How the crisis is unfolding, and the technical reasons behind the bailout. LOUIS COUTTS
By Louis Coutts
Because of quite a bit of feedback as a result of my article on the credit crisis, I thought it would be worthwhile trying to give a little explanation of how the crisis is unfolding and the technical reasons behind Paulson’s rescue bid.
I have just come across this graph courtesy of Bloomberg. It is a graph of the difference between the interest rate being charged for interbank loans over the rate for Treasury bonds, and is known as the TED spread.
You will see that the rate spiked in August of last year when the sub-prime scandal first hit. It abated a little over the year but never got back to normal and has shot up dramatically since the full discovery of the disaster has become known.
What this means is that the cost of funds to banks has sky rocketed, lessening banks’ appetites to borrow. In addition, because banks do not know what skeletons other banks are holding in the cupboard, such as bundled mortgages worth a lot less than their face value, banks are discriminating about those banks that they believe are credit worthy.
Not only have the costs of borrowings increased enormously at the wholesale level (even if a bank borrowed at twice the Treasury bill rate it would then have to pass on a margin to its end borrower, making the cost of retail money incredibly pricey) but the fear of lending to troubled banks has effectively frozen credit markets.
This means that just managing day-to-day operations by making payroll becomes more expensive. Starting new businesses with borrowed funds is out of the question and running ongoing businesses that are dependent upon credit for a life line is becoming more difficult and in some cases impossible.
If you take this to the housing market where you can’t borrow money on the one hand to buy a home, or if you can and you can’t pay the mortgage on the home you own, it means that the housing market becomes frozen.
What the proposed bailout in the US is intended to do is not to bailout Wall St or the banks but to reduce the fear of interbank lending so that credit markets can operate again, and at the same time reduce the cost that banks have to pay for funding and therefore reduce the cost of funds to the ultimate borrower.
This will be done by removing toxic assets from banks so that other banks will feel more comfortable about lending to them. The taxpayer will in fact own these assets but the Federal Treasury has the capacity and the time to manage these assets in such as way that there will be less stress to people in houses.
It will reduce dramatically forced sales of real estate and thus stabilise property prices. Over time, the value of the mortgages taken up by the Fed should improve in value and as it will have purchased them at a discounted price, the taxpayer could end up on the winning side.
It seems that the scheme was the brain child of the Secretary of the Treasury (Henry Paulson) who is an ex-banker and an economist. Unfortunately, it needed political support and no one in the administration had the political clout (Bush has absolutely no credibility with the United States voters) nor the communication skills to adequately explain to the American people the reasoning behind the scheme and the necessity for its rapid implementation.
Paulson was pretty much the person to do it, but had no direct access to the people to explain what he was doing. He invented the tool but had to leave it to politicians to make it work, and predictably they didn’t do a very good job.
I am not sure that people understand the brilliance of the scheme. Even the gurus who go on TV and tell us that it is not going to solve the problem because the banks are undercapitalised don’t seem to get it.
Hell! What happens to the capitalisation of a bank if it can suddenly shed its bad debt provisions which, because of accounting rules, amount to billions? The capitalisation increases by the amount that they off-load to Uncle Sam.
But what really happens is that the “TED spread” decreases and trust between banks increases and the flow of money gradually resumes. It is an issue of trust, and this initiative will gradually introduce trust into the banking system.
One of my respondents to last week’s article sent me a quote of Winston Churchill that went something like this: “Congress can always be relied upon to do the right thing, after exhausting all other alternatives.”
I suspect that the reason the Reserve Bank is going to reduce interest rates by 0.5% is in the knowledge of this so called “TED spread”. If they just reduced interest rates by 0.25% it wouldn’t be enough to reduce the cost of funds to banks, but if they reduce it by 0.5% there is room for the banks to access funds, and there will be something to pass on to the borrower.
If Paulson’s scheme works, and it will work if miraculously the US gets a president who can lead, then the “TED spread” will come back to normal and the pressure on the banks to pass on the full amount of rate decreases will be enormous.
Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.
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Smart Company is a sister publication to The Mandarin, catering to Australia’s entrepreneurs, small and medium business owners and business managers.
