The Hindu Business Line : Bank crisis: Core issues

The US Congress rejected the Treasury Secretary, Mr Henry Paulson’s $700-billion proposal to buy distressed mortgage and other loans from banks, heeding the sentiments of the average American who strongly felt banks should not be bailed out with public money.

But Mr Paulson is not admitting defeat. He will try to get the package passed soon in some form or the other; so certain is he that the current crisis, if it continues, is curtains for the US and global economies and financial markets. He has the support of the Fed Chairman, Mr Ben Bernanke, in his endeavours. And Congress may yet come round, the obligatory noises about the unfairness and burden to taxpayers having already been made.

Critical question

The critical question clearly is whether we are at the beginning of the end or the end of the beginning. Those who were loud in proclaiming that it had more or less played out (including Mr Paulson, if one’s memory is right) are silent now. The truth is no one knows the final bill. It could easily be double Mr Paulson’s present estimate.

Is the asset portfolio of global banks such a can of worms? The size of the bail-out and its urgency suggest that is more fact than fiction.

Removing illiquid assets off banks’ balance sheets (at a ‘mark-to-Paulson’ price as a wag has it) is going to be but a first step in a long drawn-out journey. Banks need capital and in the present state of equity markets, they will hardly attract investors, except on the stiffest terms. (Witness the hard bargain Mr Warren Buffet drove with Goldman Sachs, which has emerged largely unscathed in the turmoil).

Real problem

But that is running ahead of the story. Mr Paulson’s and Mr Bernanke’s real problem is that they must get the inter-bank and credit markets moving again. The world’s central banks are more than willing to provide more than needed liquidity against dodgy collateral (if Treasury is willing to buy it, the Fed should be willing to lend against it); but spreads have only gotten worse – overnight money rates are hundreds of basis points over central banks’ benchmarks and yields on government paper of equivalent maturities. It makes nonsense of the Fed’s rate easing from 5.25 per cent to just 2 per cent. In fact, the market’s already discounting lower rates, but will that be of any use?

If banks are unwilling to do business with one another, what hope for others to borrow from banks? Will buy-outs, write-offs and capital infusions unlock the impasse?

That is the ultimate question.