Welcome to all of you coming from the link in TIME magazine. This was my original response to a reader’s questions. It was condensed and edited for the magazine, but I’ve left it untouched here.
I got an e-mail from a reader late last week with a bunch of very good questions about the bailout bill. I hadn’t quite finished answering them when it was voted down in the House Monday. But since some version of the plan is likely to be resurrected later this week, I figured I should go ahead and finish.
Where will the $700+ billion go? What exactly will it buy and from whom?
That’s the, uh, $700 billion question. Mortgage-backed securities were to be the main target, and banks the main sellers. But Hank Paulson and Ben Bernanke wanted a fund that could buy pretty much anything from anyone.
How, exactly, is this bailout supposed to ‘save’ credit markets?
Not entirely clear. Paulson and Bernanke described it as a way to jumpstart trading in mortgage securities for which there’s no market at the moment, thus allowing banks to clean up their balance sheets and get back to lending. But a lot of economists outside government believe that the real problem is that lots and lots of financial institutions are insolvent–their losses, if they actually recognized them, are enough to wipe out their capital reserves. If that’s true it would make more sense for taxpayers to give them cash outright, and take a big ownership stake in return (with the idea of selling it off a few years down the road). The Swedish solution, they call it (and longtime readers of this blog know it was being discussed here long before anybody else in the U.S. was talking about it). The version of the bailout plan voted down in the House Monday seemingly would have allowed Treasury to take such action. But it also would have allowed Treasury not to take such action.
(More after the break.)
How/why is this situation different from investors simply losing their money because of bad judgment about what to invest in? Can I get bailed out when my portfolio tanks?
It’s a variant on the old saw (often attributed to J. Paul Getty, although I’m sure somebody must have said something like it before him): “If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” Leveraged financial institutions (banks, investment banks, hedge funds) make investments with lots of borrowed money, so when their portfolios tank they can quickly get into a situation where they can no longer make good on their debts. When that happens to a single institution, it’s no big deal to let it fail. But if it’s happening to a lot of them at once, you get the paradox of deleveraging: a downward spiral in which failure begets more failure and retrenchment begets more retrenchment.
Why should Wall Street be bailed out? Won’t it just make them all the more eager to engage in risky practices in the future? Are we bailing out the very people who created the problem?
A lot of the people who created the problem have already lost their jobs, but yes, any bailout risks rewarding the profligate and the foolish. But we’re getting to the point where financial sector problems are starting to hurt people who didn’t profit from the boom. And you can design a bailout that’s not so much a bailout as a new start–such as the Swedish solution outlined above.
There’s also the approach favored by the late MIT economist Charles Kindleberger, who thought it was the job of governments and central banks to step in and halt panics, but felt they should “always leave it uncertain whether the rescue will arrive in time or at all, so as to instil caution.” That seems to be official U.S. government policy at the moment, actually.
If more currently outstanding mortgages default, won’t the problem just keep going on and on?
Yes, that’s a big part of the concern at Treasury and the Fed. That economic trouble emanating from the financial system will cause even more people to fall behind on their mortgage payments which will lead to even more trouble in the financial system.
Are we all just supposed to trust that mortgage lenders and Wall Street types have ‘learned their lesson’ and will not continue to exacerbate the problem (or find ways to create new ones)? What safeguards are/will be put in place so that derivatives of the type that got this mess started will not continue to be created or traded?
I think it’s fair to assume that mortgage lenders and Wall Street won’t make these same mistakes for another generation at least. But they will do their best to figure out new ones to make. And while bubbles and crashes will always be with us, I think a regulatory structure that is far more restrictive of financial innovation is probably a good idea. Do we have that regulatory structure in place now? No.
Is the money going to the wrong people/institutions? Why should the money go to these institutions instead of homeowners or banks who hold the sub-prime mortgages?
A lot of the money would go to banks that hold sub-prime mortgages. Getting it to homeowners is a more complicated proposition. Would you just give the money to people struggling with their mortgages? How much would you give them? For how long?
If these so-called securities are ‘mortgage backed’ and the mortgages are in default, would the money be better spent just buying up the mortgages themselves instead of the securities? And re-negotiating mortgage rates to make it more likely that homeowners can pay down their mortgages and hold on to their homes?
A number of economists think that buying up the mortgages themselves would make more sense. I think the reason Treasury doesn’t want to do it is that it would be a far more time-consuming and labor-intensive process than simply buying securities on the open market. It was easier in the Depression, when banks held whole mortgages on their books, than it is today.
As for renegotiating mortgages, a new program goes into effect tomorrow (it was part of the housing bill passed over the summer) that uses up to $300 billion in FHA guarantees to encourage mortgage servicers to move people out of adustable-rate subprime loans into fixed-rate loans with lower face values. And if Treasury owned a few hundred billion dollars worth of mortgage securities, it could put pressure on servicers to renegotiate loans rather than foreclose on them.
And what about the 90% of homeowners who are paying off their mortgages and dealing in good faith, who have seen their equity significantly lowered by the tanking of the real estate market?
That equity will go down more if banks continue to struggle.
Is there any chance that any of the bailout money will be recouped?
Yes. Mortgage-backed securities are still, you know, backed by mortgages. They’re worth something–and in some cases more than what the feds would pay for them.
How/who will determine how much to pay for these securities?
They haven’t really figured that out yet. One possibility would be to hire private managers who would get a share of any profits. And there’s lots of talks about using various auction methods to price them. But I have yet to hear a really convincing explanation of how this would work.
Will every financial institution that holds mortgage-backed securities be able to sell them to the federal government? Who determines what will be bought and from whom? Will institutions be able to recover losses they have already written off?
In theory anybody could sell to the TARP (troubled asset relief program). The what and from whom would ultimately be up to the discretion of the Treasury Secretary. And if institutions were able to sell securities for more than they valued them at on their balance sheets, sure, they could reverse some losses.
What is to stop speculators from buying up these bastardized securities for pennies on the dollar anticipating enormous profit when the government buys them at higher rates?
The current owners of those securities aren’t going to want to sell them for pennies on the dollar if they think the government will come in soon and buy them for dimes. That said, I think Treasury would love it if there were private vulture investors bidding for mortgage assets too.
How is the current real estate crisis different from the RE bust of the early 1990s?
1) It’s bigger and more national–although it is worst in California, the Southwest, and Florida.
2) It’s also (except in, say, Detroit and Cleveland) not the result of external economic factors like Texas in the 1980s or Southern California in the 1990s. It’s a crash caused by the twisted dynamics of real estate finance in recent years.
3) The way mortgage-backed securities and related derivatives have acted to concentrate and transmit risk rather than diffuse it has added a whole new element to the crisis.
Who is at fault here? I have increasingly seen fingers pointed at home buyers for buying ‘too much’ mortgage (i.e. big eyes for big houses), who ‘lied’ on their mortgage applications about their ability to keep up payments. Surely significant fault lies with the mortgage lenders for approving such loans without due diligence? And greater fault with the creators of the mortgage-based derivatives?
Until 10 years ago, getting approved for a mortgage was a pretty good indication that you could afford to make the payments. So for the most part I really don’t blame buyers–they were relying on a time-honored financial rule of thumb that mortgage lenders and their Wall Street backers had suddenly decided to throw out the window. I’d blame the lenders, the securitizers, the regulators and Congress first, and buyers probably last. Although I’d still blame ‘em a little.
Speaking of fault, how logical (much less honorable, but we probably need not go there) was it for Wall Street to over-leverage itself? Or is it just a matter of ‘because they could’?
It was logical for individual Wall Streeters because they could reap big rewards from overleveraging and not necessarily suffer from the eventual fallout. It was not logical for Wall Street firms to do so (because it put their survival at stake) but those firms are after all just collections of individuals.
Without the bailout, is it really likely that we will see the end of the world as we know it? And what, exactly would that Apocalypse look like?
Given the existence of the FDIC and the activist stance of the Federal Reserve, it’s hard to envision a 1930s-style breakdown in which banks shut their doors and depositors lose all their money. I think the fear is of a situation where lending to both businesses and individuals stops almost completely, which would lead to a pretty sharp downturn. Not nearly as bad the Great Depression, but the worst we’ve seen since then.
What is the difference between Wall Street and a casino? (Not meant as a joke)
On Wall Street, the dealers get paid a lot more and are often allowed to bet alongside the customers. Oh, and much of the money raised on Wall Street actually goes to productive purposes. Except when markets are in bubble mode.