For stemming the rot

The global financial crisis has prompted International Monetary Fund (IMF) Managing Director Dominique Strauss-Kahn to issue a statement after a Gulf Co-operation Council meeting in Jeddah: "IMF projections indicate a decline in global growth to about 4.0 percent in 2008, reflecting the slowdown in the United States, Europe, and Japan and some deceleration of growth in most emerging markets and developing countries."
When American International Group (AIG) was in deep trouble and the world's largest insurance company was rescued by Fed through a 85 billion dollars bailout to avert world's worst collapse, it is the latest in a series of unprecedented disruptions in the history of modern finance that started with the subprime mortgage default.
The first casualty was Bear Stearns followed by the twins, Freddie Mac and Fannie Mae, the two between them accounting for more than half of all home mortgages in the US. Next two of the biggest investment banks, Lehman Brothers and Merrill Lynch, fell.
By then it had become very apparent that due to the serious liquidity crunch in the markets because of the banks hesitation to lend, the broker-dealer model of investment banking was no longer sustainable. This prompted the targeting of such institutions where investors stopped doing business with them and predators started short selling their shares, triggering a slide in their share prices.
To make matters more confounded and worse for these institutions, the credit rating agencies made an adjustment in their rating model that resulted in downgrading of a financial institution's rating on a steep fall in its share price in the market.
The remaining two bulge-bracket investment banks, namely, Morgan Stanley and Goldman Sachs see a similar fate as that befell Lehman and Merrill staring them in the face. Many argue that the US Federal Reserve Board and Treasury have been rather selective in their bailout package.
Why did the government deem it prudent to nationalise the two giants of the financial system, Fannie Mae and Freddie Mac, affected by the collapse of the real estate market and not the 158 year old Lehman Brothers with assets estimated at over 72 billion dollars and liabilities worth 68 billion dollars? Shares in both Fannie Mae and Freddie Mac had fallen by more than 80 percent in the last six months.
Henry Paulson, the US Treasury Secretary, said: "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe." However, he admitted that the move came at an unknown cost to America taxpayers, saying: "In the end, the ultimate cost to the taxpayer will depend on the business results... going forward."
But when the turn of Lehman Brothers came, about nine days after Freddie Mac and Fannie Mae were nationalised the Treasury Secretary refused a bailout package. It was perhaps the cost to the taxpayers that deterred the Treasury Secretary from bailing out Lehman Brothers.
However this did not stop him from arm twisting financially sound companies to acquire, partially or wholly, weaker companies as Bank of America did in acquiring Merrill Lynch. Unfortunately nobody was interested in taking on Lehman's complex and hard-to-value liabilities without the same kind of US30 billion dollar taxpayer-funded backstop provided to J.P. Morgan Chase when it acquired Bear Stearns for US10 dollars a share in May, or so argue analysts.
But then what prompted the government to extend a bailout package to AIG when it failed to get a bank loan to avoid bankruptcy? In what is clearly considered as a policy reversal, the Fed and the Treasury heads announced an 85 billion-dollar revolver loan for two years with a yield of three month Libor plus 8.5 percent.
AIG will now attempt to sell assets in order to repay the loan from the Fed, which is intended as a bridging loan. The New York Times writes that what frightened Fed and Treasury officials into this action was not yet another big bankruptcy, but AIG's role as a considerable provider of financial insurance contracts to investors who bought complex debt securities.
They effectively required AIG to cover losses suffered by the buyers in the event the securities defaulted. It meant AIG was potentially on the hook for billions of dollars' worth of risky securities that were once considered safe. However, the bailout appears not to have calmed global markets.
Supporters of the Fed and the Treasury point out that the two have moved rather aggressively to contain the contagion by slashing rates by 1.25 percentage points in eight days - a rate unheard of in the history of the Fed. In total, the rate has been cut 5 times by a cumulative 2.25 percentage points.
In addition, Treasury Secretary Hank Paulson has got an approval from President Bush to release up to 150 billion dollars in to the US economy for consumers to spend. Such co-ordination between fiscal and monetary policy is, according to analysts, both unprecedented and prompt and impressive.
THUS THE STRATEGY ADOPTED SO FAR TO CONTAIN THE GLOBAL CRISIS IS THREE FOLD: (i) massive credit injections by the central banks of developed countries; (ii) selective bailout after arm twisting of support from other institutions fails - bailout that depends on what is assessed as the 'risk' of each mammoth company collapse and the extent of the spillover effects; and (iii) manipulating the interest rate.
This strategy alone will not suffice to protect Main Street from Wall Street and the argument that taxpayers should not bear the cost of a bailout of these institutions begins to seem invalid as the repercussions of collapse on Wall Street may result in a much higher cost to the taxpayer.
What is required is an institutionalised approach to the issue that would help these institutions cleanse their balance sheets to remain functional. For this to happen it would require of the government to step in and introduce legislation, if necessary, as done for (the Savings and Loans Associations) thrifts, allowing for the creation of an agency or body that would buy the bad debts of these institutions, thus cleansing their balance sheets and averting their collapse.