Rejection of bailout plan causes panic across the globe

The financial markets have gone crazy after the US Congress on Monday voted down the US$700-billion bail-out package, designed to salvage the troubled financial sector. The S&P fell by 8.8 per cent, the Nasdaq by 9.1 per cent and the Dow by 7 per cent. On a combined market cap of $16.5 trillion, losses came to $1.4 trillion. This was twice the face value of the bail-out programme that had yet to see the light. In a sense, there is money out there to help bail out the financial sector. If, and only if, the financial markets could find a way to talk to each other, they could have bailed themselves out twice over that night alone.

But the message from Washington was clear. The American people do not want to bail out the rich or the smart financiers on Wall Street. When Wall Street made money, it awarded its executives and staff with huge, obscene bonuses. When Wall Street ran into trouble, it went about begging for taxpayers' money. That is precisely the sentiment that is going on now in US politics.

Despite pledges from Congressional leaders to patch things up, they could not persuade lawmakers to support the bill. The $700-billion Paulson package, designed to allow the US government to buy out bad mortgage loans from the financial institutions, was shot down by 228 votes to 205 in the House of Representatives. The Senate might need to take up the bill if it is to go anywhere.

The majority of US Congressmen did realise the magnitude of the financial crisis if the bill was not passed, but they did not want to risk the wrath of voters back in their home states. The Congressional offices had been bombarded with e-mails and messages by voters and consumer groups, who threatened to vote the lawmakers out of office if they were to support the bill.

At stake in the property sector are about 5 million homes, which are being tied up in the credit logjam. Multiply that by the number of people living in homes for which the mortgages have turned sour, and there are millions of American voters who are not happy at what is going on. The presidential election is only five weeks away. The Democrats will be glad to exploit this opportunity to squeeze the Republications in the presidential race by blaming incumbent President George Bush for encouraging the climate that led to this mess.

At the moment, Bush, US Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke must still be shocked by the collapse of the bail-out package. Nobody knows how these supposed white knights are going to revise the package to make it more appealing. They thought they had produced the most workable plan to restore confidence to the financial markets. They have to think fast about Plan B now.

Was the plan really good? Yes, but it was probably not enough. The figures for the extent of the damage in the financial sector remain confusing. Some $1 trillion in the housing-loan market has gone sour. About $520 billion has been written down by the financial institutions. The $700-billion package to buy out the bad mortgage loans had been designed as a government measure on top of the routine market write-downs.

Yet already, the Federal Reserve has acted as a safety net by churning out $700 billion in short-term loans to the cash-strapped financial institutions so that they can still breathe. The normal money markets have almost shut down. Stronger banks such as Bank of America and Citibank have taken over, or are in the process of acquiring, the weaker institutions. With a growing loss of confidence in the financial sector, we will see the Fed pumping more money into the system. The Fed's balance sheet will look pretty ugly.

But the US financial problem could have much wider implications. The FDIC's list currently has 117 institutions with $78 billion in assets. But in a testimony to the US Senate Banking Committee and House Financial Services Committee on September 24, Marin D Weiss and Michael D Larson of Weiss Research found that at risk of failure were 1,479 FDIC member banks and 158 thrifts with total assets of $3.6 trillion. This figure is about 36 times the assets of banks on the FDIC's list.

Just-released Federal Reserve Flow of Funds data show that, beyond mortgages, there is another $20.4 trillion in private-sector consumer and corporate debts, plus $2.7 trillion in municipal securities outstanding. Among banks and thrifts with $5 billion or more in assets, there are 61 banks and 25 thrifts that are heavily exposed to non-performing mortgages.

In effect, the $700-billion bail-out package, even if it were to be passed, would still represent just a drop of water in a bucket.

The US financial crisis has already spread across continents. Europe has been the first to suffer from the US tsunami, with the UK Treasury nationalising Bradford & Bingley, and the Netherlands, Belgium and Luxembourg agreeing to inject $11.2 billion to salvage Fortis. Asia will be next to take the hit. Be prepared for the worst.