Perhaps we can understand the current credit crisis if we simplify the terms and picture it on a much smaller scale…
I’m Johnnie Bank.
A couple of years ago, I went on a drunken bender and authorized five mortgages of $500,000 each to Joey Irresponsible and his four brothers. I loaned out $2.5 million in mortgages which the Irresponsible Brothers used to buy five townhouses.
Joey Irresponsible and his brothers, it turned out, put no money down. I didn’t verify their income, I didn’t verify their assets, and they quickly found themselves with mortgages they couldn’t pay. Refinancing wasn’t an option as they simply didn’t have enough monthly income to pay any type of mortgage for a house that cost that much. Four of them have gone into foreclosure and the last one is behind in his payments and looks very iffy.
I’ve got four townhouses that are unoccupied and one that might join it. If I’m wise, I’m spending money to upkeep those townhouses so that they don’t look disastrous, mowing the lawn, etc. Right now, the balance sheet here at Johnnie Bank is a mess. Even if I wanted to auction off those four townhouses, the housing market is terrible; I may not be able to find any interested buyers. My cash reserves are low. Even if Sarah Responsible comes in and applies for a more reasonable mortgage, and she and her four sisters have sterling credit scores, I don’t have the cash to loan out. And what’s worse, every other bank is in very similar situation – they don’t have much cash to loan to me, or to the Responsible Sisters. We’re all sitting around, watching the situation get worse. Meanwhile, Joey Irresponsible has long since left the house keys on the kitchen counter and disappeared.
Along comes Uncle Sam, looking suspiciously like Henry Paulson. He comes along and offers me $200,000 for each townhouse and mortgage.
That would mean taking a loss, considering I loaned out $2.5 million. On the other hand, I get rid of four townhouses and one shaky mortgage that are sitting on my balance sheet as giant question marks and preventing me from doing anything else. I go through with the deal, take the $1.5 million loss, and then have $1 million to invest, hold, loan out to Sarah Responsible, etc.
Here’s the real wrinkle – if Uncle Sam/Henry is wise, he’ll take the four townhouses, fix ‘em up a little, and offer to sell them at $250,000 each. Johnny Bank is positioned to loan to Sarah and two of her four sisters and keep a cash reserve of $250,000, or loan to four sisters (with no cash reserves, probably not a wise move). Uncle Sam/Henry is actually making money on this, and he’s in even better shape if the fifth Irresponsible brother turns out to be more reliable in his mortgage payments than we thought. And the thing is, it’s not like Uncle Sam/Henry has some deadline for selling those townhouses; he can wait until the housing market recovers. (Okay, one deadline might be the house falling down from disrepair. But in a good market, a lot in a good location is worth plenty and some will tear down the structure to build a new home to their own specifications.)
This is why it would be really wise to make sure any profits from this deal end up going into the Social Security Trust Fund or deficit reduction. Because if the government plays its cards right – basically, if they don’t wildly overpay for these properties/mortgages/assets, and as long as they’re patient enough — they could end up making money on the deal, and maybe a lot. One optimist in the Wall Street Journal puts it at more than $2 trillion. That’s probably wildly over optimistic. But there’s no reason that this rescue has to be a disastrous financial loss for the taxpayers.
And then we could all live… well, something like happily ever after, once we’ve educated the public on how a breakdown in standards and Fannie and Freddie helped create this mess.