Why America Needs This Rescue Plan (part 1)
(My husband was trying to explain the current economic crisis to me. Here are his thoughts).
Question: What's the point of this rescue?
Answer: Unfortunately, this is one of the necessary steps needed to prevent the U.S. economy from entering the next Great Depression. Currently, the entire financial system in the United States (and shortly the rest of the world) is clogged up due to the presence of many illiquid hard to value securities owned by financial institutions. This in turn is causing the credit creation process to grind to a halt. Credit worthy consumers who want to buy a house or buy a car are being turned down as banks are unable to lend. Similarly, small and large businesses are being denied access to funds needed to fund there day to day operations that could result in significant failures and the loss of jobs. Ultimately, if these issues with the financial system aren't addressed then the economy could go into a severe recession with states and municipalities defaulting on their obligations as well.
The plan as proposed by the Administration is a RESCUE and should be distinguished from a bail out. By facilitating the pricing of these illiquid securities the U.S. government could end up not only unclogging the financial system, but could end up making an attractive return for its services. However, such a rescue, with $700+ Billion in commitments is deeply unpopular and misunderstood by the general population who feel we are rewarding irresponsible financial institutions. Given the political considerations only 40 days away from an election there is a chance that the proposal may not pass or be so ridden with additional stipulations as to make it ineffective.
Many of you might ask what is going on that requires this type of intervention in the financial market? So I'll try to provide a simplified example. Lets say you have a financial institution named TFI (Typical Financial Institution). TFI in process of running its business makes money by holding financial instruments like mortgages, credit card, commercial real estate loans, and some other less liquid harder to price assets. For simplicity lets say these assets yield 7% annual return and the company has $100. TFI funds these loans through short-term borrowing that costs them 5% and through their own equity capital of $4. As a result TFI makes $2 net margin. Lets also say their holding look like the following:
TFI
Assets
Mortgages - $30
Credit card - $30
Commercial Real Estate - $30
Illiquid Investments - $10
Liabilities
Short-term borrowing - $96 (@5%)
Equity
Firm's capital - $4
TFI is limited by regulation to have a maximum leverage ratio of 25x (total assets / firm's capital) to mitigate risks to the financial system. If TFI didn't suffer losses then it would earn $2 over the year. This $2 would then support the firm owning another $50 worth of assets (e.g. make additional loans / credit expansion). However, if the firm suffers $2 worth of losses on its investments then it can't expand credit. Worse, if TFI loses $3 then it would have to shirk its assets by $25 to get back to 25x leverage (this is achieved by reducing credit).
Ok, so how does this relate to the current crisis? Many financial institutions own illiquid assets that don't have a ready market place. In the case of TFI above it owns $10. These assets may over time be worth $10 or $9 or perhaps $7. However, because there isn't a ready marketplace for them and there is considerable disagreement on their worth investors don't know how to value them. Let's say another firm went bankrupt and sold the equivalent illiquid assets under distress for $5. The fact that security sold for $5 makes lenders to TFI worry whether the $10 asset held by TFI is really worth $10 or $5 because if it's really only worth $5 then TFI is insolvent. This concern among lenders causes them to seek higher rates from TFI, say 8%, as protection from TFI's insolvency. All of a sudden, TFI's cost of borrowing is greater than the return on its holdings. If this persists then TFI goes bankrupt itself.
From the example above you see why "illiquid assets" present such a problem for the financial system. Questions about the value of these assets is causing the short-term borrowing costs of financial institutions to rise which in turn is causing them to fail / go bankrupt. This in turn results in more of the illiquid assets being dumped onto the market place diminishing their value further, creating more fear, and causing more institutions to fail. It is possible that these illiquid assets if held to maturity could in fact be worth more than $7, possibly as much as $10, and not the $5 its trading at.
The above is a simplified version of the problem that the U.S. financial system faces and why the government needs to play a key role in stabilizing it and restoring confidence. The government needs to step in a provide a mechanism for accurately pricing these illiquid assets. The big question is what price should the government pay for these illiquid assets?
Question: What's the point of this rescue?
Answer: Unfortunately, this is one of the necessary steps needed to prevent the U.S. economy from entering the next Great Depression. Currently, the entire financial system in the United States (and shortly the rest of the world) is clogged up due to the presence of many illiquid hard to value securities owned by financial institutions. This in turn is causing the credit creation process to grind to a halt. Credit worthy consumers who want to buy a house or buy a car are being turned down as banks are unable to lend. Similarly, small and large businesses are being denied access to funds needed to fund there day to day operations that could result in significant failures and the loss of jobs. Ultimately, if these issues with the financial system aren't addressed then the economy could go into a severe recession with states and municipalities defaulting on their obligations as well.
The plan as proposed by the Administration is a RESCUE and should be distinguished from a bail out. By facilitating the pricing of these illiquid securities the U.S. government could end up not only unclogging the financial system, but could end up making an attractive return for its services. However, such a rescue, with $700+ Billion in commitments is deeply unpopular and misunderstood by the general population who feel we are rewarding irresponsible financial institutions. Given the political considerations only 40 days away from an election there is a chance that the proposal may not pass or be so ridden with additional stipulations as to make it ineffective.
Many of you might ask what is going on that requires this type of intervention in the financial market? So I'll try to provide a simplified example. Lets say you have a financial institution named TFI (Typical Financial Institution). TFI in process of running its business makes money by holding financial instruments like mortgages, credit card, commercial real estate loans, and some other less liquid harder to price assets. For simplicity lets say these assets yield 7% annual return and the company has $100. TFI funds these loans through short-term borrowing that costs them 5% and through their own equity capital of $4. As a result TFI makes $2 net margin. Lets also say their holding look like the following:
TFI
Assets
Mortgages - $30
Credit card - $30
Commercial Real Estate - $30
Illiquid Investments - $10
Liabilities
Short-term borrowing - $96 (@5%)
Equity
Firm's capital - $4
TFI is limited by regulation to have a maximum leverage ratio of 25x (total assets / firm's capital) to mitigate risks to the financial system. If TFI didn't suffer losses then it would earn $2 over the year. This $2 would then support the firm owning another $50 worth of assets (e.g. make additional loans / credit expansion). However, if the firm suffers $2 worth of losses on its investments then it can't expand credit. Worse, if TFI loses $3 then it would have to shirk its assets by $25 to get back to 25x leverage (this is achieved by reducing credit).
Ok, so how does this relate to the current crisis? Many financial institutions own illiquid assets that don't have a ready market place. In the case of TFI above it owns $10. These assets may over time be worth $10 or $9 or perhaps $7. However, because there isn't a ready marketplace for them and there is considerable disagreement on their worth investors don't know how to value them. Let's say another firm went bankrupt and sold the equivalent illiquid assets under distress for $5. The fact that security sold for $5 makes lenders to TFI worry whether the $10 asset held by TFI is really worth $10 or $5 because if it's really only worth $5 then TFI is insolvent. This concern among lenders causes them to seek higher rates from TFI, say 8%, as protection from TFI's insolvency. All of a sudden, TFI's cost of borrowing is greater than the return on its holdings. If this persists then TFI goes bankrupt itself.
From the example above you see why "illiquid assets" present such a problem for the financial system. Questions about the value of these assets is causing the short-term borrowing costs of financial institutions to rise which in turn is causing them to fail / go bankrupt. This in turn results in more of the illiquid assets being dumped onto the market place diminishing their value further, creating more fear, and causing more institutions to fail. It is possible that these illiquid assets if held to maturity could in fact be worth more than $7, possibly as much as $10, and not the $5 its trading at.
The above is a simplified version of the problem that the U.S. financial system faces and why the government needs to play a key role in stabilizing it and restoring confidence. The government needs to step in a provide a mechanism for accurately pricing these illiquid assets. The big question is what price should the government pay for these illiquid assets?