In This Section

Breaking Down the Bailout

September 26, 2008

By Donald L. Schunk, research economist with the BB&T Center for Economic and Community Development at Coastal Carolina University

The U.S. financial system has been mired in a credit crunch for more than a year. However, until very recently, the spillover to the real economy has been minimal. In recent weeks, uncertainty and a lack of confidence within financial markets have brought the regular flow of funds to a near standstill. This situation led to the Treasury Department's proposed financial system "bailout" that is currently being debated by Congress. Daily, I see the anxiety this financial turmoil is causing because of the sheer complexity of the issues involved. In several presentations recently, I've tried to break up these issues into smaller pieces, and I think tackling a few of the main issues here may help shed some light on where we are, how we got here, and where we may be headed.

1. The housing market moves in cycles. Think of the housing market like waves on the ocean. Waves grow to a crest, then fall to a trough. Normally, the housing market grows during an economic expansion, then experiences a correction during a recession. Occasionally, we get a storm surge. What are we left with after the surge? Usually, it's a mess. The U.S. saw a tremendous surge in housing that began after the recession in the early 1990s. Housing should have corrected during the recession of 2001, but it didn't. The combination of historically low interest rates and ongoing financial innovation sparked the widespread use of new mortgage products - including subprime and low-documentation loans - that helped fuel an ongoing housing surge.

Only when the surge began to recede in 2006 did the resulting mess become apparent, characterized by a downward correction in sales, excess inventory, falling prices and rising foreclosures.

2. Credit markets are no longer functioning efficiently. Many bad decisions were made during the housing boom that were fueled by irresponsibility, short-sightedness, lack of information and greed on the part of borrowers and lenders. If the costs of these bad decisions could have been contained and limited only to those making the bad decisions, then our credit markets could have continued functioning normally, and we wouldn't - or at least shouldn't - be talking about government intervention.

But, the costs of those bad decisions have now spread. After a mortgage is made, it is typically bundled with other mortgages and then securitized - it is traded in the market. These mortgage-backed securities continue to be bundled, split, bought and sold, and now reside on the balance sheets of firms throughout the financial industry, including those that had no role in the initial lending and borrowing. Because these mortgage-backed securities are backed by an unknown mix of good and bad mortgages, determining the underlying value of these securities is nearly impossible. Financial institutions have no way of accurately valuing these assets; there is no market for them because their current value is unknown.

All of this uncertainty has resulted in frozen credit markets. Financial firms don't know who has how much junk on their balance sheets, and for this reason are reluctant to lend to other institutions. This prevents the normal and necessary flow of credit throughout the economy.

3. The availability of credit is necessary for the economy to function. A small business typically needs to borrow to finance its startup costs that will then be recouped over time. A household typically needs to borrow funds to finance a home purchase that will generate benefits over time. A student needs to borrow to finance an education that will generate returns down the road.

Almost every productive economic activity we engage in involves costs and benefits that occur at different points in time. The availability of credit forms a bridge between the timing of these costs and benefits. This is why we have credit markets, and functional credit markets are critical for financing economic growth.

Our credit markets are currently unable to perform this function. Frozen credit markets don't just hurt Wall Street firms. The lack of credit hurts individuals, families and businesses everywhere that have rational and productive uses for borrowed funds.

4. Bailouts are dangerous business. We shouldn't be in the business of bailing out individual borrowers or lenders who made bad decisions; clearly, this simply encourages future bad decisions.

5. The Treasury Department is not trying to bail out Wall Street firms. Rather, it is an attempt to create a market mechanism to place a value on these assets, thereby removing a significant source of uncertainty in credit markets. The real purpose of the Treasury's proposal is to help Main Street by trying to find a way to get credit flowing again. The goal is for banks to again be willing to lend to each other, and in turn be willing to lend to individuals and businesses that have legitimate and productive uses for those funds that contribute to economic growth.

As complex as these issues are, it's relatively easy to dissect the past and the current situation. We haven't even touched on the probability that this bailout plan will work, or what the ultimate price tag may be. Short answer: no one knows for sure. The long answer will have to wait for another day.