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Will the Bailout Work?, Part 2


After the bailout, a curve in the road ahead.

Editor's Note: This is Part 2 of a two-part series. Part 1 can be found here.

What if the various countries, one by one, decide to guarantee deposits in order to protect their own banks? If you're an international corporation, especially outside the US, do you want your $10 million in Europe or the US, when Europe guarantees your deposits with no limit? Could we see silent runs on US banks?

I think it's about an even chance that the US government will have to guarantee every bank deposit for a period of time, regardless of size.

That's a staggering thought. The potential will be large for almost-insolvent banks to pursue risky behavior to work their way through problems. If such a policy is pursued, tight controls must be administered so risky banks don't offer high CD rates in order to garner assets. The FDIC must closely monitor such activity. Perhaps such guarantees should be for existing depositors and not new customers. Insolvent banks and those on the edge must be shut down quickly in such an event to prevent risky behavior.

Unthinkable? I bet there's a working committee of government and Fed officials thinking about just that very thing and how to do it. It would be even scarier if there isn't one. We're in completely uncharted waters, and every contingency needs to be thought through.

In the next few weeks and months, I think you can count on more extraordinary actions by the Fed and Treasury to try and jump-start the credit markets. Actions which were highly improbable a few months ago will be on the table.

Will the Fed open its balance sheet to non-banks? Possibly. If it can guarantee money markets, will there be a scheme to insure commercial paper at some price? Not out of the question. Will European governments take more equity in large European banks? Very likely. Will the Fed and/or the Treasury invest even more capital in larger financial institutions? Given that We the People now own 80% of AIG (AIG) and 100% of Fannie (FNM) and Freddie (FRE), it's certainly within the realm of possibility that we'll soon be the proud owners of even more private institutions.

Again, this is not just a US issue. We will likely see similar actions in Europe and some of the developing world. This is a worldwide crisis, and the response will be from central banks all over the world.
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