'Limit the bail-out amount to avoid $ plunge'

Martin Weiss and Michael Larson of the independent research firm proposed this and three other recommendations in a report submitted to Congress on September 24.

The second recommendation suggests Congress ensure that a new government agency pay strictly fair market value for the debts, including a substantial discount that reflects their poor liquidity, if it is determined to provide substantial sums for that purchase.

Yet they reckon that due to the recent sharp declines in market values and market liquidity, many of the bad debts on the books of US financial institutions are at present worth only a fraction of their face value.

"When the government buys these debts at fair market value, it will still leave most of these institutions with severe losses. Many of these institutions do not have the capital to cover their losses and will fail despite the bail-out."

The third recommendation suggests Congress clearly explain to the public that there are several significant risks in the financial system the government is unable to address with any new legislation.

These include the possibility of surging defaults on debts not covered by the bail-out plan, a collapse in the derivatives market and a chain reaction of corporate failures.

It should also disclose whether the bail-out legislation is sufficient to stem the debt crisis and prevent financial panic. The government will need to prioritise the protection of its own credit and seek to ensure the stability of the dollar. The private sector, in turn, will need to handle any further spread of the debt crisis largely without government financial assistance.

The fourth recommendation suggests that instead of providing a safety net for imprudent institutions and speculators, Congress devote more effort to bolstering such for prudent individuals and savers.

Funding and staffing of the Federal Deposit Insurance Corp (FDIC), which insures bank depositors, should be increased substantially. The FDIC's funding, US$45 billion (Bt1.53 trillion) at present, is $32 billion less than the assets of those banks on the FDIC's list of troubled institutions. Moreover, it represents only 1.9 per cent of the assets of banks and savings and loans institutions believed to be at risk.

The Securities Investor Protection Corp, which was designed to cover brokerage accounts, in practice will not compensate investors for losses due to brokerage failures in a Wall Street meltdown.

State insurance guarantees have inadequate funds with which to cover policyholders in the event of the failure of several large insurers, with potentially severe consequences for millions of savers and investors.

To protect individual savers, investors and policyholders adequately, each of these safety nets will require substantial additional funding.

"In conclusion, unless Congress significantly modifies its approach and priorities, it could produce the worst of both worlds: a failure to resolve the current debt crisis plus the creation of a new set of crises that merely spread the panic and prolong the pain," the report concluded.

Meanwhile, savers and investors are recommended to seek the safest havens for their money, such as banks with a financial strength rating of B+ or better, US Treasury bills and money-market funds that invest almost exclusively in short-term US Treasury securities or their equivalent.

Weiss Research said if the rescue package was too big, the US bond market could not absorb the additional burden of funding massive government bail-outs without traumatic consequences.

The Office of Management and Budget predicts next year's federal deficit will rise to $482 billion, without taking into account the proposed $985 billion worth of bail-outs: $200 billion for Fannie Mae and Freddie Mac, $85 billion for American International Group Insurance and $700 billion for the financial-market bail-out proposal.

Weiss Research said it was undeniable the extremely huge bill could double or triple the federal deficit in a very short period of time.

"Such a dramatic increase in the deficit would drive up the cost of borrowing not only for the US Treasury, but also for other bonds and for millions of Americans seeking a mortgage or other credit, since treasury yields are the benchmarks against which most borrowing is based.

"To the degree that the Federal Reserve purchases US government securities for its own account to help support bond prices, it would devalue the US dollar, risking a dollar collapse and the flight of much-needed foreign capital from the US.

"Ultimately, either of these outcomes - sharply higher US interest rates or a US-dollar collapse - could seriously aggravate the very debt crisis that the bail-out plan seeks to address."

This is the second article in a two-part summary of Weiss Research's report to the US Congress, the Senate Banking Committee and the House Financial Services Committee.