Frozen Economy?

I had my own questions about the recent "issue" with the financial markets, so I found this blog and I wanted to share it with you.  I think it is so important for everyone to be informed about what is really happening with the economy right now.  Things are not looking good and it appears that a big change is coming! 

Why the Bailout Is Necessary

Tuesday September 23, 2008

^{NYSE Trader (Credit: Spencer Platt /Getty Images)}

Congress is now debating whether the taxpayer should pay $700 billion to bail out investment banks who purchased mortgage-backed securities that are in danger of defaulting. The bailout was triggered by an event last week that shows just how close the global economy was (is?) to a catastrophic meltdown.

Last Wednesday, a record $140 billion was pulled out of money-market accounts, usually considered the safest of investments. That's because investors were moving the funds to U.S. Treasuries, causing yields to drop to zero. In other words, investors were so panicked that they no longer cared if they got any return on their investment...they just didn't want to lose capital.

As described in Thursday's Wall Street Journal:

Huddled in his office Wednesday with top advisers, Treasury Secretary Henry Paulson watched his financial-data terminal with alarm as one market after another began go haywire. Investors were fleeing money-market mutual funds, long considered ultra-safe. The market froze for the short-term loans that banks rely on to fund their day-to-day business. Without such mechanisms, the economy would grind to a halt. Companies would be unable to fund their daily operations. Soon, consumers would panic.

What caused this unprecedented run on supposedly safe money markets?

On Tuesday, the once-$62.6 billion Reserve Primary Fund, a money-market fund, saw its value fall below $1 a share because of its investments in Lehman's short-term debt. Money-market funds, which yield a bit more than basic cash accounts by buying safe, short-term debt instruments, strive to keep their share prices at exactly $1 -- and "breaking the buck" isn't supposed to happen. Money-market funds are where corporate treasurers put rainy-day funds, where sovereign wealth funds park their excess dollars and where Mom-and-Pop investors stash savings. Now, money-market funds were selling what they could and hoarding cash to meet what they thought might be extraordinary levels of redemptions from investors, said one commercial trading desk head.

Banks were also hoarding cash, too panicked to lend to each other or purchase any assets, for fear of taking on bad debt. Normally, financial institutions have about $2 billion on hand at any given time. By Thursday of last week, they had an unprecedented $190 billion, to prepare for further redemptions. In other words, the economy was on the precipice of a full-scale run on the banks - and not by worried depositors as in the 1930's, but by corporate investors.

Through Wednesday, money-market fund investors -- including institutional investors such as corporate treasurers, pension funds and sovereign wealth funds -- pulled out a record $144.5 billion, according to AMG Data Services. The industry had $7.1 billion in redemptions the week before. Without these funds' participation, the $1.7 trillion commercial-paper market, which finances automakers' lending arms or banks credit-card units, faced higher costs. The commercial-paper market shrank by $52.1 billion in the week ended Wednesday, according to data from the Federal Reserve, the largest weekly decline since December. Without commercial paper, "factories would have to shut down, people would lose their jobs and there would be an effect on the real economy," says Paul Schott Stevens, president of the Investment Company Institute mutual-fund trade group.

Treasury Secretary Henry Paulson conferred with Federal Reserve Chairman Ben Bernanke, who agreed that the problem was beyond the scope of monetary policy. The Federal government is the only entity large enough to step in and stop the madness. Let's hope it is enough. Otherwise, as Paulson was overheard to comment, "Heaven help us all." (Source: WSJ, Shock Forces Paulson's Hand, September 20, 2008)