US Congress Clears $700 Billion Bailout Package

The US Congress approved a revised 700 billion dollar package to bail out the beleaguered US financial sector after the House of Representatives today cleared the historic measure four days after it rejected an earlier plan that stunned the global markets.

The House okayed 263-171 in a make or break vote the unprecedented government intervention designed to pull the US economy out of the brink and sent it to President George W. Bush for certain signature into law. The Senate on Wednesday passed 74-25 a revised version of the bailout package.

Calling the bipartisan Congress vote a "bold" step, Bush said the package will help the US economy weather the financial crisis.

The revised package aimed at buying up the bad debts of failing institutions included sweeteners on extending bank deposit insurance and expired tax breaks in a bid to get more Republicans behind the legislation.

Several law makers dropped their opposition to the bill when it came up for vote today capping two weeks of turmoil in the Congress and the Wall street.

The Bill was tweaked by the Senate which addded about 100 billion dollars in new tax breaks in an initiative to get the House support for the new version.

Only 85 Republicans voted for the bailout in the 228 to 205 defeat for the bailout on Monday and Democratic House leaders said before the vote they needed 100 members of the minority party to ensure passage.

The plan lets the government spend billions of dollars to buy bad mortgage-related securities and other devalued assets from troubled financial institutions. It is aimed at allowing frozen credit to begin flowing again and prevent a dangerous recession.

Analysis

Over the past several years, banks have increasingly leveraged themselves because money was cheap and the flow of dollars exceeded demand. When this happens, the tendency toward bad investment increases and a bubble is born. Banks accumulated massive amounts of assets that were tied to the housing market and were intended to be sold on the secondary market. The primary purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Like any game of hot potato, eventually the music stops and those who took the risk of deploying too much liquid capital to these assets are left holding the bag. As a result, many banks have very little liquid capital and a lot of illiquid capital - and no way to price their quantity and quality. The Fed responded by lowering rates, enabling these banks to borrow money from the Fed with these toxic assets as collateral. The Fed also created many other facilities in which money is auctioned off. All-in-all, I believe that the total amount released by the Federal Reserve is nearly $2 trillion. Given the lack of liquid capital, banks have hoarded these funds released. Apparently you can lead a bank to capital, but you can't make it lend.

At the heart of the current financial crisis is the fact that banks are no longer lending to each other. This fact can be reflected in the one-month LIBOR, which is trading well above the federal funds target rate. The chart currently shows a value of 96.06, which means that world banks are able to borrow money at 4%. That is significantly higher than the Fed's rate of 2%. The deterioration of confidence in bank credit worthiness began on September 16. The banks' inability to lend to each other is symptomatic of a lack of confidence about lending to anyone. The reality is that the current proposal of $700 billion doesn't address this situation directly.

The proposal is primarily designed to transfer bad assets of foreign and domestic banks to the U.S. Treasury, but that isn't necessarily its only impact. An unintended consequence of the Sarbanes-Oxley regulation is that it requires mark-to-market accounting of assets. The problem with many of these mortgage-backed securities and other vehicles held by banks is that there isn't a market with which they can trade. Therefore, the price discovery process has been a large issue for banks and has caused massive write-downs across the financial sector. With this bill, the federal government is really trying to set a price for these assets above current market prices, so banks can artificially inflate their balance sheets and cause their share prices to rise. A higher share price allows banks to raise capital more readily through borrowing or issuing stock.

One point to consider is a lesson learned from the Great Depression, of which Chairman Bernanke is a student. At that time, popular economic thought was that the main issue affecting the economy was deflation, and if only they could solve the problem of falling prices, everything would be better. Therefore, production quotas were instituted to create scarcity and drive prices higher. As a result, unemployment continued to rise as workers were underutilized, and prices weren't allowed to fall toward an equilibrium point that reflected the state of wages and employment. We're seeing a similar thing today. The popular notion is that falling prices of homes and related assets is the problem, not the fact that there wasn't enough savings to support the debt level that was issued.

In the end, passage of this legislation will likely help the market in the short run and ease some of the pressure that is building, but it doesn't allow the market to adjust to current preferences and continues to allow useful capital to flow into unproductive activities.

The hope of a quick economic turnaround seems to be a distant memory and will likely be even more protracted. The ability to improve bank balance sheets by arbitrarily setting a price floor of $700 billion and also set mortgage rates below any market-determined level may ultimately lessen immediate impact, but is highly inflationary in the long term and will not allow us to move toward a more productive economy.