry and Ben perform an angioplasty (a bailout). The next day you feel even worse. Henry and Ben tell you are about to go into complete cardiac failure because your heart and arteries are full of plaque (bad mortgage debt), blocking the flow of blood (credit). Ben and Henry tell you they need to perform open heart surgery immediately. This causes you to pass out, and Henry and Ben look to your family (Congress) to sign the consent form (the bill for the $700 billion bailout). That about sums it up.
Make no mistake that these past weeks have seen monumental changes to the ways in which finance operates in America. If the Paulson/Bernanke proposal is not enacted quickly by Congress the future of our economy is at risk. To put it in perspective, when asked by one member of Congress what would happen if the bill failed, Secretary Paulson replied: “If it doesn’t pass, then heaven help us all.” So stay tuned. Stay informed. It could be a difficult recovery.
