The Financial Crisis for Laymen
I think the most common question people have about the current financial crisis is, "Wait, what's going on?" The media, blogosphere, pundits, and politicians of all political orientations seem to be more interesting in screaming and pointing fingers than in actually answering this simple question. So I've taken it upon myself.
No snark here. This is just a straight-forward explanation so that laymen can understand the situation.
Banks and other financial institutions have various short term obligations. As well as the obligations every business has, such as payroll and rent on their buildings, they also have to pay any withdrawals that their customers make from their accounts. Banks try to keep enough cash to meet these obligations. And there are laws requiring them to keep a certain amount of cash around.
But sometimes they unexpectedly have to pay out more than they planned for. When this happens, they borrow money from other banks. In addition to the cash they have sitting around, banks also have long-term assets. These are future revenue streams that they and other banks know they can collect. One of the most common of these revenue streams are mortgages. John Q. Homeowner is going to be sending the bank $3000/month for the next 30 years. So when Bank #1 needs to borrow money to meet short-term obligations, Bank #2 will say, "I know they'll have this mortgage money coming in, so they'll be able to pay us back. Or if they don't, we'll take over that mortgage ourselves." Either way, loaning money to Bank #1 is a pretty safe investment.
Of course, when dealing with institutional loans like this, they aren't looking at the level of individual mortgages. Many mortgages are collected together into mortgage-backed-securities (MBS), which are bought and sold between financial institutions as well as being used as collateral for loans. But as long as the value of the bank's long-term assets exceed its long-term obligations, the bank is fundamentally solvent. Even if the bank's short-term obligations exceed its cash on hand, it shouldn't have any problem getting a quick loan from another bank.
At least, that's what happens when the system works.
The problem is that a lot of people are defaulting on their mortgages. When John Q. Homeowner doesn't sent in his $3000 check this month, the bank has $3000 less cash with which to fulfill its obligations. Worse yet, they don't have the long-term asset of the future revenue stream, which gives them less collateral when they need to borrow. They can foreclose on the house, but that takes a lot of time, means they'll lose money on their investment due to falling home prices, and costs them even more money in the short term.
So these MBSes are worth a lot less than the banks previously thought they were. Some of them are worth nothing - when there isn't enough money to go around, the MBSes that are at the back of the line and will never collect are worthless pieces of paper.
This causes two problems. The obvious one is that due to their long term assets being worth less than they thought they were, some banks become fundamentally insolvent. They have more long term obligations than assets. The only thing to do is declare bankruptcy, sell off their assets for whatever they can to pay their depositors, and let the FDIC make up the rest.
But the other problem is with banks that are still sound in the long term, but have a short-term cash crisis. Ordinarily a bank in that situation would just borrow money from another bank. But nobody knows exactly how much Bank #1's MBSes are worth, so Bank #2 is reluctant to accept that for collateral. Moreover, Bank #2 is worried that it might have its own short-term cash crisis in the near future, so it's especially unwilling to put itself more at risk by lending some of that cash out.
Once a bank has trouble meeting its short-term obligations, depositors will panic and start pulling their money out, which causes the bank's short-term obligations to skyrocket, turning the possibility that the bank may fail into a certainty. This can happen even if the bank is fundamentally sound.
So to sum up, banks are having a short term cash crisis due to their MBSes being difficult to assign a value to but the undetermined value being below what they previously thought. This causes banks to stop loaning money, which makes the crisis worse. This in turn causes depositors to get nervous, which exacerbates the problem more-so. This could lead to a systematic meltdown where even the sound banks fail.
This problem can easily spread beyond the banks. The banks are unwilling to lend money, so Joe Schmoe can't get a car loan. In turn, Ford sells less cars. This leaves Ford with less cash, so they may have difficulty making payroll. Even though they have plenty of assets to use as collateral, they can't get a loan because the banks aren't lending money. It's not like Ford can sell off a factory and collect the cash in a matter of days. Especially considering any company that might want to buy the factory can't get a loan to do so. So companies that have nothing to do with real estate and have plenty of assets could start going bankrupt because of this short-term credit crunch.
So the government's plan is to buy $700 billion of these MBSes at their true value. This will give the banks cash and end this short-term crisis before things get worse. Once the immediate crisis is resolved, people will be able to figure out how to value these securities, and the government can sell them, possibly at a profit. This isn't bailing out the fundamentally insolvent banks. If they have more long-term liabilities than assets, this will still be true if they convert their assets from MBSes to cash. The plan would only be helping the solvent banks get through the crisis.
Now, if you understand Economics, that last paragraph should have caused you to jump up and down and scream. Value is based one what people are willing to buy and sell something for. Basic Economics says that if nobody outside of the government was willing to buy the securities for $700 billion, the government can't be paying the true value of them, and instead must necessarily be paying significantly more.
But the counter-argument that proponents of the plan make is that the market for MBSes is currently broken. It doesn't make sense to talk about the government paying above-market rates when there is no market. But most (not all) of the MBSes do have real value, and it's only this short-term crisis that's keeping them from being sold.
There are five counter-counter-arguments to this:
1. Part of what's breaking the market is the potential for a bailout. Nobody's buying or selling MBSes because they're waiting to see what the government does. You'd feel pretty silly if you sold a MBS for $20 million, and three days later the government bought it for $50 million. You'd also feel silly if you bought it for $50 million, and three days later the government bought it for $20 million. So financial institutions are all holding their breath to see what happens. If the government were to make a credible commitment that there wouldn't be any bailout, the financial institutions would have to figure out their own solution. And this solution might be better than what the government comes up with.
2. Why on earth would you expect the government to make a fair valuation? Haven't you noticed that the government is run by politicians? Politicians who will be buying these MBSes from their friends and campaign contributors. Of course they're going to pay way more than they're worth. I mean, it's not like the politicians are spending their own money. They're spending yours.
3. Even if the government was trying to figure out an accurate price rather than funneling your money to politicians' friends, why would you expect the government to be able to do so when the markets and financial institutions can't? Economics says that this will also lead the government to overpay. When they're guessing at the price for a particular MBS, sometimes they'll guess high and sometimes they'll guess low. But when they guess low, the bank (which knows its own assets better than the government) will be more likely to turn down the offer. When they guess high, the bank will jump at the offer, and then light a cigar with a $100 bill taken from your paycheck. So even if you accept the foolish assumption that the government would be trying to come up with the right prices, for those transactions that actually go through, the prices would be too high.
4. Giving the government ownership of a massive amount of financial securities brings with it the risk that the government will start manipulating the market for political ends, which is very likely to lead to disastrous results.
5. Establishing the precedent of a bailout will encourage banks to continue to engage in excessively risky behavior, since they know that if they get into trouble, the government is likely to save them.
So that's the situation in a nutshell. Doing nothing would be very bad, and having the government buy a bunch of troubled assets would also be very bad. You can try to figure out which choice is less bad, or try to figure out an even less bad alternative. Just remember that if you're stuck in a terrible situation, you shouldn't dismiss a choice just because you know it would lead to bad results. You have to compare it to the alternatives, which may well turn out to be worse.
No snark here. This is just a straight-forward explanation so that laymen can understand the situation.
Banks and other financial institutions have various short term obligations. As well as the obligations every business has, such as payroll and rent on their buildings, they also have to pay any withdrawals that their customers make from their accounts. Banks try to keep enough cash to meet these obligations. And there are laws requiring them to keep a certain amount of cash around.
But sometimes they unexpectedly have to pay out more than they planned for. When this happens, they borrow money from other banks. In addition to the cash they have sitting around, banks also have long-term assets. These are future revenue streams that they and other banks know they can collect. One of the most common of these revenue streams are mortgages. John Q. Homeowner is going to be sending the bank $3000/month for the next 30 years. So when Bank #1 needs to borrow money to meet short-term obligations, Bank #2 will say, "I know they'll have this mortgage money coming in, so they'll be able to pay us back. Or if they don't, we'll take over that mortgage ourselves." Either way, loaning money to Bank #1 is a pretty safe investment.
Of course, when dealing with institutional loans like this, they aren't looking at the level of individual mortgages. Many mortgages are collected together into mortgage-backed-securities (MBS), which are bought and sold between financial institutions as well as being used as collateral for loans. But as long as the value of the bank's long-term assets exceed its long-term obligations, the bank is fundamentally solvent. Even if the bank's short-term obligations exceed its cash on hand, it shouldn't have any problem getting a quick loan from another bank.
At least, that's what happens when the system works.
The problem is that a lot of people are defaulting on their mortgages. When John Q. Homeowner doesn't sent in his $3000 check this month, the bank has $3000 less cash with which to fulfill its obligations. Worse yet, they don't have the long-term asset of the future revenue stream, which gives them less collateral when they need to borrow. They can foreclose on the house, but that takes a lot of time, means they'll lose money on their investment due to falling home prices, and costs them even more money in the short term.
So these MBSes are worth a lot less than the banks previously thought they were. Some of them are worth nothing - when there isn't enough money to go around, the MBSes that are at the back of the line and will never collect are worthless pieces of paper.
This causes two problems. The obvious one is that due to their long term assets being worth less than they thought they were, some banks become fundamentally insolvent. They have more long term obligations than assets. The only thing to do is declare bankruptcy, sell off their assets for whatever they can to pay their depositors, and let the FDIC make up the rest.
But the other problem is with banks that are still sound in the long term, but have a short-term cash crisis. Ordinarily a bank in that situation would just borrow money from another bank. But nobody knows exactly how much Bank #1's MBSes are worth, so Bank #2 is reluctant to accept that for collateral. Moreover, Bank #2 is worried that it might have its own short-term cash crisis in the near future, so it's especially unwilling to put itself more at risk by lending some of that cash out.
Once a bank has trouble meeting its short-term obligations, depositors will panic and start pulling their money out, which causes the bank's short-term obligations to skyrocket, turning the possibility that the bank may fail into a certainty. This can happen even if the bank is fundamentally sound.
So to sum up, banks are having a short term cash crisis due to their MBSes being difficult to assign a value to but the undetermined value being below what they previously thought. This causes banks to stop loaning money, which makes the crisis worse. This in turn causes depositors to get nervous, which exacerbates the problem more-so. This could lead to a systematic meltdown where even the sound banks fail.
This problem can easily spread beyond the banks. The banks are unwilling to lend money, so Joe Schmoe can't get a car loan. In turn, Ford sells less cars. This leaves Ford with less cash, so they may have difficulty making payroll. Even though they have plenty of assets to use as collateral, they can't get a loan because the banks aren't lending money. It's not like Ford can sell off a factory and collect the cash in a matter of days. Especially considering any company that might want to buy the factory can't get a loan to do so. So companies that have nothing to do with real estate and have plenty of assets could start going bankrupt because of this short-term credit crunch.
So the government's plan is to buy $700 billion of these MBSes at their true value. This will give the banks cash and end this short-term crisis before things get worse. Once the immediate crisis is resolved, people will be able to figure out how to value these securities, and the government can sell them, possibly at a profit. This isn't bailing out the fundamentally insolvent banks. If they have more long-term liabilities than assets, this will still be true if they convert their assets from MBSes to cash. The plan would only be helping the solvent banks get through the crisis.
Now, if you understand Economics, that last paragraph should have caused you to jump up and down and scream. Value is based one what people are willing to buy and sell something for. Basic Economics says that if nobody outside of the government was willing to buy the securities for $700 billion, the government can't be paying the true value of them, and instead must necessarily be paying significantly more.
But the counter-argument that proponents of the plan make is that the market for MBSes is currently broken. It doesn't make sense to talk about the government paying above-market rates when there is no market. But most (not all) of the MBSes do have real value, and it's only this short-term crisis that's keeping them from being sold.
There are five counter-counter-arguments to this:
1. Part of what's breaking the market is the potential for a bailout. Nobody's buying or selling MBSes because they're waiting to see what the government does. You'd feel pretty silly if you sold a MBS for $20 million, and three days later the government bought it for $50 million. You'd also feel silly if you bought it for $50 million, and three days later the government bought it for $20 million. So financial institutions are all holding their breath to see what happens. If the government were to make a credible commitment that there wouldn't be any bailout, the financial institutions would have to figure out their own solution. And this solution might be better than what the government comes up with.
2. Why on earth would you expect the government to make a fair valuation? Haven't you noticed that the government is run by politicians? Politicians who will be buying these MBSes from their friends and campaign contributors. Of course they're going to pay way more than they're worth. I mean, it's not like the politicians are spending their own money. They're spending yours.
3. Even if the government was trying to figure out an accurate price rather than funneling your money to politicians' friends, why would you expect the government to be able to do so when the markets and financial institutions can't? Economics says that this will also lead the government to overpay. When they're guessing at the price for a particular MBS, sometimes they'll guess high and sometimes they'll guess low. But when they guess low, the bank (which knows its own assets better than the government) will be more likely to turn down the offer. When they guess high, the bank will jump at the offer, and then light a cigar with a $100 bill taken from your paycheck. So even if you accept the foolish assumption that the government would be trying to come up with the right prices, for those transactions that actually go through, the prices would be too high.
4. Giving the government ownership of a massive amount of financial securities brings with it the risk that the government will start manipulating the market for political ends, which is very likely to lead to disastrous results.
5. Establishing the precedent of a bailout will encourage banks to continue to engage in excessively risky behavior, since they know that if they get into trouble, the government is likely to save them.
So that's the situation in a nutshell. Doing nothing would be very bad, and having the government buy a bunch of troubled assets would also be very bad. You can try to figure out which choice is less bad, or try to figure out an even less bad alternative. Just remember that if you're stuck in a terrible situation, you shouldn't dismiss a choice just because you know it would lead to bad results. You have to compare it to the alternatives, which may well turn out to be worse.