The Bailout: Yes, But Will It Work?

Every week, it seems, we see a new high-water mark for government intervention in the financial sector, culminating (?) in today’s announcement that the government is buying $125 billion of preferred stock in nine banks, with another $125 billion available for others. The recapitalization, loan guarantees, and expanded deposit insurance are the most aggressive steps taken yet in the U.S. and were all on on our list of recommendations.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.

3 thoughts on “The Bailout: Yes, But Will It Work?

  1. Well, bailout may work for this time, but there is threat that it will cause stronger crisis in the future, since such actions create moral hazard and banks become more willing to undertake high risks to get higher returns.

  2. Well Felix, that would be where regulation comes in. Besides, we already looked into the abyss and may yet slide straight down.

    Instead of worrying about moral hazard, we ought to worry about paying down the National Debt. I mean, the whole system only works to the extent that “The Full Faith and Credit of the United States” actually has any meaning.

  3. If we have gotten to the stage that bailout is a viable option for large insurance companies and banks, where do we draw the line where the free market regulates poor business decisions (aka business closure, etc.)? We have stepped over a very dangerous line underwriting fiscal irresponsibilty by mortgaging our children’s futures. Is socialized banking next on the agenda? Given the runaway national debt that our federal government conisders acceptable, this is hardly the board that we need running our top finaincial institutions!

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