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Will Growing Number Of Bailouts Make Economic Problems Worse?

September 11, 2008

By Nicole Gelinas

Two days after the White House nationalized Fannie Mae and Freddie Mac, all eyes were on Lehman Bros.

It's quite possible that the taxpayers' inn for indigent financial institutions is about to get dangerously crowded, because much of the rest of the beleaguered financial world looks similar to how Fannie and Freddie looked six weeks ago.

After it helped engineer the rescue of Bear Stearns' creditors in March, the Federal Reserve began allowing the surviving investment banks, including Lehman, to borrow directly from the Fed.

The Fed's action here was supposed to stop creditors, trading partners and counterparties of the remaining investment banks from doing what they had started to do to Bear—deserting the company in a panic and causing even more panic throughout the financial industry.

But the Fed hasn't made clear how far its support for the investment banks' creditors will go, just as the government wasn't clear, until last weekend, just how far it would go to support Fannie and Freddie creditors.

And creditors of the remaining investment banks are worried that the Fed will stop its lending and thus its protection of them—especially since the Fed's cohort across the ocean, the European Central Bank, last week implemented stricter rules on its own similar program.

How Far Will The Feds Go?

So just as was the case with Fannie and Freddie last weekend, the markets seem to want clarity about what, exactly, Uncle Sam would do to protect another investment bank from the threat of bankruptcy, especially if the feds can't entice a white-knight buyer to rescue it with federal guarantees against deep losses, as JPMorgan did with Bear in March.

The markets seem to want a more explicit guarantee that creditors won't suffer from their firms' folly, as such creditors would—and should—in a real free-market economy.

Further, having been freshly reminded of what happens to shareholders in a financial failure, shareholders of investment banks are deserting them, just as Fan and Fred shareholders fled.

Unfortunately, the feds could justify making explicit government guarantees and injecting capital into investment banks, and taking similar actions at huge commercial banks that have the potential to overwhelm the FDIC's reserves, with the same rationale it used in the Fannie-Freddie and Bear Stearns cases.

For starters, there's the housing market. President Bush and both presidential candidates all agree that it's the government's job to slow the slide in housing prices.

They might think their chances of succeeding here are slim unless they prop up the investment banks.

And, perversely, they might even think that doing so is their only chance to give Fannie and Freddie some competition in a few years, thus providing the government with an exit strategy to wind down those two behemoths.

Too Big To Liquidate

Then, there's the "too big to fail" phenomenon. The feds said back in March that Bear's creditors needed protection because otherwise, they'd swamp the financial system, selling off the collateral that they had demanded in return for lending to Bear Stearns.

The same could happen if another big firm failed, or came too perilously close to it for the feds' taste.

The weightiest justification the feds could cite, though, is the dollar. With Fannie and Freddie, the feds acted partly because, if the Chinese and the Japanese and the Kuwaitis and all the rest of our creditors had stepped up their sales of Fannie and Freddie bonds, such a sell-off could have caused a general panic and a run on the U.S. currency.

Another investment-bank failure or a shattering commercial-bank failure—despite all of the efforts the feds have made to prevent such occurrences in the past six months—could heighten the same grave risk.

So there's a chance that within the next year or so, the American financial-services sector will be a wholly owned subsidiary of the U.S. government.

The real nightmare would be if the government were to take on hundreds of billions of dollars of new risks on behalf of the taxpayers, as it has already begun to do with Fannie, Freddie and Bear, and find that there's not enough money in the U.S. Treasury to stem the decline in housing prices and thus end the banking crisis.

The open-ended risk here is already startling. Consider: If Fannie and Freddie experience losses in their mortgage portfolios of just 10%, such losses could cost taxpayers $500 billion. Losses of 20% could cost taxpayers more than $1 trillion.

The possibility of such losses is real. Between 2000 and 2006, home prices across 20 urban areas from Las Vegas to Cleveland more than doubled, on average.

They've fallen by less than 20% since then—meaning we could have a long way to go. Last week, the Mortgage Bankers Assocation said that nearly 9.2% of mortgage borrowers are at least a month behind on their payments, the highest since the association started keeping records four decades ago.

The government's shouldering of such losses through its Fannie and Freddie bailout and through future protection of other financial institutions could pose a danger to our fiscal health.

A trillion-dollar loss at Fannie and Freddie would represent more than 10% of our national debt.

Such a hit, protracted over several years, could discourage foreign governments' banks and investment agencies from investing in our Treasury bonds, pushing up interest rates and mortgage rates, too.

In going down the path we've already started on, we risk a slow desertion of our currency and government bonds that could be just as devastating as the rapid desertion the feds were trying to prevent with the Fannie and Freddie action.

What would have been a painful economic adjustment would become torturous.

We'd have to recover our economy after having lost the world's confidence and having hampered, through massive government intervention, the ability of our markets to recover slowly on their own.

Such an outcome could make the government and its supporters wish that the feds had managed a real Bear failure in March, with hits to creditors as well as to shareholders, and shown where it draws the line in protecting the lenders to supposedly private, risk-taking companies.

Original Source: http://www.ibdeditorials.com/IBDArticles.aspx?id=305936617669604

 

 
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