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Monday, September 29, 2008

$ 700 Billion bail fails and slams the US into Depression as the Stock Markets Crash

Nearly all Austin area stocks fell on Monday afternoon as the Dow Jones Industrial Average plummeted on news that the U.S. House of Representatives had rejected the $700 billion federal bailout plan.

The Dow fell more than 700 points in afternoon trading. Among local public companies, some of the biggest drops in share price were with Forestar Real Estate Group Inc. (NYSE: FOR), which fell more than 15 percent; Fieldpoint Petroleum Corp. (AMEX: FPP), which fell more than 21 percent; Guaranty Financial Group Inc. (NYSE: GFG), which fell more than 11 percent; and Brigham Exploration Co. (Nasdaq: BEXP), which fell more than 13 percent.

Congress and the White House in recent days hammered out the bailout bill, called the Emergency Economic Stabilization Act, which is intended to free the flow of credit by allowing financial institutions to offload their nonperforming mortgage assets.

The Monday vote, 205 in favor and 228 against, came as a surprise, despite bailout being an unpopular proposal among many American voters. The bill had been modified to satisfy its Congressional opponents, and included language curbing executive pay and creating an oversight committee to review the Treasury Department’s actions. With no other alternative plan immediately in the works to halt the financial crisis, the rejection triggered a slide in financial stocks.

In the early hours of yesterday morning, as he was flying back from America, Gordon Brown walked to the rear of his Boeing 777 to address reporters in the cheap seats.

The global financial system was teetering on the brink, lawmakers in Washington were at loggerheads over what to do and the reporters, tired after a long trip, were getting stuck into the champagne. If ever there was the moment for an inspired bon mot, this was it.

Not for Brown. With typical leadenness, he reached for a statistic. “There is a 90%-95% correlation between economic indicators and what voters think of the government,” he told the assembled media, who promptly concentrated on their fizz.

In his own dour way, however, Brown had hit the nail on the head. The banking meltdown besetting the world was moving beyond Wall Street, the City and other financial centres. It was moving beyond consumers’ immediate fears over their high street accounts.

By fateful symmetry, the economic crisis was colliding with politics on a momentous scale. When the meltdown went critical last week, America was entering the final 40 days of the election to choose its next president. The wrangling over the biggest financial bail-out in history is now becoming a battle over power and the soul of US capitalism that has dominated the West in recent years.

Should ordinary taxpayers bail out the rich? Would delay hurt the poor even more? Is the bail-out really socialism by the back door? In the White House and on Washington’s Capitol Hill, Democrats, Republicans and presidential candidates argued while smoke rose from the burning banks.

One US economist said decisions taken now would “shape the type of capitalism we will live in for the next 50 years”.

The fallout also spells a changing political mood for Britain. Brown, addressing the United Nations in New York, had declared the need for a “new global order founded on transparency, not opacity” to control finance. “The age of irresponsibility must be ended,” he said.

He should know, the Tories were quick to retort. As David Cameron, the party’s leader, witheringly pointed out: “Yes, this prime minister has got experience: he has got the experience of building up the biggest budget deficit of any industrialised country; he has got the experience of designing the regulatory system that failed to prevent the first run on a bank in Britain in 150 years.

“He has got the experience of saying year after year, ‘I have ended boom and bust’. And yet now we face really difficult economic circumstances. I don’t think that is the experience we need right now.”

Members of the US Senate and House of Representatives argued into the small hours over ways to stave off collapse in the financial system and appease the anger of voters. A deal could be announced today.

In Britain the need for action was driven home as Bradford & Bingley came under pressure with its shares falling to an all-time low. The Treasury is expected to make an announcement today that it is nationalising the bank and holding a fire sale of its assets.

Will the US rescue so far proposed work? Does Britain need a similar bail-out? And how is the global political and economic landscape likely to change?

TO critics the original bail-out proposed by Hank Paulson, the US Treasury secretary, was the most barefaced money-grab since Goldfinger, the James Bond villain, tried to rob Fort Knox. In a plan that ran to only three pages, Paulson asked for the power to spend $700 billion (£380 billion) of taxpayers’ money buying up the dodgy assets that are dragging banks down.

The sum was almost as big as the entire economy of Australia and equivalent to $2,300 for every person in the United States. Yet there was no mention of help for homeowners nor room for outside scrutiny. His spending of the billions, Paulson proposed, could “not be reviewed by any court of law or any administrative agency”.

All that Congress and taxpayers got was a gun to their heads: agree the deal or financial collapse will be much worse for you, Paulson warned.

Although his motives may have been well intentioned, the plan was a serious political misjudgment. With an election looming, the Democrats were acutely sensitive to accusations that the poor were being asked to pay for the excesses of rich bankers on Wall Street. On the other hand, some Republicans were appalled that the American capitalist dream appeared to be morphing into a socialist nightmare.

One Wall Street trader, who made a small fortune betting on Goldman Sachs shares, paid for newspaper advertisements showing President George W Bush, Paulson and Ben Bernanke, chairman of the Federal Reserve, planting a flag, Iwo Jima-style, in the graveyard of capitalism. Nationalising banks and bad debt was tantamount to communism by the back door.

On the other hand, John Mikus, a homeowner from Houston, Texas, summed up the mood of many of his fellow citizens: “Low-interest loans to homeowners and small businesses, yes. Federal bail-outs of Wall Street banks and investment firms, no. Americans should not be burdened with mega-bail-outs of the rich and politically well connected.”

Bush tried to railroad the plan through by speaking in apocalyptic terms. “Our entire economy is in danger,” he told the nation in a televised address. “Major sectors of America’s financial system are at risk of shutting down . . . Without immediate action by Congress, America could slip into a financial panic.”

The public, however, balked at paying to rescue the bankers and financiers who had largely caused the shambles in the first place. Protesters railed against the Paulson plan outside the New York stock exchange. Thousands of other opponents bombarded Congress with e-mails. One Democratic congressman said calls from constituents were “running at 50% ‘no’ and 50% ‘hell, no’. Out of 100 calls you are lucky if one of them is positive”.

Demonstrations were organised in 41 states. In Denver, Regina Jackson made her point baldly. “I don’t want to bail out Wall Street millionaires,” she said. “I say let them go bankrupt.”

Part of the fury — and the financial meltdown — stems from the strain that households are under from rising debt and falling income. While incomes rose steadily during the 1980s and 1990s, they have fallen in real terms for lower earners since 2000.

To many Democrats it seemed as if Paulson, a former chief executive of Goldman Sachs, the Wall Street investment bank, was looking after his own. In 2006 he had made more than $18m in bonuses at Goldman and many millions more in the years before — during which time he had overseen trading in the sort of “toxic assets” that now threaten financial collapse.

Speaking last week to Time magazine, Paulson defended his plan: “The average American looks at this as being about Wall Street and they’re angry, and I’m angry too . . . but the average American doesn’t understand the implications this has for them: money needs to flow through the system.”

What the average American does understand, however, is that he or she has a vote — which is going to flow through the political system on November 4. Paulson had failed to appreciate that neither the presidential candidates nor the members of Congress — many of whom will defend their seats on the same day — could be seen to endorse a straight bail-out for Wall Street.

Barack Obama, the Democratic candidate, made it clear that he wanted a better deal for taxpayers: “It is wholly unreasonable to expect that American taxpayers would or should hand this administration or any administration a $700 billion blank cheque . . . If taxpayers are to be asked to underwrite hundreds of billions of dollars to solve this crisis, they must be treated like investors.”

John McCain, the Republican candidate, although more cautious, took a similar tack: “There must be a path for taxpayers to recover the money.”

The crisis was playing in Obama’s favour. In opinion polls 70% of voters thought he was more concerned with protecting the interests of ordinary people than of big corporations, while only 32% thought McCain was.

On Capitol Hill the Democrats waded into action. Chris Dodd, chairman of the Senate banking committee, proposed numerous changes to Paulson’s plan, including a new board to oversee the rescue programme; monthly reports to Congress; the ability of the government to take stakes in the companies it bails out; limits on executive pay; and a programme to manage and reduce the debts of homeowners in trouble.

Republicans were also angry. One inveighed that he and his colleagues “were being asked to choose between financial meltdown on the one hand and taxpayer bankruptcy and the road to socialism on the other” — and “to do it in 24 hours”.

AFTER Bush’s dramatic television appeal, the fate of the nation seemed to hang on a meeting at the White House on Thursday, where the president gathered senior lawmakers, including Obama and McCain.

The economy was on the edge of the Grand Canyon, but Bush was hopeful of lassoing it back. “My hope is we can reach an agreement very shortly,” he told the television cameras as the meeting began.

Once the media left the room, however, the fireworks began. It became clear that divisions ran very deep and an agreement was a long way off.

Democrats, led by Obama, clung to proposals for more help for ordinary citizens. John Boehner, the most senior Republican in the House of Representatives, opposed a massive state rescue. Sticking true to the principles of free enterprise, he wanted less government intervention.

One Republican proposal was for all banks to pay into an insurance scheme on which those in trouble could draw. What did the presidential candidates think? Obama asked questions but McCain sat largely quiet. Obama seized his opportunity. “What do you think of the plan, John?” he repeatedly asked. McCain did not answer. By one account, for 40 minutes of the meeting McCain said absolutely nothing.

As the meeting began to break up in disarray, Paulson collared Nancy Pelosi, the Democratic speaker of the House of Representatives, in a nearby room. He went down on bended knee, according to a source close to the talks, as he pleaded with her not to “blow up” his rescue plan.

“It’s not me blowing this up,” she said. “It’s the Republicans.”

Bush made an appeal in wry desperation, according to two of those present. “Can’t we all just go out and say things are okay?” he asked.

However, the president who has fought two wars seemed impotent. There was no bombing to be done — banks were doing enough of that by themselves. All he could do was warn: “If money isn’t loosened up, this sucker could go down.”

Not long afterwards the credit crunch toppled another giant. Washington Mutual, a bank once valued at more than $50 billion, was seized by authorities for fear that it was about to collapse. Sold for just $1.8 billion into the tender embrace of JPMorgan Chase, it was the biggest single bank failure in US history. Yet amid the political battle it was almost a sideshow.

While opponents of Obama pointed to his inexperience, McCain seemed unable to decide what to do. After his reticence at the White House, the next morning he relayed a message to Republicans on Capitol Hill. According to a senior Republican aide, McCain urged: “We need a deal, we need a deal, we need a deal.”

He put forward no plan of his own. He struggled even to decide whether to participate in the first presidential debate scheduled for that evening. Having earlier said that he would not, he decided to go ahead.

As McCain flew to Mississippi for the debate, his chief of staff, Mark Salter, revealed that McCain had made his decision only an hour before leaving Washington. Everything, including the economy, seemed to be on a knife edge.

CAN a deal be done and, if so, will it work? Last night lawmakers suggested that a deal, with the core of the Paulson proposal intact, would be announced this evening and passed by Congress tomorrow.

Earlier Bush had tried to assuage taxpayers’ fears, saying in a radio address: “The rescue effort is not aimed at Wall Street; it is aimed at your street.” He claimed the final cost would be far less than $700 billion because the government would recoup much of the money in years to come.

Plenty of doubts remain over whether the package will be enough. The losses piling up in the financial system are likely to be even more enormous than the $700 billion. According to Robert Schiller, an economist at Yale, the bursting of the “biggest property bubble in US history” has wiped out about $5 trillion in wealth.

“And the last time we looked house prices were still falling,” he said. “It throws off individual and corporate balance sheets. That has all kinds of effects on confidence and our sense of wellbeing.”

According to BusinessWeek, the US magazine, defaults are spreading from sub-prime mortgages to what are known as Alt-A loans, which were made to people with better credit ratings. Normally only 2%-3% of such loans run into trouble; now 15% are in difficulty.

Other experts savaged the Paulson plan for failing to address the issue of recapitalising the banking system. Paul Krugman, professor of economics at Princeton, suggested that a government buy-up of toxic assets might help, but it would not solve the lack of bank capital unless taxpayers hugely overpaid for the assets. Better to inject capital directly into failing banks and take a share of ownership, he said.

Nouriel Roubini, professor of economics at New York University, was even blunter about Paulson’s original proposal: “The Treasury plan is a disgrace: a bail-out of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the taxpayer.”

Even Professor Geoffrey Wood of the Cass Business School in London, who is no doomsayer like Roubini, believed the Paulson plan was flawed. “It seems to me the whole thing is too large,” he said. “Try something smaller to establish a price for this debt. Fine. But then a simple, efficient way to recapitalise the banks would be to force a debt-for-equity swap.”

Does Britain need a similar plan? It now seems likely that Bradford & Bingley, Britain’s eighth largest mortgage lender, will cease to exist as a high-street entitiy, and that its assets will be sold off to rivals.

Other lenders showed the strains they face by raising their mortgage rates. HSBC, Woolwich and First Direct all raised rates on some loans by 0.25%. One victim of the tightening credit conditions was Hardy Amies, tailor to the Queen, which fell into administration after struggling to raise new loans.

As in the United States, property prices in Britain are still falling. John Muellbauer, professor of economics at Nuffield college, Oxford, believes the housing collapse may be only halfway through and his research shows that the plunge in housebuilding dwarfs previous busts in the 1970s and 1980s. “The magnitude of effects — high debt levels, the credit crunch and falling real incomes — make a UK recession virtually certain,” he said.

The problems of UK banks are less severe than those in the United States, and our banks may benefit from the rescue deal being put together in Washington. British banks have £95 billion in bad assets that may qualify and Brown, having taken the country’s finances already deeply into the red, wants to avoid a widescale state bail-out.

Last week, however, Capital Economics, a leading consultancy, warned that “it would be unwise” to rule out the need for a bail-out in Britain as well.

AMID the American chaos, the cheese-eating schadenfreuders of Europe could not resist a bit of self-satisfaction. Global capitalism needed retooling, declared President Nicolas Sarkozy of France, who is considered too much of a fan of America by some of his countrymen. “Self-regulation is finished,” he said. “Laissez-faire is finished. The all-powerful market which is always right is finished.”

Peer Steinbr├╝ck, the German finance minister, told his parliament: “The US will lose its status as the superpower of the world financial system. The world will never be the same again.”

While their barbs may reflect long-standing rivalries between US and European economic models, even US experts recognise that the crisis will weaken America’s place in the world. Before the meltdown the United States already had by far the biggest debts to foreign lenders of any country and by far the biggest trade deficit as well. It owes $13 trillion and had a trade deficit of $712 billion in 2007. (China, by contrast, had a trade surplus of $360 billion.)

Uncle Sam needs $2 billion a day from foreign investors just to keep going. “For years to come, Wall Street and Washington will be unable to manage without strong co-operation from other markets,” observed Jeffrey Garten, professor of international trade and finance at Yale.

“Most governments and investors outside the US never shared the American system of cowboy capitalism. Now they have good reason to demand that fundamental changes be made in the way the US manages its financial institutions.”

In Asia, politicians and economists remember with bitter irony their own financial crisis of a decade ago: then the United States and other western powers imposed tough remedies based on market forces.

Changes in financial markets are already under way. Short-selling to drive down shares has been restricted. Last week Christopher Cox, chairman of the Securities & Exchange Commission (SEC), the US regulator, urged lawmakers to control the $62 billion market in insurance-based financial derivatives known as credit default swaps (CDS) “to enhance investor protection and ensure the operation of fair and orderly markets”.

The markets were wide open to abuse, he said, because “neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure”.

Other regulation is sure to come, according to Simon Taylor, a former banker who is now director of the master of finance programme at the Judge School of Business in Cambridge. “It is pretty much inconceivable that you can have such major intervention from governments with taxpayers’ money,” he said, “and not have some kind of response — at the very least a tightening up of regulation.”

The danger was that the pendulum might swing too far the other way, he said, suggesting there could be “a more generalised scepticism about markets, even in areas with nothing directly to do with finance.

“If unemployment keeps rising and ordinary families believe, probably rightly, that the financial crisis has made their positions worse, they will have good reasons to be angry. But politics or laws made in anger are generally not very good ones. ”

Matthew Elliott, head of the TaxPayers’ Alliance, expressed the resistance of many to a general bail-out when he said: “The government has a role in terms of protecting deposits in banks, but when it comes to bailing out shareholders the government should have no role at all.”

In the United States the backlash against unfettered capitalism is likely to benefit Obama. He emerged the winner, by a slim margin, from the first presidential debate with McCain. Some 40% of uncommitted voters thought he was the better performer, compared with 22% for McCain; 38% saw it as a draw.

In Britain the picture is more complicated. Labour is the party of regulation but it is also the government that has presided over the financial fiasco. By contrast, Cameron has tried to move the Tories away from being seen as the party of the fat cats.

Ahead lies a political as well as a financial battle. As Luigi Zingales, professor of entrepreneurship at the University of Chicago, put it: “Do we want to live in a system where profits are private but losses are socialised? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions?

“For somebody like me who believes strongly in the free market system, the most serious risk is that the interests of a few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.”

What you could do with $700 billion instead

Return $5,072 to each of America’s 138m taxpayers

Set up the 17th largest economy in the world, with a gross domestic product roughly equal to Turkey’s, or about twice that of Saudi Arabia, Greece and Austria

Pay for about 10 years of British defence spending

Run the US Treasury and departments of defence, education, state, veterans affairs and interior for a year - and have enough left over to fund Nasa’s space programme

Buy gold and foreign currency worth more than 12 times Britain’s reserves

Fill America’s cars with free petrol for about a year and a half

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