Figuring Out the Financial Crisis

What really is the crisis right now?  I can’t seem to really figure it out.  Here’s what I’ve heard or read in the last few days on CSPAN, the internet and on TV.

Lost Confidence

Banks have lost confidence in each other to the point where they will not loan each other short term funds.  Normally, at the end of every business day, if the bank has a surplus of cash, they will lend it to other banks.  If they have a deficit, they will borrow from another bank.

Now, banks have so little faith in each other, that they will not make these loans.  There isn’t one specific reason for this.  It could be that the other banks have too much subprime holdings or don’t have enough of a capital cushion.

These banks are still getting the loans they need, but the Treasury is serving as an intermediary.  Banks with a surplus buy Treasury debt, and the Treasury loans that money to banks with deficits.

So, one step to solving this is to restore confidence and faith back to the short term, bank to bank funding system.

Illiquid Assets

According to what you are hearing every day on the news, there are billions of “toxic” debt and “illiquid assets.”  These are all holdings that were tied to subprime lending that are now filled with loans that will never be paid off.

Illiquid means that there is no market for them.  Trust me, there is a market out there for these securities, it’s just that the banks don’t want to drop the price low enough for someone to buy them.

In accounting, these subprime loans were valued with “mark to market.”  This means their values were based on what the market price is for them.  Basically, when the were put on the books, they were valued very highly, probably on a dollar for dollar value.  All the write downs you heard about were banks “marking” them down to market value.  However, if they never sold them, how did they know the value?

If the banks right now cut the price to 1 cent for every dollar, there would be a market for them.  Investment banks and foreign countries would scoop them up.

In order to restore faith between banks, they need to know that the other banks aren’t going to be burdened by this subprime debt and not be able to meet their obligations.

The Bailout

This is where the bailout comes into play.  The Federal Government is going to buy these illiquid assets to take them off of the banks books.

The risk for the taxpayer, who is funding the deal, is that the Federal Government is going to overpay.

You’ve heard a lot about “reverse auctions” too with all the bailout talk.  This means, the Government is going to say, “here’s $1 billion, what will you sell us for $1 billion.”  The banks would offer up different packages of their illiquid assets.

This does not set the market price for these.  This sets an artificially higher price because the Government only has a certain number of packages to choose from.

It should work in a pure auction format.  The banks should present a package they want to sell.  Then they can start the bidding between other banks, private investors, and the Fed.  The package then goes to the high bidder.  Using this method, the true market price is found.

Does This Fix the Problem?

There are many roots to this problem, but a main one was people defaulting on their subprime mortgages.

A lot of people right now are upside down.  This means they owe more than their house is worth.  If they bought at the peak, their mortgage could be for $300,000 but their house is only worth $250,000.

Many people defaulted on their loans when they could no longer make the payments.  Their adjustable rate period is up and they can not make the higher payments.  However, there are some people who are just walking away from their homes.  They can get foreclosed on and walk away with only a hit to their credit score.  There is no incentive right now for them to try and pay the bills.

A New Approach?

The focus should be on the subprime loans and how to get them to be current, rather than having people lose their homes.  There are still waves of adjustable rates jumping up, so there are still a lot of homeowners in trouble.

If the subprime loans would get paid, then the illiquid assets would have value because investors would know they would pay off.

Since the Fed has taken control of Fannie and Freddie, they are basically the ones who decide who gets a loan and who doesn’t. They also generate mortgages and re-sell them to investors.

The Fed should offer attractive, 40 year refinancing to any homeowner that wants it.  They should write off the losses of the home compared to the mortgage as well.  So homeowner’s would no longer be upside down, and they would have more affordable payments.

I am not a fan of government intervention at all. If they are going to intervene though, they should do it to help the root of the problem, not a symptom.  The banks failing are a symptom of the subprime meltdown.

Already the Fed has pumped billions and billions into the market and that money hasn’t done anything.  What is another $700 billion going to do?  It’s too big of a risk to throw that much money at a system that is not functioning.

They need to address the root of the problem and stop homeowners from defaulting.  If they fix that, they can fix the system.  Bailing out big Wall Street banks will help their fat cat friends, but will only patch holes in a dam that is about to burst.

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2 Responses to “Figuring Out the Financial Crisis”

  1. USA Says:

    The root cause for the necessary emergency bailout seem very interesting. Here is a very informative video:
    http://ca.youtube.com/watch?v=H5tZc8oH–o

  2. bevans623 Says:

    Your video is interesting until the point it turns into a smear campaign against Obama.

    What about he Republicans led by Gram repealing the Glass-Steagall Act? That was the one where commercial and investment banks could not co-mingle their assets. That is a big problem right now because all the derivatives and CDOs are so intertwined, that no one knows where it is.

    Why not just present the facts and let people decide? The political attacks discredit the information you present.

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