Bringing back memories of Black Monday in October of 1987, the House of Representatives killed the Bush administration's $700-billion rescue package for America's beleaguered financial industry in a dramatic turn of events this week. The 228-205 vote sent the stock market into a plunge and renewed fears that the United States may be facing a protracted recession. In its largest single-day point loss ever, the Dow Jones Industrial Average plummeted by 777.68 points. Losses to shares on the Dow Jones Wilshire 5000 stock market index, which represents the stocks of nearly every publicly traded company in the United States, amounted to $1.2 trillion.
How did we end up in this mess?
Some blame Clinton & Co. and government manipulation of the free-market in the late 1990s (with the repeal of the Glass-Steagall Act). Others claim the reasons for the credit crunch stem from Bush's tax cuts for the wealthy, which put money into the hands of people who had no choice but to bet the new money on the housing and mortgage market. Both sides of the aisle, however, seem to agree that the origin of our current financial crisis lies in a dodgy home loan program that lead to the fall of some of America's largest commercial and investment banks.
During the second term of President Clinton, the United States saw an increase in employment largely because of the high-tech industry boom. But like all booms, it led to a downturn. The money supply had increased and the only market that was making money was housing. So in 2001, there was a large injection of money into houses and construction; U.S. home ownership jumped to almost 70 percent. The "securitization" of home loans began to grow - e.g. mortgage banks switched their original business of making mortgages to making packages of home loans that could be sold off as investments (securities) on Wall Street.
Making it possible for unqualified people to buy homes increased demand for and prices of houses. And as long as housing prices rose, the problems inherent in not requiring down payments and lowering lending standards were buried. As long as prices rose, no one had to default - simply because if someone was unable to pay a mortgage, they could sell the house at a profit.
The market, however, always plays out - and soon enough, "the bubble burst." When prices and construction began to fall as the housing market flattened out, foreclosure rates began increasing and mortgage debt was suddenly a real issue. Home borrowers, many of whom had poor credit, defaulted on their mortgages, causing a steep decline in demand for mortgage-backed securities on Wall Street.
The bailout plan was designed to enable financial institutions to begin lending again by having the federal government buy up mortgages, securities and other financial holdings that are undermining market confidence and resulting in the stock market decline.
But who really deserves to receive a bailout from the Treasury? The original proposal was to give it to the financial institutions that hold all this bad debt. But underlying all the bad debt are bad mortgages that people can't pay off. This raises an obvious question - why not put a moratorium on home mortgage foreclosures and re-write the mortgages? If mortgages are written down and people can make the payments, it would cost tax payers and the economy far less than a foreclosure. This approach was taken during the Great Depression and it actually made money for taxpayers.
The problem with bailing out financial institutions is that the unqualified home borrowers will still default on their loans and lose their homes. In some cases the bank or lending institution might decide it's worthwhile to reassess a mortgage but in many cases that might not happen. If the financial institutions sell their bad debt to the federal government, they no longer have any incentive to renegotiate a deal with the home borrowers.
Since blame is equally shared by all the parties involved in this financial crisis, the bailout should also be equally shared. Of course, if I'm someone who's been making his payments on time, it might bother me when someone down the street who bit off more than he could chew got bailed out. But it will bother me less than a Wall Street executive who got bailed out after making the same mistake and was paid millions to do it.
As free market capitalists, we have a tendency to worship profit-seeking institutions as perfectly efficient and sensible. We find complacency in the perfection of the system. But the present crisis proves this mentality is misplaced. It shows that all institutions have built-in incentives that lead to risky, irrational behavior and all institutions are capable of self-destruction.
