Economy and Rescue Bill for Dummies

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The title of this article (above) is the name of the Bill which passed the Senate last night. It is voluminous and the time between its issuance from the Banking Committee to its vote on the floor likely precluded most Senators from having time to read it themselves. But rest assured their staffers did. Visit and support the Sunlight Foundation for the full text of the Bill. Or, read this article, for an overview of what is happening, the rest of us can understand.

First, it should be understood that the House Bill to be voted on as early as Friday, will have differences. But those differences will be minor or irrelevant to an understanding of what is really taking place here, between those in the know who want to kill this Rescue plan, and those in the know who want to pass it.

Notice the absence in the Title of the Bill of any reference to the words bailout or rescue. The skeptics of this bill tried to unsell it to the public almost immediately as a Bail Out of Wall Street. Its original 2.5 page White House proposal could easily be viewed as just what the skeptics called it. However, it has transformed from a bailout written by Henry Paulson, former Goldman-Sach's executive worth 10's of millions of dollars, to a bill designed more to rescue our economy from entering an even deeper, but near certain, economic recession.

An economic recession is marked by job layoffs, rising unemployment, a slowing or negative growth in our nation's economic activity overall, and harder, more anxious financial times for non-wealthy American workers and their families, over a period of 6 months or more. This Bill may not avert recession, but it is hoped by its champions that it will prevent a recession from affecting even more workers and their families, as well as businesses.

The Stabilization Act attempts first and foremost, to address the problem of financial institutions hoarding their money and refusing to lend it to other financial institutions and you and I, Mr. & Mrs. Consumer. The reason for this sharp decrease in money being loaned and borrowed is really rather simple, and I will use a homeowner worker as an example.

Mr. Jack's old car just died. The cost to repair it: $3000.00. The car is only worth $200 for salvage if he junks it. If he repairs it, he will have a car worth $700, but which he paid $3000 to repair. Mr. Jack views this situation as throwing good money after bad, and decides to get a loan to buy a much newer used car for $10,000 which will last 4 or 5 years before needing major repairs. Mr. Jack bought his home 2 years ago for $210,000, and he still owes $208,500 on the mortgage.

Mr. Jack goes to his local bank and asks for a loan to buy another car. The Bank asks Mr. Jack, how much his net income is each month. He replies, $1400 per month. They then ask how much he owes on his home, and he replies $208,500. They ask what amount he paid for his home, he replies, $210,000. The banker then checks his index sheets and sees that home valuations in Mr. Jack's area have fallen 20%, on average, in just the last year.

Now Mr. Jack, if he were to try to sell his home today, would not be able to sell it for what he paid for it. But, how much less than what he paid for it, might he get for the house? There lies the problem with our financial institutions at this point. No one knows how much he could get for the house, or even if he could sell it at all at a "reasonable" price.

The 20% estimate of home prices having devalued in the last 24 months, is just that, a rough estimate. Mr. Jack's home may not sell until he lowered the price to $105,000, half its original cost. No one knows. Normally, property assessors have vast amounts of data on recently purchased homes to compare a particular house to, in estimating what its current market value should be. But, these aren't normal times. Housing values are falling and no one knows where they will bottom out and stabilize.

Therefore, Mr. Jack's bank asks Mr. Jack if he has any other collateral to put up for the loan? He says yes, he has his gold wedding band which has risen 500 % in value since he bought it. But, since he bought it for only $110, it is now worth only $550 and Mr. Jack's bank turns Mr. Jack down for the car loan, because the car will depreciate faster than he would be able to pay off the loan, his ring doesn't cover the difference, and he owes more than his house is worth. Additionally the bank knows a recession is possible ahead, in which case Mr. Jack may become unemployed, making the bank's potential for collecting their loaned money plus interest from Mr. Jack, doubtful at best.

In many ways, Mr. Jack's situation is identical to our current large financial institutions and indeed, financial institutions around the world. They have loaned money out to others and accepted mortgages as collateral on those loans. A sizable portion of those mortgage loans were for the full, or near full market value of the home as appraised 1 to 5 years ago. But the value of those properties have dropped considerably, and are still dropping.

These are now referred to as 'Toxic Debt' or 'Toxic Mortgage Backed Securities', in which the amount of the mortgage paper, or promissory note to repay, is greater than what the property is actually now worth. How much more, is very difficult to determine due to property values still dropping, and in many cases the amount of the mortgage IOU could be as much as 50% more than the actual value of the property itself, if the property could be sold today.

Now, the majority of the mortgages these financial institutions (lenders) have on their books as assets (IOU's from home and other property owners), are less than what the properties are actually worth. In other words, these are non-toxic mortgage backed IOU's which, if the borrower defaulted on payments, the financial institution could foreclose, (repossess) and sell the property to recover the amount of their loan and make a bit of profit in the bargain. But in order for these 'banks' to make new loans, they have to borrow money, (IOU's aren't money in hand), and in order to borrow money, they have to open their books of IOU's to show their lender that their previous loans are good for what the IOU's say they are good for.

Too many of these financial institutions, when they open their books to a potential lender, expose the fact that they are holding a lot of 'toxic debt' and therefore, other banks are refusing to lend them money. If banks and other financial institutions don't lend each other money, they can't lend you, or I, or Mr. Jack any more money, either. This is called a credit crunch, or, in our case, crisis. The money between top tier lenders to lesser lenders, gets hard to acquire and more expensive as interest rates for borrowing going up. Interest rates go up when the risk of lending goes up.

Corporate lending interest rates have been climbing steeply, recently by as much as 250 to 300% or, 2% to as high as 6 and 7%. The cost of lending money is rapidly growing. And that is going to reduce how many people are able to borrow and buy things. As more people cannot afford to borrow money and buy things, stores and manufacturers sell less, lose profits, and start laying off workers. As more workers are laid off, there are even less people able to buy things, causing business profits to drop further or not make a profit at all, which in turn leads to even more layoffs, or worse, bankruptcy for the company or corporation. That is a recession.

These are precisely the effects which this Emergency Economic Stabilization Act of 2008, is designed to minimize and lessen. There are many folks in the population and in professional trade magazines writing that this "Rescue Bill" should not go forward; that this is a financial bubble which should be allowed to burst, taking nation's into recession, which occur quickly, and eventually bottom out; stabilize, and thereafter grow again on a much sounder financial footing. This projection of what would happen is accurate and true.

Critics of such a proposal to let the markets self-correct, argue such a remedy will destroy the financial lives of millions and millions of newly unemployed workers and their families. That is also accurate and true. They argue that most people would rather keep their job and home, even if they can't buy as much for the next few years, than to lose their jobs and homes, and have to spend their savings trying to keep the family afloat for a year or two awaiting the economy's recovery to the point that they can find a job again.

So, the debate really boils down to 1) those arguing for a deep but short recession, and economic recovery a year or three later, and 2) those arguing for a prolonged, slow growth, belt tightening period, in which millions of people see themselves get poorer in consumer terms, but, keep their jobs and homes in this slow economic growth period which could last for several to many years before wages increase and begin catching up with inflation again.

MoneyWeek for example, whose target audience is investors, champions the self-correcting option because the sooner the economy tanks and recovers, the sooner investors can get back to making significant gains on their equity investments again and not have to do other work for a living.

On the other hand, government representatives know that reelection is not likely if headlines for a year or two are full of stories of rising unemployment and growing throngs of homeless persons due to dramatically rising home foreclosures, which would result from allowing the markets to self-correct without government intervention. Therefore, on behalf of their constituents, politicians are trying to chart a course that minimizes these effects on their voters and families.

And that pretty well covers the overview of what is taking place in Congress and our economy, and why it is, there are two camps of thought on how we should handle this crisis. The details of financial markets are extremely complex. But, understanding the overview of what is happening and who is on which side of the solution fence, is really very easy and simple to grasp.

So, which camp do you feel more comfortable in? The fast and furious self-correction investing camp, or the less severe pain and longer recovery camp?

Those in the middle of the Middle Class are likely to find themselves straddling both camps, as they have significant long term retirement investments they would like to see grow again as soon as possible, but, they are also employed workers with jobs and homes and dependents at stake, and don't want to risk their jobs and savings to date, in a market-self correcting option.

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This page contains a single entry by David R. Remer published on October 2, 2008 6:36 AM.

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