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Big Economic News: Financial Bailout $700 Billion HR 3997

Economics, Politics = Bad mixture…what is really going on?
PART TWO

Last week we discovered that the current credit crisis seeds had been sown after the bursting of the dot com bubble. In addition, we learned that during recessions that the Fed supplies markets with liquidity in order to jump start the economy and grease the machine of financial markets. This week we pick up with the Sub-Prime collapse and the freezing of credit markets.

Collapse of the Sub-Prime Market and the Credit Freeze
Finally, with banks realizing that many of the mortgages on their books would ultimately begin to fail, they pulled out of the “Sub Prime Market.” Unfortunately at this time there was no longer a secondary market in which to sell the sub prime mortgaged backed securities, which forced major mortgage companies to keep these risky assets on their books. This would prove to be one of the biggest catalysts to causing the overall credit freeze. With real estate markets in parts of the country such as California, Las Vegas, Florida and the Midwest beginning to falter; mortgage companies would begin to feel the pinch. Since, mortgaged back securities are backed by real estate, and as these markets would begin to falter, the value of the mortgaged backed securities on banks books would fall as well. In addition, since banks are required to have capital to cover the write down of an asset on their books, banks would begin to have an urgent need to raise capital! Perhaps the biggest problem is that no one could know how far these assets would fall.

Bold Moves by the Federal Reserve and the Treasury Department
With banks now experiencing continual capital needs, the Federal Reserve (Fed) was forced to take action to supply much needed liquidity to markets.
First, the Fed encouraged banks to borrow from the “over night window”. The over night window is when banks can borrow from the Fed on a short term basis. Normally banks would not use the overnight window because of how they would be viewed by other banks. Those other banks would feel that if a bank utilized the overnight window then it was a sign that a bank was experiencing problems and could fail. However, the Fed enticed banks to use the over night window by convincing banks that were not having difficulty, to borrow from the window. With strong banks utilizing the window, weaker banks felt confident that they would not be viewed negatively by using the over night window. This was crucial because it gave the Fed a way to supply markets with much needed liquidity.
Second, the Fed extended to banks longer loan terms.
Third, the Fed financed the purchase of Bear Stearns by JP Morgan Chase by lending JP Morgan Chase the money to purchase Bear Stearns. In return for the money, JP Morgan Chase gave the Fed the mortgage backed securities from the Bear Stearns books. Since that bank would not have to pay the Fed back, as it normally would have, other banks now can view the over night window as a safe vehicle to borrow money.

Solutions to Crisis
There are two solutions to the current crisis. The first solution is to allow markets to correct themselves. This is what we did in the 1920’s when the federal government sat back and allowed financial markets to fail. At the time it seemed to be the best plan that those financial institutions who had taken overly risky bets, should have to pay for their mistakes. However, as we now know, one of the key impetuses of the Great Depression was the government allowing financial markets to fail. The second option is to supply liquidity to markets as Alan Greenspan did in early 2000, to buffer the bursting of the dot com bubble. By doing this instead of having a prolonged recession, we had one of the smallest recessions in our history. Clearly, the government has decided on the latter decision. Although there are many critics of the governments decision, it is the safer route for our economy as a whole.

Cliff Pape
Home Buddies