The Financial Bailout for Big Banks

The economic meltdown in the United States stands out as one of the most debated about issues in the last quarter of 2008. The period has been marked by series of financial bailouts, as well as takeovers and buyouts of some of the most successful US companies in the financial services sector in a manner that has baffled investors and economists alike. A clear manifestation of the impending economic crisis in the US financial sector occurred in July 2008 when a bailout plan for Indy Mac Bancorp failed miserably.

This was later followed by a series unexpected collapse of investment banks and giant financial institutions that included Freddie Mac and Fannie Mae on September 7, 2008, Merrill Lynch on September 14, 2008, Lehman Brothers on September 15, 2008, AIG on September 16, 2008, Washington Mutual September 25, 2008, and Wachovia Bank September 29, 2008. It was this shocking trend that prompted congress to approve the controversial $700 billion bailout plan on October 3, 2008 to rescue the US banks and entire financial system from further collapse.

The Fed and the treasury under the guidance of Fed Chairman Paul Bernanke and Treasury Secretary, Henry Paulson respectively are leading concerted efforts to ensure strict and successful implementation of the US financial bailout for big banks. There is no doubt that the $700 billion financial bailout plan for big banks is a new process that has been designed and prototyped successfully. Given that the simulation and modeling tools for the implementation of the bailout plan have demonstrated success, adequate structures must be put in place to check the logical operations of the program.

It is important for the treasury and the Federal Reserve Bank must ensure that all aspects of the bailout plan are handled sensitively and with due reference to the conditions set by the Congress. However, it is important to note that although the dwindling economic prospects for the United States came to the fore in third and fourth quarter of 2008, the crisis had actually begun taking shape in the last quarter of 2007.

For example, according to statistics contained in the New York Times of Sunday, October 12, 2008, one of the earliest financial bailouts happened in December 12, 2007 when the central banks across North America and Europe detailed a plan to cushion banks with a $90 billion short-term financing plan. The statistics further confirm that the US Federal Reserve offered another $200 billion 28-day loans to banks in America in March 7, 2008. This was followed by another $200 billion bailout for investment banks which involved exchanging mortgage-backed securities for treasury securities.

Therefore, the financial meltdown of September 2008 was only but a culmination of a crisis cycle that sparked off in 2007. Just like the great depression which began in 1929 and culminated to catastrophic recession, the current economic crisis in the United States is centered on credit crunch. The Wall Street is considered to be entirely responsible for the current economic woes and the current credit crunch in the United States. The great depression remains the best reference of what the banking sector in the United States is bound to lose should the bail out plan fall short of its objectives.

For example, the close down of hundreds of banks during the great depression caused what economic experts refer to as lose of information capital. This was a situation whereby bank officers who had accumulated important knowledge in the credit sector disappeared to oblivion. So, when the economy finally picked up, the banks found it difficult to loan individuals and businesses because the new bank officers could not ascertain the reliability of borrowers. Financial mismanagement at the Wall Street saw the unprecedented collapse of the mortgage industry and plummeting stock markets all at one go.

The big question that begs in the minds of many is: why did the United States fall prey to the economic meltdown despite the country’s status as the world’s economic superpower? It is equally surprising that the US government opted for the bailout plan and yet the country is the home of free market economy. Arguably, the $700 million bailout plan for US banks may be perceived as a conceptual contradiction of the free market economy which prohibits government intervention in markets.

Indeed, the concept of free markets economy is based on the reliance of market forces to determine the direction of the economy. But a close look at the current economic crisis in the United States confirms that the bailout plan was needed badly. For instance, the collapse of Lehman and the subsequent American International Group’s takeover by the Federal government in September 2008 put banks to high alerts as the banks responded by a risk aversion strategy of acquiring treasury bills rather than giving out loans.

Moreover, interest rates on loans nose dived to all time highs to the disadvantage of business and individual borrowers. If the principle of free market economy was to hold, banks should have taken the advantage of the high interest rates to make loans and shore up the credit markets. However, such a market oriented mechanism did not and is yet to happen because the banking sector has been characterized by consistent nervousness, one of which is the fear that solid borrowers today may crumple in the near future should the US economy fail to take an immediate upturn.

These particular fears can be traced back to the 1930’s depression which disintegrated into an elongated recession, and brought down most of the businesses that were in the finest of shapes during the depression phase. As David Leonhardt points out in his article titled “Lesson from a Credit Crisis: When Trust Vanishes, Be Worried” and contained in the October 12, 2008 issue of the New York Times, the position of US banks in the lending markets has further been complicated by the tendency and preference of banks to long-term assets and short-term debts.

As such, banks must be able to borrow short-term loans in order to offset the short-term debts effectively. Unfortunately though, the inter-bank lending opportunities also dried out as lending banks developed more reservations about extending short-term loans to borrowing banks. The collapse of Wachovia Bank as one such example of a bank that collapsed as a result of capital hoarding by likely lenders (Leonhardt 20). With sources of short-term loans having been diminished by the current credit crunch prevalent in America, the bailout plan stands out as the most probable solution for the besieged American Banks.

The impact of the financial bailout plan will impact on the economic consumption habits of consumers across the United States. From an economic perspective, government expenditure, usually referred to as transfer of payments improves consumers spending habits through increased savings and reduced interest rates. The consumers’ propensity to consume is largely determined by distribution of wealth and anticipation based on past experiences. Thus, as consumers get accustomed to the anticipation of higher income, the marginal propensity to consume rises to its long-run level.

Marginal propensity to consume refers to the total consumption divided by the total national income of a country. When economic growth stagnates, the national income will subsequently reduce and market confidence will be significantly eroded. Such converse movements of income place the short-run propensity to consume above the long-run levels (Livesey, 503). But it remains unlikely that the stimulus plan will assert immediate impact in the consuming habits because, according to Professor Friedman, the income hypothesis demonstrates close relationship between anticipated permanent income and actual expenditures.

So for positive changes in economic prospects to take effect, there will be some time lapse, usually referred to as lagged adjustment. In order to avert an unfortunate eventuality for the current economic crisis, the financial bailout for big banks has been taken a notch higher. For example, the Federal Reserve is adequately lending rescue funds to distressed financial institutions but also buying assets experiencing serious financial distress.

The Fed’s buying spree is evidenced by its recent acquisition of the American International Group, Inc. (AIG). According to Real Time Economics, a Wall Street Journal blog, the AIG rescue plan includes $40 billion buy out of the collateralized debt obligations (CDOs) as well as the buyout of AIGs mortgage securities by the Fed. The latest AIG rescue effort adds to the earlier rescue plans of $85 billion and 37. 8 billion which were initiated in September and October respectively.

The AIG example illustrates just how far the United States government is willing to go to restore the financial capacity of the big banks and financial investment institutions. “The United States government has also vowed to provide an additional $200 billion to finance securities purchases on wide ranging loan products by investors” (Hilsenrath and Solomon 14). The United States Treasury and Federal Reserve Bank are currently spending $250 billion of the bailout funds to assume the equity of the United States big banks and other financial institutions.

Ultimately, the treasury will soon exhaust the $350 billion of the $700 billion program. The Treasury will yet again be required to seek approval from the Congress to access the other half of the of the financial bailout fund. With some lawmakers having already expressed reservations about the Treasury’s and the Fed’s decision to spend some of the bailout fund in buy-out and acquisition programs for distressed assets, one cannot rule out a looming showdown between the Treasury and the Congress.

Considering the fact that America is currently undergoing political transition amidst an economic crisis, the financial markets will crumble drastically should the congress object to sanctioning the remainder of the bailout funds. Lawmakers must be prepared to expedite the release of the remaining portion of the bailout funds because extended debates and reluctance on the part of Congress will only jeopardize the entire economic recovery program. So far, it is apparent that credit is a key economic ingredient without which no economy can flourish.

The current economic crisis in the United States is adequate testimony to the reality that diminished or complete freezing of credit opportunities ultimately render businesses as well individual investors dynamically dysfunctional and operationally unproductive thereby disabling significant potions of economic growth functions. “That is why the Wall Street has to be revived at all costs because like it or hate it there can be no credit markets in the United States without the Wall Street” (Gaffen 11).

Lending taps have literally dried up, and investors requiring financing for large scale acquisitions need to approach more than one lender so that they can acquire multiple small loans from different lenders. Such inconveniences affect project implementation timelines for such investors. Should the United States have delayed to unveil the ambitious economic stimulus and financial bailout program, then the US economy could have headed to its worst decline only comparable to the great depression.

Thus, the $700 billion bailout plan for banks in the US will go a long way in averting risks that would otherwise have spelt irreversible doom for the globe’s economic superpower. For example, the US Congress has called on the Treasury and the Fed to ensure that all banks benefiting from the bailout fund extend the same to the public by increasing the volume of lending to businesses and individual borrowers, apart from lowering interest rates and easing the prevailing tight lending restrictions.

The US lawmakers also want the Treasury and the Fed to ensure that the compensation packages for top bank executives are subjected to tougher and stringent measures to ensure that the executives do not draw bonuses and other individual performance benefits from the bailout funds. The main concern with the entire economic stimulus package is the direct government intervention in the US economy, a move that is undermining the principles of free market economy.

This is because there is no way the government can commit the taxpayers’ money to economic recovery without putting into place stringent regulatory measures to ensure proper use of the money. Nonetheless, the financial bailout plan for banks does not sound a death knell for free market economy but rather serves as a capitalist intervention designed to restore capacity and confidence in the US financial markets. The United States government cannot afford to abdicate the responsibility of ensuring the stability and growth of the gross domestic fixed capital formation which forms the country’s major portion of investments.

Failure the shore up the economy spells doom because once the gross domestic fixed capital formation stagnates, the United States government, banks, companies and households will be rendered helpless because there will be no new investments, schools, factories, hospitals, houses and roads. Works Cited Crittenden, Michael. “Treasury Draws Fire for Shift in Rescue. ” Wall Street Journal 14 November 2008. Enrich, David and Robin Sidel. “Banks Promise to Use Rescue Funds for New Loans. Wall

Street Journal 31 October 2008. Gaffen, David. “Bailout Plan Needs Funds. ” Wall Street Journal 10 November 2008. Hilsenrath, John and Deborah Solomon. “Mortgage Rates Fall as U. S. Expands Rescue. ” Wall Street Journal 26 November 2008. Izzo, Phill and Sudeep Reddy. “Fed Takes Step into New Territory: Buying Distressed Assets. ” Real Time Economics: Wall Street Journal 10 November 2008. “Latest Bank-Bailout Plan Drives US Stocks Higher: Bofa, J. P. Morgan, Xerox Rise With Citi, UBS, Total Advance.

” Wall Street Journal 25 November 2008. Leonhardt, David. “Lesson from a Credit Crisis: When Trust Vanishes, Be Worried. ” New York Times 12 October, 2008. Livesey, Frank. Economics: An Introduction for Studies of Business and Marketing. Oxford: HPP. Palletta, Damian and Deborah Solomon. “Panel to Criticize Handling of Bailout. ” Wall Street Journal 10 December 2008. Riedl, Brian. “Why Spending Stimulus Plans Fail: What Congress Gives to Some it Takes Away From Others. ” Wall Street Journal 14 November 2008.