Given 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.
For instance, 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.
Mortgage-linked 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?
September 23, 2008