The trillion dollar questions

In the last couple of weeks (and especially the past 10 days), the financial world as we have known it for some years now, has changed dramatically. Fannie Mae and Freddie Mac had to be bailed out by the US government. Lehman Brothers has filed for bankruptcy. AIG is in big trouble. Merrill Lynch was acquired by Bank of America. 20% of Morgan Stanley might be acquired by Mitsubishi UBJ. Stock markets around the world have lost tens of billions of dollars in market cap. And finally, the biggest news of them all- Uncle Sam is planning to pump in close to a trillion dollars in the US financial system to make sure it does not collapse any further.

The US government’s speed of response has been admirable. It has done what needs to be done in the short term. But the entire situation raises several uncomfortable questions, the answers to which could well decide how many years more the pain will linger. Not just for the US, but indeed, for the entire world.

1. How is the US government going to finance this clean-up? Raise taxes? Borrow more? Creditors turn wary when individuals or companies become highly leveraged. Is a government any different?
2. If printing additional currency notes seems like an easy answer, think of what it will do to inflation? And if inflaton climbs, interest rates must follow. That in turn will make borrowing more costly and may well dry up the funds required to rebuild the beleaguered financial system.
3. Which foreign country (or countries) can afford to lend the US the huge amounts of money it needs? Will more of America be owned by the Japanese, Chinese or Indians?
4. By helping Bear Stearns and then Freddie and Fannie, the government showed weakening trust in “the market”. Then, by letting Lehman file for bankruptcy, the government signalled an apparent change of heart. Is all this an admission that unbridled, unregulated capitalism is not the wonderful system many thought it to be?

And just as people started to debate the merits of unregulated capitalism versus partially regulated capitalism, comes the news that the US government has just decided to turn the clock back on a regulation that was enacted nearly 70 years ago- the Glass-Steagall Act, which precluded commercial, deposit-raising banks from carrying out investment banking business. Ironically, the Act came into force in the 1930s, during the Great Depression. With the most recent change, the so-called Wall Street investment banks (the ones that remain, that is!) become bank holding companies. They thus become more regulated- with the Fed and other government agencies now having more regulatory supervision- instead of just the SEC. There will be greater disclosures- which is only good for shareholders. Also, these banks will have access to a steady flow of deposits- which is what the standalone I-banks lacked and were therefore forced to leverage their funds to make the kinds of esoteric investments that have made them fortunes over the past decade.  But with this change, the superstar I-bankers with their million dollar bonuses might become a thing of the past- but hopefully, investors will make some money- after the clean up.

Wonder when Bank of Goldman Sachs will open for business? I also wonder if the US government would have made the same decisions if Mr Henry (Hank) Paulson, the former CEO of Goldman Sachs had not been US Treasury Secretary.