The $700 Billion Plan is a First Step for the Economy

It is clear that the U.S. financial market and markets across the world are not working efficiently, and this is a huge risk for the prospects of the U.S. economy and the rest of the world. While many have criticized the size of the expected monetary injection planned by the government, the truth is that estimates of the potential total cost of this financial crisis are larger than the $700 billion requested by the administration. But the administration knows that they will buy these financial instruments at a “fire-sale” price so that means that in many instances the “multiplier” effect of these $700 billion may be very close to $2.1 trillion, just to give an example if the Treasury is able to buy these assets at, let’s say, 30 cents on the dollar. Thus, this is the reason why many argue that if the administration is successful in this process, taxpayers could even make a profit, assuming the administration can sell these instruments back to the market at a price higher than $0.30.

Of course, there is always a risk that this may not happen, but the assumption being made by the administration is that the current problems in the U.S. financial market is a temporary loss of confidence and a tremendous aversion to risk that is making investors too afraid to get back into the financial market. Thus, the current plan is to take all this “toxic waste” from the financial firms, clean them up, improve them and sell them back to the market with an improved risk profile. The biggest risk with this plan today is if the price of homes drops so much that the price paid by the administration ends up being higher than the true value of the assets. Another important risk, and one that cannot be taken lightly, is that investors may just be waiting for the administration to step in so they can make money on the upside. Of course, the argument against this possibility is that nobody wants to wait and see whether this risk is real or not, because if it is, then it will be too late to fix it.

Having said this, markets know that this is just the first step in solving this crisis. Markets know that the financial sector needs to go through a full-fledged transformation that would guarantee that this situation does not happen again. The first stage of this transformation has already started with the disappearance of the investment banking firms, be it through mergers, bankruptcy or just because they have asked the Federal Reserve’s permission to become a commercial bank. Furthermore, the Treasury’s package doesn’t mean that the U.S. economy is going to recover growth immediately after the approval by the U.S. Congress. The reason for this is that the $700 billion injection does not include a plan to recapitalize the banking system, which is another reason why the system is not working and also the reason why the Federal Reserve’s policy of lowering the Federal Funds rate has had no effect on the expansion of lending by the financial market. Very few financial institutions are lending today and the reason is that losses have left them in a very delicate capital position. Furthermore, the aversion to risk is so large that firms are unwilling to risk any capital in this market, and many even prefer to stack it under the mattresses or hoard it until things normalize. Thus, until the system recovers the confidence of the markets and starts to attract fresh capital, it will remain weak and the economy will not be able to recover the strength of years past.

Just Thinking Out Loud

As I have argued in previous reports, the Federal Reserve and the Treasury Department are terribly concerned with a further decline in home prices and have been trying to do everything in their power to try to stop the decline in these prices. Their argument is that until home prices stop declining, the financial crisis will continue to linger. One of the ways they can keep home prices from going down further is by keeping mortgage interest rates down. However, up until the takeover of Freddie Mac and Fannie Mae, they had not been able to achieve that goal, because mortgage rates were still going up even though the Federal Funds rate was going down. After the takeover of the two mortgage giants, mortgage interest rates have come down a bit, but the yield of the 10-year Treasury has increased once again and that is putting, once again, more pressure on long-term interest rates.

A different alternative to attack the problem is to act on the income side of the equation rather than on the price side of the housing equation. Tax cuts could create higher disposable incomes, and this higher income could be used to pay mortgages. The biggest problem with this alternative is that the administration cannot control what the individual is going to do with that extra income. Furthermore, the government may not be in a strong enough fiscal position to offer the permanent tax cut that would be needed. Another alternative may be to unleash untapped household savings. Although our national savings rate is close to zero percent, I should add that the nation’s 401(k) savings are not included in the national savings rate, and this could be counted as an “untapped” source of savings. Could there be a scheme to allow re-allocating a portion of 401k assets from retirement for use as down-payments, thereby encouraging home ownership (a traditional source of retirement income in its own right)? The political hurdles would be daunting, not to mention all sorts of potential unintended consequences. The point is, unless homes get cheaper, or incomes and savings are increased, the fundamental housing supply and demand imbalance will not go away.

Of course, not all is positive with this idea. Homeowners would have to realize that either they will have to work more years than what they were planning to work during their working life, increase 401k contributions in the later part of their working lives, or be able to live with less money than originally planned. Of course, homeowners could implement a combination of all these strategies.

Of course, I still believe that the Federal Reserve and the Treasury should allow home prices to reach a level that will allow demand to recover. And furthermore, once we are out of this financial crisis, home prices are one of the first prices in the economy that could recover, as has been the case in almost every nation that has suffered a credit crisis like the one we are suffering today.

I know right now nobody believes that home prices could possibly recover any time soon. But remember, we were convinced, less than two years ago, that the housing market was a highly liquid market, that home prices were always going to go up, and that interest rates were always going to go down. Thus, my argument that home prices may increase fast in the future may not be so far-fetched!

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