The $700 billion question: Can bailout fix economy?

WASHINGTON (Reuters) - The best test of whether the government’s $700 billion check will be enough to save the U.S. economy is how much of that money flows back to consumers and companies.

An American flag that incorporates 100 dollar bills is displayed at the Museum of American Finance in New York September 18, 2008. REUTERS/Eric Thayer

Even if the government gets Congressional approval this week to buy bad debts off banks’ books, satisfying some of their cash needs, the financial sector will still need to raise money -- and investors haven’t exactly been lining up to help. Unless banks can find funding somewhere, they won’t be eager to resume lending, and that will leave the economy sputtering.

The good news is, outside of the financial sector, Corporate America is remarkably cash-rich with some $620 billion sitting on the books of large firms, so companies should be primed to spend once confidence is restored.

But household wealth has taken an unprecedented double hit from the real estate and stock market shocks, and it could be years before consumers feel flush again -- particularly if credit conditions remain tight.

Treasury Secretary Henry Paulson argued on Sunday that opening up federal coffers to Wall Street would benefit Main Street by preventing a deeper economic downturn.

“Last week as the credit markets were frozen, the capital markets were frozen, we had a situation where American companies weren’t able to borrow money,” Paulson said on ABC’s “This Week”. “This could ultimately affect small banks, loans to businesses, loans to farmers, jobs, people’s retirement.”

U.S. companies have cut more than 550,000 jobs this year, sending the unemployment rate up to a five-year high of 6.1 percent in August. Those figures are likely to worsen in the coming months, with or without a bailout.

The housing market is at the root of the year-long financial crisis, and some members of Congress -- expressing concern that Paulson was taking a roundabout route to helping homeowners -- are expected to push for more direct mortgage assistance when they hammer out terms of the bailout legislation this week.

“I’ve talked to Secretary Paulson, and I’ve told him that while his plan is a foundation and we certainly have to do something, we need changes in it relating to housing,” New York Sen. Charles Schumer said on Fox News Sunday.

Federal Reserve “Chairman (Ben) Bernanke -- no less than he -- said if you don’t solve the mortgage crisis, you’re not going to solve the financial crisis. We need to put the taxpayers first, ahead of bondholders, shareholders, executives,” Schumer said.

Lawmakers and the administration will get the latest readings on the housing market this week as they hash out the Paulson proposal. Sales of both new and existing homes likely fell in August, according to Reuters polling data, and the pace of transactions remains near the slowest in more than a decade.


Shoring up the housing market means ensuring that would-be buyers can get mortgages, and that means banks will have to find a way to keep lending. Even before this latest bout of financial market unrest, a Federal Reserve survey of senior loan officers showed that credit conditions were tightening, even for borrowers with good credit histories.

“The U.S. banking system needs a lot more capital,” said Jan Hatzius, chief U.S. economist at Goldman Sachs. “Capital infusions are needed to avert a sharp contraction in lending.”

Hatzius said three things needed to happen in order to resolve the crisis. First, banks must figure out the true value of assets on their balances sheets; then they must raise more capital; and finally, home loans needed to be restructured.

The government’s bailout plan in effect addresses the first point by establishing a price for hard-to-value assets, and Congress may tackle the third issue this week. Raising more capital won’t be easy.

Lehman Brothers failed last week because it couldn’t find investors. Getting $700 billion in bad debts off banks’ books will certainly help, but it remains to be seen whether that will be enough to convince investors that it is safe to put their money in financial firms.

If the government’s money succeeds in helping Wall Street strike a healthy balance between fear and greed, U.S. companies are well-positioned to fund a strong recovery once they are confident that the economy is on the mend.

The Standard & Poor’s industrials, a group of 368 large companies that excludes banks, insurers, utilities and transportation firms, held about $620 billion in cash and short-term securities as of June 30, according to data compiled by S&P analyst Howard Silverblatt.

That was roughly the same amount that they had in March 2007, before the financial market crisis mushroomed. Since then, companies have cut back on dividend increases, share repurchases and expansion, essentially hoarding cash because of concern about the state of the economy.

“They’ve got money,” Silverblatt said. “They’re not spending it yet.”

Editing by Gary Hill