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YOU DECIDE: Are there answers to the 'bailout' questions?

October 03, 2008

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

As I write this week's column, the proposed $700 billion rescue of the nation's financial system is still up in the air.

However, this hasn't prevented folks from having lots of questions about the plan. Here are some of the most common I've received along with my attempts at answers.

How did banks and other lenders get in such a mess that the federal government - and the taxpayers - must come to the rescue?

First, not all banks and lenders are in trouble, but enough are that there's a problem. The source of the trouble is the housing market, and the dramatic slowdown in sales and reductions in prices in many markets. These trends are the downside of the housing "boom" that occurred earlier this decade. The boom was fueled by super-low interest rates, easy and ample credit, foreign money flowing into the U.S., favorable tax laws for residential housing and governmental programs that favored home ownership. Borrowers and lenders alike came to view residential housing as a "can't miss" investment, where any risks would be bailed out by rising housing prices.

The boom turned into a bust when the Federal Reserve (the nation's central bank) took away the easy credit and raised interest rates. Borrowers with adjustable loans saw their payments rise and this sent some into default. Home buying cooled off and the rise in housing prices first slowed, then stopped. Investors and lenders who counted on escalating home prices saw their deals turn into disappointments. And because the housing market is so big, even a small percentage of defaults and disappointments was enough to erode the balance sheets of the financial system and bring us to where we are today.

So why do some say the financial system needs a "bailout"?

The home mortgages that have turned bad are a major liability for the financial system and are inhibiting many lenders from making new loans. In other words, the bad loans are "clogging" the system and preventing credit from getting to new borrowers. And the simple fact is that our economic system relies on credit. Both consumers and businesses use credit daily to purchase products and services. If this credit isn't available, then buying and spending -- and the income they generate -- can grind to a halt. So the federal government is proposing to buy up the bad loans, get them off the books of the lenders, and thereby "unclog" the system so good credit can flow.

Why not let the lenders take their losses, just like most households or businesses would if they got into financial trouble?

Indeed, this is what happened 100 years ago, and the result was very severe recessions, much worse than we have today.

The financial system is different. It affects all of us directly or indirectly because money needs to move easily from one person or business to another for the economic wheels to turn. If the movement of money stops, the economic wheels fall off. In fact, the Fed, which is at the center of today's rescue plan, was created specifically to serve as a backstop to the financial system and to address just the kind of system-wide financial problems we have today.

Federal Reserve Chairman Bernanke says that if the losses in the financial system aren't soon addressed, unemployment will rise and household wealth will drop. Every percentage point increase in the unemployment rate costs workers about $100 billion, and every percent drop in housing wealth translates to more than $200 billion of losses.

Where would the bailout money come from?

The federal government would borrow the money, so the ultimate source would be a mix of domestic and foreign lenders. The borrowing would increase the budget deficit and possibly put upward pressure on interest rates. It would also limit any program initiatives the next president and Congress might contemplate.

Would the government get the bailout money back?

The money would be used to buy the non-performing loans, which have very low values today. However, some analysts think those loan values could rise in the future once the housing market gets back on track. If so, the government could recover some or all of the bailout money. Some analysts even suggest the government could make a profit.

If the government doesn't rescue the financial system, are we facing another "Great Depression"; and if the rescue plan goes through, will the economy get well soon?

Most economists think a Great Depression-type downturn is out of the question. We have a bigger, stronger, more resilient economy than 70 years ago. But fixing the financial system won't automatically cause unemployment to drop and incomes to rise. The housing market must first be balanced, and that will still take time: probably at least a year.

You decide if you feel better or worse with these answers.

But, at the least, hopefully you're more informed.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Suzanne at October 3, 2008 08:00 AM