Friday, October 3, 2008

Why Pump Money Into A Failed System?

Readers Question: If the banking system is collapsing, why pump money into failed money markets?
  • The banking system has not completely failed. Many mortgage loans are not completely worthless, as is often stated. Even if general mortgage defaults reached say 10% ( a high figure), 90% would be paying back their mortgage with interest.
  • The problem is one of confidence. Even though some mortgage loans are sound and will be paid back, banks still don't want to (or can't) buy these mortgage backed securities.
  • Therefore, banks don't want to lend anyone else money because they are already overstretched and need to attract savings not take on more debt. You could argue the current market price of mortgage debts undervalues their true value.
  • Therefore, the government could be buying them at a discount on their expected return. There is even a chance the government could profit from buying mortgage securities, when people later repay in full.
  • It is hoped that injecting liquidity into the market will loosen the fear over lending and help banking system go back to normal operating.
  • If banks are allowed to go bankrupt it affects the wider economy. Consumer spending will fall, investment will fall, output will fall and unemployment will rise.
Banks may not deserve to be bailed out. (why bailout banks) But, if we don't prevent them going bankrupt, we will face a bigger economic costs in terms of a deeper recession and higher unemployment.

Rescuing banks is also a chance to introduce tighter legislation so that the banking system don't make the same mistakes again.

This is the argument for a bailout. However, of course, there are many criticisms, such as
  • moral hazard
  • Mortgage defaults could get worse as the economy enters recession.
  • Banks may try to get rid of their worst performing bonds and loans. The government will be left with the worst.
  • $700bn may not be enough to get deal with the 'bad debts in the system.

No comments: