An Understandable Expanation of the Credit Market Bail Out

This past week is a pretty big deal. If you are paying attention, you would know that the Treasury and the Federal Reserve have a plan to address the failing investment banks on Wall Street.

This plan will work to free up the credit markets and may help avert a larger disaster. However, the press seems to focus on the taxpayers bailing out rich banks. In fact, this has little to do with saving the banks. I will explain further. I will say, that the taxpayers are as much a part of the problem as the banks. It takes two to tango. Likewise, it takes both lenders and borrowers to make a mess this big.

Before I go further, please don't use the usual ADD response and say that this stuff hurts your brain or is too complicated. It is important and the more people who understand what is happening the better.

What has happened before this week:

In the past five or six years, we have seen access to mortgages open up in a way never before seen. Home prices rose at fantastic rates across the country. People who had never bought a home before were able to get adjustable rate mortgages with no money down and no mortgage insurance. Brokers, underwriters, and Wall Street happily took the money and passed on the risk to others in what is essentially, mortgage backed securities.

What went wrong:

Obviously, the problem was bound to happen. People started defaulting on their loans. Everyone has known there were bad loans out there for the past year. The problem is that no one knew where those bad loans were. They were mixed in with good loans and traded from one bank to another as securities. Everything limped along until investors (depositors) at the big investment banks started wanting their money back. Those big banks (Lehman Brothers for example) needed to liquidate (sell) their holdings in mortgage backed securities to give the money back to their investors. The problem is that no one wanted to buy them (they were illiquid). So with the investors screaming for their money back, the only answer was to file for bankruptcy (in Lehman's case). As more investors demand their money back, more banks face failure.

Since the investment banks are giving all their free cash back to their investors, then they are no longer loaning money to good companies for expansion, working capital or other projects. This will threaten to cause non-banking businesses to fail if not fixed quickly.

What the Treasury wants to do:

The fundamental problem is that banks cannot convert these securities over to cash. Treasury Secretary Paulson wants to use federal money to buy these securities from the investment banks. That will fix the run on the investment banks as well as thaw the frozen credit markets which will enable other businesses to borrow money for expansion or working capital.

Here is where the reporting is wrong. People are saying that the taxpayers are bailing out the banks and getting stuck with the bill. But in reality the taxpayers are the ones who owe the money back to the banks in the first place. (Circular market). With the Federal Government owning the mortgage paper, there are a number of things they can do which will help.

First, they can separate out the good loans from the bad loans. They will then sell the good loans back to Wall Street for a pretty fat profit.

Next, they can take the bad loans and work them out. This may mean changing the interest rate back to the first year rate for that loan. This would allow time for the homeowner to refinance or sell their home. In either case, they would avoid foreclosure.

Finally, since the banks are the ones selling the loans to the Fed or Treasury, then they will have to play by the rules set up to make this fair. That might mean the CEO's of the banks are limited to their pay. It may mean they have to take a big hit on the sale price. It might mean some other security is given. In any case, the banks are not going to "win" under this proposal. The banks will survive, but certainly will not make money on this thing.

Going Forward:

In the future, it is going to be like the past. For instance, when I bought my first home, I had to have 20% down. I had to prove that I didn't borrow that money. If I had only 10% of the purchase price, then I had to pay for PMI or Primary Mortgage Insurance. In other words, I had not only the security of the house, but the insurance plan to protect the lender.

This means that going forward, it is going to be much harder to buy a home. It means that people will have to save for years before being able to afford their homes. We can count on some 20-30% of the buying market not able to qualify for a home loan.

So in a nutshell, the American Dream will go back to being something you worked for 20 or 30 years to attain. It will no longer be something a typical 25 year old will be able to achieve.