The Price Of The Stock Is Falling Slower And Slower.Derivative The Mother of All Bailouts Will Not Save the Economy

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The Mother of All Bailouts Will Not Save the Economy

Treasury Secretary Paulson has proposed a $700 billion bailout of the financial system. The main thrust of the plan is getting mortgage-backed credit derivatives that are near or already worthless off the balance sheets of major financial firms. Using new borrowings, the Federal Reserve System hopes to, in one major sweep, remove all the fear of loss that is paralyzing the credit markets. The same fear that put Lehman Brothers out of business and AIG into federal ownership.

Under questioning from Congress, Federal Reserve Chairman Bernanke made the curious statement that failing to pass his proposal would lead to a recession. That statement is curious on two counts. One, there is ample evidence to demonstrate we are already in a recession. Two, even if the bailout succeeds it cannot keep the economy from falling into a recession. And that is the biggest myth surrounding this mother-of-all-bailouts.

The day after the plan was announced, Friday, September 17, the stock markets rallied, with the Dow Jones Industrial Average gaining 370 points. On Monday, September 22, the markets gave back all of those gains on worries the plan would not make it through Congress. On September 25, stocks surged again as President Bush made a major effort to sell the bailout. Clearly, investors believe that the policy will help end the economic dysfunction. But it cannot possibly succeed on that front, and here’s why.

The US economy and the global economy have suffered a shock. Just like the oil shock of 1974, a major, necessary input to economic activity has been reduced. Instead of oil, this time the problem is credit. Our modern economy depends on credit to run smoothly. The credit markets allow everyday business to function. Even more important is the impact credit has on projects for expansion and growth. Cheap and easy-to-get money makes expansion and growth possible.

Our economy, just like with oil, also has a finite capacity to supply credit. That capacity is dictated by the balance sheets of banks and investment companies. Financial institutions that have healthy balance sheets can multiply money through the credit markets, facilitating economic activity and growth. Without healthy balance sheets, the current condition of the banking system, money multiplication is restricted.

A temporary restriction in money growth is enough to cause an economic dislocation, or slower growth. But a permanent reduction in the capacity of the banking system, or shock, causes the economy to contract. Again using oil as an example, if the amount of oil supplied to the US economy is reduced the amount of goods that can be made from it has to shrink to fit the new supply equilibrium.

The overall capacity of the US economy to supply credit has been permanently reduced, regardless of any bailout. The bankruptcy of Lehman Brothers, the forced purchase of Bear Stearns and Merrill Lynch by JP Morgan and Bank of America, plus the conversion of Goldman Sachs and Morgan Stanley from investment firms to traditional banks have permanently reduced those firms’ ability to multiply money. Since traditional banks have higher capital requirements, converting those companies to traditional banks has increased their capital requirements, reducing their capacity to supply credit.

And those are only the high profile examples. Even regional banks are struggling with loan losses and capital reserve ratios. So far in 2008 there have been twelve bank failures, covering $42 billion in assets. With those banks no longer in business the banking system has permanently lost their ability to supply credit.

This permanent reduction is causing the economy to shrink to fit the new credit supply equilibrium.

There is a historical example for just this scenario. In 1989 the Resolution Trust Corporation was created as a bailout for failing Savings & Loans (thrift banks). Altogether 747 thrifts were closed in the bailout, totaling $394 billion in losses (initially sold to the public as only costing $50 billion). That effort was not enough to fend off a contraction. In the fourth quarter of 1990 and first quarter of 1991 the economy shrank to meet the new credit supply equilibrium.

The current bailout plan estimates losses at $700 billion. But that may prove optimistic when you factor in the astronomical liabilities of derivatives ($64 trillion notional value of credit default swaps). A total price tag above $1 trillion demonstrates the severe nature of the credit crisis, and by extension the potential for lost capacity.

The bailout will not, and cannot, replace the lost credit supply capacity. This bailout only removes problematic assets from troubled institutions. Such a move will only stem the tide of losses, not replace losses that have already occurred.

Stock investors betting on the success of the bailout are setting themselves up for deep disappointment. Without augmenting the supply of credit this bailout will not stop the declines in jobs, corporate earnings, and global growth. That may mean trouble ahead for stocks.

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