September 29, 2008
Should a government bail out a sick bank, insurance company, hedge fund or investment company?
This is a tricky question to both ask and answer.
As I write, the Dow has just closed down by over 770 points on news that the US$700 billion bail out package has not approved. This appears to be a disaster to markets, but it is it?
Will helping stricken banks out really improve the situation?
Confidence is, it appears, the real problem. Or more accurately, the lack of confidence is the problem. But will confidence be restored with all that money?
Alas, the answer is almost certainly no. The major US investment banks do not use a clearing house to process trades. This means that they deal directly with each other. More than anything, this is to control their little slice of the market and keep third parties out. No third parties means more profits – or at least fewer costs.
Other types of markets, commodities for example, use a clearing house system which is why this credit crunch problem has not appeared on the trading floors in Chicago. In Europe, these markets use LCH (London Clearing House) and – if I recall correctly – Clearstream.
Of course there are other issues. By spending $700 billion, the taxpayer picks up the bill. This bill could do incredible damage to the strength of the US dollar and therefore the economy as a whole. That is the world economy, by the way.
The problem is that by not helping out these banks and insurance firms, the entire financial system of the world hangs in the balance. The world economy is now so interconnected that big problems in one area will quickly spread elsewhere. If AIG were to fall, the world would essentially be uninsured – and the derivatives market would almost certainly be dragged under. This would take other banks, investment funds, insurance companies and more under as well.
In other words, the potential downside is too terrible to contemplate. So we need a bail out.
Isn’t it ironic? The US needs to spend $700 bn to not solve a problem. How did we get here?
It is hard to imagine that an incredible number of fraud charges won’t come from this in the coming years.
Cross your fingers. Hope for the best. Pray.financialguy