The following is note from one of our bank-analyst contributors. He explains why the government had to do something (because the Fed can’t provide enough liquidity to save the entire system). He also argues that the bailout won’t work. For more background on this, see “Why We Need a Bailout“
Why Do We Need A Bailout? Can’t Banks Just Borrow From Fed Instead of Each Other?
The Fed has enough of a balance sheet to backstop this or that institution and maybe two or three at a time, but it does not have enough to backstop the whole system.
The Fed has roughly a $1.2 trillion dollar balance sheet. Of this $262 billion was borrowings at the discount window, up from effectively zero in normal times. I also see $150 bn in “Term Auction Credit” up from zerothis time last year, and Repos of $111.7 bn up $72.6 bn from this time last year. The rest of the assets are mainly the treasury securities that the Fed uses in its normal operations. So you can see that adds up to a couple hundred billion of funds to banks.
Now put that into the context of the asset sizes of the big banks: BAC $1.7 Trillion, C $2.1 Trillion, JPM $1.8 Trillion,WB $800 Bn, GS $1.2 Trillion, LEH $600bn, MER $1 Trillion, MS $1.0bn, to mention just a few. Now obviously those balance sheets are not funded all by overnight borrowed funds, but a big chunk is (as you saw with Citi), but it’s obvious that you would quick swamp the Fed’s balance sheet if no one lends to the banks. The Fed just can’t do it all. That’s why this is so scary. If you don’t re-establish the borrowing ability of the banks you are ultimately toying with a return to a barter economy….
Will The Bailout Work?
If we’re just relying on the raw power of the Federal government’s dollars to tilt the balance in the favour of demand rather than supply, it’s a tough road. Paulson, meant this plan to be a “shock & awe” where people would say–“The government is finally stepping in. This is the bottom. I’ve got to buy my MBS position before they do.” He meant to set off a mad scramble among vulture investors to plow into the asset class. The more they did, the less taxpayer dollars he’d need to use.
Had congress just given him the blank check he asked for, I’m sure that’s exactly the effect he would have gotten. The DCF of the likely future cash flows of most of this paper is well above where it’s trading in the market right now. If all of a sudden you think there’s an incremental large buyer’ you cover your shorts and start buying. This is why the market rallied as it did. I for one am totally convinced that Paulson would have gotten exactly the effect he was hoping for had congress just lined up behind him and said “We’ll give you whatever you need.”
But of course it’s an election year. We’re not just going to give Paulson whatever he’s asking for. We’re going to make him twist and dangle for a while. We’ll say,”Why not try with $150 billion first, and then come back to us before you get the other $600….” McCain, who has absolutly no clue whatsoever about how dire the situation is, jet’s in, riles up the Republican base, jabs Paulson with his cane a few times, and moves on. So much for the “shock and awe” effect. Paulson is left looking weak. The financial world knows that he is on a very tight leash. He’s been talking his big Bazooka game, but first let’s send him in with a BB gun and see how that works…..
To cut to the conclusion: Ultimately this will work. There is no other option but to succeed. You just can’t function if no one is willing to place money with country’s largest banks. People need to understand that the consequence of failure is a barter economy with a Mad Max mode of exchange. It’s not an option. It is just a question of how much money the government needs to throw at the situation, how much they will need to debase our currency in doing so and how much inflation we will suffer in the aftermath, but the government will ultimately throw enough money at the situation to make the problem go away
Paulson’s gambit was to spur private capital into action by demonstrating that the government was there in size. He was hoping to ask for $700bn and really only use $70bn. That’s less likely to happen now. The government will have to put a lot more actual dollars on the line to get the same effect. But ultimately they will keep on throwing dollars at the problem until the banking system is functional. There is no alternative.
See Also: Why We Need A Bailout
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