The MOAB, in narative form

Alright, I promise some really special and original pie recipes for everyone who's had to put up with this. Heck, I think I have few enough readers I can send you all baked goods if you ask (radio stations bribe their audience, why can't I?).

So, in narrative form, how the banking crisis happened, and how the MOAB just might fix it:

Step 1)
Anytown USA, late 2006:
Bob and Sally move into Anytown USA and buy a house in a new subdivision on 10th Street. Everyone is happy, because they used their $70k combined income at Pie Widget Maker to get a mortgage for $250k on a house that the previous owner bought 5yrs ago for $200k. Anytown Bank, which originated their loan, also issued a couple dozen other loans, effectively depleting the $10m it was allowed to make based on its $1m in deposits and capital. However, Anytown is growing like a weed, and needs someone to offer more loans so that people can buy the new houses being built on 11th Street. So Anytown Bank (AB) offers Wall Street Bank (WSB) the income from $500k these loans if WSB will just give AB the cash value of the loans plus a small fee, with a promise that AB will make WSB whole if the mortgages foreclose and the value of the homes goes down. AB can't find well qualified buyers for the houses on 11th street, but decides to offer "sub-prime" mortgages, fully expecting them to refinance into standard mortgages or sell before anything goes wrong.

Step 2)
Anytown USA, late 2007/early 2008:
Something went wrong. The people who bought up the properties on 11th street were not able to turn their widget-sales jobs into something that would justify owning $250k homes. Also, the market was finally saturated, and no one wanted to move to 11th ST because housing and gasoline had become too expensive to justify the long commute to Main Street. In the meantime, Pie Widget Maker, a small company on Main Street that employs Bob and Sally, begins developing the SuperCrust Widget.


Step 3)
Anytown USA, Sept/Oct 2008:
The subprime security issued by AB and held by WSB blew up in both of their faces. WSB had taken it and sold shares in that income to many customers, along with insurance policies in case the subprime holders or AB defaulted, only to discover that the insurance company didn't have enough assets (this is what brought down Fannie/Freddie and AIG). AB was forced to bring all of it's mortgage backed securities "on balance sheet", meaning that instead of having a fresh $10m to loan, it has to hope that the securities it issued haven't lost more than $1m, or the bank becomes insolvent (kickin' it WaMu-style, in other words). The SuperCrust Widget, incidentally, was a big hit at the Pie Convention, and Main Street's biggest employer needs $300k for the machine and materials to make enough to satisfy its customers. Sadly, AB can't issue any loans because its capital, which should have been freed up by securitization, is instead being held hostage by the threat of defaulting on its obligations.

So, what are the subprime houses on 11th St worth? How about the houses on 10th St, where Sally and Bob are working hard to pay their mortgage? Because of new accounting rules, AB is required to "mark to market", express how much capital is has relative to obligations, which means AB's accountants need to pick a number. If they pick one that's too high, they will be accused of fraud. To low, and the bank goes WaMu.

Everyone knows that the $250k houses on 10th St are beyond the means of all but the president of Pie Widget Maker, who sensibly lives on 1st St in a small house. If AB was able to sell half of the foreclosed homes for $100k, does that mean all of its securities are worth 40% of their original value? If the median income of Widget Stampers is $35k, then a pair of them ought to be able to afford $210K, implying that the homes are worth 84%.

The answer to that question, then, really lies with Pie Widget Maker. If they can get their new machine up and going, they can hire, say, six more Widget Stampers. If they can't get the loan for the new machine, then they will only be able to pay their existing Widget Stampers like Bob and Sally for as long as the current product lines and production facilities last, in which case any property in Anytown is basically worthless in the long run.

So, if the Treasury Department steps in and buys up the securities issued by AB at a price that leaves them alive and able to lend a little, this story has a happy ending. The new Widget Stampers move into homes on 11th ST, and in turn justify opening a 24hr Pie House there, which employs a couple more people, and so on. Housing prices stabilize after falling a bit more, and the Treasury Dept. can sell the securities on once someone is willing pay a good price for them. By taking an equity stake in AB, they heartily discourage risk, and make sure the next shareholder's meeting includes plans to avoid exposing the bank to that kind of risk again. In the end, the equity (stock) in AB and mortgage-backed securities will be sold by the Treasury, in this case at a tidy little profit.

Conclusion:
We will not avoid a couple years of hard times. No matter what, some businesses and banks will fail. My favorite thing about the Paulson plan is that its relatively small magnitude will most heavily favor smaller banks with fewer shareholders (and thus less resistance to dilution of shares) that can turn around and make small business loans. We need this to happen, and we need to do things to encourage production rather than consumption. Markets, like people, can be irrational, and the most rational thing to do now is help everyone settle down. Pain will come, but it need not be a collapse.