EPTA lot of the information in this post is really really outdated, and in retrospect, a lot of it was pretty inaccurate. If you're confused about the mess in general, i think the way i explain things might help clear up some of the economics, but just take everything with a grain of salt.
Ok, I started writing this in my blog but I had such a negative reception because of my ahem *indignant* tone and I figured this was important enough that if that's what was costing me readers, I should post it again a little toned down. Frankly though, I am pissed about what's happening. It's something I feel passionate about. I think educating people is one way to keep shit like this from happening again, so here goes:
Unrelated: anyone hear about this? LOL, from 9/25
“I didn’t know I was going to be the referee for an internal G.O.P. ideological civil war,” Mr. Frank said, according to The A.P.Thursday, in the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulson Jr., literally bent down on one knee as he pleaded with Nancy Pelosi, the House Speaker, not to “blow it up” by withdrawing her party’s support for the package over what Ms. Pelosi derided as a Republican betrayal.
“I didn’t know you were Catholic,” Ms. Pelosi said, a wry reference to Mr. Paulson’s kneeling, according to someone who observed the exchange. She went on: “It’s not me blowing this up, it’s the Republicans.”
Mr. Paulson sighed. “I know. I know.”
“I didn’t know you were Catholic,” Ms. Pelosi said, a wry reference to Mr. Paulson’s kneeling, according to someone who observed the exchange. She went on: “It’s not me blowing this up, it’s the Republicans.”
Mr. Paulson sighed. “I know. I know.”
WARNING
IF YOU MAKE A STUPID POST I WILL KILL YOU
DISCLAIMER
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After some reflection, I think it's fair to criticize my credentials, and that it probably sounds arrogant to say I'm qualified just because "I read a lot." So let me qualify that statement more.
1.) I have taken Macroecon, and most of my understanding is "grounds up" learning. That means I picked it up in bits and pieces through my reading, and used my macroecon text to weave it all together. That leaves holes in my knowledge in places that aren't covered as often in my reading. Obviously in the discussion of the fed is one example.
2.) I'm on the debate team at my school (I'm a decent debater I might add) and about 2-3 hours of my day consists of reading from the Economist, NYT, and a selection of 20-30 think tanks from every side of the spectrum. I've been doing this for a few months, and while admittedly there are still holes in my knowledge, my understanding of world events is pretty comprehensive.
3.) It's frustrating being accused of ignorance by people who have neither made the effort to show how I am factually incorrect. You may disagree with me ideologically, but except for the parts that's clearly MY OPINION, you never tell me where I'm wrong. I make a good-faith effort to keep the facts straight and to clearly distinguish my ideology. I'd appreciate that anybody posting in response make a similar good-faith effort to approach my work with respect.
1.) I have taken Macroecon, and most of my understanding is "grounds up" learning. That means I picked it up in bits and pieces through my reading, and used my macroecon text to weave it all together. That leaves holes in my knowledge in places that aren't covered as often in my reading. Obviously in the discussion of the fed is one example.
2.) I'm on the debate team at my school (I'm a decent debater I might add) and about 2-3 hours of my day consists of reading from the Economist, NYT, and a selection of 20-30 think tanks from every side of the spectrum. I've been doing this for a few months, and while admittedly there are still holes in my knowledge, my understanding of world events is pretty comprehensive.
3.) It's frustrating being accused of ignorance by people who have neither made the effort to show how I am factually incorrect. You may disagree with me ideologically, but except for the parts that's clearly MY OPINION, you never tell me where I'm wrong. I make a good-faith effort to keep the facts straight and to clearly distinguish my ideology. I'd appreciate that anybody posting in response make a similar good-faith effort to approach my work with respect.
The News 10/1
Revised bailout with concessions to House Republicans passed in Senate with a very good margin. Bill will likely be at Bush's desk by next week. Bailout, here we come!
The News Yesterday
The Bailout was rejected in a not-even-close vote in the House, and the stock markets plummetted. The DOW dropped, 800 points (9%), an all-time record, although proportionately less than the 20% it fell on Black Tuesday and 14% on 9/17, because of 9/11.
The Fed's Role
(the following is from cAtAcLySmIc)
Not sure if it was covered (too lazy to read through all these pages), but, for anymore that cares, you are missing two huge components of what happened. HnR)hT covered one of them, in that Congress pressured banks to lend to minorities (most of them couldn't pay their mortgages).
The second is a little more complex:
Amid the dot com bust and 9/11, Greenspan cut the target federal funds rate to 1% to keep the economy going. As a result the rates on the treasury bills fall drastically. Institutional investors, more so pension funds, want low risk investments that yield ok returns. Treasury bills are the "safest" investment, but the yields had fallen so low, it just wasn't what they wanted.
These pension funds are calling the banks asking how to find an investment that gives a better return. This 1% rate is exactly what banks wanted. It let the banks borrow money cheaply, and let them leverage to ridiculous amounts. They used their leverage to buy a lot mortgages from mortgage lenders. They packaged up all the mortgages into CDOs, cut them up by risk rating, and sold them off to the institutional investors. Pension funds obviously wanted the safest mortgages, and they got them. Investors who want more risk, more return, like hedge funds, took the risky mortgages. These safe mortgages were like the new treasury bills to pension funds, and they wanted more and more and more.
The banks want more and more and more money so they told the mortgage lenders to sell them more and more and more, and the mortgage lenders told their mortgage brokers to get more and more and more. The problem is that all the people who qualified for the loans already had them. But, the greedy institutional investors, banks, and mortgage lenders wanted more money, so this made the mortgage lenders lower the standards for giving out loans... Uh oh. The banks didn't care because what happens if the person defaults? Well, the bank gets the house, and house prices have been rising and rising; so they would just sell the house and make a profit.
As a result, more and more people started defaulting. This caused more supply of houses, which caused the housing prices to decrease. The "safe" mortgages the pension funds wanted were not so safe. Institutional investors stopped buying CDOs from the banks, and banks stopped buying from the mortgage lenders. Suddenly, they were all holding a bunch of useless securities, and the problem was that because the banks had bundled everything together, no one knew which piece they had; thus, writedowns were the big thing last year.
The second is a little more complex:
Amid the dot com bust and 9/11, Greenspan cut the target federal funds rate to 1% to keep the economy going. As a result the rates on the treasury bills fall drastically. Institutional investors, more so pension funds, want low risk investments that yield ok returns. Treasury bills are the "safest" investment, but the yields had fallen so low, it just wasn't what they wanted.
These pension funds are calling the banks asking how to find an investment that gives a better return. This 1% rate is exactly what banks wanted. It let the banks borrow money cheaply, and let them leverage to ridiculous amounts. They used their leverage to buy a lot mortgages from mortgage lenders. They packaged up all the mortgages into CDOs, cut them up by risk rating, and sold them off to the institutional investors. Pension funds obviously wanted the safest mortgages, and they got them. Investors who want more risk, more return, like hedge funds, took the risky mortgages. These safe mortgages were like the new treasury bills to pension funds, and they wanted more and more and more.
The banks want more and more and more money so they told the mortgage lenders to sell them more and more and more, and the mortgage lenders told their mortgage brokers to get more and more and more. The problem is that all the people who qualified for the loans already had them. But, the greedy institutional investors, banks, and mortgage lenders wanted more money, so this made the mortgage lenders lower the standards for giving out loans... Uh oh. The banks didn't care because what happens if the person defaults? Well, the bank gets the house, and house prices have been rising and rising; so they would just sell the house and make a profit.
As a result, more and more people started defaulting. This caused more supply of houses, which caused the housing prices to decrease. The "safe" mortgages the pension funds wanted were not so safe. Institutional investors stopped buying CDOs from the banks, and banks stopped buying from the mortgage lenders. Suddenly, they were all holding a bunch of useless securities, and the problem was that because the banks had bundled everything together, no one knew which piece they had; thus, writedowns were the big thing last year.
Deregulation
NOTE: This part is controversial, to be fair. Before you start spouting my left wing propoganda to your friends, read some of the other views on the causes of the current crisis in the thread below. Ignore the idiot posters, but definitely read what jgad has to say, and onemephisto.
WHAT IS DEREGULATION YOU ASK? In short, it's a fetish. Mostly Republicans have it, but Democrats too, under different circumstances. Technically, it's the belief that rules and regulations are bad for economic growth, and that the less regulation the better. This is true, as we'll see, to an extent. Anyway, sometimes the stars are in the right alignment, and Democrats and Republicans will come together in an all-night long orgy of deregulation. This happened in 1999, with the Financial Services Modernization Act, also called the Gramm-Leach-Bliley Act after the people involved in the menage-a-trois that started it all. What this did was fuck you over. What it really did was repeal large portions of the Glass-Steagall act, which if you remember from history, was passed in 1933 to keep the Great Depression from happening again by regulating banking.
Regulations are not necessarily a bad thing. All economies need regulation. In an ideal world, when every investor has very good information about which companies will succeed and which will fail like ... like THE ECONOMY IS FAILING LOLOLOL ... we wouldn't need regulation, because the free market would regulate itself: bad investments won't find investors. But in reality, nobody has perfect information. A good analogy is if you're looking on Craigslist for a female companion, and they turn out to be a guy. You got bad information buddy. You got ripped off. As a result, you just wasted time and resources, and you hurt the economy because you could've used those resources for something productive, like posting on TL.
Regulation can also be a bad thing. More rules means more red tape, means higher costs to make any business transaction. The higher these costs, the less efficiently the economy operates. The key is finding the right balance: how much regulation and in what areas will give us the fastest growth and the most stability.
The FSMA (and many other bills which tbh, I don't know enough about) took it too far. It deregulated areas it shouldn't have. Most importantly, it led to the housing bubble.
The Housing Bubble: Subprime Mortgages and Stuff
First of all, you need to understand supply and demand to really understand the rest of this. Basically, the more there is of something and the easier and cheaper it is to produce, the less something will cost. The more people want something (demand), the higher something will cost. These two forces interact to create an "equilibrium price", which is the price at which a perfectly competitive market will sell that good for.
Houses are really expensive. It would take years, even decades, for most people to save up the money they need to buy a home. For that reason, banks offer a little service they like to call "mortgages". In a mortgage, the bank lends you the money you need to buy a home, on the condition that you will pay it back PLUS a premium of x%. Mortgages are a product, just like a car is a product. In exchange for letting you buy a home sooner, you pay the bank a premium. Ideally, banks would only lend money to people they were sure could pay them back: people who had a clean criminal record, good credit, and a solid income.
Unfortunately, because of deregulation, this didn't always happen. Banks and less reputable financial organizations began lending to the "sub-prime" market. These were people whose credit history meant they had a good chance of defaulting on their loan. One reason banks made these loans was because they figured that housing prices would keep rising forever. If these guys couldn't pay back their loan, we'll just repossess the house and sell it at a profit to someone who can!!!1111 (LOL HOW WRONG THEY WERE).
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correction for below paragraph: I said earlier that the banks packaged them into Collateralized Debt Obligations. Wrong. Actually, the secondary mortgage market -- Mae/Mac did this.
After selling a bunch of these mortgages, banks would sell them in the secondary mortgage market to investors. You're probably thinking, "how do you sell debt???" It's simple, just remember that loans are a product. In exchange for paying for the total sum of the loan, the investor gets a portion of the premium the borrowers pay the bank. Because of rising housing costs, these mortgage backed securities were considered good investments, and were quite popular, to the point that they were acquired in the trillions of dollars by investors here and overseas.
The Housing Bubble Deflates
So long as investors kept buying mortgage backed securities, banks continued to make subprime loans. Essentially, they were speculating: gambling that because housing prices would keep rising, they would eventually make a killing. Unfortunately, speculation has the added effect of artificially inflating demand, raising prices. Thus the financial system created a self-fulfilling prophecy: By betting on increased housing prices, they made housing prices increase, creating the housing bubble.
Of course, this couldn't go on forever. Eventually, the rise in housing costs outpaced what consumers were willing to pay. This began in July 19, 2007, when the DOW hit an all-time record high. A month later, the DOW had fallen by 7%. Among the worst hit were mortgage lenders. When stocks become a bear market (it increases in volatility, and is tending toward falling), what naturally happens is that investors put their money on "safer" investments, commodities in particular. Billions were withdrawn from the mortgage industry and as a result, and banks responded by tightening their credit belts and raising interest rates.
The people on the front lines of this crisis were the subprime lenders. Most of them had signed up for Adjustable Rate Mortgages -- meaning that their interest rates were subject to change -- hoping that the inflating housing market would mean that the interest rates would gradually decline in respect to real wages. Because sub-prime mortgage lenders had been hit so hard in the stock market, they needed to raise capital, fast. So they increased interest rates. The reasoning was that even if these people couldn't pay back their loans, the banks would foreclose on them and they could sell the houses again for money. The problem with this logic was supply and demand: Because millions of homes were being foreclosed across the country at THE SAME TIME, supply went up. Because banks were tightening their credit and it was becoming harder to get a mortgage, demand was down. These two factors combined to create rapid deflation in the housing market that is still continuing today.
After a while, as banks hemorrhaged more and more money, it became not just the subprime borrowers who got fucked over, but prime borrowers as well. This happened because banks had to really tighten up credit everywhere to keep themselves afloat. Rising interest rates, combined with declining wages and increased unemployment sent even qualified homeowners into foreclosure, dropping housing prices further. This is an important theme that will appear again and again here: as one sector of the economy blows up, the rest must make up for it.
While we normally think of inflation as an indicator of an economy gone sour, in this case deflation is much worse. The more housing prices fall, the less money banks can get back from their bad loans, and the more investors lose on their mortgage backed securities.
The Next Domino: Wall Street
Until now, I haven't really talked much about what's happening right now with wall street. But this is crucial to understanding the bailout. Everything in the economy relates with what's happening now, including your wages and how long you'll be holding on to your job. People tend to think of wall street as the place rich people go to make more money, but that's just not true. When you deposit money into a bank or certificate of deposit or savings account or mutual fund or hedge fund or whatever, that money doesn't just sit there and magically grow. It's invested. Without investment, if everybody just hoarded the money they had, the economy would cease to grow. Without investment and easy access to credit, you can't start a new business, buy a new tractor for your farm, or buy a new home. Credit and investment is everything.
Bear Stearns was among the first big names to go. Bear Stearns was an investment bank, meaning you didn't just go to a bear stearns office and start a checking account. People put large sums of money into Bear Stearns through equity (shares of stock) or their "wealth management" division that got invested into things like other investment companies, oil, and SUB-PRIME MORTGAGES. Obviously, it's the last that did Bear Sterns in. What was so shocking is how fast it happened. One day Bears was trading at $130 a share, the next they were down to $10 or $20. The reason for the rapid decline was the fact that the executives over at Bear Stearns finally decided to admit just how much money they lost in the two hedge funds they had that specialized in sub-prime mortgages. BOOM! And the floor fell out right under those poor investment bankers. The only way they could even sell their company off was if the fed promised JPMorgan Chase it would cover any losses they suffered from buying out Stearns.
Which brings me to federal bailouts. I don't have the energy to cover every bailout (although I will do more work on Mae and Mac later), but in general, here's the reasoning behind them: When an investor loses lots of money in whatever, that makes them much less likely to invest again in the same sector because 1) they have less money to invest 2) they don't want to take the risk. When someone loses a few billion in mortgage backed securities, they are less likely to invest in mortgages again. The federal reserve feels it has to bail out or at least guarantee the solvency of these companies because if they were to go bankrupt, the consequent losses would have such a powerful damping effect on investment it would exacerbate the housing and credit crisis. I will openly admit that my knowledge of investment banking is limited. I think Last Romantic who is majoring in this shit (POOR GUY) knows more than I do, and if he reads this he can fill you all in more. But here's a quick review of what's going on:
Fannie Mae and Freddie Mac:
onemephisto posted an excellent review of the history of these mortgage giants, and how they contributed to the housing bubble very significantly:
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On October 01 2008 07:11 theonemephisto wrote:
Well, how I understand it:
Fannie Mae and Freddie Mac were originally both created by the government as government agencies, but were later partially privatized, resulting in them being called Government Sponsored Enterprises, or GSEs. Their purpose was to use their large supply of capital to buy mortgages off of the market, repackage them into securities and other derivatives, and then sell them to other firms.
However, even though they are partially privatized, they still retain a lot of government control and influence. They're regulated by Department of Housing and Urban Development (I think this started in the early 90s) and are chartered by Congress. Since HUD has become their regulator, they have had yearly goals; they're supposed to buy a certain amount of "affordable" loans (read: low-down-payment loans to low-income families). Of course, this sounds good, as everyone wants low-income families to have housing right? However, the fact is that many people simply can't afford housing, and the government mandate for Fannie and Freddie to buy these bad loans has made them viable for banks to offer (especially considering how large Fannie and Freddie are, they buy something like 40% of mortgages created each year). And to encourage even more of these subprime loans, Congress also passed a law giving tax credits to Fannie and Freddie when they bought subprime securities, further increasing the demand for them.
So these government mandates and incentives greatly increased the amount of bad loans the Fannie and Freddie bought. What allowed other banks and investment firms to buy these repackaged securities from F&F was the implicit government guarantee behind them, basically, since the government had so much stake in F&F, people assumed that the government wouldn't let them fail or let their liabilities disappear (which was obviously true), creating a moral hazard situation where people disregard risk because there is no downside to failing.
So government regulation and interference with Fannie Mae and Freddie Mac contributed to the creation of the bubble, and the implicit government guarantee behind the securities allowed it to spread.
Of course, this isn't the only reason, but there are also many other government regulations that have helped create this crisis. The Community Reinvestment Act, which was substantially strengthened in 1995, mandated that banks make a certain amount of loans to low-income families, again creating a misallocation of resources into the housing market. There was also a recent act that reduced the capital gains taxes that people had to pay on homes substantially, but I can't find a source atm.
I'm not clearing investors of all blame, sure, they acted greedy, ignored risks, and took advantage of new derivatives and the market situation. But I'm saying that fundamentally, the problem was with too much government regulation and interference, not too little. More government regulation probably could've delayed this problem, but it would've only been a short-term fix to the underlying problems introduced by the government itself.
tl;dr, Government mandates for affordable housing loans to low-interest families and it's control over the Government Sponsored Enterprises of Fannie Mae and Freddie Mac created the underlying driving force for the creation and subsequent popping of this bubble.
Well, how I understand it:
Fannie Mae and Freddie Mac were originally both created by the government as government agencies, but were later partially privatized, resulting in them being called Government Sponsored Enterprises, or GSEs. Their purpose was to use their large supply of capital to buy mortgages off of the market, repackage them into securities and other derivatives, and then sell them to other firms.
However, even though they are partially privatized, they still retain a lot of government control and influence. They're regulated by Department of Housing and Urban Development (I think this started in the early 90s) and are chartered by Congress. Since HUD has become their regulator, they have had yearly goals; they're supposed to buy a certain amount of "affordable" loans (read: low-down-payment loans to low-income families). Of course, this sounds good, as everyone wants low-income families to have housing right? However, the fact is that many people simply can't afford housing, and the government mandate for Fannie and Freddie to buy these bad loans has made them viable for banks to offer (especially considering how large Fannie and Freddie are, they buy something like 40% of mortgages created each year). And to encourage even more of these subprime loans, Congress also passed a law giving tax credits to Fannie and Freddie when they bought subprime securities, further increasing the demand for them.
So these government mandates and incentives greatly increased the amount of bad loans the Fannie and Freddie bought. What allowed other banks and investment firms to buy these repackaged securities from F&F was the implicit government guarantee behind them, basically, since the government had so much stake in F&F, people assumed that the government wouldn't let them fail or let their liabilities disappear (which was obviously true), creating a moral hazard situation where people disregard risk because there is no downside to failing.
So government regulation and interference with Fannie Mae and Freddie Mac contributed to the creation of the bubble, and the implicit government guarantee behind the securities allowed it to spread.
Of course, this isn't the only reason, but there are also many other government regulations that have helped create this crisis. The Community Reinvestment Act, which was substantially strengthened in 1995, mandated that banks make a certain amount of loans to low-income families, again creating a misallocation of resources into the housing market. There was also a recent act that reduced the capital gains taxes that people had to pay on homes substantially, but I can't find a source atm.
I'm not clearing investors of all blame, sure, they acted greedy, ignored risks, and took advantage of new derivatives and the market situation. But I'm saying that fundamentally, the problem was with too much government regulation and interference, not too little. More government regulation probably could've delayed this problem, but it would've only been a short-term fix to the underlying problems introduced by the government itself.
tl;dr, Government mandates for affordable housing loans to low-interest families and it's control over the Government Sponsored Enterprises of Fannie Mae and Freddie Mac created the underlying driving force for the creation and subsequent popping of this bubble.
This bailout was absolutely crucial. I told you earlier that Mortgaged Backed Securities were sold by the people who did the lending in the first place, right? Before that happens, the individual debts are sold in the "Secondary Mortgage Market" to Mae/Mac, these two semi-governmental entities created during the Great Depression to make it easier for people to get homes. These two companies serve as "lubricants" of the housing market. They help money flow to where housing demand is highest. For example, if I am a banker and where I live all of a sudden has a huge increase in demand for homes, but I only have a little bit of capital to lend, I can look to Mae/Mac to fully exploit this demand and meet the needs of the market. These guys together were responsible for 70% of American mortgages. SEVENTY FUCKING PERCENT HOLY SHIT.
But Because of Democrat idiocy (SORRY BUT OUR PARTY ISN'T PERFECT, DURRR), these two lenders are practically unregulated. The idea was that this would help them make it easier for people to get a home. What it actually did was to enhance the "moral hazard" situation for home lenders. Because they knew they could just sell off sub-prime mortgages to Mae/Mac, they made more subprime loans, but wiped their hands clean of the risk when they sold it. This is what economists call Moral Hazard: when somebody does something risky but the consequences of that risk is felt by someone else. It encourages unwise behavior like subprime lending. If I press a button that maybe kills YOU, I am more likely to press the button than if it maybe killed ME.
Here's the thing. When Mae/Mac sell those Collateralized Debt Obligations/Mortgage Backed Securities, they guarantee to the investor that they will pay them the full value of the investment even if the homeowner defaults on the mortgage. Uh oh. Moral Hazard anybody? Anyway, if these two companies failed, there would be TRILLIONS of dollars of losses globally. I'll go more into why that's bad specifically for the housing crisis later (although it should be obvious it's a bad thing in general).
Lehman Brothers
Allowed to go bankrupt because fed felt they did not have assets into crucial enough areas of the economy. The reason Bear Stearns was "guaranteed" was because it collapsed so quickly, and for classification reasons was outside of the fed's oversight jurisdiction, so it wasn't possible if Stearns was important to the market.
American International Group
AIG is unique because it is an insurance company that has its fingers everywhere, in every sector of the economy. It specialized in "credit default swaps" which I'm not going to even pretend to understand completely, but basically they guaranteed through insurance a lot of bad debt investments, similar to Fannie Mae and Freddie Mac. It absolutely COULD. NOT. fail. Without going into detail, it was still a profitable organization, but because of procedural issues, it needed more capital. So the fed lent it $85 billion it could use to fulfill those procedural obligations and keep working. As punishment, it took over 80% of the company's equity, or stock.
More from cataclysmic:
Another issue I want to address, and again, sorry if it has already been addressed, is AIG:
So, credit default swaps. Basically, you're a bank or someone and you loan out money. Because you want to make sure that principal loan is 100% guaranteed to get back to you, you engage in a credit default swap with a third party. The terms of this swap are, you pay some type of fee to the third party, and they will payback your principal if the loan were to default. When times were good, obviously these CDS insurance companies were not required to carry the amount of capital equaling how much they are insuring. However, once the loans started defaulting, lenders are running to the insurance companies holding their hands out. The problem is that these companies don't have all the capital to pay all the lenders their principal. You see companies like Ambac and MBIA suffering greatly.
AIG is another one of these. I don't know how educated any of you are on why the government bailed out AIG. Well, AIG is, or was, the largest insurance company out there. Obviously people want to do business with such a credible company. Most of these credit default swaps were between AIG and some lender. If AIG were to go under, none of those lenders would receive the principals that were defaulted on. This would mean that there would be more gigantic writedowns all over the world. There was major, and I mean, major systemic risk involved if AIG were to fail.
So, credit default swaps. Basically, you're a bank or someone and you loan out money. Because you want to make sure that principal loan is 100% guaranteed to get back to you, you engage in a credit default swap with a third party. The terms of this swap are, you pay some type of fee to the third party, and they will payback your principal if the loan were to default. When times were good, obviously these CDS insurance companies were not required to carry the amount of capital equaling how much they are insuring. However, once the loans started defaulting, lenders are running to the insurance companies holding their hands out. The problem is that these companies don't have all the capital to pay all the lenders their principal. You see companies like Ambac and MBIA suffering greatly.
AIG is another one of these. I don't know how educated any of you are on why the government bailed out AIG. Well, AIG is, or was, the largest insurance company out there. Obviously people want to do business with such a credible company. Most of these credit default swaps were between AIG and some lender. If AIG were to go under, none of those lenders would receive the principals that were defaulted on. This would mean that there would be more gigantic writedowns all over the world. There was major, and I mean, major systemic risk involved if AIG were to fail.
A nasty situation
Ok, before we go on the last leg of this GINORMOUS post (nobody is reading this whole thing anyway, I know), let's look at just what the situation was like before the $700 billion bailout was announced.
1.) The housing market continues to deflate. As of early September, banks had totaled some $500 billion in writedowns, and that number is growing. Write-downs are only "recognized" reductions in value. The real losses will number in the trillions.
2.) As for wall street, the problem is getting worse. Every time the fed has bailed out a company, the markets rallied, only to fall again the next day as more bad news was reported, and it became clear that the market was not done collapsing in on itself. Part of it has to do with the fact that we're in a bear market -- again, a market where the mood is generally pessimistic, and people are much more willing to sell. Part of it has to do with uncertainty that the next company will get bailed out. Finally, people are actually DISCOURAGED from investing in the companies who need it the most because in every bailout, the fed has wiped out shareholders (they acquired a large portion of the company's equity).
3.) Money is going into safer, but less profitable investments. This is evidenced by the fact that the U.S. Treasury Bill, considered one of the safest possible investments, has lowered its yield to something like .16% from 1.6% earlier this month. The yield drops as more people invest in bills. Just look at what happens to the 1 month bill after 9/12: http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml (note: it rose above 1% today, not sure why :\).
I told you earlier that consumer credit was tight because of the sub-prime market collapse. Now, the credit problem has spread to wall street. Interbank lending interest rates are at about 2% higher than normal. Depending on inflation, that's a 200%-1000% interest in the premium banks pay to borrow money from each other. Inter-bank lending serves to "lubricate" the financial system, just like Fannie Mae and Freddie Mac. Interbank lending directly affects consumer lending. A bank could WANT to give you a loan for a car can't but it might not have enough capital, so it borrows some from another bank. But if that interbank loan is really expensive, your loan will also be more expensive. Over in London, it's up to 7% for overnight loans: http://www.cbc.ca/money/story/2008/09/30/libor-record.html
BAILOUT my ass
After the failure of AIG, the Fed realized that it couldn't go on giving these Ad Hoc bailouts. It had to once and for all fix the housing problem. When you want to fix anything, the best solution is to attack the root cause.
Essentially, the problem is one of liquidity, or liquid capital. Liquidity describes how easily an asset can be transferred into a different kind of asset, and at what cost. Cash is the most liquid asset possible: Anyone will accept cash for anything, except under excess inflation. A car, on the other hand, is less liquid. You have to go through a lot more trouble to trade a car for something else of equal value, and you will always sell for less than its real value. Before the housing crisis, mortgage backed securities retained some degree of liquidity. After the crisis, they became practically illiquid: Because of the risk associated with them and all the negative headlines, nobody would buy them at a reasonable cost. Essentially, these securities still have SOME worth, but because nobody will buy them for a reasonable price, banks may as well have a black hole where these securities are. It is because they lost so much money on these securities that is fueling the credit crisis.
To fix a liquidity problem, you have to create a market for the illiquid assets. You have to help these companies convert mortgage backed securities into capital they can use to help the economy get back on its feet. Treasury Secretary Henry Paulson teamed up with Fed Chairman Ben Bernanke to write up a plan that would allocate $700 billion to create a market for these securities. Meaning, the government would offer to buy up these securities: they would take them off the hands of investment banks and replace them with cash. Then, the government would either hold on to these securities until they mature (when they "put out" in other words) or sell them to someone else. A similar system was set up in the 80's during the Savings and Loan crisis, but not at this scale.
How this will fix the problem should be obvious. By injecting liquidity into the system, banks will be again willing to lend, and credit will be looser. It will become easier to buy a home, but not so easy the bubble will begin to inflate again. Demand for housing goes up, and prices stabilize. The losses will still be there, but at least the problem won't get any worse.
There's some kinda irrelevant and esoteric information about how the fed will determine prices for these securities. If you're really interested, it's in spoilers. But it wasn't fitting into the narrative as a whole so I cut it...
+ Show Spoiler +
You may have heard the term "reverse auction" thrown about. Basically, that's the method the fed plans to use to determine how much they want to buy up these securities for. Why can't they just pay the market "equilibrium" price, you say? Because there IS no market. Moreover, each mortgage backed security is different from the next: it's impossible to tell exactly how much is worth. It's like trying to buy off a whole bunch of different paintings. Each one is different. You can only guess how much it's "worth". Like art, the fed plans to determine the price through auction, except that because there's only one buyer, it works in reverse: First the fed will announce the kind of security it plans to buy, then the sellers will bid for the lowest price. The fed will also be hiring help people who can "appraise" the value of each security. This doesn't play a significant role in the story... but I figured it's worth discussing and has to do with the arguments for or against why a bailout is good or bad.
So there's a few things about the bailout that are under debate... but it's hard to talking about that without inserting:
My Goddamn Opinion
At this point, there's not much more to tell you that you don't already know. So I reserve my right to soapbox for a few minutes.
1.) The Bailout is not as expensive as $700 billion.
As I said earlier, while most of these securities are losing money as a whole, they still retain SOME value. Not everyone is going to default on their loans. The fed can either hold these mortgages until they mature or sell them off, if the market has recovered. They could end up earning back between $500 billion to nearly breaking even.
2.) It's not a bailout.
The worst thing Bernanke did in selling the bailout was to call it a bailout. Nobody is coming in and arbitrarily injecting capital into companies that don't deserve it. They are doing it in exchange for these securities. What we're doing is trading much needed liquidity into companies that don't have it.
3.) Don't handicap the bailout.
All this talk about limiting executive pay, creating incentives to negotiate, etc. etc. are valuable policies (to an extent). Geez Congress, maybe you should've instituted them BEFORE THE FUCKING CRISIS YOU TARDS. The economic crisis is not happening soon, it is not happening next year, it is happening NOW and you shitholes need to something about it and not, as my esteemed congressman Pete Stark said this morning, "hold a month of hearings". No I'm not kidding, the fucktard actually said that. Then he blamed tax policies for the crisis. Palin is more fucking informed.
Second, it's important to keep in mind that the bailout is voluntary. If companies don't want to sell their mortgage backed securities because the government requires that they have to give up equity or their severance packages, then they won't sell them, handicapping the bailout.
4.) Not bailing out is much worse.
OK, here is the important part. The argument by free-market fundamentalists is two fold. First, they say that the market is undergoing a "correction". Second, they tell you that bailouts create a moral hazard.
First, it's true that the housing market is undergoing a correction. However, you have to keep in mind that most homes are bought through mortgages. A lot of banks are unwilling to lend even to qualified buyers, so the price of housing might even be BENEATH the ideal equilibrium price. So long as credit remains tight, housing prices will continue to fall, banks will keep bleeding money, and the economy goes down a vicious spiral into stagnation and recession.
Second, this is an inappropriate use of the concept. Bankers have already suffered plenty from the housing crisis. They know better than to let this happen again. Moreover, the costs of NOT bailing out are much higher than the cost of creating this minimal moral hazard.
Conclusion: Why you care and don't even know it
I'm really running out of steam... I don't feel like I could do a good job if I wrote this right now. I'll save the conclusion for another day, if I get around to it. But the gist is there. As more questions come up I'll try to fill them in here i guess.
Inside joke for debaters
I hope the Bailout/Nuke War disad I ran all weekend were as flaky as judges kept telling me they were.
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