To counter what some experts have threatened to be the beginning of a new Great Depression, the government has officially decided to pass a law to bail out the financial system with $700 billion in taxpayer dollars.
In addition to the financial panic on Wall Street, approximately 760,000 jobs have been lost this year and unemployment is at 6.1 percent, the worst figures for these categories in five years. However, these figures are the symptom, not the cause of the financial crisis.
The current economic crisis began through a home-owning dilemma. When borrowing money to purchase a house, the loan taken out from a bank or finance company is called a mortgage. Typical mortgages spread the cost over several years, sometimes even decades, to keep the cost of housing manageable with other costs of living. The bank or finance company that owns the mortgage might sell the loan to another bank or finance company because that mortgage, which is essentially a signed piece of paper, is now worth the value of the loan plus the interest of the mortgage. A bank may sell the loan to another company like any other asset, in which case a notice will be sent to the homeowner informing them of the change in mortgage ownership. Otherwise, the terms of the mortgage will remain unchanged. Banks cannot sit on too many loans for a long duration of time because they need to have cash as well as loans.
To regulate mortgages, the government created Fannie Mae and Freddie Mac. These companies are not commercial banks and were not private when they were created as they belonged expressly to government. The government intended Fannie Mae and Freddie Mac to buy loans and in doing so keep cash flowing to banks, which is also known as liquidity. Banks exchanged loans with the government for funds so they could continue the loan-making process and operate as normal. Fannie Mae and Freddie Mac were eventually privatized when they became profitable institutions and the government allowed the transition to private consolidation so that the public could buy their shares of stock.
The first sign of trouble surfaced in the wake of the housing boom in America. The prices of homes were going up and banks were competing to make more and more loans so that they could make more money. As a result of this competition, banks started giving loans to people who were not qualified. They did not check the incomes or papers of those asking for the loans, and lowered their standards for qualification of loans. Both home buyers and banks were operating under the delusion that house prices would continue to go up.
The most important concept in these exchanges is equity. Equity, put simply, is the part of the value of a home that belongs to the owner. For example, if a buyer wanted a home for $100,000 and only had $10,000 to put down, the bank would loan the buyer $90,000 and the buyer’s equity would then be $10,000. If the value of the home rose to say $130,000, then the buyer’s equity would be $40,000, meaning the $30,000 increase in the home’s value is the buyer’s, not the bank’s.
Assuming ideal conditions, if the buyer sold the home, he or she would receive $130,000, would owe the bank $90,000 and would walk away with a profit of $30,000. The banks made their profits off of the interest rates and fees that accumulated throughout this process. Because of this, banks felt secure giving money to people who did not necessarily have enough to purchase a home, and buyers felt comfortable buying beyond their means because they felt that their “means” would increase as the value of a house went up.
Two things happened to burst this bubble. One, the prices of houses stopped increasing, and two, the economy slowed down, including the loss of jobs.
One other thing that contributed to this crisis was interest rates. Banks had been offering buyers very low interest rates during the first few years following purchase of a home. For example, banks would put the interest rate at a lower percentage or homeowners could pay them only the interest on the mortgage for the first few years. As buyers began to pay back their loans in small amounts, they would pay a very low amount compared to what they owed the bank in interest. The logic behind this financial strategy was that once the value of these homes went up (which everyone was certain would happen), the buyers would have accumulated sufficient funds to pay the banks the regular mortgage payments and interest rates with ease.
The crisis began when the economy slowed down and housing prices began to decline. Some homeowners who depended on the increase of value to their homes failed to pay back their mortgage, making those mortgages less valuable because no other bank wanted to buy the depreciatingly-valued paper from a bank. Since they were no longer receiving payments from previously bought loans, Fannie Mae and Freddie Mac were no longer buying new loans from banks.
Yet, if Fannie Mae and Freddie Mac had the money, they likely would not have taken new loans considering the state of the economy, the housing market and the homeowners’ inability to pay what they owed. The banks that could not raise money from new loans, such as Indy Mac Bank, failed. More successful banks, such as Bank of America, have recently bought other suffering banks such as Washington Mutual and Merrill Lynch.
The government seized Fannie Mae and Freddie Mac because they were holding about half of the mortgages in the country, and their potential bankruptcy could be catastrophic for the American economy.
The government bailout is a $700 billion plan by the government to buy the bad mortgages from these banks so that they may be saved. As a result, the government will own these mortgages. Those who did not pay what they owed have lost their homes. Those who were paying, if their loans were one of those bought by the government, will now pay the government. The taxpayers will be paying the $700 billion for the bailout, which averages to about $2,200 per person. Therefore, a family of four would end up paying about $10,000.
The debate in the House of Representatives has concerned the moral implications of financially resurrecting companies that knowingly engaged in risky, careless and greedy financial practices. The debate is still unsettled, but the bailout has now been passed in what financial advisors fear to be the first of many more government-funded bailouts without the promise of returning taxpayers’ money.