My two cents on the bailout

Congress and the Executive branch reached an agreement this morning for a financial bailout of the banking sector, totaling three-quarters of a trillion dollars. This is the biggest government response to financial crisis in this country – and perhaps in the world – since the Great Depression. The question that seems to be on everyone’s minds is about whether or not the bailout is a good idea for America as a whole or not.

I think back to a recent quote from a European economist who defined the difference between the European and American economies. He said that, while theirs was based on exports, ours has been built for decades on consumption and credit.

Seventy years ago, only one in fifty homes in America had a mortgage. There was no economy built on the idea of borrowing for things like homes, cars, college, let alone credit cards for everything else, which has literally exploded exponentially in the last 25 years. Thus, a whole new economy was born, based on debt, which in turn, was based on the American sense of entitlement that we deserve what we want right now, whether we can afford it or not.

The thing is that selling credit is actually much more profitable than producing goods. As an example, Ford Motor Company makes more money off the loans they give to people to buy their cars through Ford Motor Credit than they do on the actual cars themselves. Granted, you can’t sell the credit if you don’t have the car, but with so many imports available at lower prices, we’ve largely phased out production and focused on debt.  

This is a profitable industry for investment on Wall Street too. Think about what a great position a bank is in that lends out credit at a 10% to 18%. They can pay dividends that rival any old-school blue chip stock, and they have a resource for the promise of future business much more valuable than any natural resource: human greed.

Therefore, investors decide that, not only should we invest in a company based on immediate revenue projections, but based on what we think the stock itself will do in the future, based on public demand/perception. So instead of basing our valuation of stock on the realistic formulae of what kind of wealth they can actually produce, we leverage the P/E Ratios (Price-to-Earnings Ratios) until they are inflated to an incredibly unrealistic degree. We have these companies whose stock suggests a value that would take them thirty years to justify in projected profits, but because momentum begets momentum, the stock keeps going up.

Then, because these companies have all of this “value” in their stock, they use this to leverage borrowing of their own to expand. The lending institutions are the worst about this, leveraging up to thirty-to-one in debt versus real value based on revenue.

On top of all this, about 25 years ago, institutions started bundling mortgage loans as commodities and selling them in bulk on the market. This fueled more interest in trading these bundled mortgages, which succumbed to the same sort of speculation that other stocks have, pushing their prices up way beyond what is reasonable. Of course, there’s more wealth to be had in this sort of market only when there are more mortgages to sell, so we had to start scraping the bottom of the barrel with respect to who would qualify for a home loan and how we would possibly structure it so they could afford it.

So we see things like 40 and 50-year mortgages come along, as well as things like variable interest loans which allow people to afford a home they have no business buying, at least for a while. The individual buyers justify this because either they do not understand what they are signing on for (their own fault, in my opinion), or because they’re banking on being able to refinance or sell the home before the balloon on their mortgage pops. Lenders don’t mind doing this because it gives them short-term liquidity, and then they can bundle all these loans and sell them off to investors, who then try to sell them off.

All of this only works as long as home prices keep going up and people keep taking out new loans. When that didn’t happen, the whole thing fell apart.  So to me, here’s who is responsible:

Ø       Investors (including the average Joe in stocks for savings and retirement) are liable because they put their money into something that had no sound financial basis for its value.

Ø       Investment banks are liable for making profits as fast and as much as they can, while ignoring the reality that, at some point, an over-leveraged system cannot sustain itself.

Ø       The original mortgage lenders are responsible for giving out bad loans in the first place, just to make a few bucks in the short term

Ø       The government is responsible for turning a blind eye while things were going well, unwilling to impart regulation on an industry turning out billions in wealth – and thus, billions in tax revenue and tons of lobbying power – regardless of the fact that it was a house of cards. It was too politically risky to do so.

So we have homeowners overextended on credit, consumer banks overextended on high-risk loans, investment banks overextended on loan packages that are not only already overvalued, but which they borrow on to go into even more debt themselves. Then the stockholders – all of us – are overextended by expecting high returns, regardless of what makes logical sense.

Ø       CEO’s don’t want to be fired for flat stock values.

Ø       Politicians don’t want to be pushed out of office by big corporations for cutting of a source of income for them while the getting is still good.

Ø       Stockholders don’t want to be told that a stock’s value will retract by 40 to 50% because it’s been overvalued for years, and that it will now be worth less, but actually will be based on profitability and dividends.

Ø       Homeowners don’t want to be told “no’ when they want something, period. And they are willing to pay with the wealth and futures of their children and grandchildren to keep from being told “no.”

Here we are. The house of cards has fallen, and everyone wants someone else to blame. The problem is, we all have blood on our hands.

Is the bailout the answer to fixing the problem? I don’t know. Yes, there are some limits and safeguards that can be added to the proposal to limit executive benefits and to help stem foreclosures – at least for now. But ultimately, are we investing close to a trillion dollars in a system that has been broken for a generation at least, and in doing so, are we only forestalling the inevitable collapse which eventually has to come?

In my opinion, America is getting precisely what we all deserve with this crisis.