A bailout tutorial
When I quipped, “Save yourselves, Wall Street“, I was only half-kidding. I’m definitely still infuriated by the situation - and the apparent inability or unwillingness of parties on both sides of the aisle to raise sufficient alarm before now - and disgusted by the terms of the bailout bill (you won’t catch me calling it a “rescue”).
I’m not convinced that we need a bill of this magnitude, but we do need some means of putting cash back into the banks. I’ll explain why; call it a “bailout tutorial”, if you will.
When a bank approves you for a mortgage, they loan you a lump sum of money - which is paid to the seller (or, more likely, the bank that holds the seller’s mortgage) - under a contract that states you will pay back that lump sum, plus a specified amount of interest. The bank expects to receive a certain amount of money from you, just as they expect to receive a certain amount of money from all of the other mortgages they hold.
But a bank doesn’t just sit there collecting money. Based on the expected income from these mortgage contracts, other entities - such as investment firms, universities, foundations, and individual investors - buy these groups of mortgages. An easy (although not fully accurate) comparison is to bonds, such as municipal bonds - where investors who buy bonds are essentially loaning money to a town or city for expansion or development in exchange for an expected rate of return.
These groups of mortgages are how banks get money to approve more mortgages. If they didn’t sell them to investors, they wouldn’t have enough cash coming in to continue approving mortgages.
Selling groups of mortgages as investments isn’t new; that’s how banks have always operated. The problem now is that because so many homeowners have defaulted on their sub-prime mortgages, the collective anticipated rate of return on these mortgages has dropped. Investors - corporate entities, universities, foundations - have stopped buying them. Without that cash flow, the banks are left holding the mortgages and have no cash with which to approve more loans.
That’s what the $700B bailout does - “buys” these groups of mortgages from the banks and puts cash back into the banks so that they can approve more loans. Obviously the intent now is for the banks to make more judicious decisions regarding the loans they approve so that the new groups of mortgages will deliver the anticipated rate of return to the investors (who will hopefully be inclined to start buying them again).
But an idea floated by Sen. Biden in Thursday night’s debate, which might seem at first to be a “for the good of the country” solution, would actually undo the collective benefits of the bailout. And it’s lines of thinking such as that which continue to give me pause when I consider voting the Democratic ticket.
Want to know why Biden’s idea would actually perpetuate the problem it would be intended to solve? I’ve explained it further over at The Parental is Political.
October 7th, 2008 at 6:54 am
Good post here, and I love how you’ve brought the issue down to an easily-understood level on your other post. My head (and my husband’s head) just about blow off every time we allow ourselves to think about this mess. We’re screwed again, the responsible ones, while the irresponsible are bailed out. To do it all again, I am sure.
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October 7th, 2008 at 9:43 am
Great post. Really, great post.
Aprils last blog post..Moody Monday.
October 7th, 2008 at 11:30 am
Thanks — it is SO hard to make sense of this whole mess.
(But I’m still begging you to vote Democrat.)
October 7th, 2008 at 1:07 pm
I really like the way you make this easy for normal people to understand because I gotta say this whole mess has me all confused. I truly hope someone corrected Biden after he went off stage because what was the whole bailout for if they’re just going to turn around and put us back in the same spot?