Is the proposed Bail-out Plan a good idea?
First let’s try and understand the problem. There is a lot of confusion out there about who needs help, why they need it and who stands to gain from this plan. I don’t have all of this mess figured out but I can give an overview that might help the average consumer understand what’s going on…
Many lenders are in big trouble and if Banks are short on money then they can’t lend money to the people who need it (like homebuyers). Banks are running out of money to lend. Let me explain…
Banks lend money to home buyers to purchase a home. The banks get their money back to continue lending by packaging the loan into a bond and selling it to bond investors. The bond interest is gauranteed so even if the homeowner doesn’t make their payments the bond has to be honored so in reality even though the bank got their money back to continue lending they are still at risk the loans they make. Foreclosed properties take time to sell, so if you have enough of them out there it can tie up the banks’ money and cause a big problem. Even worse, since this credit crisis has become so well publicized investors stopped buying the bonds for the bad loan products a long time ago, so the banks with huge amounts of money tied up in these risky loans just have them sitting there on their books and can’t get their money back to keep lending.
KEY - If banks can’t replenish their money to lend it again, they can’t grow or make new profits and eventually will fold. NO MONEY = NO BANKS = NO LOANS = GREAT DEPRESSION! (we all would prefer to avoid this one!!)
Here is a practical example of how the bail-out can work…
“ABC BANK” has $40 Billion in bad loans. The U.S. Government would pay them a largely discounted value to buy these bad loans. Let’s say it is 65 cents on the dollar so to buy $40 Billion in loans the government only pays $26 Billion. The government then can take its time with selling the loans, selling the foreclosed homes, collecting the payments, etc… The U.S. can even realize a profit on this deal if the right price is paid upfront. “ABC Bank” has a loss of $14 Billion but frees up $26 Billion is cold hard cash! This can at least get some of the biggest banks back in the game, lending money and doing business.
Bill Gross, head of PIMCO (runs largest bond fund on earth), stated today on CNBC that according to his numbers the U.S. could end up making 6-8% profit on every dollar spent! He said these numbers were conservative. Bank in the 1980’s, the government stepped in to solve the savings and loan crisis and ended up making money in the end. This would be similar except that in this case the government is not taking over debts but buying them. The upfront price is the key to the U.S. taxpayer making or losing money on this deal long term.
Will this plan solve the problem? No one knows the answer to that question over the long term. There is a careful balance when it comes to credit. Make getting a loan too hard, and the economy can shrink fast. Make loans too easy (like what has happened here) and the whole credit system can fail. We have to ensure the health of the lending system so there are banks to lend, but credit must be available at a reasonable level for homes and cars to sell. This plan can and will get money flowing again, and at least for the short term that is a big win for the economy and the housing market!
