My armchair economist analysis of the bailout says that it’s a bad idea. To think this out, I’m going to write my understanding of the problem and see if I can figure out whether the bailout makes sense or not. Bear in mind that I’m really stupid so this could all be wrong (else I got lucky). Most of what I write on this blog is for my own use, now and in the future. I put it out there for my own benefit, not yours. ;) If you get something useful out of it, great. If not, you were warned.

As I understand the problem, companies in the financial industry (Lehman Brothers, Bear Sterns and, I bet, lots of other biggies) as well as companies not in the financial sector (only AIG that we know of, but I suspect many others) took out loans using mortgages that they bought as collateral for the loans. They bought “Credit Default Swaps“:http://www.investopedia.com/terms/c/creditdefaultswap.asp (CDSs) with the money they borrowed. CDSs were essentially virtual securities. The investment banks created them out of thin air, Enron-style, and they all agreed that they had value. Then they decided that they had even more value. That value went up, up, up. Apparently, the value of all CDSs was higher than the combined GDP of every country in the world! It doesn’t take a rocket scientist, and certainly shouldn’t take an investment banker either, to understand that this makes no sense. Nothing can be worth more than what everyone can afford to pay for it.

Reality wasn’t enough to make CDSs implode because, it turns out, “no one really understood what a CDS was”:http://www.economicpopulist.org/?q=content/derivatives-investment-vehicles-no-one-understands. They had value because everyone else believed they had value. And the SEC and investors didn’t know they existed because they were outside the regulatory laws so no one could tell that the financial industry was living in a fantasy. The stocks of the financial companies went up, up, up because they owned CDSs whose values went up, up, up. Again, it’s Enron all over again except that Enron was not the underpinning of our entire economy the way the financial industry is. The financial industry is the oil in our economic machine.

What made the financial industry realize CDSs were worthless was the mortgage industry’s collapse that “started in 2005”:http://en.wikipedia.org/wiki/Subprime_mortgage_crisis. The mortgage industry cratered because of all the mortgages that were made in the late 1990s and early 2000s couldn’t be paid. Thanks to very low interest rates, everyone wanted to buy a house and everyone else wanted to give them a mortgage. That wasn’t enough mortgages so the sub-prime mortgage, a mortgage at an even lower interest rate that was below the prime rate, became fashionable. It used to be that the mortgage industry had to verify and prove that the person getting the mortgage had a good chance of paying it back. That’s in their self-interest, of course. But they can also sell that loan to someone else. That’s not a problem because no one is foolish enough to buy a bad loan. Again thanks to de-regulation, banks no longer had to provide the details about the loan to the buyer of the loan, so the buyer didn’t know they were buying a risky loan. This worked out pretty well for banks. They could collect mortgage fees and not carry the risk. With the housing bubble and all the mortgages that were being done, these fees amounted to big money.

Homeowners became unable to pay their mortgages because these loans were written “creatively”, which is a euphemism for “illogical”. They used Adjustable Rate Mortgages (ARMs) and even stranger payback schedules so that the math worked out so that people with not enough money could buy expensive houses. Then interest rates started going up again and so did the mortgage payments. People couldn’t pay. Obviously, when the owners of the loans realized that they bought loans that weren’t going to be paid back, the loans became worthless and banks had to start writing them off as losses. Over and over and over again. Boom, the mortgage industry fell apart. Washington Mutual, the #1 mortgage lender, just “went belly-up”:http://www.bloomberg.com/apps/news?pid=20601087&sid=aMDDN2oMLQus&refer=home. I’m sure there are more to come. I’m glad about Washington Mutual going away, I hated that it was called “WaMu”. Living in Seattle, everyone talked about “Whaamoo this”, “Whaamoo that”. Ugh.

On a side note, there are people who blame the people who bought houses. That’s true to some extent. Who wouldn’t take out a sweet mortgage if they were approved for one? That’s how everything works in our economy: if someone wants to sell me a Ferrari for $1.50 I’ll buy it, it’s not my job to make sure the seller’s business is sound. Why should new homeowners have to make sure that the bank giving them a mortgage is not being stupid? Granted, the new homeowner should have understood the math to realize that they’re not going to be able to pay the loan back when the interest rate increases. It’s their fault they’re losing their home, but it’s not their fault the mortgage industry collapsed. (Note: if you want to sell me a Ferrari, I may go as high as $2.50).

Now the Federal Government comes to save the day by buying these bad loans. That saves the people who made the risky bets on top of bad loans because their bad loans, which aren’t worth much, are being exchanged for dollars, which are worth something (we hope!). But now the tax-payers own a lot of bad loans. Why would we want them?! The government says that these are mortgages and, since real estate is a good investment, the mortgages will eventually be worth something and the government can earn a profit later either by selling the loans to the private sector or, since we officially own Fannie Mae and Freddie Mac, will earn the interest on the mortgages. All the profits will be passed back to the tax-payer. But will there be profits? These loans are mostly likely to default, which is why we’re in this mess in the first place, right?

I don’t get it. I realize that we have to do something. The economic machine needs oil or it grinds to a halt and we all suffer – companies go bankrupt and new businesses can’t be created, unemployment increases, people can’t buy widgets, widget companies go bankrupt, unemployment rises, people can’t buy food, food companies go bankrupt, unemployment rises, we can’t afford to buy beer, beer companies go bankrupt and then we all move into caves and hit each other with clubs.

It seems to me that the government has other options:

  1. Buy the bad mortgages, re-evaluate them all with the now low values of homes and, if the homeowners can afford the newly-written mortgage, they can keep their house. People remain homeowners, they have a valuable asset and a mortgage that makes sense for the value of their house, they start feeling good about their financial situation, they start to spend money and the economy starts spinning up again.

  2. Forget the loans and buy all or part of the banks that have these loans. This keeps the banks afloat and makes them solvent and liquid again. People can borrow money again and the economy starts spinning up again. People still lose their houses, but the only people who seem to care about that are the people who are losing their houses (who says Americans are empathetic?). And because the banks were on the verge of bankruptcy, they’re cheap, which makes it more likely that their value, and tax-payers’ value, goes up.

  3. Some combination of those two.

Both of these solutions are “hand-outs” (to individual people or to banks), but that’s what the government is for, especially if it makes the entire country better-off. And the government is far more likely to profit when the mortgages are paid back and/or the banks do well. Others say this is the dreaded socialism, but those people are free market idealists who haven’t yet realized that the free market isn’t the answer to every problem.

Now I’m going to go read what The Economist says about it and see if I change my mind or learn something…