Yesterday in my classroom, I explained to my students the financial crisis that is occurring in the U.S. economy, and the Federal Government bailout bill that both houses of Congress are trying to agree on to save the economy. This is such a national crisis that our key government officials were working on this bill just late last night in hopes of agreeing to a bill this weekend before our economy potentially reaches a new level of recession.
Sooooo: Here is a simplified summary of what is happening in the US economy today relating to the “financial crisis”. I’m going to use simple example US Dollar numbers for you to explain what is happening, but the direction of the numbers is real and the simplicity will really get you to understand the real problem at hand and what the Government is proposing to do to fix it.
Here we go:
Gigantic U.S. financial institutions such as AIG, Fannie Mae, Freddie Mac, Lehman Brothers, & Merrrill Lynch all have the SAME problem: They are holding $100 in a “paper asset” that they invested in called mortgage-related securities. These same financial institutions also have debt of $60 of which the lenders of the $60 all have legal collateral on the $100 of mortage-related securities. Since many U.S. homeowners are not paying or are unable to pay their home mortgage (loan) payments, the Government’s (SEC) accounting rules require that these same financial institutions write their mortgage-related securities down from a value of $100 to a value of $40. This reduction in asset value causes a reported loss of $60 and is frightening the lenders as the shrinking value of their collateral (securities) has fallen below the debt repayment amount causing the lenders, per the legal debt agreement, to demand immediate payment from the financial institutions.
Thus, these large financial institutions do not currently have or carry enough cash or other assets on hand to pay off the lenders since no one will buy the falling securities they hold because other potential buyers do not trust their market value. Thus, these large financial institutions are currently screwed and are said to be in a “liquidity” (cash) crisis, and they certainly have no cash to lend to small businesses or households. The financial institutions are said to be “freezing up” and they are stopping their loans to businesses and households. Thus, it is really difficult for “main street” (you and me) to get a loan today at most banks.
In steps Hank Paulson (U.S. Treasury Secretary) and Ben Bernanke (Chairman of our Nation’s Bank, the “FED”), the President, and the U.S. Congress to try to avert a deep recession or depression, because if the banking system fails, then the economy is thought to quickly fail.
Using the same example numbers above to explain, the Government plan or “Paulson Plan” (backed fully by Bernanke) proposes for the Government to pay an estimated $70 to the financial institutions to purchase the mortgage-related securities from the financial institutions even though the securities have been written down by the accounting rules to a value of $40. It appears, on the surface, that the Government may be overpaying ($70 payment for new value of asset at $40) but most economists and accountants say the accounting rules have resulted in too much of a write down and the real economic value (ie, cash collection of the mortgage security) is probably $70 -$90 out of the $100, which will cause the government to either lose a little on the bailout or perhaps nothing on the deal. Glen Hubbard, a noted and respected economist said on a talk show yesterday that the average American does not understand what is really happening and incorrectly believes that the Government is spending $700B that will be “billed” to the tax payer, but, in reality, the $700B is expected to be recovered by the Government as the Government collects on their newly purchase securities from the financial institutions.
In summary, the Government (Paulson Plan) is proposing that the American tax payer put their money at risk with an “investment” (not an expense) by swapping Government (taxpayer) cash for an asset (mortgage-related securities) that the Government will recoup the cash through collection, freeing up the financial institutions by giving them $70 in cash for an accounting asset worth $40. Many say the original crisis was started by accounting rules, which is only a partial reason. The main reason is lack of regulation on asset-debt ratios and other similar requirements. Increased regulation will result from this improper risk taking by large financial institutions so that it doesn’t happen but that doesn’t help us at the present moment since the damage has already been done.
Of course, only time will tell how much the proposed bailout will really cost the tax payer. Also, it is possible that before the bill is passed, the Paulson Plan may look a lot different than what is explained above. Stay Tuned!!!!!!
Originally published on September 26, 2008 at Welker’s Wikinomics and reproduced here with the author’s permission.