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It seems strange to suggest that the UK rescue package announced today is of a far greater size than the US counterpart but it is true. However, that is where any kind of similarity ends with the US operation aimed at ridding the system of toxic mortgage investments which have dogged the US property sector for nearly 18 months.
In exchange for taking on these toxic investments and offering liquidity to the various mortgage lenders and banks in the US it is hoped that property markets will begin to perk up, the pressure on the economy recede and a general sense of calm return to the financial markets of not only the US but the whole worldwide money market. But how can the US government hope to get themselves out of trouble when they are taking on dangerous toxic investments in exchange for taxpayer’s money while gearing up the US economy up to the hilt to do so.
Where is the sense in the move? How could they possibly hope to retrieve any value for tax payers if the US markets take a further tumble?
Background
The term toxic investment will be fairly new to those outside of the financial markets but in simple terms it is an investment which has gone bad, may have plummeted in value and has the potential to hit other investments. If you compare it to one bad apple in the barrel which rots all of the others you would not be too far from the truth, except there are literally thousands if not millions of barrels being affect.
Normally a banking institution would use mortgage agreements and other assets as collateral to obtain money from the money markets to ensure the company can meet its short term spending obligations without selling off the ‘family silver’. However, now that many sub-prime mortgage agreements have now gone ‘bad’ the banks have fewer assets to use as collateral to cover short term liabilities. This is where the problems begin……………
US government proposals
The US government has proposed to use up to $700 billion of tax payer’s money to correct the markets, to take toxic investment away from the banking sector and free up a whole array of new funding and liquidity by exchanging these assets for cash.
However, this is where the deal starts to get interesting because in the current market many of these toxic assets are worthless or have shown a large drop in value. If the authorities were to prompt a recovery in the markets then there is a chance that many of these toxic investments would gain a new lease of life. The assets to which they are tied would stop falling in value, if the economy recovered it would likely see less people defaulting on their mortgages which would increase cash flow to the banks and subsequently the money markets.
The short term outlook
The short term outlook without the $700 billion rescue package is bleak as toxic investments will continue to eat away at the financial markets from the inside out. We would see more and more defaults on both the sub-prime and investment grade mortgages arrangements and more and more banks and other financial institutions would hit troubled times. In hindsight the US government made the schoolboy error of announcing a deal before it had been ironed out and put to Congress. This led to the markets expecting a deal to be confirmed immediately when in reality it took a couple of weeks to even get it through the US political system.
However, it must be noted that it will take time to put the deal in place, to ensure the right areas of the financial system are supported first and the end result, i.e. an increase in liquidity, will not happen over night. If the authorities can encourage even the slightest increase in market confidence this will be the seed they need to nurture and feed in order to return the markets back to their former strength.
Liquidating the toxic assets
At this moment in time it is difficult to value many of the toxic assets which the authorities will be taking on their books never mind trying to find buyers, but as the US property market recovers many of these investments will leave their sick bed and walk again. They will return from the dead and while they are unlikely to reach the value levels seen prior to the credit crunch there is every chance that they could have some significant value.
The beauty is that the authorities will literally have acquired many of these assets at distressed levels but they have the power to move the markets which these investments depend upon. However, this is not a win for the government if it all goes to plan, this is a win for the US taxpayer who will see the return to life of the housing market, a return on their investment into toxic bonds and life breathed into a dying economy.
Conclusion
Even though the UK move is being hailed as one of a kind, and in many ways it is, it is no where near as radical as the US bailout which is literally putting up to $700 billion at stake in order to take toxic investments out of the system and replace them with money market liquidity. Let us not forget that the US authorities will also ensure that outstanding mortgages levels are reduced by 10% in order for companies to take advantage of the bailout fund.
While the US property market is still in big trouble there are hopes that we might be on the verge of a period of consolidation. This would see panic buying reduced and prices return to ‘real’ levels as oppose to distressed market driven values.
There is still a long way to go with the US and the UK rescue packages although after initial delays of a different kind it seems that they have been well received by investors. Now they both need to deliver and hope that other countries around the world will join the party.