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Can government bailouts avert crash?

Today's Financial News - Posted October 17, 2008

Krista Das on TFN Market Insights

It looks like debt has finally caught up with banks around the globe. The currency markets are being taken on a roller coaster ride as interest rates get slashed across the board. Global economist, Andrew Gordon explains where to find hidden profits.

Watch this video…

by Krista Das

Baltimore - (TFN):The banking crisis is being heard around the globe and government bailout stories are sounding all too familiar. I’ve invited international banking expert Martin Hutchinson from Money Map Report to get his take.

Martin, the Federal Reserve recently decided to provide funding for the paper market. This is an unusual role for the U.S. Central Bank. What do you think about this and the $700 billion bailout plan? Is too much government intervention going to create more problems in the long run?

Martin Hutchinson: I think it probably will, but the Federal Reserve backing the paper market is sensible. The banks have stopped lending not because they’re terrified of the credits they’re lending to, but because they’re trying to get their balance sheets smaller and if you’re leveraged 30 to 1, $30 for every dollar of capital and you’re trying to get to 10 to 1, the only way you can do that if people won’t give you much more money is to reduce your loans.

So therefore they’re not buying commercial paper, they’re not making loans, they’re not giving out new credit cards, etc. etc. So at the moment you’ve got the banks deleveraging and that’s messed up the commercial paper market so the fed’s buying a bit of commercial paper. They did that in the 70s and that’s pretty sensible.

The 700 billion is a different question because for one thing that’s going to hang around for five or ten years because it’s long-term mortgages; not commercial paper.

For another I think it’s probably necessary for the government to bailout the banking system, but there were cheaper and easier ways of doing it. They could do what Britain’s doing and put 87 billion into its banking system in the form of actually investing in the banks by preference shares.

The thing about preference shares in banks is you can figure out – they’ve got a fixed interest rate or coupon of eight or ten percent. You can figure out roughly what they’re worth. You can make sure that the investor’s getting a decent deal. You can put in a couple of terms about not allowing the executives to pay themselves too much and away you go. Eventually the executives want to pay themselves too much and they’ll pay you back and the taxpayer will come out whole.

Whereas buying these $700 billion worth of dodging mortgages, there’s no way that you know what those dodgy mortgages are worth because it’s not a mortgage against a regular house. It’s a bunch of securitized rubbish with a bit of mortgage here and a bit of mortgage there and all over the place.

So Wall Street are very likely to stitch up the taxpayer with the taxpayer ending up with $700 billion of mostly rubbish. So I think that was a terrible deal, but the commercial paper’s a decent one.

Martin Hutchinson on TFN View the video here…

Krista Das: In your opinion where does the U.S.’ current financial crisis rank historically among past events such as the 1929 stock market crash and the collapse of 1987?

Martin Hutchinson: It’s worse than ’87 because that was really just a stock market crash and nothing else. It’s not as bad as ’29 yet. ’29 turned into the Great Depression and disaster for everybody because the government at the time made a lot of stupid moves to try and battle it.

One of them was they brought in a huge new tariff and another was they put taxes up at the bottom of a recession and a third was that they allowed the money supply to collapse when all the banks went bust.

Well this time the fed’s pumping out money like a madman and so money supply is certainly not collapsing even though banks are going bust.

The government hopefully is not going to put up taxes in the middle of a recession and we’re not going to have a huge new tariff even if we’re not going to reduce the ones we’ve got.

So, even though this is a bit like 1929 or particularly the sort of early 1931 position when you started having banks going bust, it’s most unlikely to turn into the Great Depression.

It’s probably more like the 1970s either here which was a long slow slide in the stock market or Britain where all the banks went bust in ’73-’74 and they had a short and very nasty dip and quite a lot of inflation and then gradually it sorted itself out.

Krista Das: The U.S. stock market has been inflated to an artificially high level over the past ten years or so. What’s it going to take for this market and how it relates to the economy as a whole to get back on track?

Martin Hutchinson: Well, its been inflated by too high a level because the Federal Reserve’s been printing money faster than economic growth since 1995. What that’s done is everybody’s gone out and bought assets and asset prices, housing and stock shot upwards. The people expected them to deflate after 2000 and instead the Federal Reserve pumped in more money so the stock market never deflated properly and housing prices shot up as well.

If you look at where the stock market was in early 1995, it was at about 4,000 and that’s where monetary policy changed. If you then add the growth in gross domestic product since then, it’s almost doubled, but not quite. GDP nominal in cash terms.

So that suggests that the Dow Jones should be at about 7,800 and that that would be a sort of middle level. So what you’ve really got now is not a crash and disaster and the ending of human civilization. What you’ve got is a return to normal levels and once it gets to around 7,800 there’ll be no reason for it to go down further.

Now probably it will go down further. It’ll over shoot. But then it’ll come back again and if you’re thinking of buying stocks, start buying them when it gets down into the 7,000’s or so.

Krista Das: Good point. What do you think about Russia’s recent move to lend its banks $37 billion? The Russian stock market seems to have reacted negatively just as the one in the U.S.

Martin Hutchinson: Well, the Russians are lending their banks $37 billion because the banks have all got in bad trouble because Russia’s got deflation. Their real problem is that oil prices went up to $147 and they thought they were going to get as rich as anybody and take over the world. Suddenly they’ve dropped back to 87 and at 87 Russia’s suddenly in a financial crisis.

So what they’re trying to do at the moment is throw money at the problem here and there, but they don’t really understand a capitalist system at all in Russia. Certainly the government doesn’t. There were some people that do that have got companies there.

You’ve got a country that’s making huge amounts of money out of oil and nothing much else and suddenly it’s making less money out of oil. So I think they probably have severe problems ahead and hopefully they won’t react to the severe problems by trying to invade somewhere.

Martin Hutchinson is an senior analyst for Money Map Report. Learn more about his service here.


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