Economics 101--Why does this Wall Street Mess Matter to You?

I have been hearing a lot of doom and gloom about the financial health of the country lately. What I think is scary to most people is that, unlike previous recessions, no one can really articulate what the problems are, and what the solutions should be.

Previous economic hard times, going all the way back to the Panic of 1907, were at least understandable by economists, financial experts, and relatively solveable, either with cash infusions, or the indominable will of leaders like JP Morgan.

This situation is so difficult, because there isn't a clear cause, nor a clear solution path. Here is the best way I know how to break down the problem:

Problem:

When all these people started to buy homes in the 1990's and 2000's, mortgage companies discovered they could sell the mortgages to a bank who could "package" the mortgages, and sell them on the market, just like a share of IBM stock. The "shareholder" who bought these securities (called Collateralized Mortgage Obligations, or CMO's) would get an interest payment each month, just like a bond. The mortgage company would package your monthly mortgage payment, along with all the others they received, on the first of the month, keep it for 15 days (earning interest), and pass it along to the bank, who would "pass through" that money to the shareholder. Everyone along the way got a cut--the mortgage company got 15 days interest, the bank made money on the difference between what they received from the mortgage company, and what they paid the shareholder, and the shareholder made a return on their investment of around 5-7%. What a deal.

Only one problem. A lot of those CMO's were financed on Adjustable rate mortgages, which was fine when the mortgage payment for joe six-pack was $500 at 2% a month. Suddenly, mortgage rates went up, and the mortgage payments went from $500 to $750 a month, as interest rates went from 2% to 5%. In business, it only takes about 5 in 100 people to not be able to afford that jump, and have to foreclose on the property. Suddenly, the banks had all these properties they had foreclosed on, and no mortgage payments coming in to pass through to their shareholders. They still had obligations, though, to pay the amounts to the shareholders. What to do?

Start selling other bank assets to cover the difference. Only one problem with that. People see that you are fire selling assets, and it creates a sell off on the markets, and the value of your securities you are trying to sell. Now you have to sell MORE just to get back what you need to cover your debts. And if you default on the security payments to the shareholders? Big trouble. Now EVERYONE will be trying to sell those securities, and no one will lend you money, because they think you are in trouble. When no one lends the banks money, the credit system freezes up.

When that happens, all of the "Main street" businesses (car dealerships, restaurants, etc) using credit to make payroll at their shops, can't get the funds they need to pay their workers. Because the bank doesn't have spare funds to lend them. That creates either mutiny for the employees, or means that the employers have to start laying off people.

And THAT is how Mortgages effect Wall Street, and Wall Street affects Main Street. The scary question is "What's the timespan on this cycle?" My biggest fear is that this cycle has already started, and every 15 days we will see it get demonstrably worse, until something is done. but WHAT CAN BE DONE?


Solutions:

Honestly, I don't know what the right answer is. Congress passed a bill that allows the federal government some leverage to invest in these banks to give them the funds they need to make loans, and keep business afloat in the short term. then the banks would have to repay them. Initially, the feds wanted the money to actully "BUY UP" these CMO-like securities, and, in a sense, become the mortgage servicers, collecting monthly mortgage payments as their own payback of the $700B bailout money.

Apparently that plan didn't appear feasible. Britain came up with the idea of just buying stock in the banks themselves, thus giving the companies money to start to work out some of the bad mortgages, and get capital money flowing again. The US has adopted this idea somewhat, but it remains to be seen if this can stabilize things. It seems to have.

My hope is that the credit crisis has reached its nadir, and that all we are facing right now is just a good old fashioned recession. We could do a LOT worse...

On the political front:

McCain suggested having the federal government BUY the mortgages at FACE value, and negotiate failed mortgages to a reasonable rate. On the positive side of this arguement, it would stabilize home prices, and put a floor under the damage this is causing the US Economy. On the negative side of things, using Taxpayer money to guarantee a loss on investment, and bail out the least fiscally responsible among us is totally anethema to the Conservative philosophy.

Obama suggested a strengthening of FDIC guarantee limits, and has said little else, other than he supports a bailout. The guarantee comes with a potential to balloon the deficit, but could stabilize the panic people have about their savings.

Both are good ideas, and not mutually exclusive. So each has validity on the issues here.

What distresses me is that no one seems to be able to break down how we get out of this mess other than wait and hope. I am not so good with "wait and hope..."