You know its bad when my wife, who under normal circumstances immediately dozes off when I start talking economics, is checking finance blogs looking for news on the credit markets. She is getting into heated arguments with friends over the bail out legislation. And to top it off, she's made a request that I explain to non-finance people why they should support a massive bailout of Wall Street. So here is my case. Hopefully regular readers as well as people far removed from finance will find this stimulating if not convincing.
First let's think about how modern lending works. Pick any type of loan: student loan, car loan, credit card, home mortgage, small business loan, etc. Any time a loan is made, whether its to pay for meal with your credit card or to pay for tuition, someone actually has to come up with the cash to lend to you.
Where do lenders come up with this cash? Primarily three places.
- Borrowing from investors or from other banks.
- Securitization. This means that the loan isn't held by the lender, but sold to investors.
Lenders don't want to use deposits to make loans right now, because there is serious risk of depositors suddenly demanding their cash. Remember that banks don't ever actually have enough cash to give all their depositors their money on any given day. So when depositors are nervous, banks are nervous.
Normally if too many depositors happened to take money out (not in a panic, but just by happenstance) the bank would simply borrow cash from another bank. That's nearly impossible right now. Banks are generally unwilling to lend to each other. Banks can still borrow from the Federal Reserve, but they are so desperate for cash right now that they are accepting any interest rate, and the Fed is finding it nearly impossible to control short-term interest rates. Today banks took overnight loans from the Fed at 7%, 3 1/2 times the target rate set by the Fed. This is historically unprecedented.
Banks also cannot sell loans to investors. Even loans that are backed by governmental guarantees, like certain student loans, are not sellable in the current environment. Forget about automobile loans or business loans.
So if banks and other lenders cannot get cash, they cannot lend it. So what? Isn't our society doing too much borrowing as it is? Maybe, but let's consider the consequences of a world with no lending.
First of all, there would be no housing market. Very few people can buy a house with cash. Housing prices would continue to fall for many years. The result would be that people would almost universally live in rented housing. Wealthy land lords would own all the housing in America, and would reap all the profits from rentals.
Second, there would be no secondary education. Like housing, the vast majority of people need loans to get a college education. Granted, colleges would probably pare back on the quality of the education offered in an attempt to lower their costs. Even so, it would likely be that only wealthy people could afford college. The income gap in our society would increase as a result.
It would also be extremely difficult for average people to start a new business. Most businesses require start-up capital, most of which is normally borrowed. In addition, many small businesses need working capital, which allows the business to make payroll while waiting for accounts receivable to come in. So here again, only the wealthy would be able to start new businesses.
How will this bailout help? Mostly by creating a outlet for banks to sell "troubled" loans. What constitutes "troubled" isn't yet known. But suffice to say the Treasury will mostly be buying mortgage loans that probably shouldn't have been made in the first place. The price paid to the bank will be less than face value, thus the bank will suffer losses. Hopefully enough of these loans will recover their full value that tax payers do not suffer large losses.
But its a mistake to assume that, as tax payers, we aren't already on the hook for this mess. Currently there is about $8.6 trillion in assets that the FDIC insures. The truth is that the FDIC is ultimately funded by tax payers. So as tax payers, we are already on the hook for bank's behavior. And for way more than $700 billion.
In addition, municipal governments are suffering greatly in this crisis. Not only are their facing the prospect of decreased property tax assessments, but the cost of funding municipal projects has skyrocketed recently. Today, 7-day floating rate municipal bonds are carrying interest rates above 8%, breaking all records. Who will ultimately pay for these extremely high interest rates? Tax payers.
I completely understand the visceral anger that many Americans feel about the situation we're in. I'm sick over the fact that its come to this. But this is what it's come to. We would be foolish, as Americans, to destroy our long-term economic prosperity just to satisfy our righteous anger with Wall Street.
If we don't do this bailout, Main Street will pay anyway, and pay much more dearly. So I would encourage you to write your Representative and tell him or her exactly that. You are angry at Wall Street, but you also want to see some justice for Main Street.
Fell free to e-mail this or send links as you'd like. I don't really care about getting credit.