Earlier, we talked about Government’s efforts to get out of the turmoil. Let’s »»]]>  

Earlier, we talked about Government’s efforts to get out of the turmoil. Let’s now take a moment to briefly discuss the package offered by the Government to bailout AIG.

Government bailing out AIG

·  Fed announced on Tuesday, September 16, 2008 that it was bailing out AIG with $85 billion to cover its liquidity needs.

It was a good gesture on part of the government to restore sharp fall in stock markets. However, stock markets reacted adversely to the news and plunged.

Many started wondering if Government should have bailed out AIG. Government spent taxpayers’ money which could possibly lead to higher deficit. Moreover, government did not bailout Lehman Brothers but helped AIG. Why? The controversy remains and will be a hot topic for discussion for days to come.

One of the main reasons for helping AIG is its extensive business ties with almost every financial institution worldwide. The rumor that AIG will file for bankruptcy was already creating tremor in stock markets all over the world. If government would not have rescued AIG, then the investors who have insured their securities with AIG would have been in deep trouble. The government wanted to help the insurance giant to have enough liquidity to cover its obligations.

The main criticism the government faces now is that if this does not work out in the long run, there will be more government debt, as tax payers’ money are already spent on AIG. The short- term reaction was even worse. Stock markets all over the world fell dramatically after the announcement.

Why did stock markets fall further even when government announced helping AIG?

Government bailing out AIG confirmed that the rumors about the insurance giant were indeed true. First the investment banks (Lehman Brothers, Merrill Lynch) and then the insurance company, which had been assuring a healthy life, was out in trouble. Investors started wondering which other companies are in similar situations. It is not only in the financial sector but probably many other sectors are in deep trouble. The sheer panic that more institutions will come forward with thier woes in days to come made investors shuffle their money from stocks to buying hard assets, like gold.  How long will this downward spiral continue is difficult to ascertain and totally depends on how fast investors gain back confidence*.

It is sometimes necessary to help your rival

As we speak, more institutions are coming forward with their troubles. Other institutions, whose financial conditions look stable are trying to help them out. Every financial institution understands that there days are numbered if the troubled ones do not survive. So, in coming days, new negotiations and deals will unfold.  Some of the deals now on floor are as follows:

· Lehman Brothers (North American investment banking and capital market business) being bought by Barclays

· Merrill Lynch was bought by Bank of America

· HBOS Plc. being bought by Lloyds TSB Group Plc.

More negotiations likely for:

· Washington Mutual (likely to be auctioned off)

· Morgan Stanley

·  Goldman Sachs

* Update: As we were finishing up this part of the write-up, more news were unveiling. Among them, the most striking one is that Dow Jones industrial was up 400 points on Thursday (September 18, 2008) afternoon owing to a possibility that the federal government might create an entity to absorb banks’ bad debt. This news reverted investors’ confidence.  However, this positive turn in stock markets should not be taken for granted. Market is still extremely volatile.

Continuing from our earlier post on the same topic (Fall of the Lehman »»]]>  

Continuing from our earlier post on the same topic (Fall of the Lehman – narrating in the Econ101 way: part 1), we now move on to discuss government (U.S.) rescue measures that followed after the news of the weekend made stock markets plunge on Monday.

Government rescue packages:

· The Federal Reserve (or the Fed) pumped in $70 billion in reserves to the banking system on Monday, September 15, 2008.

· The Fed did not lower the federal funds rate on Tuesday, September 16, 2008.

· The government announced $85 billion taxpayers’ money to the American International Group, Inc (AIG) as a two-year secured revolving credit to ensure the company can meet its liquidity needs.

Why does the economy need more money?

As the news about Lehman Brothers surfaced, banks panicked that they will not have enough funds to give out loans (popularly known as the “credit crunch”). Usually, in order to get adequate funds quickly, they borrow from other banks. However, as banks scurried for limited amount available for borrowing, they in turn, bid up the price for borrowing (interest rate).

As a response to increasing interest rate for inter-bank loans (federal funds rate), Fed increased supply of reserves to cover for the immediate credit (money) needs for banks. The objective was to lower the interest rate. Now let’s review the consequences of lowering the interest rate this way.

Theoretically, if interest rate falls, banks have more money to loan out, and since interest rates are lower, people will ask for more loans. Basically this will increase investment in the economy. If investment increases, demand for goods and services will go up and in order to meet up with higher demands, more goods and services will be produced. Hence, more workers will be hired to produce the extra amount. So, does it ring a bell? Yes, that implies an economy with less job cuts. Good News!

However, there is a problem. Higher demand for goods can lead to inflation (rising prices of goods and services). American people are still reeling from the economic hardship faced due to increase in gas prices. They are spending more on food and other necessities now than they were doing a year back. So, this increase in demand for goods can put further pressure on their pockets. However, in August, as the gas price eased a bit, it brought down inflation. So, it looked perfect! But was this enough?

Reaction of the economy to increased money supply and speculation about further federal funds rate cut

According to Bloomberg and ICAP Plc., federal funds traded at over 4 percentage points above the set federal funds rate on September 12. After the injection of reserves by Fed, the rate dropped to as low as 0.5 percent. Well, this was not enough to bring back the economy on its feet.

On September 16, when the Fed met for deciding whether they should further lower federal funds rate, speculations were high that Fed will lower rate by at least 25 to 50 basis points. However, the Fed decided to leave the funds rate as it is. The main concern was that further lowering the rate can lead to inflation.