October 1, 2008


Just got this email from Fidelity:

Insight on Government Rescue Plan (Dirk Hofschire, CFA, September 29, 2008, Fidelity Investors Weekly)

The first lesson learned throughout the history of financial crises is that when financial markets simply stop working on their own, the government may be the only backstop available to prevent a systemic financial collapse that jeopardizes the entire economy. That is the stage in which the U.S. government finds itself now. During the past few days, Washington Mutual bank became the largest corporate bankruptcy in U.S. history. Despite the Federal Reserve providing billions of dollars of liquidity, short-term credit markets have been in complete distress, with inter-bank lending rates spiking to all-time highs compared to safe Treasury yields (see exhibit 1, below). The psychological crisis of confidence has paralyzed the financial system, which threatens to spill over to the already ailing real economy in the form of sharply tighter credit for households and businesses.

In the extreme, the government's powers are theoretically limitless, so it can go to great lengths to nationalize banks, provide blanket government guarantees to financial entities, or do anything that is necessary to prevent a systemic crash. However, for a financial system to sow the seeds of recovery, it must purge itself of the bad loans or assets that caused the crisis in the first place, so that surviving institutions can recapitalize and be unencumbered in future lending. There are historical examples of governments that prolonged financial crises into decade-long economic catastrophes (e.g. Japan in the 1990s) by allowing bad debts to fester on the balance sheets of financial institutions. In contrast, government-led financial rescues that have been regarded as more successful (such as Sweden in the 1990s and the U.S. Resolution Trust Corporation during the S&L crisis) were marked by relatively swift disposal of bad assets. (A detailed discussion of lessons from history is found in MARE's September 15 article, U.S. Financial Crisis Enters New, But Perhaps Necessary Phase.)

Despite the intense negotiations that preceded the proposed legislation, the two key provisions of the plan's centerpiece -- the Troubled Asset Relief Program (TARP) -- remain largely unchanged. First, the program is designed to remove impaired assets from the balance sheets of U.S. lending institutions. Second, it provides massive resources -- $700 billion -- to accomplish this task and facilitate a recapitalization of the financial system. Therefore, the broad objectives of the plan -- replacing troubled assets with an enormous infusion of money in the financial system -- are consistent with the essential ingredients of past successful crisis-response programs.

Posted by Orrin Judd at October 1, 2008 10:21 PM
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