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September 24, 2008

The Bailout Part 2

OK, I looked into this situation, and I think I understand it better. And I think it's... even more wrong and misguided, and I don't think it's going to help anyone out.

Here's what happened. Banks lent a ton of money to "no doc" loans (meaning that people didn't have to prove they could afford to make the payments) and "subprime" loans (meaning the banks loaned money to people who in the past had already not been able to pay back money they had borrowed.)

In the business world, that is called a risky move. But it was one the banks decided to take because they felt like the payoff (more mortgages! more fees! higher interest rates!) would be worth it.

But uh-oh, a huge percentage of those loans are now going bad. As in, people aren't paying them. And the housing market fell at the same time. They took a gamble, and they lost. I was in vegas earlier this month. Normally when you do that, you walk away without any money.

Enter the U.S, government. With our taxdollars - $3000 per US citizen, to be exact (that's $12,000 for my household!) is going to buy these horrible bad misguided greedy loans. You see, these banks can't find anyone to buy these loans. The last bunch of bad loans that were purchased on the open market were bought for the price of 22 cents on the dollar. (So, 1 dollar of bad loan was purchased for 22 cents). But it looks like the government is stepping in and buying these bad loans for around 50 cents on the dollar. At a time when no one in their right mind is buying bad loans at all.

That's called a bad investment. A very bad investment. It's like someone owned a horrible terrible car that they wanted to sell for 10K and everyone said, "No, that's such a horrible car I wouldn't even buy it for anything!" and then the government came in and said, "I will give you 20K for that fine car."

There is something very fundamentally dangerous about the government artificially inflating the value of things (in this case, bad loans.) It leads to inflation. Because they are devaluing our money by doing so. (It's no coincidence that the dollar plunged today while gold soared.)

It's really not a good idea. And it's really not fair either. Oh, I forgot to mention. What was originally conceived as a bailout on bad consumer home loans has now apparently been expanded to potentially include bad commercial real estate loans, bad consumer credit card loans, even bad auto loans. Yes, courtesy of the taxpayers, it looks like everyone is trying to get one big giant UNDO button on their horrible business decisions.

Posted by jason on September 24, 2008 02:14 AM


I don't really understand any of this, but was listening to Ron Paul speak on a news show. It seems he totally would agree with you. I don't know much about him at all, but he seems like a voice of reason in this situation.

It's a scary time.

Posted by: Mom on September 24, 2008 06:00 AM

It's a mess for sure. Is this the idea though? . . . it seems like the thing that is being said is if they don't bail out these companies, then possibly the whole financial web will be in trouble. Like if AIG goes down, then people with investments in AIG will have their retirement savings messed up, and any banks, credit card, insurance, and other financial institutions with investments in AIG will do the same. Then, if banks suffer, we'll be left with another crisis like 1929. Seems like they should also be putting in some legislation do ban sub-prime lending at the same time!

Posted by: Chris on September 24, 2008 07:06 AM

Here is a link to Secretary of Treasury Paulson's press relief on why we need to bail out these institutions: http://www.ustreas.gov/press/releases/hp1149.htm.

Basically, he is saying that the "credit pipe" is clogged up with all these bad loans, so that even companies that are safe bets can't get loans. This means that they can't get loans to replace inventory (if that is how they run their business) or expand. His solution is to clear these bad loans (by buying them up) so that lending institutions will be able to lend money again. What is unclear to me is whether lending institutions aren't lending because they are fearful of incurring more bad debt, or if there is something that is actually restricting their writing more loans. It seems the latter when Paulson claims that companies may not participate in the bailout if their executives are asked to restrict their salaries and bonuses.

In testifying before Congress he said "This is all about the American taxpayer... That's all we care about." This sounds like the old trickle-down theory of economics: the best way to help the common citizen is to make big business be successful.

In an interesting side issue, I heard that this whole bailout may depend on McCain. If he doesn't back the plan, other Republicans probably won't because they don't want to weaken their candidate by saying that he is wrong. However, it is politically risky for him to back it right before the election. I wonder if the issue will be delayed until November.

Posted by: peaj on September 24, 2008 07:40 AM

Peaj has it right...and to add to it, the people aren't lending money not because of fear but because of capital constraints...that have to keep money on their books to cover their own loans which means they can't loan out more money....we are really stuck in a catch 22...they also said that the government will help determine the right amount for the loans and try to sell them off....because the government is the one setting the price, there is a higher likely hood of people purchasing them....

All that said, I still don't think $700mmm of our money is the right way to fix it....

Posted by: Heidi on September 24, 2008 09:29 AM

So what are the alternatives to this crisis? If we do nothing, then perhaps we tumble down into a huge depression and none of us want that.

The government believes they can make a profit on these bad loans down the road. Is that possible? Also, these loans are tied to actual houses right? Do people just believe these houses will never sell and therefore the loans are worth nothing?

Posted by: Jonathan on September 24, 2008 10:03 AM

I don't trust any of these people. The government, namely the Fed, got us into this mess, so why should we trust them to get us out of it. Depressions, recessions, or market downturns are all by products of government interference with the market. Since the Fed had set the interest rate so low for the past several years, they created a huge artificial boom, now the market needs to correct itself and they're trying to stop it from doing it. All of the things they want to do will only push off the market correction and will make things all the worse when it finally does hit.

I honestly fear the worst case scenario of a market crash and inflation. Say you have $100K in stocks for your retirement; If there is some sort of market crash or reduction, your stocks may now only be worth say $75K, but if we have inflation (which we will have b/c where do you think the government will get that money, they'll just print it) that amount of money will really only get you $50K worth of stuff. This is worst case, but I'm afraid its going to happen.

Lynn mentioned Ron Paul. He was talking about all of this last September when I first heard him and he has truly been prophetic when it comes to financial markets. Unfortunatly, like most prophets, he was mostly ignored. Its a shame, because he is the only politician that I've heard that has an accurate assessment of what is going on.

I'd love to see Obama and McCain step up and assert leadership on this issue. They both want to talk about the situation, but both of them are senators. If either of them were REALLY interested in correcting this situation, either of them could draft legislation and try and get it passed, but I honestly don't think either of them knows what is going on nor how to fix.

Posted by: jason j on September 24, 2008 10:45 AM

Why would anybody think that a "subprime" loan was a good idea? I have no background in any of this, but even I can see that that will get you into trouble...

If one loans to somebody who has a record of defaulting on loans-and they are aware of this--then, it is pretty stupid of the person to loan out money and expect to get it back.

Nobody could foresee this promblem?!?!

Posted by: jessica on September 24, 2008 12:27 PM

I read an interesting take on how this crisis came about. The low interest rates set by the Federal Reserve earlier in the decade as a means to brighten the economy led to a large increase in the number of mortgages written. Naturally, this let mortgage companies post large profits. Once the interest rates started coming back up, the mortgage companies were under pressure (either through the stock market or their own internal pressures) to continue their steep growth, which is why they started approving more and more marginal borrowers. Apparently, the insurance industry liked all the continued good business, and didn't care to notice that they were insuring more and more risky loans. This then led all the derivative securities based on debt and insurance - usually pretty stable - to become more risky as well, which is why this affects so many people.

Some people are blaming the Fed's policies for the crisis, but the Fed's job is to manage monetary policy, not to regulate the mortgage or insurance industries.

Fundamentally, the problem with this crisis is the same as the one with the dotcom bubble: people argued themselves into believing that the fundamentals of the economy had changed and that they could escape the consequences of a cyclical market, and they only focused on the stock price and the next quarter's results.

Posted by: peaj on September 24, 2008 04:53 PM

Thank God our security is in HIM, not money, financial institutions, or the government, whatever does or does not happen!!!

Posted by: kathiek on September 25, 2008 12:49 AM

Someone sort of said this, but to reiterate and expand: What's causing the problem to snowball, and why it needs to be addressed quickly, is this:

When the value of all those securities related in one way or another to bad loans dropped, it basically reduced lending institutions' fluidity to the point that they could not pay their bills (loans made to them, for example) let alone sell any more loans. So they lost money and they couldn't make any more money. This is why WaMu just fell apart.

Banks lend money to each other all the time. Some are very short-term loans, and these are the most important to the daily fluidity of these banks. But nobody knows what is going on inside of these banks. If Bank 1 asks Bank 2 for a quick loan, Bank 2 is now saying No Way because they don't know if Bank 1 is going to bite the dust.

So the bailout plan is a way to say to Bank 2, "It's okay to lend to Bank 1. The government has taken care of any bad gunk inside Bank 1, so you'll get the money back." Once everyone gets lending again and things are moving smoothly, the economy should pick up. And the legislation should prevent this situation from happening again if it's written right.

It's so scary to live in a debt/lending-based economy. We need to start saving like the Japanese. Lending is based on things that don't exist yet. It's not a good way to maintain fluidity for the entire market. It has to be balanced by true reserves and savings. This is why some investment banks are going bye-bye, and others are turning into traditional, deposit banks.

So, to sum it up, a lot of the problem is confidence in the marketplace. Unfortunately, confidence costs money.

Posted by: Mike on September 26, 2008 03:21 PM

Also, the percentage of bad loans is not very high. Less than 3% of mortgages are bad. I don't know about the no-doc loans.

Posted by: Mike on September 26, 2008 03:25 PM

NEW YORK (Reuters) — Billionaire investor Warren Buffett on Wednesday called the $700 billion U.S. bailout plan "absolutely necessary" to help pull the financial system out of an "economic Pearl Harbor."


Posted by: Anonymous on September 26, 2008 08:53 PM

looks like congress shares your reservations...

Posted by: Jonathan on September 29, 2008 07:09 PM

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