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Third Quarter Review
We have received many questions from clients regarding the tumultuous economic and financial markets that prevail today. For this Investment Outlook, we are adopting a question and answer format to provide our view on how the current financial and economic environment may likely evolve.
What is your view on the $700 billion “bailout” plan? Will it work?
Something more had to be done. American home loans represent the largest debt market in the world. Through the process of securitization American mortgage debt is spread throughout the world. As homeowners are unable to meet their bills, rising delinquencies and defaults in locales from California to Florida have caused the value of mortgage securities to decline. As a result, investment portfolios worldwide which hold mortgage securities have lost significant value, causing many firms to fail or merge for lack of sufficient capital. The $700 billion bailout plan surfaced when the problem became particularly acute in mid-September. The credit market, which facilitates short-term lending of money between companies and banks to finance payrolls and inventories, essentially closed. This “freezing up” of the credit market shuts down normal business activities and is the primary reason for such a large plan being proposed by the U.S. Treasury. The market for commercial paper and inter-bank lending needs to move freely and at a low cost. So, the need for a more comprehensive plan is understandable although politically unpopular.
Governmental bodies such as the Federal Reserve or the U.S. Treasury have long interceded with funds to stabilize falling asset prices in periods of financial crisis. In fact, for the last several months, the Federal Reserve has exercised numerous, broad and aggressive strategies to provide liquidity to banks. The U.S. Treasury also has acted forcefully as evidenced by their absorption of Fannie Mae and Freddie Mac.
The bill should help credit markets in the short-term. In its efforts to help financial institutions, the Treasury finds itself in a difficult position—buying troubled assets at prices that prevent further significant damage to the financial institutions while, at the same time, not paying excessive prices that will cost taxpayers too much. At a minimum, now that the plan is passed, it should restore some confidence in short-term lending. We are not in a position to judge whether $700 billion is a reasonable amount to allay fears or will prove to be the maximum amount actually paid. The auction of these securities will occur monthly in no more than $50 billion monthly chunks. The longer term effects remain unclear because the ultimate costs of the program are not known. This will be a complex auction process, largely administered by a new administration. Although the bailout plan is the largest part of the rescue effort, it should not be viewed in isolation as some magic potion to cure the situation. There have been other efforts to improve liquidity before this plan and there will be many following it.
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