22 September 2008

The Hunger That Never Ends

The Paulson plan to relieve hundreds of billions in seriously de-valued assets from the financial industry can’t possibly succeed. The more successful the government is in purchasing “toxic” assets, the more they will be squeezing private money out of the global economy and preventing the natural discovery of market prices and the re-allocation of resources to where they will be productive.

Instead of stopping the collapse in house and debt instrument prices, this massive bail-out will instead speed up the deflationary process by hovering up whatever capital still remains. For every dollar the US government raises by auctioning off a treasury bond for the bail-out that is one less dollar available for raising capital and purchasing assets in the private market. Banks will find it even harder to raise additional capital (which would enable them to lend more freely) than it already was since the US government is sucking all the capital out of the system. Which pension fund, sovereign wealth fund, or central bank, will want to participate in a CitiGroup share issue in such an uncertain economic environment when they can buy safe t-bills?

Of course, this assumes that this super-sized bail out will even succeed in acquiring the troubled assets it is designed to consume. It is far from clear that this bail-out entity will be willing to offer sufficiently high (above market) prices that the lenders need. There is no way financial institutions will sell their defunct assets at anything close to market prices since doing so will render them immediately bankrupt. It’s possible the government might be willing to pay the high prices these institutions demand, but that is far from clear right now, and we won’t know until the final details emerge.

Worse, even assuming that the bail-out entity does buy derelict assets at inflated prices, the government will further be forced to hang onto foreclosed properties in its portfolio indefinitely, keeping masses of vacant properties looming over the market. Selling these millions of homes at the actual market clearing rates will further drive down prices even more, causing greater financial disruptions (requiring the bail-out entity buy even more over-priced assets), and cause political problems when it becomes apparent that tax-payers will be taking a bath on their investment after-all.

And none of this is even mentioning the difficulties with other forms of toxic debt assets beyond the scope of real-estate. Will the US government also be purchasing GM and Chrysler bonds that have dropped in value?

The more the government buys, the more prices will drop forcing the government to buy even more assets, which keeps the cycle going. At some point the whole bail-out concept will come to an ignominious end.

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