Why hasn't the bail-out plan lifted stock markets?

The US 'Emergency Economic Stabilisation Act' was meant to save the world's financial markets. But the FTSE is down again and US markets are still looking sickly. So what's the problem? John Stepek explains.

The US 'Emergency Economic Stabilisation Act' (EESA) was meant to save the world's financial markets. Yet so far, the FTSE 100 has fallen by as much as 200 points today. The US markets are looking grim too, and as for the money markets, the Libor-OIS spread (as Bloomberg puts it, "a gauge of the scarcity of cash") hit a fresh record which doesn't bode well.

So what's the problem? Well, it seems that the EESA just hasn't quite turned out to be the cure-all that some were hoping. Here's what we've gleaned so far.

The EESA will give the US Treasury up to $700bn to buy mortgage-backed securities and other dodgy assets via the 'Troubled Asset Relief Program' or Tarp. The Act says that the Treasury should buy these assets "at the lowest price that the Secretary determines to be consistent with the purposes of this Act."

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Anyone participating, says Capital Economics, will have to "provide the government with equity warrants" (the right but not the obligation to buy shares in these companies). There are also limits on executive pay which are still being drawn up. The President will also have to submit legislation within the next five years, to recover any losses to taxpayers from the participants.

And that's about it. Capital Economics says that "the scheme is better than nothing" but it "does very little to address the fundamental problem of the lack of bank capital." The key problem, it seems, is that line about prices. No one actually knows exactly how prices for these assets will be set.

And the problem is, "the only way the Treasury's plan would have any meaningful impact on bank capital is if it vastly overpaid for the securities are buying." This would enable banks to book some profits from the sales, and then that would allow them to improve their balance sheets, and presumably lead to a pick-up in lending. The trouble is, that would be too much like the ordinary taxpayer bailing out Wall Street, and that's the last thing that the politicians want to see happening.

In fact, DBS Group reckons this isn't a bail-out at all.

The key issue is that this $700bn will still only deal with the liquidity problem in other words, the fact that banks lack ready cash. It'll buy up dodgy assets, but the banks will eventually have to repay in the end. "Banks will have to make good on any losses suffered by the government. Taxpayers will bear zero bailout cost. In economics, zero cost usually means zero value. Such seems true in this case."

According to DBS, any bank whose only problem is liquidity can already get as much short-term liquidity as they want, without the strings attached, from the Federal Reserve. And a bank which is actually insolvent (its assets simply aren't worth as much as it owes) will have to eventually pay back any overpayment it gets from the Fed. So, that's not much help to them - "unless you have struck the jackpot in the meantime, you are still insolvent."

The group reckons that all that will happen after this bail-out is pretty much "business as usual." And at the moment, business as usual isn't very inspiring. Insolvent banks will be taken over by the government, and illiquid banks will either merge with stronger partners or keep drawing on central bank help.

As Capital Economics puts it, "the bottom line is that the financial and economic imbalances have taken years to build up and may well take years to unwind we still expect the economy to endure a torrid recession next year." So no wonder the markets aren't cheering.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.