MYM Series: Wall Street Bailout Explanation 1 of 4
You’ve heard the news; Wall Street’s biggest financial institutions are in need of a major financial Government backed bailout in order to stay afloat. What does this actually mean? How will it affect me? Why should the taxpayers pay for the Wall Streets errors? What are the pros and cons of such a bailout?
My day job, working in Government Affairs in Washington, DC, has given me an insider’s perspective on the makeup of the bailout package and the politics that have gone into the drafting of the legislation. If you find yourself confused, don’t feel bad, I have found that many Congressman and Senators are equally as lost and are relying on party leadership and staff to help aide them in their votes. Frankly, some questions asked by Congress during hearings that took place last week with our top financial leaders (U.S. Secretary Paulson, Federal Reserve Chairman Bernanke, and Chairman of the Securities and Exchange Committee Cox) were asked without any true understanding of the makeup of our financial markets in addition to an inexcusable knowledge of the subprime debacle (an issue we will cover on Friday).
As legislation continues to fight its way through Congress, we thought it would be helpful for us to put a real word spin on the issue as well as offer our opinions, formed mostly by observing firsthand the Congressional hearings of last week. We will write a short series this week, covering a different topic each day that will hopefully help you better understand the crisis and feel more confident and secure about your financial holdings. The order of writings for the week is:
• Why Does Congress Need to Pass Bailout Legislation?
• Understanding the Crisis: Timeline of Failure/Who’s at Fault?
• What is Actually Included in the Bailout Legislation?
• Insiders Perspective: Embarrassing Congressional Reaction to an Originally Dangerous Bailout Plan
MYM Series: Why Does Congress Need to Pass Bailout Legislation? 1 of 4
While it’s debatable, depending on your political views, if Congress should intervene in the markets at all—it’s not debatable to conclude that our markets are facing something so severe and so unprecedented that any valid comparison is only to the market crash during the Great Depression.
Lending
According to Secretary Paulson, one of the main threats our housing crisis has on the U.S. economy is the availability of credit. When banks started realizing their bets on the housing markets were drastic mistakes and subsequently cost them money hand over fist, they found they no longer had any money or capital to continue with their everyday business—lending. Although the concept of lending to get out of debt seems ridiculous, it’s important to remember that lending is a lifeblood to our economy. If banks can no longer afford to lend money, consumers can no longer borrow for a house, car, or lines of credit. Small businesses can no longer get the money they need to prosper or even begin. Students could not take out loans to attend college. As you can see, our economy truly relies on lending, which is one enormous reason Congress is desperately trying to pass legislation ASAP.
The reason lending is such a fruitful endeavor is because only about 10% of the money lent out needs to be backed up. They can claim interest to be paid to them on the full amount while only having to give out a much smaller amount. Its essentially the interest the banks are after.
Scared Investors = Panic Selling
Another very important and often overlooked reason Congress needs to pass bailout legislation is the affect these failures by our major financial institutions (“Super-Banks”) would have on the overall market. Not only would credit begin to dry up, but investors would start thinking with their feet, and running out the door. Major selloffs in our markets, like we experienced yesterday, could continue. The reality of such a scenario would most likely put the U.S. markets in a deep recession, possibly taking years to overcome. Most damaged by this would be senior investors currently living in retirement. Although they thought they saved enough, the loss they would experience from selloffs would force them to start living off their principal savings rather than pull from interest earned. We could have a wave of retirees simply running out of money.
We Need Financial Institutions to Succeed
Lastly, the overall health to our financial institutions is something we all benefit from. Congress has taken numerous calls from constituents begging them to vote against any sort of Wall Street bailout because they feel taxpayers should not be on the hook for Wall Street’s failures. While there is a lot of truth in these concerns, it’s important to realize the severe threats of doing nothing poses. In addition, it’s likely many of these constituents calling their Congressional Representatives live in a house afforded only by the lending techniques that eventually buried our economy. While I believe those that acted fraudulently in the housing crisis deserve to get punished, our Government must act quickly to first stabilize the markets or we will all be punished by their behavior.
Current Bailout Legislation Concerns
Just like you, I have many reservations about the latest bailout proposal. I’m not thrilled with the Treasury Department receiving an unbelievable amount of power and money, especially at the same time. I’m not happy that ultimately a new Administration and subsequently a new Treasury Secretary would be tasked with taking over Paulson’s expensive plan. I hope that any passed legislation addresses the issue of CEO’s getting paid millions to walk away from jobs of which they sucked at. While it may be necessary, I’m not thrilled that the proposal includes monies to bailout foreign banks that have business in the United States.
Hopefully, a decision is reached in the short-term that will give our markets a little stability and more importantly, some confidence. In the long-term, the U.S. needs to take a step back and look at the regulatory structure that allowed our crisis to happen and legislate changes that will help our regulators keep pace with the innovation in our markets without infringing or discouraging the innovation that makes our markets so great. $
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Comments
A fear and panic oriented article. The world will survive with no bailout. how about bailing out the poor or the un-educated or those needing health coverage.
It is time to let the chips fall where they may. If some banks fail, others will step in. This crisis is just an extension of the Bush follies of deficit spending on a war that never should have been started. It is just this is a different group of “monied” that we are giving dollars to.
NO BAILOUT PERIOD
Rick, thanks for commenting. With the majority of U.S. citizens in disagreement with the bailout, I’m surprised more haven’t responded like you. Trust me, I don’t want to spend 700 billion to get us out of a mess we didn’t start. But we as consumers defiantly fueled the crisis by agreeing to bogus loans (I realize not everyone did, but how would we single them out?). I guess this is kind of a fear and panic oriented article, but frankly the markets are in panic and investors are in fear. Unless something is done, I don’t see that changing. Something that gets lost in talks about the bailout is the potential for earnings. It’s possible, though not the goal, that the U.S. could make money on purchasing these securities in the future.
Rick, part of me wants to agree with your Darwinistic outlook…let these super-banks crash and burn and new ones (with better regulation) will rise from the ashes and be stronger for it.
But lets not forget that those toxic loan packages aren’t going to magically go away, they have to get eaten somewhere. I am more in favor of not having taxpayers pick up the tab but then we also see more things crashing coming down the pipeline like derivatives. An extra 2 trillion dollars extra to be exact. We should also remember that this bailout is an infusion of money where its not liquidity that’s the issue, but insolvency.
Will todays vote give us a jump for consumers to sell off again? Its hard to judge but predictions don’t get much easier then this. Of course its all speculation in the long run…Frank would know since he is on the Hill a lot more than I am.
Most of the arguments that I have heard against this is that we shouldn’t “throw money” at the fat cats on Wall Street. I think the average person doesn’t understand the liquidity crisis and how it could cost a large number of people (outside of the banking/real estate/financial sectors) jobs due to the fact that businesses will not have sufficient credit reserves to make payroll. Additionally, most have not considered that if managed correctly, the government stands to make a profit with this as an investment. Buying loans at 40 cents on the dollar and selling later at a profit. It would take a default rate of greater than 80% for the government to lose its investment (even when the loans default, they would need to foreclose and sell the home for less than 40% of the loan amount for the government to lose money). For this reason, Warren Buffett has said this is a great investment for the government.
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Afterthought
Not passing bailout legislation could also:
1) Increase Foreclosures
2) Increase Unemployment
3) Continue the Slide in Housing Prices