Saturday, October 4, 2008

Should US & UK Government Intervene In The Mortgage Crisis?


(1) Strategic industries argument. Banking, finance, insurance & investment are backbone to both UK & US economy. It is also the home to tenths of thousands of employees. If there is no contingency plan such as nationalisation, strategic mergers & acquisitions or capital-pumping to increase liquidity, these banks & institutions will be dragged onto their knees. As a result there will be mass scale of structural unemployment once all of them go bankrupt

(2) To prevent another depression. If banks & financial institutions are left bankrupt, it will trigger another round of credit shortage as not many banks are left standing. The liquidity bottleneck, will force remaining banks to increase the cost of mortgage products by the way of higher interest rates. Of course one can also argue that this is to increase its profitability & covering up the bad debts that have been written off previously.

As interest rates increase, consumption will fall, investment will fall, output will fall & unemployment will rise. If all these happen simultaneously, it will exacerbate recession then depression. Furthermore, banks are now more stringent in their lending. Numbers of loans approved dropped significantly. This causes further fall in house prices due to fall in demand for houses. Again this carries negative wealth effect

(3) Restore confidence in financial system. If banks like Halifax risked bankrupt, savers would rush to get their money out, just like Northern Rock last year. Somehow, it will not be able to meet savers demand in such a short notice as most of the deposits will be lent out in the form of mortgages & loans. The widespread news of people being unable to withdraw money will spread across economy & causes panic. Soon people will want to withdraw their money even from those banks that have healthy balance sheet. The repercussion will be the collapse of financial system. Therefore bail out is important as it restores confidence

Should not

(1) Moral hazard. Recall about moral hazard in my previous postings? It means with insurance, often it can change the behaviour of one or more party & often for the worse. We can’t rule out the possibility of another risky engagement in future e.g. reckless lending since these banks know that the government is always there to bail them out

(2) Prevail of free market system. Some economists argued that inefficient firms, in this case the banks should be left to perish. The working of free-market force is the best way to distinguish those incompetent firms from the competent ones. However one can also argue that financial institutions are unique in the way that they are heavily interdependent e.g. through interbank lending. As such, a collapse of one institutions will negatively affect the others

(3) Worthless assets. The US government is spending massively buying over worthless assets e.g. credit default swaps that is high above market prices. Furthermore nothing is being addressed about home repossessions, falling house prices, worsening national debt that is standing at $9.7 trillion currently etc. Some economists argue that the government should take the bottom-up approach & that is solving the fundamental problems in economy e.g. measures to ease burden of public

(4) Burden to taxpayers. At the moment, US national debt is about 65% of its GDP. Somehow it is estimated that this figure will mount up to 85% in nearest time, given the huge government expenditure of $700 billion to bail out those inefficient banks & the committed $85 billion to the insurance giant, AIG. Of course, we must also take into consideration the decision to possess worthless assets owned by Freddie Mac & Fannie Mae, through the nationalisation deal. To finance such large expenditure, is non other than through the taxpayers’ wallet

Interesting facts:
How large is US$ 700 billion bailout in terms of a country's GDP?

(a) 103.86 times Namibia's GDP
(b) 35.88 times Iceland's GDP
(c) 5.41 times New Zealand's GDP
(d) 4.34 times Singapore's GDP
(e) 3.39 times Hong Kong's GDP
(f) 2.85 times Thailand's GDP
(g) 0.60 times India's GDP
(h) 0.21 times China's GDP
(i) 0.16 times Japan's GDP
(j) 0.05 times US' GDP (can you imagine size of US economy!)

Source of data: The EDGE, October 6, 2008

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