Though the devil's in the details of the emerging government response to the collapse on Wall Street, a clearer picture is beginning to emerge. Here are answers to some common questions about what it means for homeowners, consumers and taxpayers.
Why is this happening?
The system of financing homeownership has run off the rails after lenders — and the investors who put up the money — made what has turned out to be a trillion-dollar mistake.
There were a number of actors: borrowers who reached too far, mortgage brokers who pocketed big commissions on loans they knew were bad and Wall Street banks that packaged those bad loans, applied a little alchemy and sold them to investors, who didn’t bother to check carefully what they were buying and relied on rating agencies who gave their unfounded blessing on the investments.
What got Fannie Mae, Freddie Mac and the big investment firms into so much trouble?
When they bought investments backed by shaky loans, these financial giants compounded the problem by relying on too much borrowed money themselves. Just like the “no money down” home buyers, these institutions didn’t have enough cash to withstand the drop in mortgage-related investments when the housing market started to slump.
What is the government doing about it?
Starting last summer, the Federal Reserve agreed to lend money to big banks and brokerages that were short on cash — just as a homeowner falling behind a mortgage might turn to a rich uncle. But the loans weren’t enough.
In March, Bear Stearns became the first firm to run out of options, so the Fed stepped in with a $30 billion loan, which helped it find a buyer in JP Morgan.
But in just the past few weeks, Fannie Mae and Freddie Mac, Lehman Bros., Merrill Lynch and insurance giant AIG all faced a cash squeeze. Even though the Fed had $880 billion on hand when the calls started coming, it soon realized it didn’t have enough money for the bailout. So the Fed went to their richer uncle — Uncle Sam — to borrow more money from the Treasury. It then became clear that it would be more effective to have the Treasury act directly as Wall Street's rich uncle.
What happened to all the money these lenders lost? Where did it go?
In many ways, it never existed. As lenders kept pushing mortgages to people further down the income ladder, they added buying power — based on credit, not real income — pushed up home prices much faster than incomes. Mortgage brokers pressured appraisers to inflate home values. Those higher values forced new home buyers to stretch further to buy a home; lenders were happy to sell credit to shaky borrowers.
The scheme was based on the belief that rising home prices would let stretched home buyers cash out their new equity and refinance into a new loan before low "teaser rates" reset, trapping them into loans they couldn't afford. When home prices started falling two years ago, adjustable mortgages reset to their true cost, and homeowners began defaulting and losing their homes to foreclosure. Those homes are being dumped on the market at fire-sale prices, pushing home prices even lower.
Why isn’t more being done to help homeowners?
That’s a key question being asked this week by congressional Democrats, and it’s a major sticking point in the current debate over the details of the bailout. The debate has gone on for the last year, and both sides are pretty well dug in.
Opponents of aggressive measures to “bail out” homeowners argue that this would reward bad behavior — or at least bad financial decisions. Homeowners who reached too far, this thinking goes, should suffer the consequences.
Proponents of more aggressive assistance, including a change in bankruptcy law to let judges negotiate more affordable terms, argue that if the government is now bailing out lenders who made bad investments, it’s not fair to leave homeowners hanging. So far, voluntary efforts to rework mortgage terms haven't gotten very far.
Isn’t this all the fault of irresponsible borrowers? What part of ‘adjustable’ didn’t they get?
Some borrowers — especially “flippers” looking for a quick buck — took on too much risk. So did people who borrowed more than they could afford and are now losing their homes.
But these people hardly got off easy: Real estate investors were wiped out and risky borrowers are losing their homes. Many homeowners now in trouble were perfectly responsible borrowers who got burned by the severe downdraft in homes prices and now have mortgages bigger than their homes are worth.
There’s another practical reason for rewriting mortgages that people can’t afford: Until the pace of foreclosures slows, the pressure on home prices will continue.
Since the value of all this bad paper the Treasury is trying to clean out of the financial system ultimately depends on the value of the underlying homes, the value of mortgage-related investments will keep falling until home prices stop falling.
Is there really $700 billion in bad mortgage-related investments?
No one knows. For one thing, these investments were not regulated: None of the Wall Street banks that issued them, nor the investors who bought them, have to report their holdings. More than $2 trillion in residential mortgages were issued annually at the height of the boom earlier this decade.
It’s also impossible to put a value on whatever investments are out there because there’s no open exchange for them to trade on. Even if there were, each bundle of mortgages is different, so it’s hard to compare apples to apples.
What’s all this going to cost?
No one knows that one either. A lot depends on what kind of deal the government strikes when it buys up these bad investments. If, for example, the Treasury buys them for 60 cents on the dollar, and they end up losing more value, the Treasury eats that loss.
If the Treasury drives a hard bargain and buys them for 30 cents on the dollar (on your behalf — it’s your money that's paying for all this) we all could end up making money later after the housing market recovers. But if the Treasury drives too hard a bargain, it will put more stress on a financial system that is already on the edge.
Is this going to raise my taxes?
Most likely. You won’t get a bill from the Treasury for your share of the bailout. In theory, the Treasury could just borrow more money to cover what it needs — just like it’s borrowing another $400 billion-plus annually to provide you with services without collecting enough in taxes to pay for them.
This latest giant government expense will make it much harder to justify extending massive Bush administration tax cuts that are due to expire next year. Doing so would push the annual budget deficit well over $1 trillion. Even for the free-spending U.S. government, that’s a little too much for the world to bear.
It’s the rest of the world, after all, that’s lending us the money. If the U.S. government begins to look like a subprime borrower, living well beyond its means, the global investors and governments who lend us money will do what any subprime lender would do: Charge us more money. The resulting jump in interest rates would add yet another burden to our economy.
What happens if this doesn’t work? Why is the worst scenario so dire?
While you may get a regular weekly paycheck to pay your bills, most businesses see a very uneven stream of money coming in the door. Sometimes it varies widely. Big orders come in at the end of the month, the new spring fashion line launches once a year and stores stock shelves for the holiday well in advance.
To smooth these ups and downs, companies rely on credit, both short- and long-term. On any given day, trillions of dollars of this debt has to be “rolled over” by borrowing fresh cash to pay off older loans.
The problem now is that fears over losses in mortgage-backed credit have spread to the entire credit market and lending system. If banks, lenders and investors who buy this debt get too spooked, the lending machine grinds to a halt. Business can’t function. Bills don’t get paid. Payrolls are frozen. Workers get laid off.
If your business fails, your lender is out the money you borrowed. That leaves less money to lend to someone else. As more business fail, and the lending dominoes fall, the economy slides into a deeper recession.