Bailout of the banks

It seems to be that nobody has any true idea of what to do about bad assets held by the banks at the current time. These “bad assets” as they are often called, consist of “packages” of credit default swaps and mortgage-backed securities. CDS and MBSs are basically consumer credit card loans and mortgages that the originating bank (notably Countrywide Mortgage) packages together and then sells to another bank for a profit.

In this process, the original bank is the only entity that knows the risk of the loans, if they are made to people that will pay them back or if they are made to individuals with low credit scores where the likelihood of repayment is low. The purchaser of the “package” does not truly know the value of these loans due to the magnitude (usually in the millions) of loans in the package. Although packages are rated by a company such as Moody’s for their credit worthiness, the rating company does not have ability to “unpack” the loans and look at each one individually. Thus making the rating less accurate.

It must be understood that two government supported entities were created to facilitate this process. Fannie Mae and Freddie Mac were created to buy the “packages” of securities from the issuing bank. By having the ability to sell the loans to Fannie Mae and Freddie Mac for a quick profit, banks were encouraged to make loans to regular consumers. Some banks, again Countrywide, took this to the extreme and made loans to practically everybody they could without regard to the creditworthiness of the consumer. Once banks started to realize that some of the loans that they were buying as part of the “package” would not be repaid, banks were forced to lower the value they recognized for the loans. Banks then stopped buying the “packages” from each other and quit making loans to consumer, which is why the fed had to step in and forcibly lower interest rates. In essence, the entities that were created to enable banks to loan money effectively created a moral hazard in that banks started lending to everybody.

Now, the government wants to step in again and buy the bad assets from banks to encourage lending again. In my opinion this will create another moral hazard and just push the problem into the future, perpetuating bad lending techniques. Banks will know that if they screw up bad enough, someone will step in and save them. By making banks suffer for the poor lending, the banks will be forced to more carefully examine the loans that they are making available. This will also help combat inflating home prices and stop consumers from taking out loans they can’t afford. Are there solutions to this? Yes. Are they easy? No. Will the economy have to suffer for a while? Yes.

More to come. I think I will post next about inflated house prices their role in this mess.

First Post

I will be using this blog to post thoughts on the topics above. I look forward to comments and if you feel that I am wrong about a topic or have a different opinion please share them with me. I know I do not share the same views as everybody would love to hear everyone's opinion.