With the recent news of the Fannie May and Freddy Mac bailouts, I thought it might be interesting to go over the exact process of a bailout.
So here's how it goes. A privately owned or publicly traded company gets itself into financial troubles, in this case by buying a whole bunch of debt (in the form of mortgages). Unfortunately, they vastly overestimate the face value of these items. (E.g., a 30-year mortgage for $250,000 ought to be worth $250k over 30 years (simplified here by leaving out interest). However, they purchased hundreds of thousands of these and overlooked the fact that many of these new homeowners had no possible means to to pay $250k, even over 30 years.) So they pay a bunch of money for something and actually get nothing in return. When this becomes apparent, everyone who's loaned them money comes asking for it, and the company approaches the verge of collapse. Then, for whatever reason (friends in high places usually), the federal government decides that allowing such a company to go under would be "bad for America" and steps in with a bunch of cash to fund the debt of such a company. That cash comes from tax payer dollars. The net monetary effect is to take tax money from every American and transfer it to a few Americans. (Slightly different this time, see below). It also prevents what free-marketeers say is the upside to a free market, that the company in question (and the people that invested in it) get punished for their poor choices, thus preventing such problems in the future. (This is why Dick Cheney was against the housing market bailout.)
Savings and Loan scandal of the late 80s/early 90s followed the same pattern. Bear-Stearns was similar, and rumor is Lehman Brothers is next.
This type of action, which occurs at regular intervals in America, is the antithesis of the free market.
The new wrinkle with Fannie and Freddy is that for perhaps the first time, the majority of the investors in question were foreigners. Meaning that rather than sending tax dollars to a few select Americans, we sent that money overseas. America is being sold for parts, and it's being done by the very institutions that are supposed to protect it.
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14 Sep: Anne's link: NPR link
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3 comments:
First of all, I like how you start out this entry as if it's going to be a lesson in economics... and it slowly dissolves into a political rant. If this were on wikipedia, it would start out "the neutrality of this section is disputed."
A couple further comments:
-I certainly would not call this "the antithesis of the free market". I can think of many economic systems that are far further from the free market than this.
-To imply that America is supposed to have a free market and now we're somehow failing ourselves is an oversimplification. While there's a wide spectrum of beliefs as to the extent and mode of government intervention in the economy, even the most fervent Chicago School economist accepts that a completely laissez-faire policy is unrealistic. Despite the fact that we, as a country, consistently harps on other countries to open their markets, America has had a regulated market for the past hundred years. So to imply that a government bailout is un-American is categorically untrue.
-Saying that tax dollars are being taken from every American and sent overseas implies that Americans are getting no benefit from this action. Keep in mind that a lot of the institutions lending money to Fanny and Freddy were foreign central banks and foreign sovereign wealth funds... so yes, it's sad that we have to send them a lot of our money, but if Fanny and Freddy were to fail, it could have horrific implications in terms of the strength of the U.S. dollar. So while letting them fail might be a lesson to everyone about making good decisions, this isn't a "very special episode" of Seventh Heaven, where we all learn a valuable lesson about the dangers of drunk driving (or faulty accounting practices).
According to this article: http://www.npr.org/templates/story/story.php?storyId=94424809 , allowing Fanny and Freddy to fail would result in a "meltdown of the global financial system."
So, when you claim that America is being "sold for parts" by the "very institutions that are supposed to protect it", I'm not sure to which institutions you are referring. Fanny and Freddy? I'm pretty sure they never agreed to "protect" America. The U.S. Government? I'm pretty sure they ARE protecting America - from a cataclysmic global financial crisis.
Hmm, yes, I should have consulted you about this. I knew I was at fringe of my knowledge while writing, but at least I know how to get your attention. Thank you for the comment, I defer to your knowledge. (Also, I know text is difficult to read emotion from. I'm not trying to be pissy, I offer the following as part of what I hope will be an academic conversation...)
Some follow up responses / questions:
Did I get the basic mechanics of a buyout correct?
I do hate sounding like a ranter...my complaint in all this is about the general inefficacy of the federal government (failing to prevent the mess, then failing to bite the bullet and say, "Sorry guys, you screwed yourself on this, we're not saving you this time.")
Yes, "antithesis" was the wrong word. I didn't really mean that this was the farthest thing possible from a free market, I was trying to describe such a move as antithetical, i.e., counter to a free market.
I titled this entry as I did because I talk with a lot of people who claim that America is a free market, and it always pains me to point out the myriad ways that it isn't. A question on this point: I've heard Milton Friedman really did try to create a free-market paradise to the hilt in Chile...is that not so?
I agree, this isn't a special episode of 7th Heaven. 99% of the populace will not learn the lesson here.
Regarding the supposed benefit to all Americans, screw what the press says; I trust you a lot more, what do you say? Every time one of these events comes along, we hear anew that the sky is falling and the the government "must" step in...and a small group gets richer at the expense of the rest of us.
As I understand it, Fanny and Freddy are government sponsored enterprises, originally created to maintain capital flow to people supplying mortgages so Americans could buy houses. The fact that they were allowed to become investment banks with the special advantage of being able to tap a line of government credit is again a failure of the government; their job was to facilitate U.S. home ownership.
As far as the government, we are now seeing U.S. domestic economic policy being dictated by foreign central banks. I would say that is a failure of or government, to allow ourselves to become so unbalanced that they have to step into the market at the request of a foreign government. Maybe they are protecting us with this, maybe they aren't, but I pessimistically believe that they will fail to followup with the requisite regulation or oversight to prevent such a thing happening again, let's say, within the next 20 years.
A final question: I read a source saying that part of the problem here was the repeal (in 1999) of the Glass-Steagal act of 1933, which kept investment and commercial banks separate entities. Thoughts?
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