I have to give kudos to Bunning for his hard core stance against the government bailout. He is completely right that this "bailout" is Un-American. In fact it is down right socialistic. A "solution" that will do more harm than good. But let's take a step back and understand what is happening and how we got into this state.
It all begins with mortgages. Mortgages traditionally have been a safe economic investment for banks. The best way to understand this is to look at example. Family X wants to buy a $100,000 house. Banks traditionally have required 10-20% in a down payment. That means the loan is for $80,000 to $90,000. If the family defaults the actual house whose worth is around $100,000 can be sold to cover the cost of the loan.
In addition, people tend to make mortgage payments before any other debts. All of which means home loans are almost guaranteed to provide a consistent return on investment.
Now if I bundle multiple mortgages together I am almost assured of a safe investment that will provide a solid rate of return. If we have 100 loans with an average interest rate of 6.5%, then when we factor in a normal rate of defaults we can assume they will provide a long term rate of 6% guaranteed.
Enter Wall Street companies. They bought up these mortgage bundles (mortgage backed securities, MBS) and leveraged these safe assets to get short term loans. The short term loans are then used to extend "credit" to companies (think line of credit) and individuals (think credit cards). The Wall Street companies make their money off the transactions and interest rates from credit extended. A very profitable business.
Now we bring government into the equation. Many moons ago Fannie Mae and Freddie Mac were set up as semi-private organizations that would buy loans from banks and mortgage firms and package them as MBS's for other companies. They guarantee the principal will be paid regardless of the original buyer's ability to pay.
In theory they provided liquidity for both the banks and the wall street companies.
As with all things government, we bring politics in the mix. Liberals have long tried to ease loan policy in effort to get more poor people into homes. Democratic legislators demanded that Fannie Mae and Freddie Mac open up their loan practices to encourage more loans to economically disadvantaged. Add in financial mismanagement by Democrats who ran the organization (two of the CEO's are on Obama's economic policy team). The ones who created an environment for bad loans and then tried to cover up the paper trail. Add on top of that liberal groups and community activists (Obama) that put pressure on banks to force them into making ethnically diverse loans. What you get is a bunch of bad loans. Loans that inevitably end up defaulting.
The bad loans had a secondary impact. They artificially increased housing demand which drove up the price of housing above market values. Creating a housing bubble. The bubble pops, which it did last year, and now a bunch of MSB's are no longer as valuable as they were a year earlier.
Now our formerly reliable home loans are much more risky causing two actions. MBS's are downgraded away from AAA safe investments and the value of the MBS's drop. The increase in risk causes the short term capital lenders to demand that the Wall Street companies have more equity for the loans they currently have. It is otherwise known as a margin call. Companies like Wachovia, Lehman Brothers, AIG all didn't have enough cash to pay for the call. Thus they ended up selling off assets to create cash. The problem is the assets aren't worth as much as previously which makes them hard to sell.
So what we have is short term lenders wanting Wall Street companies to have more cash on hand and the Wall Street companies don't have the cash and are having a hard time getting it. Since it is the Wall Street companies that create credit and they don't have the financial resources to create the credit, we end up with a credit freeze.
Why is a credit freeze a bad thing? Many companies use short term loans to bridge the gaps between ups and downs in their sales. The best way to understand this is with an example. Company X has $1 million cash on hand at the beginning of the month. They have to pay out $1.5 million twice a month in payroll. They expect get in $10 million on the 20th of the month in account receivables. The only problem is payday is on the 15th. They don't have enough money to meet payroll so they get a one week bridge loan of $500,000 to cover payroll.
If the credit freeze is bad enough companies won't be able to get the loan and make payroll. They would have to downsize almost immediately.
What if everyone's credit card companies decided to come around and collect on everyone's outstanding balance immediately? It would force a lot of people into immediate bankruptcy.
If either situation came to pass, it would be disastrous and the economy would spiral into a very deep recession.
Those who think this will happen are the ones who are clamoring for the bailout. What the bailout will do is buy up these bad MBS's at some rate around market value and bring liquidity back to the Wall Street companies. Since not all of the MBS's are bad and the price of housing will in time recover, the government should in theory recoup most of the money and potentially could make a profit.
My concerns are two fold. The bailout is clearly a socialist move. It is the government ensuring the financial responsibility of Americans. In this Bunning is absolutely correct. An interference in the market of this size will only be the beginning of what government can and will do to the free markets. I think such an action should only be the taken as a last resort and I am not so sure that we are that close to the economic abyss as many pundits think.
If Main Street was going to be slammed by the collapse of Wall Street, I think the stock market would have dropped considerably more than it did. I think you would find more CEO's of these major companies coming out and saying the end is near. I think you would have universal agreement among economists that the end is near. So far only those in the financial market, the media, and politics have been crying uncle.
It seems to me rather than give a bunch of money to the people that caused the market distortions in the first place, we should take much less drastic steps. Give the changes some time to see if the markets can work themselves out. Especially before we decide to jump off the cliff.
Their is plenty of liquidity in the market. We just need to jump start the credit engine. The first thing we can try is to change the accounting rules that have exacerbated this mess. It is time to lift the mark to market rule for a few years and allow for more reasonable means to evaluate MBSs.
So what is to blame for the "worst financial crisis since the Great Depression"?
The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.
For example, the prices of assets on the books of Washington Mutual, when it was bought by J.P. Morgan at a fire-sale price, were cited as a reason to mark-down the assets on the books of Wachovia. This, some say, forced the FDIC to arrange its sale to Citibank.
The same is true of what happened to Fannie Mae and Freddie Mac, which had positive cash flow when they were nationalized by the Treasury. Here's something you won't believe: Fannie Mae and Freddie Mac have not drawn a dime from the Treasury's $200 billion facility that was created to bail them out. It was the use of mark-to-market accounting that allowed Treasury to declare them bankrupt. On a cash flow basis, they were solvent.
Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.
Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.
The best way to think of Mark to Marketing is by the following example I came across today.
Say you have a $300K house and owe $200K on it. At that point you are in good shape. Now let's say a similar house down the street is foreclosed and sells for $150K. Now your mortgage lender comes to you and says you promised to keep 20% equity in your house. The market says your house is only worth $150K, thus you are only allowed a $120K mortgage. Therefore, you must right us a check for $80K today.
Now you can see how the accounting regulations have exacerbated the problem. It only makes sense to lessen the immediate burden on companies holding the MBSs and allow private money to come in and make a profit on the deal. That way we can avoid more government coercion of the markets and the problem will work itself out. If after 6 months this doesn't clear up the credit freeze, we can start looking for more dramatic actions.
Therefore I am opposed to this bail out plan no matter how much some in the Senate try to sweeten the pot. It is a horrible idea and should go down in defeat. I want to again give props to Bunning for coming out and fighting against this from the beginning for the right reasons and not because it is politically expedient as some others have. On the other hand, I am disappointed that McConnell has chosen to back the bailout. Hopefully he will see that the crisis is a crisis that isn't.
