"The principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale." --Thomas Jefferson

Monday, September 29

Bailout Basics

With the very real chance of a financial meltdown, the Congress has now sent a bailout bill to the House to vote on. I ask myself if the average Joe American has any idea what this bailout actually is supposed to do and what the ramifications are if it doesn't work. I thought I would lay it out as simple as possible.

"Capital Markets"-There is a constant need for credit in our economy. Big companies and corporations need capital to do business and often float credit to meet expenses. For example-Say GM needs to borrow $20 Million to buy steel to manufacture cars. In the current financial state, no one is willing to lend money because they need those reserves for their own companies and are worried about lending to a company that's already in trouble. If GM can't get the capital required, it has to cut costs somewhere else. You guessed it, probably jobs. This is how quickly the matter could escalate. When large American companies start laying off employees then that affects every aspect of the economy in a negative way.

"Credit Crunch"-This refers to the unwillingness of banks and other financial institutions to loan money to each other. Banks loan to each other on the overnight market at the LIBOR rates. These rates have decreased to because no one is lending to each other. Banks are fearful of their solvency because of their bad loans and their customers "making a run on the bank" because they are fearful that their bank is one in trouble financially. Thus, they hold on to any of the reserves they can. It was reported today that there is over $5 Trillion in capital available in treasury notes and other assets that could flood the markets. The purpose of the $700 Billion bailout that Congress is negotiating is intended to alleviate fears and concern about lending and will thus free up these trillions that are out there. If this doesn't happen, the bailout will fail. The $700 Billion is not intended to rescue the entire economy by buying all the bad assets. It is mainly an emotional trigger that the government is now hoping will make a difference in overnight lending.

"Sub-Prime and lax lending practices"-Foreclosing on your home seems to be something that someone with a good steady job will never have to worry about. Back in the 1990's under the Clinton administration, many lending practices were altered and underwriting requirements were made much more liberal citing "affirmative action" in the lending arena. Banks agreed because they were often only agents in the deal. You sign the mortgage and within a few days, they had packaged and sold the majority of these mortgages as securities to investment banks and other investors. They didn't care if the underwriting was bad. They only have to risk their own money for a few days. So as long as you make your first payment, the bank if off the hook and has made a handsome profit on the origination and sale of the loan.

"Predatory Lending/Borrowing"-I am sure you've seen houses on the hill and wondered how that person affords that mortgage. In the past, you had to have some money down to buy a house. The down payment was your way of showing the bank that you were serious enough about the house purchase and the ensuing payments that you were willing to put up thousands of your own money to back that up. As of lately, you have been able to get 100-125% financing on your home with no down payment. In addition to this, you have been introduced to a mortgage called the Option ARM that allows you to pay a 30 year payment, an interest only payment or a minimum payment. The minimum payment is also called a negative amortization payment. Your monthly mortgage payment does not even cover the interest on the loan. So if you choose to pay the minimum payment, you are actually increasing the mortgage balance every month. This worked for some people when the property values were going up. It also enabled the bank to sell a mortgage considerably higher than a 30 year mortgage, thus making the bank more money. Now for the fine print. In 3-5 years your payment reverts back to a 30 year payment (much higher) and your interest rate begins increasing each month. Tough if your mortgage balance has also increased 20% due to the negative amortization. At this point you have two options. Sell the house and get out of the mortgage. Also tough if you owe more than your house is worth and the market is flooded with other houses in the same position. Option two, walk away. Most are doing this because they have no down payment and no stake in keeping the mortgage. Banks that hold these mortgages are going out of business left and right because the homes are now only worth a fraction of what has been borrowed-and the bank can't sell the house either. Banks used these mortgages as collateral to buy other assets, stocks and other securities. Thus bad debt on the books. We the taxpayers will now buy these bad debts from these greedy companies to enable them to continue on with their business. This is the major cause of our financial mess. Greedy banks and greedy borrowers.

"Investment Banks"-Banks and Securities firms are required to allow themselves to be regulated. Their books are examined and they are supposedly overseen by the regulators. They in turn are offered the ability to access money from the Federal Reserve at a lower rate and loan out at a higher (arbitrage) However, investment banks are different. These investment banks act as agents and investors in the global financial markets without any regulation at all. They deal in hundreds of billions of dollars and have no rules. The only rule is to make money on the deal. You can imagine the corruption and greed that would abound in such an environment. Up until a few weeks ago, the only two major investment banks left were Goldman Sachs and JP Morgan. They have since applied for bank charter. Because of the global ties of these investment banks, the world economy as a whole is under the same stress.

The proposal as I understand it at this point gives the treasury secretary $250 Billion to use immediately, another $100 billion to use with a letter request to Congress and the other $350 Billion on reserve to be accessed if needed but only with Congressional action.

I hope this helps you understand the commonly used terms that are so important to understanding why we are in this mess.


Carlee Hoopes said...

This is a great post. Very informative! So, what is your take on the Bailout? Do you think it should have passed?

Kirk said...

Carlee, Your comments are always questions about my next post! I wrote the "End of an Era" post in response to your question. Thanks for the feedback.. It's nice to know someone gets something from my posts besides me.