Wednesday, September 24, 2008

The bail out

*sorry if this is a little difficult to understand or non linear, I'm really thinking "outloud" here.*

So like many (I think most) Americans, I'm reading and listening about the bailout, and think....is this good or bad?

so I'm on a quest to understand what's happening, why it happened and what will happen. I have a friend who is a financial analyst who I'm sure understands this all so hopefully I'll get to ask him, in the meantime, the most illuminating explanation I've seen so far was Bill Clinton's on the Daily Show.

This is what I understand at this point, forgive any egregious errors and please feel free to correct them, I in no way stake any claim to any great understanding, and this is actually mostly gleaned from conversations that I've had and then my own logical pinning of things together, not research as such.

At the end of the economic boom of the 90's there was a surplus of cash in the economy and in order to create places to invest it the residential sector was expanded. To sell these homes more "unqualified buyers" were given loans at very high rates. These are high risk loans: the loanee's are less likely to pay them back (as per their history) but if they do pay them back the loaner stands to make a lot of money.

What happens next is that the banks sell their loans in bulk to other banks and investment companies. They sell the debt because it is better for them to have money in their pocket now, than to have potentially more money later, but the risk of having no money. Why would someone else buy high risk debt? This sounds really confusing but really we should look at it like any other investment: they pay x for the debt/investment and stand to make a great deal of interest if the loanee repays. The "if" has been turning out to be a bit of a problem. So what happens next is where things break down.

In mortgages there is a foreclosure clause, the collateral. This way the bank does not end up high and dry if their loan is not paid back, they repossess the house and the sell it themselves thus ideally making back the money that they have loaned. This is not ideal as they stand to make more money from the interest of being paid back, then from selling the house, but it's their security.

but now many people are not paying their loans back, does it pay to foreclose on all of these people? Well it seems like no, who's really in the market to buy a house these days? The cost of foreclosing on all of these people and then trying to sell all of these houses is too great for this I think. So what? all of these folks are defaulting on their loans, do we hit them up with higher interest rates thus making it harder for them to ever get out of debt, but increasing the investors chance of making their money back?

That's the whole thing with high risk investments, they're high risk for a reason, and these big investment companies stand to loose everything. A free market attitude would say, well they should lose everything. But looking at the bigger picture gets confusing.

The folks who bought up these loans are not necessarily the folks who own the debt. People who buy diversified funds (I think) own some of this debt, they trusted their investors/brokers to do this for them. They did not necessarily decide to buy these particular funds...I don't know.
It effects more people than made the decisions to buy up these loans.

The bailout:

We, the people of the United States of America lend the companies, and ultimately ourselves 700 billion dollars. LEND. I think that's the part that's evading some people. Ideally the treasury is not just giving banks et al 700 billion dollars, but making an investment. Hopefully an investment that will be paid back and ultimately cost the tax payers far less than 700 billion dollars. It sounds like if it's done wisely it will cost the tax payers about 100 billion dollars. That's still a lot of money. While I can conceive of a million dollars and what that means, it is difficult for me to conceive of a billion dollars and what that means, let alone 100 billion dollars.

(but it's a vicious circle yes? an investment on an investment, and a bad one at that)

So what happens if we do bail out? Foreclosures don't have to happen, eventually things are paid back, the government is re payed and there is greater oversight as to who is loaned what? It's not just a loan though, the government will take a greater interest in how the banks that they now "own" a part of operate.

If we don't bail out? There are lots of foreclosures, our money in the banks (over $100,000 the insuring policy changes but it can be more or less apparently? I actually have no idea) is not particularly safe. commodity prices continue to rise, salaries do not, (this can still happen with a bail out yes?)

Anyhow, there is clearly a place where I just stop understanding.

there are nagging questions though. Do the folks defaulting on their mortgages "deserve" to have their houses repossessed? Do the folks with their high risk investments "deserve" to loose all their money? All of this money that was invested...where is it now?

finally just a quick thought (Noel and I were talking about this) there is all this talk of the stock holder vs. the tax payer. Presumable all stock holders are tax payers, and some tax payers are stock holders, so these categories are not quite as mutually exclusive as debate makes them to be.

More hopefully when I get this explained to me.

5 comments:

ayn said...

If you want to know more about how this all happened in the first place (the mortgage crisis), I highly recommend this episode of This American Life called The Great Big Pool of Money: http://thisamericanlife.org/Radio_Episode.aspx?episode=355

As for the bailout, I have really just begun informing myself about it, what it is, and what it will mean. Unfortunately, I feel like that's the state that most Americans are in in terms of understanding the situation--what's unfortunate about this is that they're trying to get a decision pushed through as soon as possible, which could very well be sooner than most people have come to understand exactly what's going on.

My mother emailed me today to tel me that she had written our representatives to tell them not to support the bailout. I listened to some minds discussing it on the Diane Rehm Show today and one person put it in terms similar to how I feel: the heads of these investment firms take risks that stand to make them a huge profit while at the same time don't cost THEM anything if they fail; consequently, these people are willing to take a lot of risks, ones they probably shouldn't, because there aren't any consequences for them. This disaster wasn't by mistakes, it was caused by calculated risks that failed, and bailing them out feels a lot like rewarding them for taking unnecessary, greedy, selfish risks with other people's money.

The other side to this, as you mentioned, is that refusing to bailout the companies hurts consumers (and realistically, the people in charge probably wouldn't feel a thing). But if the firms aren't punished, they'll never figure out that they should not do this in the future.

Additionally, the $700 billion dollars isn't exactly a loan, and there's no promise of it getting paid back (admittedly there's no promise of it all getting spent, either, but that's the best case scenario)--it depends on the price of the assets.

The guy on the radio today also made the point that if the government does come to own the industry, it's going to be a mess figuring out who is going to run it and how.

Like I said, I'm not as educated on this as I'd like to be, but I'm working on it. Check out today's and yesterday's Diane Rehm Show (http://wamu.org/programs/dr/) and this article on nytimes.com: http://www.nytimes.com/2008/09/24/business/24leonhardt.html?scp=4&sq=bailout&st=cse

Neen said...

You've got a pretty good synopsis here, but you don't fully explain why the foreclosure crisis happened to begin with. It wasn't just that high-risk people got loans and wouldn't pay them back: there was predatory lending (often illegal), in which many families with low levels of financial literacy were convinced to sign up for flexible rate mortgages. Essentially, banks would offer them what looked like a really good rate, burying in paperwork the fact that that rate would rise sharply after the first year or so, and continue fluctuating after that. The Banks didn't care that they were misrepresenting the product -- they wouldn't be holding on to the risk, that's someone else's tough luck. So a lot of people ended up with mortgages that they could afford... until the suddenly they were being told to pay 10% - 300% more per month than they had been told they would have to.

Needless to say, I have a lot more sympathy for the folks defaulting on their mortgages than for those who issued the loans in the first place. California has been trying to pass legislation for a while to ensure better regulated lending practices (suing the ass off some of the predatory lenders for example), but one state can't really make a dent until the Feds really step in to prevent banks from taking advantage of the financially illiterate in the future.

(Sorry for sounding so rampage-y. The foreclosure scene is exactly my area of specialization in grad school right now)

Alex said...

NB: These are theories of a layman. Total speculation to follow.

It seems to me like all of the action that is taking place now is leading up to some huge something. I was living with a family friend last summer who was already cynical about the entire thing before the crisis first hit (oh so many months ago).

I've kind of been waiting for the Second Depression, truth be told. I think we kind of deserve it as a nation. First the credit crunch, then the banks, now the bailout. Each time the amount of money seems to balloon out of proportion. We've already got the overinvestment requisite down. add in natural disaster (perhaps hurricanes instead of drought?) and who knows. I know that I;ve decided to reign in my spending a bit more, save a bit more, and see what happens. If the consumers as a whole are doing similar things, than we have three of the biggest instigators of the Great depression sitting on our doorstep.

The Fed bought up what? 80% of AIG this past week? I haven't read the details of the bailout yet, but It seems to be more of the same overinvestment. If it does fail, what happens? does the grand US of A go even further into debt? will we be held at all accountable for this debt as a country? ever?

A sick part of me would love to see the rest of the world call in our debt. I know it won't actually happen to the US, but I've heard of close cases: Has a Nation ever declared Bankrupcy? What kind of international law is set up t deal with that? Neeners? any idea?

Neen said...

Hmm... the U.S. declaring bankruptcy... we'd be just like Argentina back in the late 1990s I suppose... and would have to call the world bank to our rescue. Throw some galloping inflation in there at it'll look just like the apocalypse. You're right, you're not the only one drawing comparisons between now and immediately pre-Great Depression. Robert Reich, this super cool political scientist, made exactly that point during the keynote of Berkeley's grad orientation (very jovial way to start your grad school career). He particularly stressed the disappearing middle class and the investment bubbles...just like in 1928.

Actually, though, um, Alex, you do realize that if your direst predictions are right and the shit does hit the fan, your savings will be the first things to go? If they're in any sort of investment, gone (along with most families' college savings) and if inflation hits they won't be worth much. A big problem in the country right now is that people, banks, etc. aren't willing to spend/invest at all, so there's nothing to grease the ol' economy's wheels. Hence the dropping Fed interest rate and the stimulus package.

Where's Lisy? Can we get Lisy's read on this? She's a better economist than I am.

Alex said...

I say that I want to see the US have to deal this only because it would humble us as a nation(an almost completely separate issue from what is actually going on right now). I understand the precipice which we stand on, and really don't wish it on America, or any of the economies dependent upon us.

It's especially nerve-wracking because it's completely out of our hands as citizens. At least thats the way it seems. These are merely consequences of past decisions, no? A conflagration of the predatory lending, greedy companies, and some genuine mistakes along the way I'm sure.