Why the $700 Billion Isn't Helping

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After last week's political theater in Washington over the $700 billion bailout bill, the stock market's continuing woes have left many people shaking their heads. Isn't that huge sack of money Treasury Secretary Hank Paulson sought supposed to be solving the problem?

What Americans are fast learning is what the market pros knew all along — the bailout bill may turn out to be a pill that dulls the pain, only to leave deeper global economic wounds festering. "We're in the midst of a panic," says James Angel, professor of finance at Georgetown's McDonough School of Business. Angel, who teaches a course on financial crisis, says that even the injection of federal dollars may not convince banks to shed their fears. "If banks go from being too reckless to being too conservative, there may be general starvation for the economy due to insufficient good credit."

The Treasury's willingness to eat up toxic mortgage-backed assets stuck on bank balance sheets could help temporarily improve those banks' standing, but there's no certainty it will adequately ease the flow of lending in a market permeated by fear of further failures. In fact, the Federal Reserve's move Tuesday to take an active role in the commercial paper market for short-term loans was a tacit acknowledgement that the bailout bill will not on its own stem the bleeding.

A number of economic signals suggest as much. Market volatility indices are way up. In addition to economic stagnation reflected in nine consecutive months of job losses, retail sector struggles and a suffering automotive industry, the market is fretting about potential disasters yet to come in the banking arena. European banks appear increasingly unstable, and doubts remain about American insurance companies and financial institutions stuck with dubious debt obligations.

The cost of insurance against a Morgan Stanley credit default recently exceeded an unheard of 1000 basis points, even after the bailout bill was signed into law. That means the market price for insurance against a $10 million Morgan Stanley default hit $1 million per year, more than 10 times the typical ceiling cost for such insurance in a normally functioning bank sector. "The bailout is a step forward, but it's not at all clear that it's going to work," says Darrell Duffie, professor of finance at the Stanford University Graduate School of Business.

Duffie says sky-high rates for default insurance for 10 of the world's most prominent banks, including Morgan Stanley and Goldman Sachs, demonstrate that there is a lot of market concern about the stability of leading financial institutions, even after the Treasury's recent steps. Another piece of evidence: the premiums on three-month interbank loans remain very high in comparison with overnight loans, signaling banks' deep uncertainty about the sector's stability.

None of that is to say that the bailout bill won't help at all. Paulson and Co. have a lot of flexibility under the legislation, and could ultimately act as a kind of sovereign wealth fund, injecting cash for equity, as famed investor Warren Buffett recently did with Goldman Sachs. Or the Feds could avoid carrying equity by lending money to financial institutions willing to buy up questionable bank assets at discounted rates. But first the Treasury seems ready to dip into its $700 billion to establish a reverse auction set-up to ensure that the government doesn't pay too high, or too low, a price for the distressed securities. The auction system will likely take at least a month to set up.

Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, says the Fed's actions this week — effectively lending a trillion dollars into the financial system — may have a more dramatic immediate impact. "Given what the Fed is doing now, I wonder if we even need the $700 billion,"Siegel says. If the Fed and Treasury steps turn out to be effective, the market could turn the corner sharply. The most dramatic growth in U.S. stock market history took place between 1932 and 1933, out of the depths of the depression.

Even if the $700 billion is spent efficiently on buying up toxic assets, though, it may not be sufficient. The Treasury may yet go back to Congress begging for additional dollars from a new administration if the initial allowance doesn't yield sufficient liquidity. And having fewer junky assets on their books may not cure banks of stinginess in the current climate of constraint. "Once confidence is destroyed, it's not easily restored," says Angel.

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(See how the market meltdown happened here.)