Why the US Government’s $US700 million rescue package might not work at all: Kohler

The US Treasury Secretary Hank Paulson’s $US700 billion mortgage bale-out, announced last week, sounds okay until you think about it.

The US Treasury Secretary Hank Paulson’s $US700 billion mortgage bale-out, announced last week, sounds okay until you think about it.

It’s supposed to be a modern version of the Resolution Trust Co (RTC), which was set up by the US Government in 1989 to hold the assets of failed savings and loan institutions. This worked nicely and the RTC ended up with $US394 billion worth of assets that were transferred to the Federal Deposit Insurance Corp in 1995.

But things are different now. There are three reasons why the Paulson plan may not work as smoothly, and in fact may not work at all:

1. The 1989 S&L plan was all about home mortgages. Although the 2007-8 credit crunch began with the bursting of the housing bubble and the collapse of mortgage backed securities (MBS), there are a lot more distressed assets on the balance sheets of high-geared firms now than MBS. Just ask Glen Rufrano at shopping centre owner Centro Properties. The Paulson plan requests Congress to authorise the purchase of other assets as well, but is the US Treasury really going to be allowed to become Steptoe & Son – a yard for the collection of all types of junk?

2. The Treasury plan will only recapitalise insolvent firms if it overpays for the assets it buys. The whole problem at present is that mark-to-market accounting rules and an uncontrolled process of deleveraging are wiping out large amounts of equity. Banks, investment banks and other intermediaries are being forced to recapitalise or go into insolvency administration and, as a result, a credit squeeze has developed. If the US Treasury pays market value for the assets of these firms, it will make no difference to their equity or their ability to lend.

3. The US budget is in deficit so the plan will involve the issuing of $US700 billion in extra treasury bonds to finance it. The bond market and the US dollar are already fragile. The 10 year US bond rate has gone above 4% after the plan was announced and is likely to keeping rising (that is, bond prices will fall) as global wealth funds react to the prospect of a bond overhang and the likelihood of a lower currency by selling. That is likely to put a lot more pressure on the US dollar and the bond rate. And as the risk-free rate rises, so will property valuations fall.

None of this is theoretical; the more the US treasury successfully recapitalises insolvent lenders by buying their junk assets above market, then the more the bond rate will rise and the US dollar will fall, putting further pressure on US asset valuations.

This article first appeared on Business Spectator

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