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ECOCafe'
TIENTIP SUBHANIJ
When I began to write this, I was quite surprised that the $700-billion emergency rescue package to save the US financial system had been rejected by the US House of Representatives. A revised version was subsequently approved by the Senate but a further challenge awaits in the House of Representatives tomorrow morning, Thailand time.
The House's rejection of the first version of the rescue plan sent the Dow Jones Industrial Average tumbling by 778 points - the largest one-day drop on record - causing panic throughout all markets. The SET index fell immediately by 33 points upon opening on Tuesday to 568 before climbing back at the close.
Capitalism is really at a crossroads. On one hand, the crisis is simply too big for the market to deal with, and the only solution seems to be the US government. The rescue plan aims at stabilising the market which has been hard hit by the credit crunch.
The key part of the plan is buying up "toxic" mortgage-related securities that have worsened the balance sheets of several leading banks.
On the other hand, the bailout has been largely criticised. The plan to help the private sector for their reckless investment is deemed unfair to taxpayers. If the plan is enacted, the US may have to scale back its other plans such as health care and education to pay for the bailout. Many also think that it could lead to increased moral hazard incentives of big institutions, encouraging them to take on even greater risks in the future.
Grassroots groups and activists have widely protested the rescue plan. In an "Open Letter on the Bailout", American university professors questioned the plan's fairness to the taxpayers, and objected to the plan due to its ambiguity and possible long-term consequences.
The plan to bail out Wall Street came after the understanding that smaller responses to these problems were inadequate and the market could not heal itself. US government faith in the market is not as great as before and hence the proposal of the comprehensive "too-big-to-fail" policy.
Events of the last few weeks - the takeover of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, the sale of Merrill Lynch, the rescue of AIG and the move by Goldman Sachs and Morgan Stanley to change their status to bank holding companies - have led to the controversial bailout package.
Let's look at the main points and government actions on these events. In the case of Fannie Mae and Freddie Mac, both have suffered net losses of about $15 billion, and their share prices have fallen more than 90% over the year. These government-sponsored enterprises (GSEs) have taken on a very high leverage ratio, one that would never be allowed for private firms. During this crisis, these GSEs needed a huge amount of capital to shore up their balance sheets. Because of their sizes and special role in the housing markets, the government had no choices but to rescue the two firms.
For Lehman Brothers, it recently reported a quarterly loss of almost $4 billion but the market believed Lehman's losses were bigger. Lehman needed to roll over at least $100 billion a month to finance its existing investment portfolios. But as investor confidence continued to erode, Lehman's cost of borrowing rose and its share price plummeted. The final straw came when Lehman could no longer keep on borrowing. The firm filed for the largest bankruptcy in US history. Many people still question why the Fed did not rescue Lehman just as it did Bear Sterns earlier this year.
Shortly after being hailed for addressing moral hazard in the case of Lehman, the Fed was tested again with the case of American International Group (AIG). The insurance giant has suffered a sub-prime-related loss of nearly $14 billion over the first half of the year. The concerns were triggered after the recent downgrade of its credit rating by Moody's and Standard and Poor's. With large positions in the credit default swaps of almost $441 billion, AIG was forced to seek additional collateral to service these contracts or it would have defaulted on its obligation, and the buyers of its insurance, including most major banks, would have incurred additional huge losses on their balance sheets. Given its size and the potential disruption to the economy, the Fed decided that AIG was too big to fail.
It looks like we are entering into the new era of capitalism where profits are privatised, and losses are socialised. A financial system is based on trust, and when that trust is broken, the usual free-market ideology that markets should be allowed to sort themselves out seems more unconvincing than ever.
With strong backing, including Barack Obama and John McCain, I believe the rescue package will pass the US Congress in some form.
Dr Tientip Subhanij holds a PhD in economics from the University of Cambridge, and currently has a career in banking as well as academia. She can be reached at tien201@yahoo.com
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