John Carney Updates Us On the Not So Wonderful Life of the Financial Crisis Bailout

Just because it is going to take an alien invasion or some such to knock the election off the front pages for the next two weeks does not mean that Wall St isn’t still going down in flames. It is. Big ones. This morning saw the return of the scary graph to the front page of the WSJ (though it has been noticeably absent from the NYT homepage in recent days). As a result we thought it was high time we checked back in with Clusterstock‘s John Carney to find out what the heck is going on!

More specifically why can’t the government come up with a plan that will work? And what about those scary graphs? Carney responds to all this and further explains to us how the Crisis of ’08 can (sort of) be compared to a plot line from It’s a Wonderful Life or, alternately, a stoop sale in Park Slope. All news is local!

So how come none of these plans are working?

JC: The reason the bailouts haven’t been working is that they are addressing the wrong problem. Like generals fighting the last war, the people at the Treasury Department and the Federal Reserve seem convinced that the banking system is experiencing a liquidity crisis when it’s actually experiencing a solvency crisis. Here’s what that means. If you have a bank that is basically healthy but is temporarily short of cash because customers have pulled out deposits and, for some reason, it can’t borrow, that’s a liquidity crisis. That’s what happened in It’s a Wonderful Life.

Arguably, something like that happened to Bear Stearns. (But only arguably: Bear might have been worse off than we know.) But we are now facing a serious insolvency crisis. That means that banks have huge liabilities and assets that aren’t worth anything, except maybe as kindling to keep us warm in the winter. Okay, that’s an exaggeration but you get the point.

Let me put it in Brooklyn terms. If you run up your credit card high enough that you can’t make the monthly payments, you can try to negotiate them down with your credit card company. If you have a job, you’ll be able to make the payments. You can hold a stoop sale and sell some of your records and furniture. That’s something like a liquidity problem. But if you don’t have a job and all your records are scratched and your furniture stained and out of style, you are basically insolvent.

If the government gives a bank with an liquidity problem some cash, it can make it through the temporary crisis. A bank with a solvency crisis, however, can be expected to run into the same problem of paying off those debts over and over again. It’s basically a blackhole. Look at AIG, which already has $122 billion of our money. It now says it needs more.

The key to a solvency crisis is allowing failed businesses to actually fail, go bankrupt. This helps restore confidence to the markets. Investors can invest and bankers can lend because they know that surviving institutions are likely to be healthy. Now we have no idea.

Hmm. At least these are analogies we can understand! So what’s the latest plan?

JC: The new plan is meant to stem the tide of defaults. The plan would be for the government to guarantee mortgages that banks agree to refinance with easier terms for borrowers. The banks would get the safety of a government guarantee in exchange for lower monthly payments, lower interest rates and perhaps even a diminished principle amount.

There are lots of technical problems with this plan, such as how to determine which mortgages should be eligible and what happens when a guaranteed mortgage defaults. Do you then owe your mortgage to the government? Will it foreclose on, say, a poor single mother who can’t make her payments?

And is the government addressing these problems or leaving it up to the banks?

JC: The government would have to determine what happens when a borrower defaults and it’s guarantee to the bank kicks in. I’m not sure all the details have been worked out. A couple of things could happen. First, the government could take direct possession of the home by foreclosing on the owner. That seems like a really bad idea. We don’t want the government to become a huge homeowner. More likely, the government would guarantee the difference between the principal value and the value realized by the bank when it forecloses on the home and auctions it off. It would, essentially, provide insurance against a bank’s losses on reworked mortgages.