It’s not just Wall Street with its back to the wall

By Liam Halligan

This time last week, the world was breathing a sigh of relief. The “bailout” had just been announced – and share prices shot up in celebration.

Financial markets were jubilant US Treasury Secretary Hank Paulson was coming to the rescue. Even inter-bank rates – what banks charge to lend to each other – were falling. So last weekend, as Paulson purred, we all saw a light at the end of the tunnel.

Yet, as we now know, that light was an oncoming train. Last weekend I warned, despite the euphoria, the bailout could cause an “almighty, debilitating political dust-up”. Unfortunately, that’s what happened.

Having spent the last few days in the US, I can vouch voters are very, very angry about feather-bedding a bunch of overpaid bankers. Even in New York, a city that lives and breaths high finance, the tabloids screamed “Fraud Street” – aimed directly at the Wall Street crowd.

Just six weeks before the most hotly contested Presidential contest in decades, it’s not surprising the politicians have waded in. In Congress, many Democrats, and even Republicans, have refused to approve the bailout.

Some want extra home-owner protection. Others say that would spook the banks even more. Almost everyone wants limits on bankers’ salaries. And there is sense, too, that huge government bailouts are “socialist” and “un-American”.

All week, the financial markets have gyrated – mostly downward – as the bailout has flirted with extinction. On Monday, as money sought a safe haven, oil spiked 16 per cent, another one-day record, to $120 a barrel.

Huge developments have come and gone – with almost no reflection or comment. Goldman Sachs and Morgan Stanley surrendered their investment bank status. Washington Mutual failed – the biggest bank collapse in US history.

The Bank of England stepped up, pumping £40bn into our credit-starved money markets. And now, Bradford and Bingley could be the next “Northern Rock”. These massive events have just happened. Yet all eyes remain on Congress. Will the bail-out be agreed? What happens if it isn’t?

The sums involved are simply unprecedented. Rather than $700bn, the US government won’t get away with spending less than $1,000bn – a trillion dollars.

The reality of “pork-barrel” politics is that many in Congress won’t vote to bail out Wall Street unless they get money for their vested interests too. In recent days, the ailing US auto industry has moved into poll position – and looks set for $30bn. Michigan and Ohio – the big car-making states – could swing the US election. Neither party will stand in their way.

At a trillion dollars, then, the money at stake isn’t far short of what economists call US M1 – total cash in circulation in the world’s biggest economy. That’s almost 7 per cent of America’s entire GDP.

With Wall Street warning of an almighty crash on Monday unless a bailout is agreed, a deal of sorts will emerge this weekend – if only something preliminary. But I’m not sure it will work.

The idea is that Paulson’s Troubled Asset Relief Programme (TARP) will buy toxic mortgage-backed securities from banks – so de-icing the inter-bank markets. But at what price?

Something between “hold to maturity” and “fire-sale”, says the Federal Reserve – leaving huge scope for uncertainty. But TARP will only inspire confidence if the market feels the total sum pledged will mop up the sub-prime mess. And that can’t be judged if a deal is announced but the price regime isn’t clear.

What’s more, many banks – in an act of on-going self-delusion – have “priced” their sub-prime securities at only a slight discount to face-value.

But when TARP steps in, and establishes genuine prices, many banks will be forced to make even more writedowns. So far, around $510m of sub-prime losses have been “fessed-up”. Ironically, Paulson’s bailout could see that escalate two- or even three-fold – so sparking a new wave of panic.

Consider, also, that the situation will remain very fragile until US house prices stop falling. The more prices drop, the more sub-prime loans will default, causing banks to incur more losses. But as new data showed last week, America’s housing market may yet have further to fall.

US house prices are already down 17 per cent from their 2006 peak. The problem is the huge overhang of unsold homes – which remains at almost 11 months’ supply, worse even that during the recession of the early 1990s.

But my biggest problem isn’t that the Paulson plan is too vague (inevitable, given the political stakes) or that US house prices will keep falling (a fact of life). My problem is that this bail-out is utterly misconceived.

The idea of buy bank’s illiquid assets sounds good in theory. But it won’t solve the main issue – namely, the banks have very little capital to lend anyway, even if their sub-prime losses disappear.

Congress should be approving a direct recapitalisation of US banks – as the Swedish government was forced to back in the mid-1990s – rather than messing about with TARP. I fear that’s eventually what will happen. So this bailout is only round one.

Liam Halligan is chief economist at Prosperity Capital Management