The Financial Bailout Explained
The Financial Crisis: What's Happened in 2008?
In 2008 and early 2009, Americans experienced an economic crisis the likes of which had not been seen since the Great Depression. Multi billion dollar banks collapsed, the Stock Market dropped by nearly 50%, unemployment skyrocketed to over 10%, and the government literally provided billions in bailout money to many financial firms and auto companies, including some of the most established companies in the United States like General Motors.
This hub will attempt to explain why this crisis happened as simply as possible. It will do so by answering the following three questions.
- The timeline of the crisis. How it started, the steps along the way. Basically how we got to where we currently find ourselves.
- The pros/cons of the bailout plan. What we as a nation can do to get out of this.
- How Americans were affected by the crisis and what you can do to weather the downturn.
The epicenter of the crisis
1. How we got here.
The Housing Bubble. Yes, there are a lot of other issues, but the root cause of the crisis is that Americans thought that housing prices would keep going up. For individual Americans it meant they thought they could keep refinancing their homes, making adjustable interest rates irrelevant. For investment banks it meant that they could sell complex derivitives based on overly inflated housing values. For individual Americans with adjustable mortgages it meant they could continually refinance their loan terms as long as housing prices kept going up, keeping their rates low. It also meant that debt was generally cheap: you had low interest rates on credit cards, mortgages, student loans, etc compared to historical averages.
Bankers got into the same state of mind as American homeowners: they assumed that housing prices couldn't fall as much as they did. Reveling in the boom, they borrowed billions of dollars to increase their stakes in mortgage based holdings. This is what brought Lehman Brothers down last October: according to some estimates they had 1 dollar in cash for every 32 dollars in assets they owned.
This is fine as long as things keep going well and prices keep going up: banks kept lending to each other (and homeowners) under the assumption that things would eventually be paid off. Why worry about risk when there was money to be made? Why worry about how much you owe on your mortgage when prices keep going up...you can always sell if the payments get too high and make a killing over what you paid for it.
This assumptions began to fail in late 2006, when housing markets across the country begin to tank. People were suddenly stuck with mortgages they couldn't pay off or refinance as home values shrunk. Banks were stuck with mortgage backed investments that were suddenly worth a lot less (though how much less exactly is still up for debate) than they thought. This meant that banks started hoarding cash in case they would have to pay off their bad investments, making it more expensive for banks to lend to each other--and to consumers. This in turned fueled more foreclosures and defaults in a deepending cycle as people and institutions found it much, much harder and more expensive to borrow money.
It is this spiraling crisis that led to the collapse of Bear Stearns in March 2008, Lehman Brothers and AIG last fall, and General Motors and Chrysler in the spring of 09. Yes, all these companies made a number of terrible decisions and borrowed way too much, but if credit markets were in a normal state they could probably have borrowed money from other banks to pay off their short term debts and stay solvent. But the credit markets were far from normal: NO ONE wanted to lend any money until things calmed down. This is why the federal government had to step in and why we saw such panic on Wall Street: a limited amount of lending is always needed to allow markets to work. And that lending just wasn't happening.
No matter what happens, the taxpayers are going to be shelling out a big chunk of these.
2. Pros/Cons of Another Bailout
Fact 1: The first bailout temporarily returned the flow of credit markets, stopped banks from failing, and seems to have stabilized the markets, which have rallied nicely so far this year. Unfortunately, unemployment continues to skyrocket as businesses have seen profits plummet and are cutting head count, reducing production, and curtailing or eliminating new hires to ride things out until things get better.
Fact 2: The market alone will not be enough to bring the country out of a recession. Despite some of the craziness of recent years, most financial products are still based on corporate profits of some sort, and if corporations are not making money (which many are not currently), they are not going to hire new people. Indeed, if they continue to lose money and demand continues at these anemic levels, there will be even more layoffs.
Fact 3: Stimulus or not, the government is going to be in debt in the short term. Most economists, even conservative leaning ones, agree that short-term spending is sometimes necessary to get an economy rolling during a deep recession. The key is to make sure that spending is targeted at institutions that will generate economic growth (like small businesses, new technology and development firms, etc) as opposed to those who will hoard cash until things look better (as some banks are doing).
Key things any new bailout should include.
- Greater oversight over banking practices. Anyone who hates government intervention should explain why, if the free market is so perfect, we ended up in the current situation we find ourselves in. Unfortunately, the banks seem to be winning this battle for now, claiming that thinks have returned to normal and that further regulation will slow down the economic recovery.
- A consumer protection agency to regulate things like mortgages, credit card disclosures, and predatory loans. Yes, you should always read contracts, and lots of people knew what they were signing up for, but too many financial institutions load their products up with far too many confusing fees that are not disclosed as easily or clearly as they should be.
- Grants to small entrepreneurs and small firms that are developing new technologies. If we're going to bailout a dinosaur like GM, we should be investing in companies that have the chance to become the new GM and lead innovation and drive economic growth in the future.
- As a more general point, anyone who thinks that pure free market capitalism works is just as crazy as anyone who thinks pure communism works. Either extreme is impossible in a world of irrational humans. The government will always have to engage in some regulation, just as their always has to be some private ownership and incentives for people to work. But claiming that "leaving everything to the market" will make things work out in the end is idiotic
3. How you can help yourself
Here's what you can deal to best protect your bankroll in these uncertain times.
1. Worry about the things you can control. Nothing you can do will change the direction of the market. Or, unless you're Henry Paulson or Warren Buffett, the status of the bailout package. You can, however, start making more money right now by cutting your expenses. Bring a lunch to work instead of eating out. Walk or take public transit instead of driving. Cut out the daily Starbucks trip: even assuming you just buy a small coffee, that will save you over 400 dollars in just one year. Remember: saving more money is essentially the same as making more money.
2. Invest money in a online savings account like ING Direct or HSBO. You can earn up to 2% interest in some of these, which is way better than a standard checking account pays. 2% doesn't sound like a lot, but that means that for every 1000 dollars you invest, you'll get 20 free at the end of the year. And that increases over time.
3. Start generating a second income! Blog, write for hubpages, start doing odd jobs around the neighborhood, you can even get paid to fill out surveys online. None of them will make you a ton of cash, but anything that makes you some extra dough should be taken seriously these days. Remember: every little bit counts, especially if you are young. A dollar you earn and save in your early 20s is worth 10X as much as every dollar you earn and save in your 40s.
4. Don't panic. All of your bank accounts and CD's are insured up to $100,000. Even if a bank fails, you will still get all of your money back: it might only take a few days.
5. Ride out the storm. Especially if you are under the age of 40 and have some time until retirement. Don't sell all of your stocks: the markets are low right now, and you might miss out when stocks turn up again. If you're older you might want to consider shifting more money into safer bonds because the markets might not recover by the time you need the money. But for everyone else, wait it out.
6. Stay informed. Read personal finance blogs. Follow the news. By knowing exactly what is going on, you'll have a leg up on everyone who acts on rumors or panics because of a lack of information.
7. Be prepared for the worst. Have your resume ready to go and have a game plan for what you will do if you are laid off. Its never a bad thing to have an emergency plan, even if the worst never happens you'll give yourself some peace of mind. If it does, you'll be a step ahead of the game and ready to go when things pick up.
I hope this helps, feel free to message me if you have any questions or have any comments/suggestions on the hub. Good luck!
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