September 25, 2008

Uncle Sam Doing the Right Thing

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If you have watched television, read a newspaper or applied for a finance job, you know that the world is about to end. The cover of the Wall Street Journal might as well have read “Apocalypse Near.” Well, the situation is not all that dire (unless, of course, you had a job offer from Lehman Brothers), but certainly something needs to be done. While it may be too late, the administration’s recent plan to purchase mortgage-related securities is a necessary step in calming financial markets.

The shock of news that American financial staples such as Lehman Brothers, Merrill Lynch and AIG will no longer exist in the same capacity that they have for years is certainly worthy of the headlines. However, the problems go much deeper. For example, the U.S. is home to thousands of small companies, public and private, who’s business model entails borrowing capital on a constant basis in order to fund operations. As a result of the credit freeze and the recent turmoil in financial markets, these companies can no longer afford to borrow funds. Libor – a benchmark rate at which banks can borrow funds and is calculated daily – had a tremendous jump. On September 16, overnight Libor rates jumped to 6.4375% from 3.10625% just a day earlier.

The problems do not end there. In addition to all of the small business owners who can no longer afford to operate their companies, mutual funds of all types have been hammered by this current market. Funds that invest in money markets and auction rate securities, which were once thought to be extremely safe and liquid, are facing severe problems.

What can be done? The administration, as a policy-making entity, has two clear options. Either the markets can continue to operate freely with limited intervention from the government, or a significant intervention by the federal government needs to occur. All or nothing. Just a day or two ago, Treasury and the Fed announced a plan to restore order to the financial markets. While still unclear and vague, the main component of the plan would entail the purchasing of mortgage-related securities by the federal government, and have control over a portfolio of these securities.

Many free market enthusiasts believe that this solution disobeys free market principles and ignores the notion of the invisible hand. Some Democrats believe that financial institutions dropped the ball, and the wealthy greedy financiers on Wall Street should live with the pain. While both of these claims have some merit, in the realm of policy making one cannot work with ideology. The problem in the financial markets still stems from mortgage-related securities that are worth just pennies on the dollar and depressed home prices. At the crux of the matter is a cost-benefit analysis. Do the potential costs of using taxpayer dollars to purchase mortgage-related securities outweigh the benefits of easing credit markets and encouraging a freer flow of capital?

The current state of the markets and market psychology suggest that the benefits are in fact greater than the costs. The idea behind the government’s plan is that by removing these toxic assets from companies’ balance sheets, credit markets will return to normal because investors and lenders will no longer be fearful that a company will have to take a write-down or default on its obligations. In turn, the government hopes to hold these securities long enough so that their value will increase and any losses can be recouped. If, however, this plan is not put into action, the headlines that surprised and shocked many may become commonplace.

Certainly not all aspects of the government’s plan are encouraging, such as the temporary ban on short selling. However, the costs of doing nothing are too high. Stopgaps will not calm the financial system. Some may argue that not only is the government plan unnecessary, but that the supposed turmoil is being blown out of proportion. The high level of fear that investors and television “experts” manifest, some would say, is not entirely founded. Yet, psychology and behavior are integral components of the financial system that can have the same, if not worse, impact as poor fundamentals. However, if the government is able to calm fears, no matter how irrational, it may be able to prevent further deterioration of the financial markets.