Page last updated at 17:03 GMT, Friday, 19 September 2008 18:03 UK

Will the bail-out work?

By Steve Schifferes
Economics reporter, BBC News, New York

President Bush on ''a pivotal moment'' in the US economy

The enormity of the financial crisis now engulfing Wall Street has led the Bush administration to abandon its free-market principles and announce a $700bn (382bn) bail-out package to buy up distressed financial assets.

At the same time, to stem growing panic among individual investors, the Treasury also plans to offer guarantees for the $3.2 trillion in money market mutual funds, which many people had treated as cash.

The rescue plan may still face significant political and financial obstacles.

With Congress set to adjourn next week for the election season, time is short to work out the details of the plan and get it passed.

Congressional leaders, including many key Democrats, had already been considering such a rescue plan, and they indicated quick acceptance of the proposals.

On the sidelines, however, there is deep scepticism on both left and right - with conservative Republicans objecting to any more bail-outs, and many Democrats asking why we should help Wall Street rather than the four million people whose homes are being foreclosed, or repossessed.

And the presidential candidates, who are being left on the sidelines in the negotiations, are also reluctant participants in the process.

Both realise that a sizeable bail-out that commits the Federal government to significant new spending will severely limit their plans - either to cut taxes or to introduce a new health care plan - in the year after the election.

One model being talked about is the Reconstruction Finance Corporation introduced in the 1930s during the Depression. But it should be remembered that in 1933, President-elect Franklin Roosevelt refused to agree a bi-partisan deal with President Hoover to stave off the collapse of the entire US banking system, which shut down completely on the eve of his inauguration.

Who gains and who loses

Among the difficult questions about the rescue plan is how much it will cost the taxpayers, the banks, and the distressed homeowners.

NYSE traders
Confidence is fragile on Wall Street

Part of the answer is what price the US government pays for the distressed debt.

If it buys at book value, the banks will have gained and the taxpayer will have taken over the liability.

If, on the other hand, the government buys up the debt at distressed values, the government stands to gain if eventually some of the mortgage debt recovers its value.

And it is not clear how much leverage the US government will get over the banks in return for its investment.

In the 1980s Resolution Trust Company rescue, the government had the power to take over any distressed Savings and Loan bank and close it or sell its assets as necessary. This eventually meant that about half of the $400bn rescue package was recovered - but most of the banks closed for good.

It is also unclear how much specific benefits distressed homeowners will get.

The cost to the government could grow if tries to hold off repossessions on the 10% of all US home-owners with mortgages - but getting too tough to make sure everyone pays up could risk making the housing crisis worse.

The government already has a plan to grant $300bn in extra mortgage help for households facing foreclosure, but the evidence so far is that the plan (which is scheduled to start on 1 October) was looking still-born, as private sector mortgage holders were resisting taking the 10% loss the government was insisting on.

Long term economic damage

The government hopes that its big new package will restore confidence in the markets and encourage banks to start lending again to individuals and businesses.

Bank owned house
Real estate market risk is shifting from the banks to the tax payer

Certainly, the prospect of the credit markets seizing up further could have sent the US economy into a tail-spin.

But it is still not clear that the package will be big enough, or implemented quickly enough, to reassure private and commercial investors who are now very worried by the uncertainty over the future of the financial sector.

Tightening of credit for both wholesale and retail borrowers is likely to continue, as markets adjust to the higher risks they perceive.

And while the move might provide temporary relief to the US economy, they also pose some long-term challenges.

The increased borrowing by the government will have to be paid for - and with the growing reluctance of foreigners to hold US debt, it will ultimately mean higher savings, and less spending, for the US economy.

The cost of the rescue could also eventually push up the cost of borrowing as the Federal deficit grows, and thus weaken the long-term prospects for the economy.

And the higher debt could also eventually weaken the dollar, forcing the Fed to intervene to raise rates to prevent a sharp fall.

Although these are big risks, the shattering of confidence is the biggest problem.

And if these measures fail, it will fall to the next president to craft a package to rescue the economy.


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