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Government intervention in market Essay

The die is cast, the losing face has turned up and now America has to face the consequences of bad luck. The Emergency Economic Stabilization Act of 2008 is US’s plan to resolve this ghastly economic crisis. This bailout plan proposes that $700 billion will be spent by the US Secretary of the Treasury to purchase bad mortgage-backed securities and make capital injections into banks. Now, with all the stress the financial crisis has brought us, it is inevitable that we could have our thoughts swirl in a series of what’s: what-if, what really happened, and what should we do.

The mortgage crisis was already lurking under our noses as the Commerce Department reported that new home permits plummeted from last year by as much as 28%. This then indicates that, for the next nine months, new home closings would be down. Confident Fed however, assured us that the housing will regain its composure by late spring with strong employment, low inflation, and increasing consumer spending. As if that wasn’t enough foreshadowing to seriously consider, the inverted yield curve, the predictor of the 2001, 1191, and 1981 recessions, entered into the scene.

At a normal rate, long-term yields are higher because investors

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want a better return for tying up their money for a longer time. Inverted yield curve is when short-term Treasury note yields are higher than long term yields. Economists ignored this sign because interest rates were still much lower than in prior recessions, and the economy had plenty of liquidity to fuel growth. (About.com, 2008)

First, mortgages were not regulated thus creating bad loans. Banks easily released loans on customers because they have this assurance that they come out absolutely risk-free. They could easily sell their loans with gains on the secondary market. In short, credit-worthiness of bank borrowers was not really checked. Unregulated mortgage brokers even made loans to those who weren’t qualified. Plus, most of the homeowners get the interest-only loans on the assumption that they could sell the home before the interest rate increases if they can’t pay for it anymore. However, with the market down, the mortgage rates skyrocketed and home prices also declined. The homeowners then could not anymore sell their houses for a profit nor pay the interests.

Second, the Fed had not realized early on that it was a credibility problem. The accumulated unpaid loans caused a shortage of funds of the banks. Banks, afraid that they would receive bad MBS in return, then became unwilling to lend to each other. To prevent the decrease of their credit rating that would cause the fall of their stock prices, no one admitted how much bad debt they had.

This government intervention in the market to fix the problem might just turn in short-lived benefits. Private markets would suffer greatly by this compulsory change of the entire market’s liquidity. This phenomenon might cause these private markets to close down, thus decreasing the income yield. The funds might not also directly increase the financial position of banks. A better solution would be buying out preferred shares of banks to provide them with equity capital.

On the other hand, the funds would contribute greatly to the buying and lending power of consumers. With the bailout plan, consumers not only can buy more, but also can borrow more to buy even more. Producers in turn, with the sudden increase of demand, will supply more. This sudden increase in consumer spending will strengthen the capital market significantly.

Putting it simply, the market intervention of the bailout plan could sound risky but with all things done right and with the cards on our side, the benefits will far outweigh the projected risks. However, there are improvements that could be done in the plan that might reduce the dangerous risks while maintaining the benefits. With a better stabilization plan, tables can be turned for the United States and its economy could now return to its steady state.

References

Amadeo, K. Could the Mortgage Crisis and Bank Bailout Have Been Prevented?. Retrieved December 3, 2008, from About.com Website: http://useconomy.about.com/od/criticalssues/a/prevent_crisis.htm

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