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Too Much Bailout Equals Too Many Effects

There are drawbacks when the government meddles beyond its limits.

Obama is pumping up the economy by injecting a large part of the $825 billion bailout rescue fund in the country’s banks. But not everyone’s optimistic about it. For example, loan officer Dan Green made a realistic comment about the dangers of a very large stimulus package. He writes, “It could draw money away from bonds into stocks, causing a rapid sell-off that depresses prices and raises rates. The Fed’s ability to counter-balance a run like this would be limited (and it) could lead to monetary supply inflation which, in turn, would spark a meteoric rise in mortgage rates. Think 10 percent or higher.”

If you’re wondering how Green arrived at these theories, it simply means that a trade off in investments is most likely to take place when the government pours in too much money. Remember that investors retreat from the stock market when the risk that they’re taking becomes too high. Treasury bonds provide a safer alternative albeit they contain lower returns. But when other types of bonds are backed by risky mortgages now called mortgage backed securities (MBS), they would naturally have lower demand.

If the government would rehabilitate the markets by buying these MBS, the demand for mortgage bonds would artificially rise. As bond demand increases, yields will move downward. Since mortgage rates move together with bond yields (not bond prices), these rates will also drop. But too much bailout would produce a different scenario. Because there’s too much demand, people are eager to sell and offer lower prices just to dispose and transfer their money in the stock market. The lower prices of bonds provide the stimulus for mortgage rates to ascend.

The second effect is obviously a case of monetary expansion. As more money circulates, consumers will face higher product prices mainly because of higher purchasing power. Since your money can’t buy the same amount of goods as it used to, it also affects the returns in an MBS whose returns will now be lower. Investors will obviously reduce their demand of such securities and the only way to raise back demand is to offer a lower price for the MBS. Again, this will propel higher mortgage rates.

While Obama’s effort to turn the economy around must be commended, careful appropriation must be considered or else, The American Recovery and Reinvestment Bill is bound to worsen our situation.

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