This Monday the stock market had one of its worst drops in history. The Dow lost nearly 800 points or 7 percent, and the S&P 500 fell 8.8 percent. World markets were also adversely affected: TSX lost over 800 points or 6 percent, Hang Seng index lost more than 5 percent, Nikkei lost more than 4 percent, and the FTSE lost 3 percent. It was expected that the U.S. Congress would pass legislation to approve of the bailout. However, much of the slides in the market were not because of the impasse in Congress, but rather the uncertainty of future events. Tonight, the U.S. Senate will vote on this bill, which was slightly revised to increase the insurance on bank accounts from the FDIC from $100,000 to $250,000 in part to prevent a “running” of the banks.
For background on this financial crisis, this one gives a timeline of events. Lastly, this FAQ-like article discusses the decisions that caused this financial mess. This financial crisis started with people’s high debt to equity ratio. With Freddie Mac and Fannie Mae both institutions were saddled with bad debts arising from increased exposure to risk by taking on sub-prime mortgage debt. Both institutions would not typically be associated with that type of financial instruments, but because of the perceived benefits, they took the risk. Their capital was spread too thin to cover these losses, resulting in the government bailout. For Bear Stearns and Lehman Brothers, both investment banks had heavily invested in mortgage-backed securities from the sub-prime mortgage industry. AIG’s inability to price and predict credit defaults led to its current downfall. Currently, there is a credit freeze, where banks are unwilling to lend funds to those institutions due to their credit ratings and also because of their lack of faith in these institutions from repaying the loans.
Will injecting $700B in taxpayer money into the banking system help resiscutate the available credit?
There are those that think it is necessary. One of the Bloomberg columnists thinks so. The Economist magazine supports the government intervention. By injecting the much needed funds into the banking system, this frees up the available funds needed in order to free up the money supply and ensure liquidity. The cap on executive pay was advocated by Senators McCain and Obama, however, the Economist argues that it may not be such a great idea because by capping the pay, the talented individuals may not want to work at those banks. By buying these distressed assets at a relatively low prices, it can potentially become a sound investment.
Others such as this Bloomberg columnist and Luigi Zingales, Professor of Economics at the University of Chicago, who argue that letting the banks and financial institutions go into a form of bankruptcy protection would be best. “Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants….As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders.”
The taxpayers are not affected by the mistake of these banks, and this affair can be sorted out among the financial community. Also, by allowing the federal government borrow more funds, and then, inject this new money supply will adversely affect the valuation of the dollar. Since the dollar is widely used around the world, this could have far-reaching influence on the world markets. Also, the nationalization of these banks would hinder innovation because of less competition. Another disadvantage can include without shareholders, there is a lack of incentive to perform and drive profits. Therefore, these nationalized banks would have differing goals than the private banks.
I do not agree with the government’s bailout of the banks. I think that government intervention would only worsen the crisis by devaluing the currency and increasing the government’s debt. Supporting the wars in Iraq, Afghanistan as well as injected much needed funds into domestic issues such as health care, infrastructure, education and the economy is not sustainable. The government needs to be more self-reliant and needs to reign in the spending. When both presidential candidates McCain and Obama advocate lowering taxes, and simultaneously increasing spending to a country that is already burdened with over a trillion dollars in debt, this cannot be sustainable. During the next four years of whoever wins the presidency, there needs to be some sacrifices made.