Why the Bailout Is Necessary
Tuesday September 23, 2008
NYSE Trader (Credit: Spencer Platt /Getty Images)
Last Wednesday, a record $140 billion was pulled out of money-market accounts, usually considered the safest of investments. That's because investors were moving the funds to U.S. Treasuries, causing yields to drop to zero. In other words, investors were so panicked that they no longer cared if they got any return on their investment...they just didn't want to lose capital.
As described in Thursday's Wall Street Journal:
Huddled in his office Wednesday with top advisers, Treasury Secretary Henry Paulson watched his financial-data terminal with alarm as one market after another began go haywire. Investors were fleeing money-market mutual funds, long considered ultra-safe. The market froze for the short-term loans that banks rely on to fund their day-to-day business. Without such mechanisms, the economy would grind to a halt. Companies would be unable to fund their daily operations. Soon, consumers would panic.What caused this unprecedented run on supposedly safe money markets?
On Tuesday, the once-$62.6 billion Reserve Primary Fund, a money-market fund, saw its value fall below $1 a share because of its investments in Lehman's short-term debt. Money-market funds, which yield a bit more than basic cash accounts by buying safe, short-term debt instruments, strive to keep their share prices at exactly $1 -- and "breaking the buck" isn't supposed to happen. Money-market funds are where corporate treasurers put rainy-day funds, where sovereign wealth funds park their excess dollars and where Mom-and-Pop investors stash savings. Now, money-market funds were selling what they could and hoarding cash to meet what they thought might be extraordinary levels of redemptions from investors, said one commercial trading desk head.Banks were also hoarding cash, too panicked to lend to each other or purchase any assets, for fear of taking on bad debt. Normally, financial institutions have about $2 billion on hand at any given time. By Thursday of last week, they had an unprecedented $190 billion, to prepare for further redemptions. In other words, the economy was on the precipice of a full-scale run on the banks - and not by worried depositors as in the 1930's, but by corporate investors.
Through Wednesday, money-market fund investors -- including institutional investors such as corporate treasurers, pension funds and sovereign wealth funds -- pulled out a record $144.5 billion, according to AMG Data Services. The industry had $7.1 billion in redemptions the week before. Without these funds' participation, the $1.7 trillion commercial-paper market, which finances automakers' lending arms or banks credit-card units, faced higher costs. The commercial-paper market shrank by $52.1 billion in the week ended Wednesday, according to data from the Federal Reserve, the largest weekly decline since December. Without commercial paper, "factories would have to shut down, people would lose their jobs and there would be an effect on the real economy," says Paul Schott Stevens, president of the Investment Company Institute mutual-fund trade group.Treasury Secretary Henry Paulson conferred with Federal Reserve Chairman Ben Bernanke, who agreed that the problem was beyond the scope of monetary policy. The Federal government is the only entity large enough to step in and stop the madness. Let's hope it is enough. Otherwise, as Paulson was overheard to comment, "Heaven help us all." (Source: WSJ, Shock Forces Paulson's Hand, September 20, 2008)
Comments
Look Paulson is leaving in 4 months which is just enough time for him to get this legislation approved and get outta dodge…
Lawmakers in both parties appeared to be coalescing around the idea that executive compensation limits should be part of the bailout, although Paulson is said to be concerned that such curbs would discourage companies from participating.
Does anyone see WHAT’S WRONG with his statement?????
If they don’t want our money for bailout they didn’t really need it in the first place
Hi Rob,
I absolutely think executive compensation should be limited. As Barney Frank said the other day, they are rewarded for the upside, but if the company loses money, they go home for dinner just like every other day.
Kimberly
What bothers me is that this bailout gives Paulson absolute power - absolute authority. The wording of the bill allows for no intervention by anyone, courts, Congress, etc.
Hi Marian,
Yes, and I don’t think that is going to stick. I think Congress will limit some of that.
On the other hand, Paulson needs the flexibility to treat each bank differently - the failure of a Lehman Brothers was not enough to cause global economic disruption, but the failure of AIG would have. It’s a delicate balance.
Kimberly
It seems to me that long-simmering resentment towards Wall Street may keep this bailout from happening. Too many times have executives gotten away with huge payments for very little done, too many times has this been excused by Wall Street, and this has resulted in a tsunami of anger from the public. And I doubt that Wall Street will learn. Or foolish consumers, for that matter, who buy things they don’t need and/or can’t afford with cash they don’t have. It defies, and mocks, the idea of getting rewarded for working hard, saving and investing, and living in a thrifty manner. How can all of this anger be blunted? It isn’t just conservatives that are blocking this legislation from happening - it’s across the board, politically speaking.
Plus, once the government exercises this power, how will it let it go? Isn’t it rather like enacting a tax, then some day ending that tax? And aren’t we giving people the lesson that they don’t have to pay for their mistakes? Who do we bail out next? After Chrysler and NYC and the S&Ls, there’s no limit.
That’s a hard sell, and in a climate not really ripe for it.
Kimberly,
I think some of the bloggers miss the point. Hank Paulson proposed the initial idea the way he did because he knew he will have to give back something to the Democrat controlled congress - basic negotiation.
The mark-to-market rule makes no sense at this point on an asset class that no one knows what the market price for it is. It is arbitrary as we are into second and third order derivatives on the underlying assets.
First, SEC and FASB suspend the mark-to-market requirment for about 3 years. Then, if FASB came up with a math equation (since all of the leverage has been created by mathematical equations) that provides a band - within which banks make a monthly adjustment and report that as a statement to SEC (like 10k etc). As banks start to value these assets better they can report where they are valuing their assets within the band and raise capital in modest amounts to offset the drop in valuation of the assets versus having to raise $5-10 billion every quarter to stay liquid. In this system an overleveraged and badly managed bank will fail and die a natural death. The good banks in trouble will have a way to work themselves back to normality.
Hi Ajay,
That proposal makes a lot of sense because it allows the banks to hint at what their assets are without coming right out and saying it. This may allow them to avoid being clobbered by the stock market and bond market, which is why they are reluctant to fess up about the amount of bad debt they have.
Kimberly