Highlights

• On September 29, the House rejected the controversial $700 billion bailout plan. The plan mainly aimed at buying troubled mortgage backed securities from financial institutions to give them enough stability so that they can ease off credit crunch and start lending. 
• Since September 30, the government was trying to pass a modified bailout plan which includes the original $700 billion plan,  a tax cut package (originally rejected by the House) which eliminates certain business and energy-related taxes and the alternative minimum tax and also increasing the federal deposit insurance limits to $250,000 from $100,000.
• The Senate passed the modified bill on October 1, 2008.
• The House passed the modified version of the bill on October 3, 2008 and was signed by the President.

There were mixed reactions among people from different arenas of the society. Some of them favored the original proposal, others differed. 

Is it wise for the Government to buy the troubled mortgage backed securities from financial institutions?

American financial market always advocated free market philosophy. Many financial institutions had been earning enormous profits so far, knowing well they should also be prepared to incur losses. If they can get involved in risky business and earn millions, they should be able to bear the loss too. That is how the market should work. So, from the standpoint of helping the financial institutions not to face the consequences of their actions does not make sense.

However, the Government’s stand on the issue had been to ease credit crunch through bailout. The logic being that if troubled securities are backed by Government, then financial institutions will be more  certain about their future and start loaning out rather than hoarding money as most of them are doing now. However, there is no certainty that this logic will work.

First, as many economists point out, the sellers (the financial institutions), have more information about the securities they are selling to the Government.  Financial institutions may try to profit out of the deal by selling really rotten securities to the Government. Hence, Government are putting taxpayers’ money at a higher risk.

Second, no one has any idea that $700 billion is enough to clear up the troubled financial institutions.

Third, and more importantly, it is not obvious that saving these institutions will solve the problem. Yes, these steps will bring back investor confidence and stock markets will stabilize in the short term. However, if any other ailing big financial institution comes forward with their woes in future, the government’s assurance that the bailout has solved the problem will fall apart. The loss in investor confidence at that time will be difficult to regain.  Besides, who knows whether the financial institutions will actually start loaning out as much as needed or not? Hence, there is no guarantee that the credit crunch problem will be solved.

Increasing the FDIC limits to $250,000 from $100,000

Now let’s discuss the possible effects of increasing FDIC limits from $100,000 to $250,000. This is by far the best provision in the bill. Increasing limits will bring back consumer confidence and specially that for small business owners. Small business owners will have greater assurance about their money being safe.  According to the U.S. Department of State (http://usinfo.state.gov/products/pubs/oecon/chap4.htm), about 19.6 million Americans work in firms employing fewer than 20 workers. The small business enterprises employing less than 500 workers constitute about 52 percent of all workforce in America.  So, it is necessary to ensure healthy functioning of small business enterprises. The increased limit of FDIC will lower the chances that of bankruptcy for these firms due to reasons related to the financial turmoil. It is very important to bring back confidence of consumers and small investors for well functioning of the economy.

Wrapping Up

Any policy should be directed towards attacking the problem of credit crunch directly and not cleansing bad deals of the financial institutions. Increasing the FDIC limits and provisions for the federal agencies to work with the loan servicers to modify mortgages are good gestures towards dealing with the problem. However, since the financial institutions got off the hook easily, it is likely that this type of behavior will be repeated again. 

Yes, everyone is worried about their future. The money they are losing in the stock market, the worry they will be laid off, their delayed retirement, dwindling education fund and so on. To ensure the economy does not face a similar fate like the Great Depression, it is extremely important to bring back investors and also consumer confidence. It is necessary to understand that consumers should maintain their spending even when they are uncertain about their future. If they do not spend enough, retail sales would fall, and as we discussed in one of our earlier posts, this would lead to more job cuts. So, it is advisable to lead the life as normal as possible.

Summary of provisions in the bailout plan are available at http://money.cnn.com/2008/10/03/news/economy/house_bill_summary/index.htm?postversion=2008100316