Getting a Grasp On the Crisis
Thursday, October 9, 2008
As the effects of the financial crisis ricochet around the globe, the number of taxpayer dollars involved in cleaning up the mess seems to grow by the minute. Stock markets go up and (mostly) down, and every day brings more news of trouble for financial institutions. All of which raises questions for anyone who thought the whole point of that big rescue package passed by Congress was to, well, rescue the system. Here are some answers.
Q What's happening?
A The world economy is tottering because banks and other financial institutions are afraid to make loans, which has created a credit crisis.
When home prices were soaring in recent years, just about any person or business could get a loan; if they had bad credit, they just paid a higher interest rate. More and more loans to more and more people helped send home values to unsustainable highs. This is known as a bubble, which is financially painful when it pops.
Rising home prices made people feel richer, so they borrowed against the equity in their homes. Banks bought up securities based on those loans. But when the housing market collapsed, those securities were suddenly worth much less and so the balance sheets of the banks were greatly weakened. Banks now are trying to strengthen themselves by hoarding their assets, rather than making loans.
So now you need a sterling credit rating to get a loan. This has a spiraling effect. Orders for new cars have fallen dramatically, which means that auto companies are laying off workers. Those workers have less money to spend, affecting other businesses -- and the problem just keeps getting worse. If there are few loans and little spending, the country could fall into a deep recession -- if it's not already in one.
The Federal Reserve yesterday cut a key interest rate by half a percentage point in an effort to end this cycle. Normally, this kind of cut would reduce the cost of credit card debt and auto and other loans, which officials hope will encourage enough lending and spending to keep the economy limping along. But the frozen credit markets make it unclear how effective that will be.
Why did the rescue package pass but Wall Street keep falling?
The $700 billion package was approved by Congress but still needs to be implemented. Treasury Secretary Henry M. Paulson Jr. said yesterday that it will be weeks before the government starts buying troubled assets from financial institutions. Investors have been spooked by the realization that the economy will take a while to improve. Also, European officials have been slower to respond to problems in their own banks, further unnerving investors and contributing to sharp declines in worldwide markets. Stock prices are supposed to be a reflection of future corporate earnings. With few loans being made and consumers not spending, corporate earnings are likely to fall. So are stock prices.
How much will this cost the federal government?