The Bailout for Dummies

So I spent Saturday night and Sunday morning up in Park City with my lovely bride, ditching the Priesthood session of General Conference because Mrs. Cornell’s sister was willing to take all five kids off of our hands overnight.

This does not happen often, and when it does happen, the opportunity must not be squandered.

We did watch plenty of LDS General Conference, though, and I especially liked Elder Uchtdorff’s talk on hope, as well as Elaine Dalton’s words about “ever texting and never able to come to a knowledge of the truth.” Not quite sure why Elder Oaks thinks a white shirt is a necessary component to passing the sacrament, but there it is. I really dig the idea of a Mormon temple in the shadow of the Vatican. That should be very interesting, indeed.

The other thing we did was spend Sunday afternoon discussing the bailout package with family members, and it became clear that very little about said package is clear at all. A brother who used to work for Fannie Mae added some light to the discussion, and others with some inside Washington scuttlebutt inspired me to write today’s blog entry, which I have appropriately titled “The Bailout for Dummies.” This does not mean everyone who is getting bailed out is a dummy, although certainly some of them are. What it means is that I’m trying to make the basic principles of what happened comprehensible to the average Joe Sixpack who may still be drunk from taking a shot every time Sarah Palin used the word “maverick” in the veep debate. In the process of doing so, I want to see if I could put it into words without embarrassing myself.

So here we go.

Once upon a time, people who bought houses went to their local bank and got a loan from that bank in order to pay for the house – a “mortgage,” if you will. These loans guaranteed that the bank a got a monthly payment from you for the next thirty years, and that flow of cash is how the bank made money on the deal. Over the life of the loan, they recovered the “principle,” – i.e. the amount of money initially borrowed – and a certain amount of “interest,” additional money charged by the bank for the right to be able to borrow all that cash up front.

With me so far? Good, because those sweet, simple days are long gone. It gets a whole lot more complicated from here.

See, now when you buy a mortgage, that cash flow is usually sold to another company almost immediately after you close on the loan. And the company to whom you end up paying your loan may not end up being the company who gets the cash. Modern technology makes it possible for every aspect of your loan to be handled by different parties, and often loans are sliced, diced, and bundled into mortgage securities that are sold to financial institutions all across the globe. Every time you pay your mortgage, dozens of banks anywhere in the world could be getting a piece of the action. And any one security could include chunks of dozens of loans – some subprime, some not. A computer spits out a number that tells you how risky any part of a security is based on how risky it’s been in the past, and the whole thing get so convoluted that nobody really knows how much risk they’re taking. As long as things continue to function as they have in the past, though, everything should be fine.

And there’s the problem.

What’s happening now is unlike what’s happened before, because two things screwed everything up.

The first is a well-intentioned and inept federal government. Through Fannie and Freddie and a host of federally-blessed lending programs to provide the “dream of home ownership” to people too poor to afford homes, people got mortgages who really couldn’t afford to pay them over the long haul. This is why Sarah Palin’s cutesy “predatory lenders” shtick sticks in my craw so much. Sure, there are predatory lenders, but the biggest ones come from Washington DC. They told poor people to buy houses with balloon-payment loans, which would be just fine, because when the balloon payment came due, the value of the house would have risen to the point that all they had to do is use the increased equity to get a new loan, and they’d still come out ahead in the long run.

But that doesn’t work if home values don’t continue to rise forever. And that’s the second shoe that’s dropped – home values have collapsed.

As much as Pelosi and Co. would like to say that this, like everything else, is George Bush’s fault, the reality is much more mundane. The bubble has popped. Just like the dot com bubble popped at the end of the last century. Just like the oil bubble – hopefully – has just popped. That’s what happens in free markets; people speculate; markets correct themselves, and bubbles pop. But this time, Fannie and Freddie had bet heavily on the bubble’s integrity.

Suddenly, an unprecedented number of subprime mortgages are collapsing, which screws up the computer models that bundled these loans into securities along with everything else. Record foreclosures mess up the model that determines the value of those securities, so nobody’s really sure what those securities are worth.

So if you’re a bank, and you’re holding a fortune in mortgage securities with undetermined worth, you have a real problem. The FDIC comes in and looks at your books, and they say “hey, these securities aren’t worth the price on the label. So unless you can determine their real value, you can’t rely on them as assets.” All banks have strict loan-to-asset ratios, and if their assets are suddenly devalued, they have to stop making loans.

This has far-reaching implications well beyond Wall Street. Lines of credit that run small businesses would all be frozen. Car dealers all across the country would have to shut their doors unless they paid cash for all the cars on their showroom floors. Without a free flow of credit, the economic engine that drives this country would be like a motor running without oil, seizing up and grinding into bits.

That is the crux of the issue at the heart of the bailout.

The Treasury Secretary and the Chairman of the Federal Reserve wandered into the White House and Congress last week and said they were out of tools to fix the problem, and the United States was just days away from total economic collapse.

The rest, as they say, is very recent history.

So what does this mean? What is this bailout – what does it do? What does it NOT do? Is it the end of capitalism as we know it? Is it going to add almost a trillion dollars to the national debt? And is it all George Bush’s fault?

Let’s address each of these one at a time.

What does the bailout do?

The bailout creates a saleable market for the nebulous mortgage securities that are cluttering up bank’s balance sheets. The federal treasury will buy those securities and free up assets for affected banks and allow them to start making loans again. This restores confidence in the credit markets and allows the free flow of capitalism to continue.

What does it NOT do?

It does not prevent people from losing their homes in foreclosures if they can’t pay their bills. It does not keep the Dow Industrial Average above 10,000. Despite the heated rhetoric, this is not a “Wall Street bailout.” It does not forestall a recession, which is on the horizon and is probably here already. It does, however, keep the recession from being deeply intensified by a full-scale financial collapse.

Is it the end of capitalism as we know it?

That’s actually what it’s trying to prevent. Had the government not been so deeply involved in getting us into this mess, we probably wouldn’t have to rely on government to help dig us out. There’s also a two-year sunset provision in the bill, so the government will forfeit the power to conduct business like this by 2010. (I should add that Mrs. Cornell says “fat chance” with regard to this provision, and she’s usually right.)

Is it going to add almost a trillion dollars to the national debt?

This is, I think, the biggest mistake people on the Right are making as they review this; they see this as the Treasury writing a 700 billion dollar check and sending the money scattered to the four winds, never to return.

That is not what’s happening here.

Although that’s not to say the Federal Government isn’t capable of doing something that stupid; indeed, they did that with about $200 billion earlier this year when they sent us all “stimulus checks.” I appreciated the nice chunk of change at the time, but that was money that went directly on the treasury balance sheets as part of our metastasizing national debt.

In this case, the only way all 700 billion ends up adding to the debt is if 100% if all the securities the government purchases end up in default. We aren’t anywhere near that number of foreclosures. Indeed, if we were to hit a 10% foreclosure rate, that would be worse than most of the direst predictions out there. Consequently, if a good chunk of these mortgages continue to be paid, there’s a very good chance that the government could end up making money on the deal.

Of course, all the larded up wool subsidies and pork-barrel gunk added to the bill to sweeten the deal for reluctant lawmakers will add to the debt, but while it’s obnoxious and shameless that this stuff was included, it’s really not a whole lot of money in the grand scheme of things.

Is it all George Bush’s fault?

Not this time. Hell, even Saturday Night Live acknowledged that this past week. Bush, McCain and the GOP have pushed for greater regulation of Fannie and Freddie, only to be called thugs and racists by the Barney Franks and Barack Obamas of the world for trying to prevent poor people from owning homes.

Remember when Enron and WorldCom went down with the dot com ship and Washington paraded a host of disgraced executives in front of Congress to give them a public, ritual shaming? Don’t you find it curious that no one in the Democratically-controlled Congress seems to have the appetite for a similar spectacle with Fannie and Freddie this time around?

This is political correctness run amuck in the world of finance, and no amount of speeches by Nancy Pelosi can change that. They can, however, demagogue the issue and muddy the waters enough so that nobody really understands the problem.

Thank you, Stallion Cornell. You're a friggin' genius.

You're welcome. This has been “The Bailout for Dummies.” I wish John McCain would read it, as he, more than anyone else in Washington, has no idea what this is all about.