Sep 26 2008
U.S. Financial Crisis!! What Is Really Happening?
Published by Steve Latter at 4:42 pm under
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WikipediaYesterday in my classroom, I explained to my students the financial crisis that is occurring in the U.S. economy, and the Federal Government bailout bill that both houses of Congress are trying to agree on to save the economy. This is such a national crisis that our key government officials were working on this bill just late last night in hopes of agreeing to a bill this weekend before our economy potentially reaches a new level of recession.
Sooooo: Here is a simplified summary of what is happening in the US economy today relating to the “financial crisis”. I’m going to use simple example US Dollar numbers for you to explain what is happening, but the direction of the numbers is real and the simplicity will really get you to understand the real problem at hand and what the Government is proposing to do to fix it.
Here we go:
Gigantic U.S. financial institutions such as AIG, Fannie Mae, Freddie Mac, Lehman Brothers, & Merrrill Lynch all have the SAME problem: They are holding $100 in a “paper asset” that they invested in called mortgage-related securities. These same financial institutions also have debt of $60 of which the lenders of the $60 all have legal collateral on the $100 of mortage-related securities. Since many U.S. homeowners are not paying or are unable to pay their home mortgage (loan) payments, the Government’s (SEC) accounting rules require that these same financial institutions write their mortgage-related securities down from a value of $100 to a value of $40. This reduction in asset value causes a reported loss of $60 and is frightening the lenders as the shrinking value of their collateral (securities) has fallen below the debt repayment amount causing the lenders, per the legal debt agreement, to demand immediate payment from the financial institutions.
Thus, these large financial institutions do not currently have or carry enough cash or other assets on hand to pay off the lenders since no one will buy the falling securities they hold because other potential buyers do not trust their market value. Thus, these large financial institutions are currently screwed and are said to be in a “liquidity” (cash) crisis, and they certainly have no cash to lend to small businesses or households. The financial institutions are said to be “freezing up” and they are stopping their loans to businesses and households. Thus, it is really difficult for “main street” (you and me) to get a loan today at most banks.
In steps Hank Paulson (U.S. Treasury Secretary) and Ben Bernanke (Chairman of our Nation’s Bank, the “FED”), the President, and the U.S. Congress to try to avert a deep recession or depression, because if the banking system fails, then the economy is thought to quickly fail.
Using the same example numbers above to explain, the Government plan or “Paulson Plan” (backed fully by Bernanke) proposes for the Government to pay an estimated $70 to the financial institutions to purchase the mortgage-related securities from the financial institutions even though the securities have been written down by the accounting rules to a value of $40. It appears, on the surface, that the Government may be overpaying ($70 payment for new value of asset at $40) but most economists and accountants say the accounting rules have resulted in too much of a write down and the real economic value (ie, cash collection of the mortgage security) is probably $70 -$90 out of the $100, which will cause the government to either lose a little on the bailout or perhaps nothing on the deal. Glen Hubbard, a noted and respected economist said on a talk show yesterday that the average American does not understand what is really happening and incorrectly believes that the Government is spending $700B that will be “billed” to the tax payer, but, in reality, the $700B is expected to be recovered by the Government as the Government collects on their newly purchase securities from the financial institutions.
In summary, the Government (Paulson Plan) is proposing that the American tax payer put their money at risk with an “investment” (not an expense) by swapping Government (taxpayer) cash for an asset (mortgage-related securities) that the Government will recoup the cash through collection, freeing up the financial institutions by giving them $70 in cash for an accounting asset worth $40. Many say the original crisis was started by accounting rules, which is only a partial reason. The main reason is lack of regulation on asset-debt ratios and other similar requirements. Increased regulation will result from this improper risk taking by large financial institutions so that it doesn’t happen but that doesn’t help us at the present moment since the damage has already been done.
Of course, only time will tell how much the proposed bailout will really cost the tax payer. Also, it is possible that before the bill is passed, the Paulson Plan may look a lot different than what is explained above. Stay Tuned!!!!!!
About the author: Mr. Latter teaches various business courses at Paul VI Catholic High School in Fairfax, Virginia (USA) including AP Economics,
Accounting, Marketing, and Personal Finance.
Mr. Latter is a Certified Public Accountant (CPA) and former Chief Financial Officer with 10 years of high school business teaching experience. Prior to his career change to teaching in 2000, Mr. Latter spent 21 years in various auditing, accounting, and financial positions with Price Waterhouse, Sprint, and Teleglobe. Related posts:
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Submit your Econ questions here. Replies will be posted to the blog
My big problem with this is that suddenly the government will basically own a huge chunk of the mortgage debt in America. That is not a good idea from the free market perspective. How will this affect the market knowing that the government (an entity without a profit motive) is holding debt? Will we push to make this debt earn increase in value? Will we let it decrease and how much will we let it decrease? What good is freeing up more credit, isn’t that like giving a gambler a new line of credit? And if the government makes money on this deal will we then spend it frivolously or use it to pay down debt?
Hi Brendan,
You ask some great questions, and I would be lying if I said I knew the answers to them. It also concerns ME that the government may well end up with a taxpayer asset of approximately $700B that they are responsible for either collecting or selling. But I believe we should take that chance to avoid more serious consequences.
How will the (stock) “market” react to the Government holding these assets is another good question, but early indications are that the stock market is not overly concerned about it for now, at least based on the professional firms swooping up stocks this week as they feel the bailout bill is getting close.
Having the government manage anything is always a concern and this deal is outside their “wheel of expertise”. That is why many respected economists propose a $700B preferred stock cash purchase from the selected financial companies so the companies will get the cash. In this alternative, the Government (tax payer) will receive an investment stake in the company which can be sold for cash at a later date, as well as a standard dividend rate, say 10%, on their purchase, but the government will not have to manage the assets since the financial institutions can keep them.
I feel the most confident about your last question or observation. The financial system needs credit to survive! Credit is a “good thing” enabling businesses to form and expand, and households to move future income streams into current purchases. Of course, you are probably thinking, and you are correct, that excessive credit got us into this situation in the first place! I use the analogy of a car: a car is not a bad thing because it kills people. Credit is not a bad thing if used correctly, it is actually essential to economic growth. Many economies, like Russia, have slowed their standards of living by being reluctant to borrow. A world without credit would be a giant step backward as households and businesses would be unable to leverage their future earnings power into the present. Without credit, World War II would have been lost, you might not start college until you are 44 or never at all, you may not be able to own your first home until you are 88!
Regards,
Steve
I belong to a credit union and will be looking to get a college loan from them for next year. Is there any chance that they (the credit union) could be affected by the economic crisis and prohibit my access to receiving a loan?
Our AP Macroeconomics and AP Government classes on Friday afternoon were devoted to talk of the unstable U.S. economy and its relation to the upcoming presidential election. As we talked in class, we shared the information we knew and garnered additional facts. During our discussion, I was able to formulate my own theories about our economy, but I was also left with more questions than could be answered.
I am in support of the Paulson Plan, although it obviously needs reformation before being able to be passed. Though many people view it as the government bailing out companies in danger of collapse, if those financial institutions fail, we (the American consumers) fail as well because we would not be able to get sufficient loans. And I’ll certainly use student loans and mortgages in the future.
However, I’m confused about how this whole mess began. Is it the fault of the new homeowners who predicted they could pay back unreasonable mortgages or are the mortgage companies to blame? Who is responsible for this mess?
Hi Catherine,
Thanks for your first post!
Good questions!
As you can imagine, there is plenty of blame to go around! Republicans are blaming Democrats and Democrats are blaming Republicans. Many are blaming household decision makers, greedy executives, and bank regulators asleep at the switch. In short, everone is blaming everyone except for themselves. I have yet to see one person blame themselves, their agency, or their companies!
I see the answers to the “what went wrong” question as a multi-faceted answer. Keep in mind that these 6 reasons are my opinions and many would disagree with the order and would also add to the list:
1. Inappropriate regulatory law allowed the financial institutions to carry too high a ratio of mortgage-backed securities to collateralized debt.
2. Banking regulators (Banking Committee, FED, regulators, etc.) should have screamed louder earlier! Although there are many documented attempts that did, in fact, identify the concern, it was more a whisper than a scream.
3. Private lenders got greedy lowering or violating their own lending standards in hopes of making more interest income by loaning to people who were very risk bets.
4. New law had been passed several years ago, urging that Fannie Mae and Freddie Mac make more loans to lower income households that carried much more risk.
5. Households borrowed more than they could afford. Citizens that borrowed need to share the blame with lenders, although I place lenders at a higher standard than borrowers.
6. New accounting regulations under Sarbanes Oxley (regulation passed after Enron) are too conservative causing assets like mortgage-related securities to be valued less than their economic value (true worth), which caused the bank debtor run on the bank.
Well, 6 reasons are about as good as I can do…..’cause there is a lot of blame to go around on this one!
Hi Kevin,
Yes, credit unions, commercial banks, and savings & loans are all at risk of not being able to make loans. This “credit dry up” does not discriminate and is affecting all financial institutions.
A credit union is a “private member bank”, but they are inter-bank dependent as well and are fully integrated into the larger banking structure and mortgage markets. Credit Unions are also under the regulatory jurisdiction of the FED.
Perhaps for you, the good news is that the bailout bill may be signed early this week which should, in my opinion, improve your personal chances of being in a better position to get an educational loan next year.
[...] Observe the comment left on this blog: [...]
Hi Brendan,
Thanks for note on the reposting of the above students blog on the SchoolFinder Blog. I enjoyed the sarcastic sense of humor!
Steve
Thanks for the info steve
I think that while this is all important for the government ultimately the peaple need to decide what’s to be done
Hi Steve,
I’m from Bulgaria. Of course I’m worried about the financial problem rising in US. As all we can see markets in Europe also take their part in the story (FTSE -5.5% or something like that, Paris – 4.5%, etc…)
I saw your previous Blog discussions, and I think now I found someone who could give a good answer to 2 questions that I have (and I cannot answer without some help
)
I’m not a financial guy but a programmer. I have liitle knowledge about markets, but as far as I feel this whole thing is leading US + Europe to a new enormous recesion.
Q1: Correct?
A1:
Q2: What is the reason for the USD currency increasing its value against the Bulgarian Lev (BGN) during this crisis development?
29.09.2008 : 1.33 BGN = 1 USD
30.09.2008 : 1.36 BGN = 1 USD
A2:
Steve,
sorry in advance if the questions might seem “dummy”, but as I said I have little Financial Markets knowledge.
Thanks in advance….
Greetz,
Pavel
Why did no one mention the GOD, the LORD, the CREATOR of this world ? Who else can do it ?
Who else can broke two of the largest US investment banks IN ONE DAY, and the same day to broke the largest world insurer – the day of 15-th of September 2008 ?
Why did no one ask each other “What is our sin before the face of the CREATOR ?”
As no one ask, I will explain this mess, and I will tell You why:
States of America, you deserve it. You deserve the pain that You will feel today and You will feel next years.
States of America, here is the shortest list of Your crimes before the face of GOD:
1. Your oil idolatry; oil’s and oil products’ pollution of the Earth. Oil is everywhere: in markets, in news, in politics, in economics, in internal and foreign policy of every government in the world. States of America, you made oil a matter of wealth, a tool of greed and a tool of corruption, a tool of bribing and a tool of sin.
2. Your computer idolatry; young men from all over the world are waiting for a new processor, waiting for “powerful” video chips to bring them into the distorted world of illusions of computer “games”. It is no more “games” when young men kill others as a result of “gaming”. And now You open in Israel the largest fabric of golden idolatry processors in the world, Fab28.
3. Your car idolatry. You reverse the ordinary tool of transportation into the army of iron monsters, who steal million human lives each year around the earth. These monsters are inhabitants of the oil. The other inhabitants of Your sinful oil are: tanks, aircrafts and rockets.
4. Your distortion of the meaning of LAW. Your 8000 pages of what you call “tax law” is more sinful, is more idiotic than pharisees’ interpretation of GOD’s law 2000 years ago in Jerusalem. Your “tax code” is more sinful than ancient pagan Rome empire’s taxation with 200 taxes.
5. Your distortion of human rights last decades. States of America, you WERE the union of defendants of human rights. No more. You TWICE elected for leadership the person who is the liar, thief and who ruined human rights in your country and other countries.
At this moment, when God decided to make You start bear punishment for these and other crimes, is the same moment when GOD decided to make modern Israel bear punishment for it’s crimes before HIM. The court, which make a decision to exile “israelitos” from the HOLY LAND, already completed. Modern state of Israel started from “Balfour declaration”, and this modern Israel recently ended with the court’s verdict on “case of Isabella Belfer”.
The highest court of Israel BAGAZ approved a decision where absolutely innocent 70-years old woman, doctor, grandmother was found “guilty” of transferring her daughter and grand daughter from Israel to Russia.
The israelitos have been WARNED in April 2008 about all their crimes and about the case of Isabella Belfer.
The “guilty” decision of high court of Israel was declared in the morning of 15-th of September 2008. It was not the verdict to Isabella Belfer, it was a verdict to modern Israel, it was a verdict to its justice system. And ACCORDINGLY the same day, for the same reason You, States of America become GUILTY for your long support of the anti-human racist modern state of Israel.
Now States of America you will see the exile of israelitos from the HOLY LAND, You will see the falling of their relatives in the States of America – your bankers, and at the same time You will bear punishment for Your own sins before the face of GOD.
States of America, You deserve it. It is LORD’s JUSTICE on all your crimes.
Hello Pavel,
I can only guess at the answer to your questions:
1. It is almost certain that the U.S. and Europe will move into a deeper recession, but probably only a slight chance of a depression (an extremely deep recession meaning, say, 20% or more unemployment). My guess is that the U.S. Congress will sign a bailout bill by the end of this coming weekend. I think the U.S. congressmen realize the mistake they have made in missing the opportunity to stop the banking demise. The optimistic perspective is that the bailout bill signature is just delayed a week, and when it is finally passed, the U.S. banking banking system will slowly improve.
2. Foreign currency trends are always very hard to explain, especially in the short term, especially a foreign currency trend of the USD vs. the BGN. One line of thinking would be that the U.S. dollar has strengthened against the Euro and BGN over the last several months as some Europeans had believed that the U.S. was a better place to invest their currency (driving up the dollar as Europeans buy dollars), relative to Europe, since perhaps the U.S. recession would be shorter than that of Europe. I’m not sure that reason holds anymore. I don’t think foreign currency trends should be your main concern though as a weaker BGN can actually help Bulgarian exports.
Hi Logan,
I like your view that ultimately the people should should decide what should be done. I agree with that principle as that is what a true democracy is about. It is widely thought in America (based on surveys) that the majority of Americans are AGAINST the bailout.
However, there is also a feeling in America (and I am one of those that feel this way) that our leadership (Bush, Paulson, Bernanke, McCain, Obama, Pelosi) has done a very poor job explaining this situation to the American people. The American people either do not understand or do not believe that this is a bailout of the U.S. economy (Main Street), but rather a bailout of some individual firms and CEOs (Wall Street)
Thanks Steve,
thanks for answering my questions so fast. Thanks for the good answers.
The article discusses the current United States Economic crisis and what exactly is going on. In class we discussed the same details of this article thoroughly and decided that despite common belief, the bailout bill is actually a good idea. Although, high officials from all aspects of the government are having a hard time deciding what exactly to inlude in the bill, they know that they must “buy” the “paper assests” to fix the problem. In class we learned how this will in fact earn the government more money because they will eventually be able to re-sell these assests for a higher price and make a profit. It is important for the American people to become educated in economics so that they are able to encourage government officials to pass a satisfactory bill that will help not only the companies in trouble but all of the American taxpayers that are in doubt.