Q&A: The US financial meltdown

Several categories of individuals and institutions stand accused for the current financial crisis in the US. We examine the blame game and how it all got this bad.

What is happening in the financial sector of the United States?

The investment bank Bear Stearns was bailed out by the Federal Reserve (the central banking system) for $29 billion, and the US Government has since taken over the home mortgage titans Fannie Mae and Freddie Mac, at a potential total cost to the taxpayers of $200 billion. Yet, the turmoil in the financial markets continues.

The venerable Lehman Brothers, one of the largest and oldest investment banks, has filed for bankruptcy. The super-insurance company AIG, the largest in the US, was loaned $85 billion by the Fed and then taken over by the US government. The great brokerage company, Merrill Lynch, was acquired by Bank of America. Morgan Stanley, another blue-chip investment bank, is likely to be acquired by a commercial bank. Goldman Sachs, another blue-chip, has been beaten down by the stock market. Finally, the largest savings bank, Washington Mutual, is also teetering on the edge of collapse.

These are the headlines. Behind the headlines, there are 117 banks which are on the “in trouble” list of the Federal Deposit Insurance Corporation. In addition, for the first time, a money market fund has announced that the unit value of its assets is no longer $1 but only 97 cents.

At the time of this writing, the bailouts announced by the US government included an insurance fund of $50 billion to protect household deposits in money market funds.

What is causing such turmoil? Is there something new, or is it the same old mortgage crisis?

The same culprit as before: the housing market collapse. From 2002 until 2005, the mortgage lenders made bad mortgage loans, loans that homeowners could not pay after the initial “teasing” period.

Since then, there have been millions of defaults and the resulting foreclosures of homes. As far as the financial crisis is concerned, the US government has not done anything to stop this bleeding problem where it is really happening, and that is at the level of the homeowners — right where the rubber meets the road.

The vicious cycle continues with falling housing prices. The defaults and foreclosures in recent months have spread much beyond the lower-middle class and middle-class home owners. The new defaulters are “prime” borrowers. These borrowers are financially savvy, because they are walking away from their houses as the price of the house falls below the outstanding mortgages. These well-off borrowers are foreclosing not on their first homes, but on their second or third or fourth properties. Hence, these foreclosures do not affect their credit ratings adversely and do not leave them homeless. Thus, mortgage defaults continue to proliferate.

Why are the investment banks in so much trouble?

They have overstepped their bounds. Investment banks used to be pure financial intermediaries. For example, firms like Lehman Brothers would underwrite a debt issue for a client like the US government, and then distribute the bonds to say, the California State Pension Fund, another client. Investment banks did not hold on to assets like US government bonds for the purposes of earnings.

Their earnings were based on capturing the difference between the price they would pay the US government and the price they would charge the California State Pension Fund, and the fees they would charge both those clients.

It is only recently that investment banks like Lehman Brothers and Morgan Stanley have been hoarding income earning assets. And guess what kind of assets? They bought mortgage securities galore for the purpose of investment for themselves!

Given that they were new to the residential mortgage business, they ended up with an inordinate share of the bad mortgages, when compared to old hands like Fannie Mae and Freddie Mac. More importantly, they paid for their mortgage securities by borrowing from the bond market.

By the end of 2007, Lehman Brothers had $700 billion in assets against a capital reserve of only $23 billion. In other words, they were “leveraged” 30 to 1 by borrowing, a number so high that it deserves to be called nothing short of reckless. When their assets stopped earning the expected income because of mortgage defaults, they started having difficulties paying back their liabilities. Finally, the “short-sellers”, sensing that these institutions were in trouble, drove their stock prices down to ridiculously low levels.

It is now becoming clear that some hedge funds have been targeting the financial institutions we are talking about and selling their stocks short. Speculators “overshoot” both ways; they create bubbles on the boom side and drive companies, and even countries, down to the ground on the downside. The modus operandi of the short-sellers have led to highly destructive results. On Thursday, September 18, 2008 the London Stock Exchange banned short-selling of stocks of financial institutions, and on Friday, September 19, 2008, the New York Stock Exchange followed suit, but only for two weeks.

How are the authorities bailing out the financial institutions? And what do all these maneuverings mean to the tax payers?

The bailouts so far have been arranged by the Federal Reserve and the Treasury. Even though the Fed and the Treasury are working together during the crisis, they are very different institutions.

The Treasury is part of the US government but the Fed is not. The Fed can create money but the Treasury cannot; however the Treasury can issue debt and use tax payers’ money, which the Fed cannot. We are very fortunate that Ben Bernanke, the chairman of the Fed, and Henry Paulson, the secretary of the Treasury, have been able to work well together and use their specific authorities in a coordinated way.

The first intervention of the authorities took place when they arranged for the troubled mortgage institution Countrywide — the biggest creator of the notorious “sub-prime” mortgages — to be taken over by Bank of America.

The next problem was Bear & Stearns, an investment bank with severe problems of the kind stated above. Investment banks have not been regulated much in the US because they do not take deposits from households, and hence they do not put the wealth of the vast middle class at risk.

The Fed took the lead to prevent Bear Stearns from failing even though they did not have to. The Fed created $29 billion of new money to fix the non-performing assets of Bear Stearns, and then arranged for that firm to be acquired by a commercial bank, JP Morgan Chase. At this time, the bailout looks like a nice gift for JP Morgan Chase, and it did not cost the US taxpayers anything.

Throughout this time, Fannie Mae and Freddie Mac were in trouble because the stock market (read the “short-sellers”) had beaten their values down to very low levels. However, the assets of Fannie and Freddie, mortgages worth $5 trillion, were mostly sound.

It is the Treasury that bailed out Fannie and Freddie, not the Fed. The Treasury has authority to infuse $100 billion of taxpayer money to each of the mortgage titans, but at the same time the US government can take ownership of 80% of each of the two titans with stocks that guarantee a 10% return.

A possible scenario is that the US government will have to infuse very little cash into Fannie and Freddie, and yet earn a handsome income flow from the profits of the two titans. In that case, the US government would have demonstrated to China, India and Russia how to run state-owned enterprises profitably!

Why was AIG, which is an insurance company, bailed out? First of all, AIG is more like a commercial bank rather than an investment bank, in the sense that they are involved with households. AIG has supposedly sold insurance of one kind or the other to 70 million households worldwide. But that is not all, AIG, even though primarily an insurance company, had diversified into wide ranging activities like leasing aircraft, and, not surprisingly, mortgage securities.

AIG’s trouble was not due to the fact that their own mortgage holdings were turning sour, but due to a type of insurance they sold widely, called Credit Default Swaps (CDS). When the mortgage holdings of other companies became “non-performing,” AIG had to make good if these other institutions held CDS issued by AIG. It would be as if AIG’s home insurance business had been hit by a hurricane.

The AIG bailout was a very unique combination of the involvements of the Fed and the Treasury. The Fed created $85 billion worth of money and “loaned” the sum to AIG. In return, 80% of AIG came under the ownership of the US government, just like Fannie and Freddie. But the AIG deal is even better for the US taxpayers, because they will be earning income from an enterprise which they did not have to pay for!

It pays to have Paulson, an investment banker formerly of Goldman Sachs, as the Secretary of Treasury.

What is the latest bailout plan, which was announced late afternoon of Thursday, September 18, 2008?

A comprehensive, not a case by case plan. The US government (not the Fed) will set up an institution just like the one that was used to take possession of the sick savings and loans in the late 1980s, called the Resolution Trust Corporation (RTC).

Let us call the new one, just for symmetry, Resolution Mortgage Corporation (RMC). The RMC will use the taxpayers’ money to buy up all the bad mortgages from the private financial institutions. This will immediately make the financial institutions more profitable and their stock values will go up. They will be able to raise fresh capital, issue new credit, and the private market financial markets which are basically at a standstill, will start functioning again.

At the same time, let us be sure that the US government will be left with all the lemons while the private companies will keep all the peaches. No doubt this will bail out the private financial institutions, but how much will it cost the taxpayers?

RTC and the rescue of the savings and loans had cost the US government $120 billion in the late 1980s. The initial cost estimates for the RMC led rescue plan reported in the media range from $500 billion to $1 trillion. Very soon it will start costing the taxpayers real money! The Bush administration has already asked Congress for $700 billion in bailout money.


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