Bailed Out: 10 things you should know about the financial crisis

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October 10, 2008

4:46 PM

Everyone knows that the economy is in the dumps.

Banks some of us have never heard of (Bear Stearns) are failing while some banks we have all heard of (Wachovia) are failing as well. What is abundantly clear is that our hard earned dollars seem to not go as far as they once did, and students from out-of-state are getting nervous about higher tuitions.

Amidst this anxiety we are all playing catch up to the financial sector, using Wikipedia to understand hedge funds, private banking, sub-prime mortgages and government bailouts.

My search for the truth about the economy has involved reading the news, consulting Mason School of Business professors, students (who seem to only contradict one another), banking professionals, and even researching firsthand the companies discussed.

My overall conclusion is that no one can tell what is going to happen in the market over the next year.
Anyone who says otherwise is full of it.

But since saying “there is nothing to know for sure” is about as helpful as retirement stock in Lehman Brothers, I have compiled ten questions about what some analysts have called ‘impending doom’ of Wall St. Here are the answers I found:

1. Are we all screwed?

No. Recessions and even depressions are part of any cyclical economic system. There are always ups and downs. Right now we are nearing (hopefully) the bottom of a pretty tumultuous downturn, but this is not the end of our economy.

Talking heads on every cable news station are likening this crisis to the Great Depression. That is not the case and commercial journalism is to blame for distorting reality.

Yes, a 700+ point drop in the Dow Jones Industrial Average (DJIA) requires attention, but do not be fazed by the staggering numbers. That day’s drop (Sept. 29) is in percentage comparison (a little under seven percent loss) only the 17th worst in history. It does not compare to Black Monday in October 1987 which recorded a 20 percent plus drop. Even that loss was not so catastrophic as to destroy the economy.

More interesting to note is that despite that historic decline, the Dow Jones closed that year above its January levels.

2. Why are people so worried? The crisis does not affect me.

Now that we’ve determined it’s not the end of the world, a lot of people are wondering what there is to be worried about. To some extent this “crisis” has not been as damaging as it should be, especially considering all of the press it has received.

Right now banks and large investment corporations are suffering the worst. We can all still afford Wawa subs – and the slight increase in the price of Natty Light hasn’t ruined any lives.

But the dangers are very real.

Right now it is becoming harder to take out a loan to buy a house or a car, to send your child to college, or to start a business. That prospect should have us all worried because many of us will need those loans in the near future.

3. Why did this happen?

At first glance it seems Wall Street got a little lazy and a lot greedy. That is a little naïve and simple for what really happened. Following the sub-prime mortgage crisis earlier this year there was a lack of liquidity in the market. That is, banks could not easily gain access to loans to back their investments.

In September, several major banks and investment groups faced this exact problem. Lehman Brothers was forced to file for bankruptcy, Merrill Lynch was bought by Bank of America to avoid the same fate and the government worries about AIG forced a bailout by the Federal Reserve.

The failures of these major financial institutions caused markets across the globe to tumble. Increasing worry caused a shortage of investments that only reinforced the shortage of liquidity.

Finally, on top of the market cycle the government failed to provide adequate oversight to the ever- increasing risk that was becoming the backbone of the market.

In an e-mail sent to the Mason School of Business, Professor Herrington Bryce described the crisis as a “core problem of this crisis is fraud” likening the market buildup of the last quarter century to building a house on quick sand: eventually it will sink.

4. What are Fannie Mae and Freddie Mac? Those do not sound like serious companies.

I agree these are ridiculous names for companies who guarantee trillions of dollars in housing mortgages. Fannie Mae, the nickname for the Federal National Mortgage Association (FNMA) was founded in 1938 under FDR to provide a secondary market for housing loans.

In 1968, the government privatized Fannie Mae to balance the budget. To prevent a monopoly, in 1970 the government created Fannie’s twin, the Federal Home Loan Mortgage Corporation (FHLMC) more commonly referred to as Freddie Mac. Since then these companies have operated as “government-sponsored enterprises,” a unique mix of private market forces and government regulation.

5. Why Fannie and Freddie important now?

Fannie and Freddie have always been important. The reason we are hearing about them now is because of their enormous collapse.

Over the past year, high risk loans and minimal oversight created a mortgage crisis, creating bigger and bigger losses for Fannie and Freddie.

This is not entirely their fault.

They are required by law (because of their quasi-government status) to guarantee loans for other companies that are high risk (high risk is a guy making $25,000 a year taking out a loan for $1,000,000; there is a high probability he cannot pay it back). As more and more people defaulted on their loans, stock in Fannie and Freddie became worthless. Ultimately the government was forced to intervene and on Sept. 7 the companies returned to being under the purview of the Housing Financial Agency.

6. What is the government bail-out?

The government wants banks to continue lending to induce further investment, deeming it the only solution to our ailing economy.

Banks will not lend because some of their assets are worthless (all those failed mortgage securities).

The government’s response is House Resolution 1424, formally entitled the Emergency Economic Stabilization Act of 2008, which authorizes Secretary of the Treasury Henry Paulson to use $700 billion to purchase mortgage-backed securities that are likely to fail. It also gives broad, undefined powers (a theme of the Bush Administration) to Paulson to direct these funds in a manner he sees fit.

7. Is this a good thing?

No. Not really.

Think about it, we the taxpayers are buying assets that banks clearly do not want.

Adam Davidson, an international economics correspondent for National Public Radio put it best: “There are all these crappy assets the banks don’t want, and the U.S. government is about to buy them. And so we’re about to be the owners of $700 billion of crap.”

Many politicians are defending their actions as stemming the tide of financial losses, but there is no sound evidence that this policy will do little more than cost Americans almost a trillion dollars.

8. How much will this affect my taxes?

It won’t. The government does not operate on a balanced budget and consequently an increase of $700 billion does not mean all of our tax returns will disappear. Instead we will all pay down the line when someone (most likely our generation) tackles the enormous national debt that is only getting bigger.

9. Who is to blame?

We all are. Borrowers (that’s everyone with a credit card) have been living outside their means for a long time. Lenders have been happy to keep feeding our gluttony and preyed on our lack of understanding on how the financial sector functioned.

The bottom line: We (taxpayers) are rescuing the lenders from the results of their own irresponsibility.

10. What should I do now?

Buy. The billionaires of tomorrow will be those who capitalized on the market today.

A good friend remarked to me the other day how he hopes the Dow Jones falls another 1000 points because that is more money he will make afterwards.

The market will rise again (remember it’s cyclical). If you have money sitting around now is a good time to start investing.

But remember, investments should be made with a lot of research and only in the long-term. Day-trading (buying and selling constantly) without expertise is no better than gambling.

And that is what got us into this mess in the first place.

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