Bailout Fatigue

Written by: David Lereah   Tue, March 24, 2009 Commentary

A wave of public rage erupted this past week when reports that American International Group, AIG, paid $165 million in retention bonuses to employees at the division that devastated the company and forced the government to pay billions of dollars in a bailout. In response, Congress is considering levying punitive taxes on bonuses paid by financial companies receiving government aid. The House of Representatives passed a bill that would impose a 90 percent special tax on bonuses of more than $125,000. The legislation’s reach would extend to bonuses paid to thousands of employees at the nation’s nine largest financial institutions that have received at least $5 billion in Federal assistance under the $700 billion financial rescue package Congress approved last year. The legislation also applies to employees at Fannie Mae and Freddie Mac.

The Federal Reserve purchase program is enormous and is a daring move to stabilize the financial markets. It is apparent that the series of Federal Reserve cuts that brought the Federal funds rate to zero have not had a meaningful impact on a broken financial system and a struggling economy. The Fed’s objective is to now bring long-term yields down to meaningfully reduce borrowing and issuance costs for corporations and state and local governments. Suffice it to say that the Fed has flooded the financial markets with gobs of money which eventually will exert a great deal of upward pressure on prices of goods and services. However, the nation’s immediate need is to fix the financial markets and revive a stressed economy and worry about inflation rearing its ugly head later.

In economic news this past week, the consumer price index for February increased 0.4 percent while the core consumer price index (excluding energy and food) increased 0.2 percent. The inflation situation remains relatively stable with the downside pointing towards negative price changes. The producer price index for February rose 0.1 percent, while the core index rose 0.2 percent. Producer prices have risen for two consecutive months, a positive sign for intermediate prices. Going forward, the concern is that weak aggregate demand will eventually pull producer prices down. Jobless claims for the week ending March 14 declined 12,000 to 646,000. Despite the decline, jobless claims remain at very high levels and we expect these levels to increase in the coming weeks due to a deteriorating employment situation. And finally, as mentioned earlier, the Federal Reserve announced that it will purchase long-term Treasury bonds as well as expand its purchase of Fannie and Freddie debt and mortgage-backed securities. These open market operations are designed to exert downward pressure on long term interest rates in an effort to stimulate the economy.

On the housing side, weekly mortgage applications for the week ending March 13 increased for the second consecutive week. The purchase index increased 1.5 percent to 257.1, while the refi index increased 29.6 percent to 4,497.6. Refinancing applications have picked up due to falling mortgage rates. The 30-year mortgage rate fell 7 basis points to 4.89 percent from a week ago and is now 109 basis points below its year ago rate. Existing home sales for February were up 5.1 percent to 4.72 million units. The median home price was down 15.5 percent from a year ago while the months’ supply was flat at 9.7. This February release was welcome news for the housing markets. An increase in existing home sales combined with an increase in housing starts reported last week suggest that the housing sector may be close to bottoming out. We await future housing releases to confirm this notion.

Bank executives warned that such compensation restrictions could seriously inhibit their ability to compete with rivals. In addition, some banks are threatening to back out of the government’s rescue programs than endure such hard tax measures. They warn that without Federal assistance, they would not have sufficient capital to restart lending, which is vital to reviving the economy. Strong words from the bankers, but there is an element of truth in what they say. We are getting upset about millions of dollars when the hard reality is that we have lost trillions of dollars in wealth and we stand to lose more trillions of dollars if the economy sinks deeper into recession. Letting off some steam may make us feel good, but let’s keep our eye on the ball.

In non-AIG news, the Federal Reserve’s Federal Open Market Committee announced that the central bank will purchase $300 billion in long-term Treasury bonds. The Federal Reserve has now committed to purchase $1.25 trillion in government bonds and mortgage-related securities. The move is designed to lower borrowing costs for home mortgages and other types of consumer loans in an effort to stimulate credit flows and reinvigorate the economy.


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