As we've watched the stock market tank over the past week, I've heard many, many comments from the population as a whole asking about or expressing very similar sentiments:
"Why are we bailing out those whose fault it is that I've just lost 30% of my retirement fund?"
"This financial crisis is too complicated and the bailout plan just doesn't make sense."
"Why are we focusing on bailing out the company when I'm the one struggling to pay my mortgage? Just give me the money. I'll put it to good use."
Well, folks, it's not that complicated. Sure, there are a lot of numbers, but the concept is painfully obvious and easy to grasp. For those of you struggling, here's a bit of help.
Acronyms (and words) they should have taught you in High School but never did
There's a pretty short list of words that get tossed around on the news these days that you might find a bit foreign. Economists are loving their chance to spout nonsense at the public while assuming it makes sense. There are just a few terms that you need to be familiar with for it all to make sense (and my apologies, for many of you, it will be a refresher course):
I've done you the favor of linking each item in that list to the respective Wikipedia article. They are very informative and, if you want to go deeper than the scope of this article, it's a good place to start. Here's a quick summary of what each of these items mean and why they are relevant (a.k.a. why you should pay attention):
First and foremost, consider the SEC. The acronym stands for "Securities and Exchange Commission". So... it's a commission (regulatory agency) that treats things called "Securities" and "Exchanges". Not a bad start, right? That brings us to "Securities" and a certain type of "Investment". "Securities" (you're loving the quotes, right?) is an investment vehicle- it's something that represents financial value. Go to the Wikipedia article if you want the dry definition. An "Investment" is something in which one can place money with the hope of a greater return. OK, even simpler than that- it's something you buy that is (hopefully) worth more than you paid for it.
The last two items are types of Securities (investment vehicles) and are particularly important right now. Mortgage-backed Securities (MBS) are a type of Asset-backed security. Both are really techy terms to describe something very simple- securitization. Unless you're masochistic in nature, don't bother clicking that link. I'll explain it for you.
Securitization is just a fancy way to describe taking a cash-flow producing asset and selling it to someone else. Before you start pulling your hair out, "asset" is just something of financial value. The computer you are reading this on is an asset. So is your car. Your house is a much bigger asset. And, interestingly enough, so is your mortgage.
Think about it for a minute. A loan (like the afore-mentioned mortgage) is valuable to someone. Really valuable. Have you done the math on how much interest the bank will earn on your house if you pay them exactly what they ask for the next 30 years? It's astronomical. A simple exercise: if you pay $1400 per month over the next 30 years, how much is that? $504,000. What's the price tag on your home? $250,000. Wow.
So your mortgage, car loan, or credit card debt are all assets... to someone else. Hey, if I were guaranteed to make $150,000 over the next 30 years, I'd be happy. If I could do that 1 million times over, I'd be rolling in it. And the banks and investors who footed the money for your house are. Really.
Which brings us to Mortgage- and Asset-backed securities. Banks don't exactly want to wait 30 years to get their $150,000 from you. And you aren't their only asset. You have great credit, but I haven't lent to just you. Let's face it. You'll pay your mortgage. The vast majority of people actually do. But the whole idea of a credit rating is to understand just how likely you are to skip town. And I, the bank, have lent to a few people that are, let us say, highly likely to skip town.
What if I were a bank and wanted to make some cash fast? I could sell your mortgage to someone else for cost + $80,000, for example. I'd still make my $80,000 and the investor would potentially make $70,000. Win-win, right? Hmm, getting rid of your safe loan would leave me with just the mortgages of those people who, well, might not actually pay up. Ah-HAH!. I'll sell a package of your mortgage plus a couple of less-attractive loans! I'll use your mortgage to stabilize the risk of the other, riskier investments and by so doing attract a buyer for the package. Brilliant!
This brilliant idea has been around for 70 years. Remember Fannie Mae? What about Freddie Mac? Fannie Mae was established in 1938 to buy Federal Housing Administration (FHA) and Veterans Administration (VA) loans with the purpose of packaging them up (pooling them) and selling them as an investment vehicle. It's a pretty sweet idea- I could buy a piece of one of these pools and reap the benefits of a fixed return (between 5 and 7%, for example) with very low risk. Certainly better than the stock market these days. Guess what? This is exactly what a Mortgage-backed Security is! Not that hard, right?
Fun in the Sun... but where's my sunscreen?!
If you're sharp (or pay attention to the news), then a big problem with the above system is running through your head. There's a big assumption that makes this whole thing work- that of lending to people who are actually going to pay back their loans. The idea that some people might not do precisely that is hinted at above. And that's where we found our risk. So... what if I (the bank) lent to 100 people who are highly likely to give me my money (plus a lot) back? We're in great shape. If we throw just a small number (like 10) loans to people who are somewhat likely NOT to give me my money back? Well, the pot is soured a bit. What if I lent to people that were not only likely but almost absolutely unable to pay me my money back? Well... if I do that enough, the pot is not only sour, but simply impossible to swallow.
Welcome to 21st century America.
Again, I (the bank) am not really planning on keeping these loans- I'll turn around, package them as securities, and sell them to the highest bidder. If I were irresponsible (cut-throat, immoral, predatory), I could offer to lend money to several people who were highly likely to not pay me back, package them up with a few other loans that were sweeter, and sell them for a nice margin to another clueless investor. I've got my money, he's got the risk. It's not wrong if someone buys it, right?
Think about the past 5 years. If you were looking for a mortgage during that time, it was a veritable field day of options. You had your standard 30-year fixed percent, fixed-payment loan. But that wasn't it- there were these APR things- Adjustable Annual Percentage Rate. Generally, an APR loan would lock in a nice, low, percentage rate for a short term (5 years, for example), after which it would fluctuate to match yearly market values. We could talk details, but it boils down to one thing: how much you pay every month. If you have a low interest rate, you pay less. Higher means more.
Suppose I (the bank, again) wanted to really stick it to someone. I could offer them an APR-based mortgage at a very low introductory rate. For the first year, I could lock in mortgage payments several hundred (or more) dollars less than they would pay with anything else. I could carefully avoid the fact that this same mortgage will nearly double in monthly cost once that fixed period is over. I've got person on the hook to pay me a lot more money over the long haul. That's a pretty sweet package to sell, right? I'll package that in with my other mortgages and resell them to investors for a better margin. Who cares if the person in question can afford the payments a year from now? I'm off the hook.
This is sounding bad, right? On two levels- the poor person who can't afford to keep their house any longer, and the poor sap who is unwittingly getting stuck with the bill. Well, it gets worse.
Another layer off the onion
Banks are only required to have 10% lending capital. Again, don't start pulling your hair out. What this means is that for every $10 a bank loans to someone (anyone), they are only required to really have $1. Interesting rule, right? Well, brushing aside the apparent idiocy (and it really isn't stupid, it does work), think about the doors this opens for banks. With each dollar they make, they can invest ten more. Of course there are restrictions, but it is a very enabling rule. But it can be a problem too, in more ways than I'm sure you are thinking.
Think if a bank is holding a large number of MBS'. They sell a few here and there to garner the capital (cash) needed to continue to invest in more mortgages and other items that come across their plate. They only need to sell a small number of these to gain the right to loan more. What if, however, there were no buyers for said MBS'? If they are, in any way, a primary source of capital for my organization, I have no choice but to stop lending. Does any of this start to ring a bell? Something about frozen credit markets? Perhaps something you heard on the news recently?
There is a lot more to the problem, but you get a glimpse of the idea. Now what exactly does this mean to you?
Where's my money?
There are a couple of very obvious points that I can't help but make here. First and foremost- what happens if your bank really fails? And I mean that the bank just ceases to exist, not being bought out by another bank or organization, not supported by the government. Where does your money go?
Think again about that interesting 10% rule. Do you think that if we all went down to the bank, closed our accounts, and asked for our money back that it would actually be there? Think again. They only have 10% (and potentially far less) of what the statement says they are keeping for you. The remainder is amortized (ooh, big word alert) over the years remaining in all the bank's outstanding investments. Yes, start pulling your hair out. OK, wait, I'll explain it.
Remember what an investment is? It's something we buy with the hope that it's worth more than we're paying for it. The value of that investment is more often tied to a time- like a mortgage, which is spread over 30 years. If our banks were exclusively backed by mortgages, it would mean that (best case) they have 10% of everything they say they own in actual dollars that they can pay you. The rest will be paid back in 30 years, when all those mortgages are fully satisfied.
"Woah!", you say. "That's not what the money in my checking account is for!". Well... it works to your benefit. Remember how much the bank stands to earn on that mortgage? That's how they can pay you your monthly dividend on the balance in your checking account. That's also how they can manage to offer that account to you without cost. They want your money so that they can continue to invest more. You don't stand to earn nearly as much, granted, but you do get something out of it.
So you don't want your bank to fail. Not for the next 30 years, at least. That's one big bonus to a bailout of banks. But that's really just the surface of the thing.
Origami for the Business
Let's talk about the buzz-phrase of the week: Commercial Paper. This is, essentially, a business line of credit to pay things like salaries or other operating expenses that has to be paid back in less than 9 months. Very dry. Well, thousands of businesses operate on this type of credit. Especially a business that does not have a fixed, month-to-month earning potential.
I bet you've recently heard a bit about commercial paper. Why? Because there's not a whole lot of it left. One problem with commercial paper is that it is entirely unsecured. There's not an asset (remember what that is?) to back it. If someone doesn't pay up, you can't just walk in and confiscate their employees. It doesn't work that way.
This isn't such a bad thing, if your company has great credit and the banks have the money to lend. What happens, however, when the money dries up? Commercial paper is the first to go. What does that mean to you? Just pray your company doesn't pay your salary with commercial paper. And pray that they don't do business with one that does. And pray that those they do business with don't either. It's the gas price syndrome. Raise the cost of fuel and everything else goes up with it- the cost to get eggs to the grocery store rises, so the cost of the eggs must go up to compensate. One key supplier operating on commercial paper is enough to start the cycle in businesses.
So the end result for the lucky few whose employers do not operate on commercial paper is that the pain is delayed a few months. It still hits. Profit margins are driven down, employers begin cutting back, looking at layoffs, not offering bonuses, and cutting pay. Who pays in the long run? You. And me.
Saving semi-grace
So where do we go from here? Take a look at the past 2 weeks and you'll get a picture. Stock prices tank because no one wants anything to do with a failing financial market. And when the banks fail, the companies go down with them. So no one wants anything to do with the business market.
Options? Well, banks need the cash to continue to operate. We need to find a way to feed that cash to them. Welcome, $700 billion! It puts a sour taste in our mouth, but we have to find a way to free up the credit markets. And the only real way to do that is to give the banks the $1 they need to lend $10.
The whole point of this (lengthy) post is bring some sanity to a sadly lacking report. I respect the journalism field and the journalists in it, but they have been found severely wanting over the past two weeks. Let's be clear. This is not a bailout plan. This is a rescue plan. Why do we need it? So that you and I can keep our job and keep receiving a paycheck. Without some action, we will lose both.
Yes, I believe firmly that the predatory lending practices should be prosecuted. It was criminal in both action and intent. I feel very strongly that you and I should not have to pay for the crimes of others. This is the primary reason for this rescue package. If only our President and Mr. Bernanke were a bit more articulate in their presentation, we might have avoided one of the most massive dips in the market since the great depression.
Still, I do place much of the blame on Congress. We would have taken a hit, regardless, but without their selfish pandering to the panic of some of their constituents, we would have doubtless been better off. As it stands, we've pushed the world into the most widespread recession in its entire known history.
As a closing note, many of you must be angry, or at least wondering, why our government stood by for so long as this crisis culminated. I would invite you to consider what would have happened it our President or any political figure with clout had stood and stated that our system would collapse. It's all about investor confidence- if you don't believe your stock is going to be worth anything tomorrow, you'll sell it today. Instead, a plan to curb the crisis was offered in the same breath. That much I do respect, even if that plan was incomplete and given the worst spin in the history of public relations.
