Bonds Vs Taxes: Which Can Solve The Economic Crisis?

Once again, The Federal Reserve and Congress finished another hectic week  as they tried to answer the seemingly never ending question. Who can solve the economic crisis?

The Fed continued to wage its war on our dire economy as it announced that it will buy up to $300 billion in U.S. Treasuries and even more in mortgage backed securities as they support their initial plan to push interest rates to near zero. The government is hoping that this monetary policy will both stimulate spending and also ensure the safety of mortgages.

Initially the economy responded well, however, there are several risk factors that will surface throughout this process.  Congress’ latest bill is a tax on bonus compensation to employees in distressed firms. This action was promptly met with criticism from companies, as they failed to see the reasoning in this move.

The Market’s Response

Upon announcement from the Fed on Wednesday, the economy received a huge boost. The Federal Reserve moved briskly to contain the financial crisis, acting without the approval of Congress. The effect of this action was felt almost immediately as it dropped the 10 year U.S. Treasury note yield from a little over 3% down half a point to 2.53%. This will keep the prices of these Treasuries high, while lowering the interest rates. This in turn will lower the rates for various forms of debt making it easier for corporations and mortgage holders to pay off outstanding loans. This was largest drop of yields in 22 years since the market crash of 1987. The 30 year fixed rate mortgage for sufficient borrowers fell to 4.75% which had the immediate impact that the government was looking for. This is expected to keep the mortgage rates very low for an extended period of time, and provide considerable relief to the public.

The Fed also decided to increase its total bond portfolio to as much as $1.25 trillion with the potential purchase of $300 billion in Treasuries to take place in the next 6 months. The government also increased its total limit on mortgage-backed securities purchased by Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) to $1.25 trillion. In addition, it also doubled the purchase of their debt to a ceiling of $200 billion. This will greatly stabilize these two institutions and increase their lending power to help inject life into smaller businesses. By increasing their loan capability, the government is hoping to spur growth from the private markets.

However, all immediate effects were not positive as the dollar immediately lost value to almost all major currencies. The Euro had its largest gain against the dollar since its origin, and is now worth $1.34. This proved to be very risky as it caused some financial stocks to plummet after the news of the currency exchange impact. Many banks fell in value on Thursday, after the economy responded very well on Wednesday. This may have partially to due with the weakening dollar as well as the bonus tax bill that was introduced and passed by the House later that day.

Congress

Not to be outdone by the Fed, Congress passed their new bonus tax bill with extraordinary speed. This bill was met with immediate resentment from Wall Street, as they are strongly opposed to the idea of a 90% tax on bonus compensation, which comprises the majority of most salaries in many firms. This tax is on employees that make over $250,000 at firms that have received over $5 billion in aid from the Trouble Assets Relief Program. This will affect thousands of employees at several companies including Goldman Sachs (NYSE:GS) with an average employee compensation well in excess of this number. The tax imposed is absolutely punitive and it should be  illegal for the government to utilize the tax system in a retaliatory manner. They need to set clear expectations for the banks and not punish the thousands of talented professionals who are doing their jobs. Many banks have been verbal in their outrage, stating that they are already going through tough times with a variety of cutbacks and cost-slashing initiatives. By punishing the employees, it is going to make it nearly impossible to retain the valued leaders, bankers, and traders necessary for the future of a successful financial industry.

This tax is expected to be the first of several bills imposed to control pay on Wall Street. The primary effect of this tax is going to be the immediate shunning of future bailout money and aid. Hundreds of companies have withdrawn their applications for aid programs, and the government needs to be cautious for they are alarming the private investors of this market.

Outlook

Patience, patience patience, is the virtue that that the Fed and Congress need to exercise for us to pull ourselves out of this recession. Congress, along with the various government agencies, will continue to rush to pass laws and impose penalties that impact the financial sector without taking the time to understand the issues.  In their short-sighted estimation, it is more important to pass laws quickly to appease their constituents to appear as though they are doing their congressional duties.

Rather, they should be more considerate of the longer term ramifications of the taxes and penalties they inflict on these companies and the industry in general. While the purchasing of bonds should help out a great deal, it will be nullified by this tax imposed on bonuses. They say they’re acting for the common man and shareholders, but stunting the rebuilding and recovery of Wall Street is in no one’s best interest.

Disclosure: The Fund the author is associated with is long GS.

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