I get asked this a lot, from my engineer friends and others who dont really follow the financial sector and American news and global events and such. So I thought it would be nice to outline an unbiased look at what happened and why Secretary Paulson of the Bush administration and now Secretary Geitner of the Obama administration have been bailing out financial institutions.
I wont get too specific but Ill try to explain the things that caused trouble and how they continue to cause trouble.
You are going to need to understand what a Credit Default Swap is, this little financial security is more aptly described as a form of default insurance with some dangerous differences. Credit Default Swaps or CDFs are derivatives that are traded where one person vows to pay a lot of money to another person if a bond or mortgage defaults, so if a company goes out of business such as Lehman brothers or Bears Stern then any CDFs issued for those bonds would then get insurance like settlements. Now CDFs are issued as insurance and the other individual who is in essence insuring against a default of some loan will basically pay periodic small payments in exchange for this insurance. Now if anybody has any knowledge of insurance there are a few basic regulations and rules that make a lot of sense: (1) you must have a certain reserve of cash to cover the potential payouts of insurance. CDFs have no such regulation because they arent technically insurance but considered a financial derivative. (2) You must own the underlying asset in which you are insuring, if you had insurance on your neighbors house why not burn it down and collect a buttload of money, this did not exist for CDFs, you could essentially speculate and gamble with what mortgages or bonds would go belly up, this brings in a lot of bad incentives for people who might prefer that defaults occur.
So yes, you can see that CDFs are flawed instruments that allow companies to really be at risk of gambling more money than they have if some company or some pool of mortgages start being defaulted.
Now lets compound this problem, we have some serious problems with management compensation, from the 1990s on we see a dramatic increase in percentage of CEO and other executive compensation being done in stock options, so instead of being paid for a job well done we have management paid for convincing people that a job has been done well. So how do you do that? leverage (borrowing lots of money) and selling loans that are insanely risky such as liars loans, liars loans are basically loans in which you don't verify information that people are giving you about their income, so you take peoples word on it that they make 100,000 a year even though they might only make 10,000. The fact that lax regulation allowed for liars loans meant that sub-prime mortgages and other risky loans could be issued with impunity. This may seem stupid, why issue risky loans that will make your company do poorly and your bonus will be weakened. True, but only in the long run. In the short run risky loans allow for really high returns because the more risk the higher the interest rate you can charge, these managers get really high and inflated profits for the company in the years in which they are CEO despite the fact that 80% of these loans will end in default and huge losses down the road. Oh, and lets not forget this, the ratings agencies basically started slapping AAA zero credit risk ratings on all these bad loans which then were traded!
Christ, so basically youre a bank, you give loans that you know will probably be bad but then you can bundle these bad loans as securities and get AAA ratings from the retarded rating agencies who were negligent at actually doing their job, then its not your problem anymore. In periods in which banks made stupid amounts of money from risky loans, the executives were able to then get huge bonuses, when the company starts to collapse due to these toxic assets turning bad on them they aren't going to be losing any money and may in the worst case scenario be fired (Oh, please don't fire me, I only gave myself 100 million dollar bonus every year for the 8 years I was CEO, how will I possibly live off that?!). Yeah, boo hoo.
So, Is the Bush administration to blame for this? Yeah they actually are, see it is an ideological problem, the republicans in control just believed that de-regulation was good for keeping strong markets, if you make things a matter of ideology you lose your pragmatism and you lose any aspect of personal judgment. CDFs were horribly unregulated and dangerous but nothing was done because regulation was vilified as bureaucracy and something that would dilute the strength of the booming American economy. Of course we can go back further, the Clinton administration peeled back regulation such as the Glass Steagall Act which was a stupid move which allowed Commercial banks and Investment banks to no longer be separate entities, meaning they would become too big to fail (ie Citigroup). So it isnt a political issue, its an issue of due diligence and competence. The Republicans of the Bush administration and the Democrats of the Clinton administration had the same flawed economic mindset that regulation is simply a way to shrink the pie of the economy, and that government intervention was a bad idea. Somehow all the lessons learned from the great depression were forgotten during the Reagan administration onward, it is not a matter of I am a republican so I believe in deregulation, nope unfortunately this was the one thing that both sides agreed with, mostly because politicians were being paid off by the industries that benefited from this risky behavior.
What does CDFs and deregulation have to do with bailing out banks though?! What the hell is the point of the trillions being spent and the huge deficits? Is it those pinko democrats spending too much? Is it Obamas fault? This seems to be what Faux news thinks, but lets look at why the government felt it had to intervene, oh and before we start blaming Obama remember that the bailout was actually done during the Bush administration, something that the average attention deficit pundit forgets. However, im not going to say the bailouts were bad, you know why? Because the bailouts werent as simple as people make them out to be, what people found was that CDFs and the high degree of leverage of these banks meant that when one institution fell, other institutions would be in risk of failing because they had issued CDFs on the bonds of the first company! All these companies started gambling that each other would not fail, they also gambled that the mortgage market would never decline but would increase steadily, we saw fannie mae and freddy mac the biggest mortgage providers in the world collapse and become nationalized during the bush administration. You want to talk about socialism? The republicans actually were the first to nationalize these large banks so lets not selectively forget that. In fact Secretary Paulson was a staunch free market advocate, he was ideologically very right and very against government intervention, and hes the one who started orchestrating the bailouts and capital injections. I dont blame him though, im actually really impressed with his ability to part with his ideology and handle this crisis, the mistake he made? It wasnt bailing banks out, it was letting one fail; ie Lehman Brothers. He wanted to send a message that you couldnt rely on the government to bail you out, but moral hazard as big an issue as it is, is dwarfed by the systemic risk that was created by deriviatives such as CDFs and the shear scale of banks and insurance giant AIG. When he let Lehman collapse, the crisis accelerated and a domino effect took place, confidence in the markets fell, CDFs on Lehman bonds were cashed in and AIG which was highly invested in CDFs as a consequence began its journey towards insolvency.
This isnt a political issue; the truth is that there is no place for ideology here. Regulation exists for a reason, it wasnt the war that caused this meltdown, it was simply the lack of effort that the Bush administration put into regulating a capital market that was bubbling like crazy. This is such a large issue but at the heart of it is simply a focus away from the due diligence in the white collar finance sector and a changed focus into foreign policy, something which has been disastrous for the US. So please, stop arguing that Obama is a socialist for bailing out banks, he didnt start this, stop blaming government intervention for this recession, the federal reserves actions HAD to be taken because the financial markets were on the verge of complete collapse, you can sit back and critique but the truth is that there was a defining moment in history in which the consequences of deregulation came knocking at Secretary Paulsons door, he had to choose one of two things: (1) let the Capital Markets collapse (2) Bail out these banks.
I may not like the deregulation and lack of intervention that the Bush administration was responsible for, and I fault them for precipitating this crisis, but I do not pretend like the Bailout was a bad decision, there was no third option and the bailout was simply a consequence, not a decision. So please, be thoughtful and do your research before you blame a political party for the problems the world faces now, blame the institutions, blame the corruption that was on both sides of the aisle, blame the ideology that deregulation is good. It is time to stop treating this like something simple, hard lose-lose decisions have to be made when you are reactionary; the real lesson to learn is that regulators and government needs to be proactive and not reactive to these problems. I wish I could go more in detail, but this blog post is already too long, the takeaway point is that you cant always let one institution fail because the deregulated markets have allowed these entities to drag down other banks and cause a domino effect that would collapse the whole market. Support regulation, support initiatives to prevent bad decisions becoming taxpayers burden, and please stop just reading CNBC or Fox and forming your beliefs from a Democrat or Republican set of talking points. Oh and for gods sake, 10 years from now dont forget about this collapse, lets remember a lifelong lesson from the greatest collapse of the financial markets since the great depression.