Taxpayers shouldn’t have to pay, but they must. The problem is not defaulting mortgages, per se—the rate of foreclosures is not significantly worse than other difficult times we’ve had. The problem is the derivatives market and the federal reserve (i.e., Greenspan’s easy money policy). If all the bad mortgages were to go belly up, it would indeed be a problem for those banks that lent that money and their’s alone. That’s not the case anymore. What has happened in the past couple decades is the explosion of the derivatives market, specifically credit swaps, collateralized debt obligations.
In simple terms, Fannie and Freddie was required by law to buy up mortgages in order to lessen the risk to banks who were required by the Community Reinvestment Act to give mortgages to “historically disadvantaged persons”. Neither Fannie nor Freddie nor any other lending bank really wanted to absorb such risk (nor would their shareholders allow it), therefore they mixed jumbo, prime, and subprime mortgage debt obligations and sold shares of these bundled debts (”collateralized debt obligations”, or CDOs). These are investment vehicles that by and large are only available to commercial and institutional investors.
With the easy money policy of the Greenspan years, the real estate market boomed—so much so that in the sellers’ market, common rowhouses in Philadelphia, for instance, were selling for $600-700k when ten years prior they had a FMV of no more than $50k. Again, that by itself is ok, assuming that the bad loans would, in times past, be risks that the lending banks could absorb with higher interest rates, etc... But now, you have the real estate bubble burst and a higher than normal amount of defaults. Again, not exactly a typhoon by itself. Problem is, the CDOs are, along with related derivatives, spread throughout the financial system to the tune of about 34 trillion dollars.
What it means is that a few defaults out of the ordinary becomes a terrific storm because the valuations of all real estate have collapsed, which in turn means that no one really knows what the CDOs are actually worth now because the good loans are fused with the bad—everything is now devalued. That’s 34 trillion dollars invested in financial instruments where no one has any idea of the actual worth of the investments. The cascade effect began last year when the RE market collapsed. Then Bear Stearns, then the big one, Fannie and Freddie.
But Fannie and Freddie were really the tip of the iceberg—AIG not only invested in such CDOs, but they insured many of them—CDOs are like bonds, in that the payment is technically guaranteed. 34 trillion dollars in guarantees for something that may be worth half of that. Suddenly no one trusts anyone in the industry. Suddenly institutional investors flee the derivatives market and start pulling stakes out of the money market sector. Money markets provide the main source of capital for commercial lending banks, so with a big hit to the money markets after the Fannie/Freddie and AIG collapses, you suddenly have a situation where by the middle of last week, there was zero money available for commercial lending. None anywhere in the US financial industry.
There is no choice; something must be done. Doing nothing will not just cause a few banks to fail. It will lead to a total collapse of the entire US economy. I am a follower of the Austrian School of economics, but even I know that because the government created this mess, they must do something now because to let the entire US economy fail in order to prove a point is irresponsible.
I am not endorsing the Paulson plan per se; I happen to like McCain’s idea myself, but something must be done short-term or there will be no tomorrow upon which to reboot the system and do it right. Unfortunately, the taxpayers must step up to bring order to the chaos. Hopefully, a new system will be brought in under McCain-Palin, but the economy will be toast in as little as a week if something isn’t done or at least agreed to so that investors will have some confidence.
Thank you for the explanation. I actually sort of understand it.
Let the NyLon geniuses, who created that market, eat cake.Americans can rebuild from the ashes without their help. We begin as soon as all their 1s are turned into 0s.The New York T-Bill party - In remembrance of the Boston Tea Party
Great explanation— finally, I understand the situation.
You should be a teacher.