The Grad Voice

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Financial news has suffered from the uncertainty of the global markets in recent months. The world markets now fear a global recession, due to falling stock prices, home prices and political unrest. Why did this crisis take place in the first place? In the United States, negligent lending by major firms such as Lehman Brothers, the 150-year old investment bank, helped to facilitate the subprime mortgage market's failure. However, many American people are also to blame; because they had easy availability to credit, they irresponsibly spent more than they could afford. Home owners were greedy and leveraged themselves to buy more expensive houses, including investment properties that were not primary residences. When the housing bubble burst, many people foreclosed on their homes which caused banks to write off large amounts of debt, leading to the demise of the investment bank. The end of investment banking came and went, with the transformation of Goldman Sachs and Morgan Stanley into bank holding companies.

As the effects failing US markets began to ripple through the global economy, the blue chip Dow Jones Industrial Average fell by more than 40%, while the NASDAQ composite fell by 44% and the S&P 500 fell by 43%. However, US markets were not the only ones to fall. The typical globally-traded hedge fund has fallen by almost 20% so far this year, according to Hedge Fund Research, an analysis firm.

Now the governments of countries with stock exchanges (such as those in the European Union) have begun to pump money into their respective major banks. In the US, it has come in the form of a $700 billion bailout that the government will use to inject life into a floundering economy. This fund will not resolve the American or global financial crisis, but is sure to slow it down.

How will $700 billion help the American economy, especially the mortgage market, and why $700 billion?

It is estimated that the United States' mortgage market is valued at $10 trillion USD. A 7% devaluation in this market accounts to $700 billion. However, US housing markets may fall further in value, which is why analysts are saying that the bailout may not be able to stop the downturn because markets may be entering a global recession.

How will the bailout be used and divided among the economy?

In basic economics, it is known that when credit markets are in a downturn, banks stop lending money to other banks, institutions, and individuals. This current credit freeze has affected the working capital of institutions and individuals, causing less spending and a freeze in growth. This bailout provides money to the banks, which will then begin to lend to businesses, which produce goods and services and pay individual salaries, in turn helping the economy to grow. Under normal circumstances, the banks keep 10% in reserve and loan the remaining 90%. Due to the multiplier effect, this input has a 10x effect on the economy.

What do analysts believe the bailout will accomplish?

Different people have vastly different views on this bailout. I do have a few concerns myself. Banks are finding it extremely hard to raise money. Just recently, Goldman Sachs, the most successful investment bank had to raise ten billion dollars but at huge costs. Goldman sold $5 billion of perpetual preferred stock to Berkshire Hathaway, Inc. in a private offering. The preferred stock has a dividend of ten percent and is callable at any time at a ten percent premium. In conjunction with this offering, Berkshire Hathaway will also receive warrants to purchase $5 billion of common stock with a strike price of $115 per share, which are exercisable at any time for a five year term. In short, Goldman Sachs is ready to sell warrants and pay ten percent rate for cash. GS also raised five billion dollars in an IPO (initial public offering).

Why will these banks use this money for their normal financing activities? If they issue loans as expected in regular markets, they may be just digging a deeper grave for themselves. My view is that they will stick on to this easily available money till this crisis is over. The government is using tax-dollars to bail us out of this crisis. In this first phase, the government has invested $250 billion out of the $700 billion in the largest banks. The sooner that this money enters into circulation, the faster it will be multiplied and the better the bailout will be for the economy.

However, banks are not obligated to put the money into circulation, and may choose to hold most of these funds within their companies. The middle class lacks confidence in the job market and in 401(k)s and other investments, which causes overall reluctance about spending money.

Where are we going?

If the current crisis doesn't improve because the bailout does not "trickle down," we could be facing tougher times ahead. With the most lucrative time of the year for the retail industry (the holiday season) ahead of us, the fact that people have been spending less may be critical to the economy. As a result, layoffs may occur in the retail sector, adding fuel to the financial crisis. Easy access to liquidity was the underlining cause of this crisis. If the bailout plan works, liquidity will be readily available to everyone. This could bring the world economy back into an endless cycle, beginning at the start of the crisis. The bailout may help the economy in the short run, but we need a long term strategy fix this issue permanently.

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