A friend of mine recently sent an email asking why TARP funds are being used beyond their intended role of buying up bad mortgages. For a very detailed and thorough coverage of that question, I would refer you to Baseline Scenario, one of my favorite economics blogs. For a more "down to earth" approach, I recomend NPR's Planet Money, which also has a very fun podcast. However, a shorter, less rigorous explaination of the real problem, called "leverage", is helpful to get started.
Here's how it works, approximately:
Bob's Investment House discovers something that gives a 5% return on every dollar that can be poured into it. BIH has $10million of their client's money, and so could be pulling in $500k/yr for the life of that investment, typically a loan to someone like a homeowner, or lots of homeowners in the case of Mortgage Backed Securities. However, $500k/yr is kinda measely if you're trying to run an investment firm in New York, especially since that needs to pay for the staff and give returns to customers.
So to increase their returns, BIH could borrow $100m from a Wall Street Bank (WSB) at 2% interest, and invest the $100m in their oh-so-reliable MBS. Now they are pulling in $5.5m/yr gross, while paying $2m/yr in interest, a net profit of $3.5m/yr, which is enough to comfortably run a small company in NYC and give their investors a comfortable 10% return on their capital.
But, what happens when the MBS stops paying 5%? In theory, as long as no one panics and the MBS can still give a return of 3%, then the system holds together. Bob's customer's get annoyed at their diminished returns, but the WSB gets its 2% and can pay off its loans from other WSBs. However, if the MBS stops paying anything, or worse loses value, then Bob has to find enough money to cover the difference at the same time his customers want their money back NOW! Once enough Bobs stop paying, WSB can't pay its loans and either needs a huge infusion of government cash to pay its loans or it goes bankrupt.
Once the WSBs start going bankrupt, lending stops, and the value of assets purchased with borrowed money declines sharply. In the modern economy, almost all raw materials are bought on credit and then the loans are repaid when the finished goods are sold. No loans means no parts are made, no parts being made means no final products, and no products means no jobs. This is what happened from 1928-1935, and explains how we got to 25% unemployment and almost had a Communitist or National Socialist revolution in the US. The other option is to use public money as a buffer against that level of castastrophe, and, hopefully, slowly unwind the system.
3 comments:
I still think that any company who uses the government bailout money ought to be accountable for how they use that money. If I loan
my kids money, I will want to know what they will use the money for
before I approve the loan. They should cut extravagant corportate retreats and immense Christmas bonuses many times larger than my household annual income. Other companies are having to do that in order to avoid needing the government bailouts in the first place. And if the failing company can afford all these luxuries with the bailout either (a) they didn't need the bailout or (b) they didn't need nearly that much money in the bailout. I'll have to check out the other links you included.
"If I loan my kids money"
Your comment underscores something pretty sad about our financial system right now: we assign about the same amount of responsibility to corporations as we do small children.
Lissa, you bring up some interesting stuff that's probably worth a second post. Accounting for this money and how it's spent is difficult for a number of reasons, and corporate pay is an issue that's been spiralling out of control since the late 1980's, when the easy credit extravaganza started.
The short version is that by buying non-voting "preferred shares", the government tosses money into the bank's general pot. From there, the bank has to take steps that its voting shareholders and board of directors think is appropriate, including paying to retain important staff members. Whether the captain who went full speed into the iceberg is "important" is a different question, and the potential conflicts of interest of major bank executives and pension fund managers sitting on the boards of each other's companies have yet to be resolved. Yes, the inmates are running the asylum.
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