Sunday, November 2, 2008

Will the $700 billion bailout package Workout?

After the US Senate passed the $700 billion bail out package, we still haven't seen any significant upside on the US Stock markets. People are wondering, "Isn't the huge pile of money allotted by the Treasury secretary Henry Paulson supposed to solve the crisis?"

Well its not as simple as we think...

Economists worldwide feel that the bail out pill may only dull the pain, but may not provide the much needed cure. Whats worse? Some people even feel that it could leave a deeper hole in the economic crisis. The Fed is taking steps to infuse liquidity into the markets which they feel would improve the cash flow in the market and stabilize the economy. But banks now have turned
super cautious. They were reckless in the past few years when it came to granting loans. The damage that has caused to these banks has made them too conservative. Even with the availability of easy cash from the Fed, banks may not opt to give off too many loans.

The Treasury's gesture of buying out the toxic Mortgage Backed Securities assets stuck with the
banks may help temporarily improve the banks balance sheets, but that doesn't guarantee the fact that banks would go ahead and give off loans. The bail out may not ease the cash flow in the market the way it plans to do so.

The current economic situation is one of volatility. Nobody is sure as to what would happen. There have consecutive months of job losses, bankruptcy, sales slowdown in automobile industry etc. Banks appear to be increasingly unstable. People have lost faith in Insurance companies. Financial companies are stuck with dubious debt products.

The Premium asked by insurance companies against Credit Default Swaps have gone sky high. Recently a major US Bank, took a credit default product with a credit spread of approximately 1000 basis points. Which is 10% of the default coverage amount. This means that if the bank to take a default insurance worth $ 10 million, it would have to pay $1 million every year,
which is more than 10 times of what companies pay. Insurance companies are not sure of the quality of the loan product against which banks are asking for credit default products and hence they are not ready to risk too much money. The Insurance companies can neither deny such products nor can they deny default claims. Hence to save themselves they have increased the credit spread.

People do not feel that the bailout package would be a complete failure. Mr. Paulson has inbuilt a lot of flexibility in the act in his attempt of injecting liquidity into the market. But first the treasury has to find out what assets to buy and at what price to buy. Nobody is sure of the quality of the assets that the treasury is going to buy. The Treasury is not going
to buy the assets blindly. This is a kind of investment which is an attempt to infuse liquidity into the markets. The Treasury is eligible for the payments that the MBS units are supposed to get from the banks. The Treasury would opt to sell these units at a future date at a profit. No one is sure whether this extreme risk the Treasury is taking with the Tax payer's money
would work out.

The process of identifying the assets and distributing the fund across the list of distressed financial institutions may take at least a month or so to complete.

A Leading financial expert feels that this $700 billion proposed by Mr. Paulson may not be sufficient to save the country's economy. Even if the 700 billion dollars is spent efficiently in buying up illiquid MBS assets, it may not be sufficient to cover up the void that has been created. the Treasury may go back to the government asking for more dollars. The reason
they would say is simple, "These funds were not sufficient to infuse liquidity". Once Investor & Bank confidence is destroyed, it is not easily restored. It would take months and even years for things to settle down.

But, in spite of all this, if this bailout plan works out the way it is expected to do so, we can expect a dramatic turn of events which could restore investor confidence and bank confidence and could boost the economy to what it was before. Though this may not happen overnight but it could
accomplish its intended effects in a few months.

Let us hope for the best :)

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