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Shock and Awe on Wall Street

By Adam Price

Worst Financial Crisis Since the Great Depression

San Jose, CA – The year-old financial crisis entered a new stage in September as the U.S. financial system suffered its worst setbacks since the Great Depression of the 1930s. Over the weekend of Sept. 6-7, Fannie Mae and Freddie Mac, two large mortgage companies that were financing three-quarters of U.S. mortgages, were taken over by the government due to their growing mortgage losses. Then a week later the 158-year old investment bank Lehman Brothers failed to find a buyer and had to declare bankruptcy. The following Tuesday, Sept. 16, the giant insurance firm American International Group (AIG), with more than $1 trillion (1,000 billion) in assets, failed to get an emergency loan and was taken over by U.S. government in exchange for an $85 billion dollar loan. The next day the Putnam money market fund had to close down as investors pulled billions of dollars out following a big loss at a smaller money market fund that had made a big loan to Lehman Brothers.

U.S. money market funds had almost $3.5 trillion (3,500 billion) in deposits that were loaned to banks, businesses and the government for one to three months. Money market funds are almost as large as total checking and savings accounts held by banks and are part of the lightly regulated ‘nonbank’ financial system. Unlike bank accounts, money market funds do not have to hold reserves (cash) nor are their deposits insured (the FDIC covers bank accounts up to $100,000). The emerging run on money market funds would have cut off loans to thousands of businesses and banks, slamming the brakes on an already weak economy. With the specter of the Great Depression bank runs that closed thousands of banks and led to millions of lost deposits, the government felt forced to act.

At each stage of the crisis the U.S. government and central bank have had to make bigger and bigger actions to try to stabilize the crisis. In August of last year, the U.S. central bank, the Federal Reserve, began making hundreds of billions of dollars in loans to banks. Then in February of 2008, the Federal Reserve chipped in $30 billion to get the investment bank Morgan Stanley take over Bear Stearns and began to make loans to investment banks, which have no deposits. The take-over of Fannie Mae and Freddie Mac involved a $200 billion line of credit. The takeover of AIG involved an $85 billion loan. After the run on money market funds began, the government announced that a $50 billion fund used to stabilize the international value of the U.S. dollar would be used to guarantee deposits at these funds. Last but not least, the Bush administration announced a plan to buy up $700 billion dollars of bad mortgages and mortgage backed bonds from banks.

The crisis has also exposed the growing dependence of the U.S. economy on a continued inflow of foreign capital. In 2007 many foreign investors from Asia, Europe and the Middle East saw the growing financial crisis as a chance to buy into U.S. financial institutions on the cheap. But after putting billions of dollars into U.S. banks, mortgage lenders and other financial firms, losses of 50% to 100% have led foreign capital to pull back. At the same time, the Federal Reserve, which had almost $1 trillion of U.S. government bonds at the beginning of 2007, has been forced to loan out more than half to ailing financial businesses. With the Federal Reserve running of resources and foreign lenders nowhere in sight, the U.S. government has had to take actions the like of which has not been seen since the 1930s.

After plunging on Monday and Wednesday following the news of Lehman Brothers and AIG, the stock market rallied on Thursday and Friday following the news of the government’s plan to buy up bad mortgages. Unlike the takeovers of Fannie Mae, Freddie Mac and AIG where the government took over large companies in exchange for emergency loans, the latest plan would exchange taxpayer monies for potentially worthless mortgages, which could give banks, mortgage lenders and other investors a huge windfall.

While the latest plan has relieved the fears on Wall Street, the economy’s condition continues to worsen. Almost lost in the midst of the financial crisis was news that record numbers of mortgages are going bad and housing starts had slipped to the lowest level in 17 years. Even worse, a measure of future housing construction, building permits for single-family homes, fell to levels not seen since the 1981-1982 recession. With the housing market still in decline, the gaping hole that is sucking down the banks, mortgage lenders and insurance companies is getting even bigger.

The world economy is also slowing, with a number of countries in Asia and Europe either in or on the verge of recession. As their economies slow, other countries will buy fewer goods from the United States, cutting into our exports, which has been almost the lone bright spot in the economy.

The trillion-dollar question is where is the U.S. government going to get the funds to bail out the financial system? The Bush administration’s tax cuts and wars in Iraq and Afghanistan have turned a $200 billion budget surplus into a $400 billion deficit, not counting the costs to rescue the financial system. Foreign investors have been buying 75 to 100% of the U.S. government bonds used to pay for the budget deficit; are they willing to buy hundreds of billions more to rescue the U.S. financial system? If foreigners are not willing to lend more, then the U.S. government would be forced to raise interest rates to attract more funds, or just start to print money, which could lead to more inflation.

While some Democrats are pushing to aid provisions to the government mortgage bailout plan that would help homeowners or the unemployed, the Bush administration wants a ‘clean’ bill that only will aid banks and investors. Even worse, Republicans who oppose government services, and some Democrats who want to balance the budget at all costs will use the crisis to try to impose draconian cuts to Medicare and further their agenda to privatize Social Security. Presidential candidate John McCain has reiterated his support for starting to privatize Social Security and said that he wants to deregulate health care like the banking industry.

With millions of Americans now more worried than ever about their retirement savings, and millions more going without health insurance, this shows the danger of four more years of Republican rule. Where would the country be now if Bush and McCain were able to privatize Social Security and put our retirement solely in the hands of Wall Street? The Republicans have already started a program to divert some Medicare monies to private insurance firms, which has proven even more costly than the government program. The insurance firm AIG that the government had to bail out is a provider of annuities, mutual funds and private health insurance. Is this who we want to entrust our retirement and health care to? This is a fundamental question when we go to the ballot box in November.

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