Friday, September 19, 2008

Today's Bank Bailout, Explained

As previously discussed, financial institutions have been losing tons of money. To briefly, briefly review, here was the problem:

1. People took out loans they couldn't afford to keep inflating the housing bubble.
2. When housing prices started to fall, people with bad loans couldn't refinance to continue paying them, so they went into foreclosure.
3. Banks who owned bundles of these bad loans called CDOs lost money, because the value of the foreclosed houses was less the amount the bank had paid for the CDO.
4. Banks lost money and had less money to give out, so they stopped putting up money for mortgages, decreasing demand for houses and decreasing prices even further.
5. Go back to #2.

This set up a cycle where the value of these mortgage-backed investments kept losing value, and accountants were struggling to assign a value to these CDOs because their value kept changing a the market changed.

(simplification alert!) Say a bank owns a CDO worth $250 million, covering 1,000 mortgages each for $250,000 houses. Today, those houses are worth $200,000 each, and some portion of the 1,000 homeowners defaulted, sending their houses into foreclosure. So the $250 million investment is now worth substantially less, though no one knows how much less. Fearful of continuing losses, banks became less likely to give out new loans, since they might wind up needing to use that cash to cover their continuing losses due to bad CDOs.

What the government proposed today to step in and spend taxpayer dollars to buy a bunch of CDOs from banks at discounts. The most likely plan is that the government takes bids from several banks, to continue the example, who each have a bundle of mortgages originally worth $250 million. The lowest (cheapest) bid would then sell the CDO to the government for that cheapest price.

It's possible that the government and, by extension, taxpayers will actually make money on this bailout, because no one really knows how much the investments are worth. But the real goal is to give banks a cash infusion and cost certainty. Because they'll wind up with a bunch of cash and will no longer have to keep around excess cash to cover CDO losses, they'll be able to get back into the business of giving out loans and reinforcing the housing market.

That's the theory, anyway. Let's hope it works out.


Scott Mendelson said...

On a related note, my boss's big thing with Obama is that he doesn't want to pay additional capital gains taxes (not that he's voting for McCain either, I'm trying to get him to vote for Bob Barr).

Fair enough, but I'm pretty sure under the current situation, that I'll never, ever have to pay a capital gains tax on my Roth IRA or my 529. I'd rather actually have profits that can be taxed at a higher rate rather than a lower tax rate for non-existent profits.

PoliticalDoctor said...

I just don't get the howls from Wall Street that an increase in the capital gains tax will ruin the stock market. Obama's only proposing returning the rate to Clinton-era levels, and even then only for people making more than $200,000 or $250,000 (I forget which).

For all you junior investors out there, Roth IRAs (individual retirement accounts) are great investments if one thinks the capital gains rate is going up. Taxes are paid up front at the normal income rate at the time of deposit (i.e., they're not tax-deductible), and then all the capital gains are tax-free, no matter what Obama and all the other pinkos decide to do with the rate.