Monday, October 13, 2008

Market Breathes a Bit With Federal Reserve Expected to Announce Plan on Tuesday

Sources: Financial Times, US Prepares $250bn Banks Push; Wall Street Journal, US To Buy Stakes in Nation’s Largest Banks

After a very turbulent, stressful week for investors, traders, and anyone who watched the numbers, global markets started the week off strong on Monday, with the Dow Jones closing up more than 900 points—its biggest point gain in a single day ever. The stocks rose in anticipation of the Federal Reserve’s announcement of the first phase of its bailout plan on Tuesday. The main goal of the plan is to attract private capital, so each component of the plan is aimed to make financial institutions, especially those important to the system, want to participate.

The major component of the plan is the Fed’s use of $250 billion (of the $700 earmarked in the bailout plan) to purchase equity investment in a handful of the U.S.’s largest financial institutions and several small ones. Preferred stock shares usually do not come with voting rights and will carry a 5% annual dividend that will rise to 9% after five years.

The Federal Reserve will also reverse its policy opposing sovereign guarantees for funding, which have become popular in Europe. Sovereign guarantees, which what make risky debt “senior unsecured debt”—meaning those securities have repayment priority ahead of all others in the event of default, are aimed at reducing the fear that underlies banks refusing to lend to each other, even short-term. Under the U.S. plan, the Federal Deposit Insurance Corporation (FDIC) will provide the guarantees. Canada and Japan are expected to follow suit. The FDIC will also temporarily offer through 2009 unlimited deposit insurance for non-interest bearing bank accounts, typically used by small businesses. An extension to the $250,000 limit agreed on by lawmakers last week, the unlimited insurance will be voluntary for banks.

Parts of the anticipated plan give the FDIC a significant amount of broad power, which it has traditionally assumed during financial crises. The FDIC gets its expanded powers from a clause in federal banking laws that allows the FDIC to take extreme steps to prevent shocks in the economy, called the “Systemic Risk” clause.

The U.S. plan comes as part of a global effort by world leaders to intervene in markets enough to restore order and confidence. The United Kingdom, Germany, France, Austria, the Netherlands, Spain, Italy, Portugal, and Norway have all announced plans to commit funds for guarantees and capital.

Questions for Discussion:
1) IMF managing director Dominique Strauss-Kahn said, “The peak of the crisis is behind us.” Do you agree?
2) Again, do you think the plan will work? Does the plan have more of a “fighting chance” now that the rest of the world has been drawn into the crisis?

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