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Get well soon, Uncle Sam!
Vinod K Sharma
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February 02, 2008

If the markets needed further proof that the US economy was headed for a recession, it came from the commerce department's advance reading of the economy, which showed that it grew by an anaemic 0.6 per cent in Q4.

For a world that needs to see two consecutive quarters of negative growth to utter the "R" word, things may not be bad enough. But if you were to look at other health complications Uncle Sam had, you would probably start saying your prayers.

A series of steps have either been taken or are in the process of being taken to put the US economy back on track. But these may not be enough to avert the inevitable.

In a space of nine working days, the Fed has cut interest rates by 1.25 per cent, something that has never been done in the past two decades.

The Fed, for all we know, may have fired the last of the rockets in its arsenal. With rates at 3 per cent now, the Fed is not left with any dramatic option but to cut by a meagre quarter percentage for the next three meetings at the most. And the effect of these steps may not be visible in the economy anytime soon as Fed injections take time to sink in.

Even the $161 billion economic stimulus package that Congress and the Bush administration are jointly working out may not be able to rescue the ailing economy. It would not be before June that the refunds cheques would be in the mail.

This package is essentially being sewed together to put some cash in the hands of consumers so that they spend and the economy gets better.

But according to a survey, 58 per cent of the recipients are likely to use the money to pay off debts, 25 per cent are likely save that for a rainy day and the balance 17 per cent are likely to spend as intended and that too if their cash flows do not get tighter by the time the cheques reach them.

Another problem is brewing in the US. This one relates to bond insurers. Around a fortnight back, Fitch cut its rating for insurer Ambac and Moody's put MBIA's ratings on review for a downgrade.

Meanwhile, Fitch downgraded another insurer, FGIC, a closely held unlisted company, on Wednesday. How does a downgrading of these little known companies effect the US economy? To appreciate the problem, one needs to understand the roles these companies play.

Companies that want to issue bonds purchase insurance for their to-be-issued bonds from the likes of Ambac, MBIA and others. When it comes to rating those bonds, a company gets a good rating either on the strength of its own balance sheet, or on the strength of the firm providing their bond insurance.

This means that even if the company's bonds aren't worth the paper they're printed on, they can still be rated highly if they have insurance from a company that's rated highly.

A downgrading of these bond insurers would not only affect the rating of the bonds to be issued but also of the bonds issued. This is where it hurts.

These bond insurers have issued close to $2.3 trillion. And these bonds are sitting as investments in the books of the banks. If the bond insurers are downgraded, the banks will have to provide for a large depreciation in their books.

Municipalities across the US, who use the strong ratings of bond insurers to get their bonds subscribed at low yields, could see a dramatic rise in their cost of borrowing if the umbrella of these bond insurers is not made available to them, further creating credit constraints in an over-stretched market.

If banks in the US cannot infuse between $5 billion and $15 billion to capitalise these bond insurers as soon as possible, they will have to ready themselves to collectively make provisions of more than $200 billion in their books by way of depreciation of the bonds held. This is one malady for which Dr Bernanke may also have no prescription.

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