It’s hard for me to watch all of the news about the financial turmoil surrounding Wall Street and the proposed bailout solutions from Congress without feeling scared. At one time, it was apparently just about some high-flying firms that were getting their wings clipped. But with news of the many mortgage foreclosures, it became apparent that a lot of people away from Wall Street were also getting hurt (not the least by the stock market losses). And if no solution is found to this whole mess, it has been said that companies not able to obtain credit to operate may well have trouble making their payrolls which may lead to more people losing their jobs.
But what really makes this so scary is not only the magnitude of problem and its proposed solutions but also their complexity. Especially when looking at the 110 page draft of the bailout proposal previously voted on by the House of Representatives, it is obvious that those of us who are not economics or finance experts are going to have a tough time understanding all of this enough to have an informed opinion. What’s even worse is that many of those in Congress who will be making crucial decisions on what action is taken don't have a whole lot more expertise on this than we do!
So for better or worse, most of us have to rely on the experts to help sort this all out. But as we know, experts often disagree — sometimes strongly. For example, watching CNN the afternoon of September 29th when Congress voted down a proposed bailout agreement, one expert after another talked about how the sky would fall without the bailout agreement being adopted. Then later on the same channel, Lou Dobbs and his experts declared victory in the failed agreement. And then there is Treasury Secretary Henry Paulson who takes on the role of the super expert who not only proposes the bailout but will also administer it almost single-handedly. But then it is pointed out that Paulson has been so wrong so many times in the past about this emerging crisis. Is this the man to lead us out of the woods?
The other problem with TV experts is that too many of them instead of trying to make things understandable for the layperson are more concerned with impressing people with their knowledge. I guess that’s all about job security. But there are resources for the layperson who is willing to invest a little time and effort to learn more.
The New York Times has a very worthwhile collection of articles called Times Topics on subjects including Credit Crisis, Credit Crisis - Bailout Plan, and the especially informative Mortgages and the Markets. For those who are not willing or able to read through all of this, since I have nothing better to do, I took the time to do some research and as a public service just like President Bush is “The Decider”, I will assume the role as “The Explainer”.
So how did this mess come about in the first place? The quick answer is ‘too much overaggressive lending — especially with home mortgages’. For lenders, there is a choice between making safe loans to rock-solid borrowers (who command the lowest rates of interest) or aggressive loans which carry more risk but command higher fees and interest. Some lenders may diversify their loans to try and get the best of both worlds.
But home mortgages are unlike most other loans because the ‘security’ behind the loan, the house, is normally an appreciating asset. So as long as the price of homes keeps going up, there is little apparent risk to lenders in even the most aggressive loans to borderline borrowers. The worst that can happen (from the lender's viewpoint) is that the house is foreclosed and the lender gets to take over an appreciating asset to resell while also pocketing the higher fees and interest associated with such loans.
But the price of homes can’t keep going up forever! When the housing market got overheated in many locations and property prices got beyond reason, the law of gravity took over and the resulting deflation of housing prices blew up in everybody’s faces. When this happens, some lenders can owe more on their mortgages than what the house is worth on the open market and may choose to walk away from their mortgage. Others facing financial distress from job loss or perhaps medical expenses are also losing their homes. The result is that the lenders are stuck with a whole lot of depreciating assets with nobody to take them off their hands.
A notable prior example of this was back in the 80s and 90s when Westinghouse Electric Corp. decided they wanted to make higher returns than what could be made in a stodgy electrical industry and decided to get more into the business of lending money to businesses along with commercial real estate. As a Westinghouse employee during these times, I was one of those wondering what was going to happen to my job as a result of their later difficulties. An outstanding series of articles published by the Pittsburgh Post-Gazette titled Who Killed Westinghouse? is still available in the newspaper’s online archives.
But what really makes this so scary is not only the magnitude of problem and its proposed solutions but also their complexity. Especially when looking at the 110 page draft of the bailout proposal previously voted on by the House of Representatives, it is obvious that those of us who are not economics or finance experts are going to have a tough time understanding all of this enough to have an informed opinion. What’s even worse is that many of those in Congress who will be making crucial decisions on what action is taken don't have a whole lot more expertise on this than we do!
So for better or worse, most of us have to rely on the experts to help sort this all out. But as we know, experts often disagree — sometimes strongly. For example, watching CNN the afternoon of September 29th when Congress voted down a proposed bailout agreement, one expert after another talked about how the sky would fall without the bailout agreement being adopted. Then later on the same channel, Lou Dobbs and his experts declared victory in the failed agreement. And then there is Treasury Secretary Henry Paulson who takes on the role of the super expert who not only proposes the bailout but will also administer it almost single-handedly. But then it is pointed out that Paulson has been so wrong so many times in the past about this emerging crisis. Is this the man to lead us out of the woods?
The other problem with TV experts is that too many of them instead of trying to make things understandable for the layperson are more concerned with impressing people with their knowledge. I guess that’s all about job security. But there are resources for the layperson who is willing to invest a little time and effort to learn more.
The New York Times has a very worthwhile collection of articles called Times Topics on subjects including Credit Crisis, Credit Crisis - Bailout Plan, and the especially informative Mortgages and the Markets. For those who are not willing or able to read through all of this, since I have nothing better to do, I took the time to do some research and as a public service just like President Bush is “The Decider”, I will assume the role as “The Explainer”.
So how did this mess come about in the first place? The quick answer is ‘too much overaggressive lending — especially with home mortgages’. For lenders, there is a choice between making safe loans to rock-solid borrowers (who command the lowest rates of interest) or aggressive loans which carry more risk but command higher fees and interest. Some lenders may diversify their loans to try and get the best of both worlds.
But home mortgages are unlike most other loans because the ‘security’ behind the loan, the house, is normally an appreciating asset. So as long as the price of homes keeps going up, there is little apparent risk to lenders in even the most aggressive loans to borderline borrowers. The worst that can happen (from the lender's viewpoint) is that the house is foreclosed and the lender gets to take over an appreciating asset to resell while also pocketing the higher fees and interest associated with such loans.
But the price of homes can’t keep going up forever! When the housing market got overheated in many locations and property prices got beyond reason, the law of gravity took over and the resulting deflation of housing prices blew up in everybody’s faces. When this happens, some lenders can owe more on their mortgages than what the house is worth on the open market and may choose to walk away from their mortgage. Others facing financial distress from job loss or perhaps medical expenses are also losing their homes. The result is that the lenders are stuck with a whole lot of depreciating assets with nobody to take them off their hands.
A notable prior example of this was back in the 80s and 90s when Westinghouse Electric Corp. decided they wanted to make higher returns than what could be made in a stodgy electrical industry and decided to get more into the business of lending money to businesses along with commercial real estate. As a Westinghouse employee during these times, I was one of those wondering what was going to happen to my job as a result of their later difficulties. An outstanding series of articles published by the Pittsburgh Post-Gazette titled Who Killed Westinghouse? is still available in the newspaper’s online archives.
A July 1986 strategic plan put together by consultants under (CEO Douglas) Danforth called for even faster growth, with an emphasis on riskier but more lucrative corporate and junk bond financing, speculative commercial real estate loans and direct loans to developers.
The message, former Westinghouse Credit employees say, was go out and make deals, deals, deals. Let the dark suits and pencil pushers have their Gateway Center offices. One Oxford Centre, the financial subsidiary's home, is where the action was.
Like other finance companies, Westinghouse Credit was virtually unregulated and proud of it. It liked being a lender of last resort. It welcomed deals its regulated brethren, banks and thrifts, couldn't or wouldn't do. And for good reason: It got hefty upfront fees and charged high rates.
Just before he retired, (CEO John) Marous did take one final action to calm the ratings agencies and maintain Westinghouse Credit's high ratings. He signed a support agreement stating that the parent company would repay any debts and cover any losses at the financial services subsidiary. In other words, Westinghouse Electric would make up any shortfalls. No one knew at the time, but it was the beginning of the end.
When the risky loans started to go bad, Westinghouse had no choice but to eventually sell off many of its businesses to avoid bankruptcy.
In today’s crisis, we have a number of Wall Street firms that have been burned by the large number of bad mortgage loans which in turn have hurt the value of securities they sold that were backed by these same bad mortgages.
The proposed bailout calls for the government to take on these bad loans and perhaps profit in the future if or when the property values come back. But while this is objectionable to many who feel that we are rewarding the bad behavior of the lenders, most (but not all) of the financial experts feel that if we do nothing, the resulting squeeze in available credit funds that allow businesses to do their day-to-day operations, including their payrolls, may trigger an even more severe recession that will result in more large-scale job layoffs even outside the financial services industry.
So this was why many legislators held their noses and voted for the bailout plan even though there were parts they didn’t like since they felt the alternative of doing nothing was worse as related in this excellent commentary by Rep. Jim Marshall (D-GA) whose background is in business, finance, and bankruptcy law.
It’s back to the drawing board to try and come with a plan enough Congressmen will approve. Many of those who voted against the bailout feel that instead of the government just taking over the bad debts, the individual homeowners should receive more direct assistance at least in the form of reworking the bad mortgage loans to make them more manageable by the homeowners just like we do with other loans in bankruptcy. In addition, some feel that additional regulation to prevent some of the overagressive lending causing the crisis in the first place is needed.
Congress wants to get home for recess as soon as possible for the campaign season. I think we all hope that this will force them to come up with a good agreement quickly. The situation is urgent. Did I mention scary?
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