The Anatomy of the Bailout

I have been taking an economics class at the right time. One of my chief frustrations has been my ignorance of the financial world, how it works, and what it all means. With all the talk these days of bailouts, mortgage backed securities, and credit swaps I would have been completely and totally lost. So here is an assignment I had in trying to explain the bailout in simple terms to someone who would not know a thing about the financial world… which I assume would be most of us.

Headlines are calling it the greatest economic challenge faced since the Great Depression. The alarm over the failure of the nation’s largest, most respected financial giants has prompted drastic action from political and financial leaders. The result of their decisions is a $700 billion “bailout” or “rescue plan” aimed at restoring fiscal credibility to the lending market that is suffering from stingy credit policies. In this paper I will explain the events and policies that brought this unfortunate state of affairs about with the hope of making it clear to the average reader.

Much of the bailout talk is connected to the failing housing market. Beginning there is crucial in our understanding of the current crisis as it is the lead weight tied to the ankles of our fledging economy. Homeownership has always been a rite of passage in the American life. It is perhaps the most definitive mark of prosperity that makes the American Dream a reality. One transcends class barriers not just by sleeping under a roof, but by being able to park in one’s own garage every night. Of course, no one has the money on hand to buy a house. Saving up for one would take decades, and would be nearly impossible. So a loan is needed to initially pay for it, and the borrower is obligated to pay it back over a long period of time. However, the borrower has to prove he or she is worthy of the loan, which simply means they have the ability to pay it back.

This is where the problem begins. Not everyone has the means to pay back a loan for a house, and therefore do not qualify for one. They fall below the “red line” so to speak. Unfortunately, these people tend to be of lower classes (not surprisingly) and minorities. However, those that politically represent these people found an opportunity. They introduced legislation that promised “affordable housing” to low income and minority borrowers by threatening lenders with punitive actions if they did not lower the red line. The most famous example is the Community Reinvestment Act passed by Congress and signed into law by Jimmy Carter in 1977, which obligated lenders to “meet the credit needs” of “low-income, minority, and distressed neighborhoods.”

In 1999 The New York Times reported that the Fannie Mae Corporation, the nation’s largest underwriter of home mortgages, relaxed their credit standards to extend loans to minorities and low-income borrowers. The reporter noted that Fannie was taking on more risk which would not be a problem during a boom, but could be troublesome in a downturn. The report quotes Peter Wallison, a fellow at the American Enterprise Institute as saying, “If they fail, the government will have to step up and bail them out the way it stepped up the thrift industry [the savings and loans industry of the 1980’s].” The “affordable” loans being issued were termed “subprime” to distinguish them from conventional loans that low risk borrowers would normally get.

Wallison’s warning would prove to be prophetic. In a recent Wall Street Journal article he and Charles Calomiris detail the history of the government-sponsored mortgage giants Fannie Mae and Freddie Mac’s unrestricted buying of subprime loans that stimulated subprime lending market. The explanation for the collapse of the market is found in the simple proposition contained in the original problem: low-income borrowers did not have the ability to pay back lenders. The huge increase of subprime loans financed by Fannie and Freddie saw a huge increase of foreclosures and defaults that resulted in gigantic losses.

It is important to note that Fannie and Freddie did not directly loan to consumers. Rather they financed the lending of private lenders by buying their loans and reselling them to Wall Street investors. But their borrowing was not only unrestricted, it was encouraged to fulfill the purposes of subprime loans. The pressure they felt from politicians in the quest for “affordable housing” resulted in a fervor of lending that reached its height during the housing boom. Not only did Washington want cheap loans, so did Wall Street.

Wall Street’s role is more complex but driven by the simple desire for profit. The boom in housing created a demand for more loans, and in turn a demand for investment in “mortgage backed securities” and “credit default swaps” (CDS’s). Mortgage backed securities are investments made on capital in the housing market. CDS’s are financial units of insurance against losses on investments. They function like mortgage insurance that a lender stipulates to a borrower to take out that will protect against potential loss. Insurance against losses on investments was easy money in the boom times, and sold at exponential rates. But when widespread foreclosures took the bottom out of the housing market, Wall Street’s investments in mortgage backed securities plummeted. The CDS’s in place simply could not compensate for the sudden dramatic losses, and the financial giants fell like Goliath on the battlefield. Goldman Sachs Lehman Brothers went bankrupt and the insurer AIG crumbled to pieces.

The financial crisis at heart is a credit crisis. With the heavy losses suffered by banks and other financial institutions like Fannie, Freddie, and AIG the availability of loans is made tight. Lenders are reluctant to loan out money to anyone, including other normally reliable financial institutions. Investors in industry have less access to money to finance their ventures, which in turn affects consumers, slows economic output and increases unemployment. The intent of the proposed bailout is to buy up and pay off the bad loans so that lenders will free up the credit market and get things moving again. However, the time lag caused by the slow approval of Congress and the inaccessibility of monies may have caused irreparable harm. Only time will tell.

On thing is for sure, however: the poor, who were intended to benefit from subrime lending, are those taking the biggest hit.

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10 thoughts on “The Anatomy of the Bailout

  1. Gary says:

    Just to clarify a few minor points:
    1. It was Lehman Brothers that declared bankruptcy, not Goldman Sachs.
    2. Bear Stearns, Merrill Lynch, and Morgan Stanley would have probably done likewise not because of the amount of “toxic” assets on their balance sheet, but as a result of a lack of confidence which is the lifeblood of the pure-play investment banks as they (until recently) wouldn’t have been able to borrow any money at the Fed discount window to fund their trades. This is why Goldman Sachs and Morgan Stanley have become Bank Holding Companies as it allows a secondary source of funding if their counterparties tighten their lending criteria.

  2. Elton says:

    It remains to be seen the % of people “suffering” from the sub-prime melt down are truly low income, poor individuals, compared to home flippers (http://tiny.cc/4DDnK), real estate agents, and other real estate investors.

    The big losers in every real estate down turn are real estate agents and home flippers who over-extended themselves by buying several homes to sell (thus keeping the difference and the commission), and the people who lost jobs or have to re-locate on their own dimes.

    To my knowledge, no one has pointed the finger at the state and local governments who were supposed to monitor the lenders and brokers. The state and the local governements stood to gain from the increased property tax to satisfy the spending programs. The local governments were not going to upset the apple cart as long as they got the tax revenue.

    Let’s face it – if I have a $40K income, $10K in the bank, and got into a $450K home on a 1% ARM with no down payment, what am I losing by walking away when the loan adjusted to 14%? I lost a low cost, nice rental from which I received tax deductions.

  3. Jason says:

    Do you have a Private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk by buying a credit default swaps (CDS) to protect them in the event you have your home that your home is taken away from you. CDS and PMI are the same thing. Make people wanting to buy a home put at least 20% down if you don’t like them. nomedals.blogspot.com

  4. Chris E says:

    It is a credit crisis in the some sense, though unqualified use of the term is misleading.

    If all it consisted of was unsecuritised mortgages to a bunch of impecunious borrowers then it would be easy to fix. The various institutions could just repossess the underlying assets (properties). Even if there was a slight fall in housing prices as a result – which is unlikely, as institutions would tend towards not panic selling in that situation – the losses would be restricted to a certain circle.

    Securitisation, CDOs with the associated regulatory and ratings arbitrage associated with this is the necessary element for making the mortgage situation a worldwide financial crisis. The associated lack of liquidity is what is really driving the problem – as you point out further

  5. Bob Sacamento says:

    I am very, very interested in this post because I think I am a smart guy, relatively speaking, but I have no clue about what is going on. So, if I may, a few of questions:

    1) When you say, “Mortgage backed securities are investments made on capital in the housing market. CDS’s are financial units of insurance against losses on investments,” I have no idea what you mean. I am sure you are completely correct, but saying that is just an act of faith on my part. If you could clarify, I would be most grateful.

    2) Just before that, you say, “Wall Street’s role is more complex but driven by the simple desire for profit. The boom in housing created a demand for more loans, and in turn a demand for investment in ‘mortgage backed securities’ and ‘credit default swaps’ (CDS’s).” I’m sorry. I don’t get it. Who was the genius who decided that you could make a profit by buying into bad loans? The CEOs of these companies are paid hundreds of millions of dollars a year to make these kinds of decisions. I could have made the right decision for only a fraction of the cost. Maybe the more pertinent question is why can’t I be a CEO and be paid hundreds of mil a year? Is there some kind of stupidity quotient these companies have to meet?

    3) OK, I think this question is going to be really stupid, but here goes. The whole problem is supposed to be “illiquidity,” i.e. wealth is all locked up in things that don’t move easily, like houses, and not distributed in things that do move easily, like cash. OK, bad loans were made. Let’s say I make a bad loan to my cousin Vinnie. He can’t pay it back because he spends it all at our mutual friend Vito’s casino. Well, that’s bad for me, and REAL bad for Vinnie. But it doesn’t affect the family, er, market, as a whole, because the money is still there. Vito has it. And, if he wants to, he can loan it out. Probably not to Vinnie, but that’s only Vinnie’s problem. Everybody else should be fine. So, stupid question: Where did all the badly loaned money go? Why can’t we just find out who got the money in these loans — i.e., who are the Vito’s in all this — and borrow from them?

    4) This all starts with mortgages, pure and simple, which isn’t all that big a fraction of the economy, really. And it’s not all mortgages that are a problem, just the ones that defaulted in the past few years. It is my understanding that these mortgages are actually a rather small percentage of all mortgages. Am I wrong about this? If I am right, then how does a financial tropical depression involving a rather small slice of the American economy turn into this financial hurricane?

    Thanks.

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