I am not the biggest current-events junkie you will ever meet. In fact, most of the time, I have no idea what is going on. However, the current financial crisis is a big enough deal that I have been trying to pay attention. Plus, considering that I just graduated with an MBA, and took many finance and economics classes, I sort of feel a duty to understand what is happening. Having said that, I gotta say, I am really confused.
Here is the way I understand the problem:
Too-cheap credit, and government pressure to increase home ownership lead to mortgages that were too cheap, too easy to get, and eventually, cheap up front, but expensive later on, and required no proof that you could repay. (These are the so-called "sub-prime" mortgages.) Unsurprisingly, this lead to many more people buying houses, including some that could not really afford them (both speculators and over-eager buyers). This sudden, big demand lead to a bubble in the housing market. At this point in the story, we have over-priced houses, many of which are owned by people who cannot afford them. Again unsurprisingly, this bubble eventually burst. (I use the word "unsurprisingly" only in retrospect - I certainly didn't see this coming.)
Now, I own a house, and I benefited from the run-up in prices, and I suffered paper losses from the burst, but since I can afford my mortgage, and intend to stay in my house for a while, this didn't really affect me. However, people who bought at the peak, and now need to move (for work reasons, or what ever), and people who couldn't really afford their mortgages in the first place, they are affected. A large number of people cannot afford their house payment, and cannot sell their house to cover the debt, so they default, or are at a great enough risk of default that everyone (including their banker) knows that it is just a matter of time.
The bank that gave you the loan doesn't really want to wait out the 30 years it will take for you to pay back the mortgage, so they sell the mortgage to another kind of bank. That bank puts a bunch of mortgages together, and sells the whole thing as a bond. The idea is that you buy a share in the bond, and the bond (using the mortgage payments from homeowners) makes monthly payments to you over the next 30 years. And it shouldn't be that risky, because although someone could default on their home loan, most people don't, and the house is there for collateral, so the money can get recovered anyway. Unless. . . an unusually large number of these mortgages are extra risky, because the homeowners can't really afford them, and unless the value of the houses is actually about to go way down when the bubble bursts.
That is the basic sub-prime mess, as I understand it. Because there are so many of these bonds, nearly every financial institution owns some. And now, no one knows what they are worth. If we don't know what they are worth, they are risky, which makes them worth even less. So now lets suppose that you are a big financial firm, and you have a bunch of these bonds that you have on your books at say, $100M, but are now worth something much less. Lets also suppose that you have debts of your own, that you qualified for by pointing to all of your non-cash assets. Now that some of those assets are worth much less, you don't really qualify for your loans. People who lent money to you, who probably have troubles of their own, start to get nervous. Maybe somebody says that the short-term loans that you have to renew next week, won't be renewed. Now you have a very large, very profitable, very old, very successful bank that has all its short-term cash dry up, and cannot pay the bills tomorrow.
This is called a liquidity crisis, and in most cases, could also be called a confidence crisis. You are having a problem because someone got nervous. Of course, maybe they had good reason to be nervous, and you deserve the problem you are about to have. If you really are a good bet, the government could step in and offer to lend you the money, and put you back on track. On the other hand, if you are a bad bet, then the government just bought a shit sandwich.
Now we get to the problems of financial contagion and moral hazard, also known as "damned if you do, damned if you don't". If this hypothetical financial institution, run by the best and brightest financial minds of the generation, got themselves into this mess, then maybe they should fail. This certainly teaches those guys and their competitors not to do business like that again, and it also makes people who do business with similar banks to be a little more wary and demanding. These are all good things for the economy. Unless. . .the sudden and unexpected failure of your bank puts enough pressure on the next bank to create a liquidity crisis for them, and the dominos keep falling until the whole economy is plunged into darkness. Could this really happen? It has happened in entire regions of the world, where one country has a currency crisis that cripples its economy, and infects all its neighbors and trading partners. That is the contagion part. The moral hazard part is that if you keep paying for your kid's mistakes, he will keep making them. If we keep a big firm from failing due to bad management, why should it change its management?
So, here we are, wanting to spend $700B to keep the dominos from falling. You can make an argument that it is necessary, and you can make an argument that it is bad. Frankly, I was taught that the financial professionals in the Wall St. firms know what they are doing, and that if they didn't, a smarter competitor would run them out of business. I don't just hate the idea of bailing out all of them at once, it undermines my fundamental view of the world. If I cannot trust good management to succeed, and bad management to fail, then what can I trust? Why should I even try to be a good manager?
What if we do something different?
Let us assume that things are indeed bad enough for the government to intervene, but lets try to avoid propping up any broken financial institution. Instead, lets start at the bottom, propping up the homeowner. Now I believe that a homeowner, or real-estate speculator who got in over his head deserves to loose his investment just like the big guys. But if you want to say that someone should have known what they were doing when they got into this mess, it seems like we should point at the big institutions before we point at the individual home buyer. When I sign the papers for my home and mortgage, I really should know what I am doing. When Bear-Stearns buys a bunch of mortgage-backed bonds, they damn well better know what they are doing. And if someone is going to pay the price for screwing up, they should probably pay first.
Here is the plan:
If the fundamental problem is that a bunch of mortgages are likely to default, then lets fix it at that level. Anyone who is planning to stay in their home, but has a problem with an increasing variable rate mortgage, can qualify for a government sponsored low-interest rate loan. And the loan is good for your original loan amount, regardless of the current value of your house. This means that far fewer of the mortgage-backed bonds will fail, because home owners who would otherwise default will just refinance with the government. The bonds might loose a little value, because paying a bunch of them off early might be worth less than running the full term, but this has to be worth much more than the defaults everyone is currently expecting. And, reducing the uncertainty improves the value of the bonds as well. Now, banks that hold these bond no longer have this trouble on the books, and should be able to go back to business as usual. If that means that a few of them still fail, so be it. But we shouldn't be talking about wholesale failure of the entire financial system. Plus, the bond holders feel at least some pain, which will make bad bonds harder to sell in the future.
There is still some moral hazard in this plan. A guy who cannot afford his house will probably get a government loan and extend his time a little, then default anyway. But there are two benefits, even in that scenario. First, a subsidized interest rate stretches out the defaults. Having everyone default at once is a much bigger problem that having the same number of people default over a 3 year period. Second, the guy who is going to default will lose his house, and probably any down payment that he made, so he has some incentive to at least try to make this work. I still will hate the idea of some jerk speculator getting a subsidized mortgage for buying houses that he never could afford. But I can live with that guy being forced to live in an expensive house longer than he planned more than I can live with the CEO of a major Wall St. firm taking my tax money and saying "well, it was really your fault, all along. . ."
I am probably exactly wrong on several points here, so someone please straighten me out.