last week’s dramatic events – the bankruptcy of Lehman Brothers,
the end of Merrill Lynch’s independence, and an $85 billion US-government
bailout of insurer AIG – most financial institutions are likely
to become more sensitive to the state of their net worth.
all it takes for a financial institution that has a net worth of
$30 billion and assets of $600 billion to go under is for the value
of assets to fall by 5%. In the current financial climate, it can
easily happen; hence, most financial institutions are not immune
from the potential threat of going belly up.
One of the
major reasons why the Fed rescued AIG was to prevent a fall in the
value of bank assets, a fall that would in turn expose their true
net worth and cause (it is generally believed) a run on banks that
would decimate the entire banking system. As long as the AIG can
keep paying the banks’ losses for their suspect (but insured) investments,
those banks don’t need to reappraise their true values.
But there is
always the lingering fear that at some stage banks will be forced
to disclose market-related valuations and that this could set in
motion a financial tsunami.
assets are regarded as being at the root of the present credit crisis
– the worst since the Great Depression. To eliminate a potential
threat from devalued mortgage-linked assets, US Treasury Secretary
Paulson and Fed Chairman Bernanke are planning to move these assets
from the balance sheets of financial companies into a new institution.
The Bush administration is asking Congress to let the government
buy $700 billion in bad mortgages as part of the largest financial
bailout since the Great Depression.
The plan would
give the government broad power to buy the bad debt of any US financial
institutions for the next two years. It would also raise the statutory
limit on the national debt from $10.6 trillion to $11.3 trillion.
But how is
the transfer of bad paper assets to some new institution and their
replacement with a better quality of assets – with Treasuries,
let us say – going to fix the economy? How can it reverse the
present slump in the housing market?