The $700 billion bailout is needed Essay

The $700 billion bailout is needed

Abstract

            The $700 billion plan for saving the mortgage industry has been received with mixed reactions. Some people see it as beneficial to the economy, while others see it as harmful.  This paper aims at analyzing the arguments for, and against the bailout plan, reaction of markets, and providing recommendations on the appropriate course of action.

Introduction

            President George W. Bush recently announced a $700 billion bailout plan to save the current mortgage crisis affecting the US economy.  This is considered the largest government intervention plan in the recent times, in fact the last time that the US saw such high levels of government intervention, was during the Great Depression.  President Bush justified this act by saying that risks of not acting are too high to contemplate.  The senate has already supported the plan, though a vote of 74 in favor, against, 25, the President assented to it and it is now law.

            Experts are divided over the issue, with several questions emerging concerning the deal.  The major questions that are being asked are, who will be the beneficiaries, how the deal will be structured and the implications of the intervention to the new administration.  In terms of the institutions to be bailed out, Treasury mentions financial institutions based in the US, such as investment and commercial banks.  Experts are inquiring about the fate of insurers and hedge funds.  This also raises the question of how foreign firms with US subsidiaries will be treated, since alienating them will raise questions on the issues of foreign long term investment in the United States.

            When analyzing the assets to be included, Treasury is vague in definition, so that there is room for it to be flexible.  Terms such as ‘mortgage related assets’ raises questions about other collateral debt instruments, besides mortgage backed securities.  The major question concerning assets, however, is the price that the government will pay for them.  Some mortgage firms have very low prices, such as Merrill, and if the government pays for the assets at those low prices, it will cost taxpayers less, as well as increase potential gains after the market recovery.  However, the downside with this approach is that the lower the pay by the government, the lesser the banks will benefit, in terms of recapitalizing their weak balance sheets.  This is compounded by allegations that Treasury will purchase the loans through auctions.

            Another fundamental question is whether the bailout plan will apply to the balance sheets of affected institutions, in addition to their mortgage backed assets.  If limited to the assets, some Democrats, including Barack Obama, see this as a move that benefits Wall Street but does not benefit the homeowners who directly face closure.  The Democrats would like to see moves that benefit homeowners, including those that assist them finance their mortgages, as well as moves that broadly stimulate the economy.  It is prudent to analyze the issues in totality, in order to reveal whether the bailout plan will help or hurt the US economy.

Market reaction

            Failure to have an agreement on the bailout plan has led to further tumbling of stocks, not just in the US, but all over the world.  In fact, when congress threw out the bailout plan, investors were dismayed, stocks such as Dow Jones Industrials dropped by almost 800 points.  According to Barclay & Chen (2008), this was the single largest plunge in a single day.  The stocks began dropping even before the voting was complete, and interestingly, there was a screen in the House where the lawmakers watched the stock market trends.  The final stock plunge was 777 points, which was worse than the plunge during September 11 attacks, of 684 points.

            After the bill was signed into law, the markets are still wary, though they have a lot of cash at hand.  The markets have fear and many investors are hoarding cash, waiting to see the outcome.  Most investment bankers are optimistic that the passage of the plan into law, will calm the financial markets.  They are however quick to add that such confidence will not be realized immediately, and it will take a couple of weeks.  President Bush reassured Americans to be patient, since the benefits of the bailout plan will not be realized overnight.  Most international markets are also optimistic that the passage of the bill will restore confidence in markets, and pledged support for the United States in stabilizing the financial markets.

Arguments for the bailout plan

            The general argument in favor of the bailout plan is that the financial crisis is getting out of hand and affecting consumers and companies, that were not part of the factors that led to the problems.   The argument goes on to say that if left unchecked, these problems will spiral out of control and affect the whole economy, unlike currently, where they are only featuring in institutions that made wrong investment decisions.  Therefore, because the average individual did not contribute to this problem, it is logical that the government intervenes and cushions the taxpayers from effects of the credit crunch.

            According to Willis (2008), the purchase of mortgages will be done at prices that are below the par value, and this provides an opportunity for significant appreciation of the prices, once the credit crunch is over.  This enables the plan to provide future capital gains, thereby encouraging future investments and growth of the economy.  He further backs up the argument, by providing an estimate of the prices that are likely to be prevailing on an auction by Treasury, as 65 cents on the dollar.  This, he says, represents a drop of a third of the cost price, and a yield of between 10%-15% on Treasury.  The low cost price is what in his view, will lead to appreciation of future prices, and hence an opportunity to invest.

            Other proponents of the bail out plan see it as an opportunity to save banks from insolvency.  This is due to the fact that there are many banks that are facing the risk of going under, due to their adverse balance sheets, that stem from non-performing loans.  The bail out plan is seen to inject a new lease of life to such banks, since they will now be able to have the capital for making new loans.  This will also help banks offer loans to each other, thereby restoring the much needed confidence by financial markets.

            The bailout plan is seen by other people as beneficial to individuals, since they will now be able to access loans.  Students will be able to access student loans, homeowners will have less burden in paying for their mortgage, people will have more access to car loans, and even others might take loans to open a credit card account.  Top executives might find the bailout plan beneficial, in that they get to keep their jobs.

Arguments against the bailout plan

            The major argument against this plan is that the current problems that are being experienced are as a result of over-reliance on money that is borrowed, in addition to wrong investment decisions.  Since the prices of the assets are falling, this is the markets’ own way of removing such assets from the market.  The argument therefore is that government interference, does not allow the market to function on its own.  Forcing a failed system to work, is seen by some experts to produce results for a few years, before leading to many years of economic stagnation.

            According to Beim (2008), the $700 billion bailout plan is too small to significantly improve the problems that are faced by Wall Street.  He further adds that in the US alone, there are almost $12 trillion outstanding mortgages and therefore $700 million is measly.  Beim further sees traces of cronyism, since the secretary of the Treasury, Paulson, and most of his advisers are alumni of Wall Street.  This, he sees as a factor that will cloud the judgment of Treasury when passing recommendations.  This is further compounded by the view that the process is open to abuse, since according to him, the secretary of the Treasury will not be accountable to anyone regarding the bailout offers.

            According to Bebchuk (2008), President Bush and Treasury officials, proposed the plan without having enough information on what to do with the funds.  He further adds that before committing $700 billion, they should have had prior knowledge of what to do with the amount.  In light of this, some experts suggest that this was a ‘knee jerk’ reaction, and that there were better ways of spending such a sum of money.  This is due to the reason that, the money is seen to help a small category of employees, those who have saved money over long periods, while alienating the majority.  It is seen to benefit the private, and not the wider public, according to them.

            Finally, Shirreff (2008), argues that the funds used to bridge the budget deficit, will not come from increased taxes or reduced expenditure by the government, but rather, the money will come from increased supply by the federal reserve.  This is a wrong approach, since in the long term, it will lead to devaluation of the US dollar, and increase in the levels of inflation.

Conclusion and recommendation

            Most investors have welcomed the move to turn the bailout plan into law.  International and local markets have welcomed the move, although it will be a matter of time before the impacts of the plan are realized.  This is due to the speculative nature of markets, and investors are taking the ‘wait and see’ approach.   Some experts view the bailout plan as hurting the economy, while others support it.  On the whole, the bailout plan is beneficial, since it aims at cushioning individuals from problems that they did not participate in creating.  The plan should be implemented carefully, after consulting all stakeholders, to prevent inflationary tendencies and loss of value of the US currency.  The general agreement, however, is that the plan will leave either McCain or Obama, in a difficult position when preparing the following year’s budget.

References.

Barclay, M., Chen, M, 2008. Bush asking for $700 billion bailout. Retrieved on 16 October, 2008 from  <phantomazero.googlepages.com>.

Bebchuk, L. A. 2008. A plan for addressing financial crisis. Retrieved on 16 October, 2008 from <papers.ssrn.com>.

Beim, D. O. 2008. Good bailouts and bad. The Economists’ Voice. Retrieved on 16 October, 2008 from ;bepress.com;.

Shirreff, D. 2008. Lessons from the collapse of hedge fund, long term capital management. Journal of  International Financial Risk. Retrieved on 16 October, 2008 from ;edge-fund.com;.

Willis, L. E. 2008. Stabilize home mortgage borrowers, and the financial system will follow. Retrieved on 16 October, 2008 from ;papers.ssrn.com;.