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What $700B won't buy: a quick fix for the economy

(Agencies)
Updated: 2008-09-28 11:11

SAN FRANCISCO - Not even $700 billion will be enough to spare the United States from more economic anguish if the government's proposed banking bailout pans out like similar desperation moves during the past two decades.

It usually takes years to recover from a financial crisis severe enough for politicians to ride to the rescue with truckloads of taxpayer money.

Take, for example, the US government's August 1989 bailout of the savings-and-loan industry. The stock market fell by 12 percent within the first 14 months of the rescue plan while the economy slipped into an eight-month recession that began in July 1990. Housing prices that had just begun to erode continued to fall for another three years.

There's little reason to believe it will be dramatically different this time around, particularly since this bailout involves harder-to-value assets and comes with the US economy already on the edge of a recession, if one hasn't begun already.

"This is going to take years to work out and it will be incredibly complicated," predicted banking consultant Bert Ely, who has extensively studied the US government's 1989 bailout.

Although lawmakers are still sparring over the precise details, the proposed bailout would authorize the government to borrow up to $700 billion to buy the toxic assets poisoning banks. Most of these holdings are tied to mortgages made to borrowers who either can't afford to make their monthly payments or have simply chosen to default because they owe far more than their homes are worth. No one seems quite certain how much these assets are worth, but the government is betting that -- with time -- it can get a handle on it and eventually profit.

Even as the government tries to clean up the mess left by reckless home lenders, borrowers and investors, more problems are likely to stack up.

The trouble could include longer unemployment lines as struggling companies faced with declining sales and limited access to credit trim their payrolls. That could lead to even more bank failures as cash-strapped borrowers don't repay loans. And most experts think there's still a good chance the downturn in the housing and stock markets will deepen to further spook already frightened consumers.

The government is hoping its intervention will unclog the lending pipeline, but that isn't a certainty either, said Sung Won Sohn, an economics professor at California State University, Channel Islands.

"If I am a medium-sized bank on Main Street, simply because the government is bringing a bailout package to Wall Street doesn't mean I am suddenly going to change my mind and start lending money again," Sohn said.

That suggests the economic statistics won't even capture some of the collateral damage -- all the lost lending opportunities that occur as banks try to bolster their rickety balance sheets. Many banks have curtailed their lending because they are already swimming in losses and don't want to risk drowning by taking chances on more borrowers.

"The real tragedy is we will never know how many businesses would have been started or how many businesses might have expanded if all this hadn't happened," said Jonathan Macey, deputy dean of Yale Law School, who wrote a book about a government bailout in Sweden during the early 1990s.

In a best case scenario, Macey said the United States will bounce back within two years, like Sweden did after the government spent billions of dollars to salvage the country's troubled banks and prop up a slumping housing market.

Before the medicine took effect, Sweden suffered through a 20-month recession that saw nearly 60,000 companies go bankrupt, housing prices fall by 19 percent and the country's bellwether stock market index plunge 45 percent from its peak. Once the hangover ended, the good times resumed; Sweden's economic growth has averaged 3.2 percent since 1994.

Sweden spent 65 billion kronor (about $10 billion at the time), but made most of the money back because it bought a stake in some of the troubled banks. The government still owns nearly 20 percent in one bank -- a stake that is now up for sale. US lawmakers also have been debating whether it makes sense to acquire stock in some of the banks that the government intends to help out.

In a more sobering situation, the payoff from the US bailout might take much longer. That's what happened in Japan after its government finally intervened in a real estate and banking crisis that began in the early 1990s.

By the time the government acted in 1997, the economic hole was so deep that it took another seven or eight years to climb out. The net public outlay to clean up mess was 18 trillion yen ($168 billion), according to the Financial Services Agency.

The abysmal times in Japan during the 1990s are now known as the "lost decade." Even though the economy is better now, the Japan's stock market still hasn't returned to its peak before the bubble burst. And Japan still has about $9 billion worth of property held as collateral that needs to be sold.

It seems unlikely that the United States will have to wait as long for a recovery because the government is wading into the financial muck much more quickly than Japan did.

In contrast, the United States is promising to bail out its banks 18 months after mortgage lender New Century Financial Corp. filed for bankruptcy -- a move that set off alarms about the rot ruining home loan portfolios.

"Some resolution measures are more effective than others in restoring the banking system to health and containing the fallout on the real economy," the International Monetary Fund concluded in a study of 124 financial crises since 1970. "Above all, speed appears to be of the essence."

Even if the US government is moving in time to make a difference, success is likely to hinge on the ability to figure out the right price to pay for an exotic mix of mortgage-backed investments and other serpentine securities that aren't easily appraised. And then the government must hope the housing market eventually rebounds to lift the value of the acquired assets.

If those pieces fall into place, the United States could profit or at least minimize its losses. On the flip side, the losses could be huge if the government misjudges the value of the problem assets or the housing market remains in a funk.

"The best we can hope for is that this (bailout) buys us time," said Edward Yardeni, who runs his own economic research firm.

The United States moved a little quicker to address the mortgage crisis than it did in the savings-and-loan debacle of the 1980s. Although warning signs of an industry breakdown started to flash in the mid-1980s, the government waited until August 1989 to create the Resolution Trust Corp. to dispose of the repossessed homes, offices, cars, planes and even artwork held by failed S&Ls.

During the next six years, the RTC sold nearly $400 billion in assets on the books of more than 700 failed thrifts. Taxpayers ended up sustaining a loss of $125 billion to $150 billion on the fire sale -- about 2 percent of the country's gross domestic product by the time the bailout was completed in 1995. Entering the S&L bailout, the government had projected a taxpayer loss of $40 billion to $50 billion.

If the ratio of losses to assets inherited in the latest $700 billion bailout is similar to what occurred in the S&L crisis, the taxpayers will be saddled with a bill of more than $250 billion, which also translates into about 2 percent of the nation's current GDP.

Data from the IMF's study suggest the losses could run even higher. The monetary fund calculated governments typically recover about 18 cents on every dollar spent in bailouts -- a rate that would translate into a loss of more than $500 billion. The United States seems unlikely to sustain a loss that large since it presumably will be buying the banking assets at a sharp discount -- leaving plenty of room for an upside.

Although the S&L bailout was the biggest in US history before this one, the challenges facing the government are radically different.

In 1989-95, the government and an army of contractors disposed of assets that were dumped into their laps as S&Ls collapsed. And it wasn't too difficult to figure what those assets were worth because their value could be easily measured against similar property. That's not the case this time. Part of the reason so many banks are imperiled is that no one is sure what their investments are worth.

Most economists agree absorbing the bailout's costs are preferable to running the risk of the entire US financial system unraveling -- a calamity that would probably trigger a global depression. But knowing things could be even worse probably won't make it easier to stomach the turmoil still to come.

"Unwinding asset and credit bubbles is a long and arduous task even with aggressive government involvement," Merrill Lynch economist David Rosenberg wrote in a report titled "Capitalism takes a sabbatical."