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How the Government Mortgage Bailout Affects the U.S. Economy and You

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Government Bailout

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The $700 billion bailout will buy mortgage-backed securities that are in danger of defaulting. This will take these bad debts off the books of banks, hedge funds and pension funds that hold them. The intent is that this will stop the panic that has stopped banks from lending to each other.

Thanks to Congressman Barney Frank, Chairman of the Housing Financial Service Committee, and other lawmakers, there are additional oversights to protect taxpayers. The additional measures include:

  • Bailout installments of $250 billion each.
  • An oversight committee that will review Treasury's purchase and sale of mortgages. The committee is comprised of Federal Reserve Chair Ben Bernanke, and the leaders of the SEC, the Federal Home Finance Agency and HUD.
  • The ability for Treasury to negotiate a government equity stake in companies that receive bailout assistance,if it is the government's best interest.
  • Limits on executive compensation of rescued firms. Specifically, companies will not be able to deduct the expense of executive compensation above $500,000.
  • Government-sponsored insurance of mortgage-backed securities,and other assets, purchased before March 14, 2008.
  • A requirement that the president propose legislation to recoup losses from the financial industry if any still exist after five years.
(Source: CNNMoney, Rescue Bill Released, September 28, 2008.)

How It Affects You

First, the bailout will stop the panic in the financial markets that led to a record $140 billion being pulled out of money-market accounts, usually considered the safest of investments. That's because investors were moving the funds to U.S. Treasuries, causing yields to drop to zero. To stem the panic, the Treasury agreed to insure these funds for a year. In addition the SEC banned short-selling of financial stocks until October 2 to reduce volatility in the stock market. (Source: WSJ, Shock Forces Paulson's Hand, September 20, 2008)

Second, by selling these bad mortgages to the government, banks will no longer afraid to lend to each other. This fear is what is caused LIBOR rates to be unnaturally higher than the Fed Funds rate, stock prices to plummet, and financial firms unable to sell their debt. Without the ability to raise capital, these firms have been in danger of going bankrupt, just as Lehman Brothers did, and AIG and Bear Stearns would have without Federal intervention. By restoring the credit markets to more normal functioning, the bailout bill will give banks the freedom to start making loans again. This means it will be easier to get mortgages and loans for cars, furniture and consumer electronics. In addition, the LIBOR rate should return to its normal level, making loans less expensive so that more people can qualify for them.

With loans more available, consumer purchases should start to increase, helping to boost economic growth. In addition, people wil be able to start buying houses again, which will cause housing prices to stabilize.

Of course, this won't all happen at once, and no one expects that the economy will return to the boom of 2006 right away. At least it will stop the panic, and give markets a chance to return to normal functioning.

Will the government be out $700 billion? No one knows, since no one understands the complex mortgage instruments well enough to say how much bad debt is out there. But, the expectation is that the government will actually be buying these loans at a low price, and selling them years from now at a high price. Of course, some will default along the way, but the total bill will probably be much less than $700 billion.

For an explanation of the events that lead to the crisis, read Financial Crisis Timeline and Could the Mortgage Crisis and Bailout Have Been Prevented?

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