Wondering what this bailout is all about?

[Cecropia]

Ignore the details of how we got to this point, for a moment.  Let's talk about our situation in simple terms.

Background fact 1: "Creative mortgages" which have a high risk of not being paid back were falsely rated AAA (best) and/or packaged with other truly AAA loans to mask that they are "bad paper".  Many individuals and companies made a mint off of creating and selling these mortgages.  Many people invested in these mortgages believing that they were very secure.  Market regulators looked the other way.

Background fact 2: It's impossible to know who owns the "bad paper" now, because it has been bought and sold and moved around so much, and the relaxation of certain laws allows banks to hide what exactly it is that they own (and banks in trouble want to hide what they own).

Background fact 4: Right now no banks really want to do business with one another, because no one knows who holds the bad paper and might be near bankruptcy and who is in good shape.  The halt in this lending is what's fueling the current crisis.

Now, let's take a look at the $700B bailout you've been hearing about.

The Treasury (Hank Paulson) and the Federal Reserve (Ben Bernanke) want to "restore confidence in the market."  Their plan is to buy the bad paper from the banks at whatever value they think is best.  They have said in congressional hearings that this will be bought at "value at maturity" which means that they will not be paying anything near the real value of the paper, but instead the value the bank has on its books for the paper.  They hope that this will shore up the banks' reserves, make them whole, and get them to start lending to each other again, without having to open their books and show each everyone whether they were on the brink of bankruptcy or not.

Then the Treasury takes the bad paper that they just bought, and sells it to the highest bidder.  The paper will have a much lower value that what the bank said it was worth.  The taxpayer pays the difference.  As of the most recent public version of the bill, the Treasury is allowed to buy $700 billion dollars worth of bad paper (which doesn't just have to be mortgages, it can be any loan which has a high risk of not being repaid), sell it, and buy another $700 billion, repeating the process as many times as it wants.  The rule is that it cannot have more than $700 billion worth on hand at any one time.  So although people are trying to spin this as "not an expenditure but an investment" or "no way we will spend all $700 billion" or "the government/taxpayer will actually make a profit", they are not being truthful.  Trillions of bad paper will be bought and the losses may be well over $700 billion.

To put it in perspective, $700 billion is $2,300.00 for every citizen - man, woman and child.

Now, let's say that this works and the banks start lending to each other again.  What bad effects would we expect?

The government does not have $700 billion on hand; it must go higher into debt to afford this (increasing the deficit).  This debt isn't interest-free.  With a higher deficit, the government must pay more dollars in interest to its lenders.  But there is more.  When the government adds on a substantial amount of debt, it becomes more likely that the government will never pay the debt back.  This actually causes interest rates on the deficit to rise because the risk has changed for the worse.  Higher interest rates mean even more money owed.  This kind of jump in interest owed would have to mean higher taxes and less government spending.  Some countries may not decide to lend to us anymore because it is too risky at any interest rate.  This would spell disaster because the government cannot function without billions of foreign investment every day.

It is also likely that the value of the dollar would fall, also as a reflection of risk.  Imported goods would become more expensive.  Since we buy most of our goods from outside the U.S., the cost of living would rise.

Ok, let's say that the bailout doesn't work as promised and the crisis continues to get worse.  $700 billion will have been transferred from the taxpayers to the bankers just before financial disaster, allowing them to more easily weather the storm, while the people are worse off than they would have been.

Whether the bailout works or not, the people who made money from fraud never have to give back a penny and they are not held accountable for their crimes.

Tags: america, bailout, bernanke, capitalism, congress, credit, debt, deflation, depression, economics, economy, federal reserve, inflation, market, money, paulson, recession, stocks, trading

Add A Comment

[Busymama07]

Sep. 25, 2008 at 2:35 AM

Thank you for posting this. It answered a few questions I had.

[arthistmom]

Sep. 25, 2008 at 7:45 PM

Sadly, you're probably right with your last sentence. But in the ideal world, there would be criminal statutes applied and there would be a criminal investigation where, at the end, those who engaged in massive fraud would be delivered into the welcoming arms of the penal system.

[MotherofIreland]

Sep. 26, 2008 at 9:03 AM

So, the interest paid back to the govt from the failed banks won't cover the interest that the govt has to pay? Ugh, this sucks. Thank you very much for this post. It really cleared things up (well, as much as it could). Although, I have to ask, is this as complex as people claim?? My initial thoughts are that labeling this as "complex" is a cop out. If you label something as complex and complicated then you wash your hands of trying to understand it and fix it.

[Cecropia]

Sep. 26, 2008 at 12:16 PM

The banks don't pay any interest back.  This isn't a loan.  We are buying their worst assets at a premium and selling them at a loss.  The only way that the gov makes a profit is to sell the risky mortgages at a higher price than we paid, but though politicians like to spin this as a real possibility "when the real estate market recovers," it's not going to happen.

It is very complex.  I learn something new every day.  My little synopsis here is not comprehensive, it's just scratching the surface, really, when you look at it on a global scale.  Credit default swaps/credit derivatives are the real 800 lb gorilla in the room, not mortgages,  If they start to unravel, we are really in trouble.  Bush wasn't wrong when he called it a "house of cards" (I still can't believe he said it in public).

 

(Original Poster)

[Karin78]

Sep. 30, 2008 at 4:54 PM

Thank you for your insight.  I've been watching Congressional hearings about this problem and proposed solution, and those who support the bailout really make it sound like a good idea.  I'm really glad that I've researched the other side (with your help, of course). 

I've been a little out of the loop on this subject for the past couple of days, though.  I know that the first proposal failed, right?  Where are they now?