TheLoop21.com

By: Darrell WIlliams (Add to your loop)
Mon, 10/06/2008 - 09:46

Is the newly-approved bailout going to be our savior?

There are two sides to the financial crises in America.  The financial bailout plan which became law on Friday addresses only one of them.

The Mortgage Crisis

At the heart of the U.S. financial woes is the mortgage crisis.   Over two million homes will be foreclosed upon this year.   Another 10 million homes are now "upside down"—that is, they owe more on their home than it is currently worth—putting them at risk of foreclosure.  The $700 billion bail out plan does little to fix this problem.

The Credit Crisis
 
There is also a liquidity (or credit) crisis that has seized up the flow of credit.  This is in part a crisis of confidence.  Healthy banks that possess excess cash reserves are unwilling to lend to banks with fewer cash reserves for fear the borrowing bank will be the next bank failure.  (Loans between banks are not backed by the government.) 

Investors other than banks are also unwilling to loan money to banks for the same reason.  There is so much uncertainty about the value and the extent of so-called "toxic debts" held by banks that potential lenders would rather wait until the dust settles rather than take the risk of extending credit to a bank that ends up as tomorrow's headline.

We are being told that the restricted flow of credit could eventually severely limit funds available to businesses and consumers.  If this occurs, the "crisis of confidence" in the banking industry could ripple through the economy, morphing from a financial crisis to an obstacle to the day-to-day operations of small and medium-sized businesses needing financing to buy inventories or pay employees.  Despite individual examples trotted out by lawmakers wanting to justify their votes for the bailout, this has not happened yet on a large scale.

The Bailout Plan

The bailout plan is intended to fix the liquidity crisis by relieving banks of the "toxic debt."  With the bad debt gone, cash-rich banks can return to lending to other banks without the concern that they may be teetering on the verge of failure. 

It also increases the limit on deposit insurance from $100,000 to $250,000 which will make it less likely that bank deposits—another source of funds to banks—will be withdrawn due to fear of losses.  The renewed confidence should open up the flow of credit between banks which in turn ensures that businesses and consumers can get loans when needed.  Whether or not this will work time will tell.

The Problem on Main Street

But even if the bailout plan restores confidence in the banking system and resolves the liquidity crisis, the mortgage crisis remains, which is arguably the bigger problem.  Foreclosed homes are sold at fire sale prices which depresses all home prices, even the ones not in default.  In turn, falling home prices make it more likely that additional foreclosures will occur.  The vicious cycle of falling home prices leading to home foreclosures leading to further decreases in home prices is likely to cause home prices to continue to fall well into 2009 and possibly into early 2010.