Getting a Grasp On the Crisis

By Glenn Kessler
Washington Post Staff Writer
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?

All told, the government is on track to shell out more than $1 trillion to solve the credit crunch. And the price may keep going up. Yesterday, the Federal Reserve agreed to give American International Group a $38 billion loan, on top of an $85 billion loan given last month. These loans are backed by collateral. The $700 billion package is intended in part to buy securities that hold low value in the market but which officials hope will rise in value, allowing the government to make back its investment.

Where is the money coming from?

Three letters: Y-o-u. More precisely, the Federal Reserve and Treasury have assets, and Treasury will sell securities to investors to make up any shortfall. Treasury securities are backed by the full faith and credit of the U.S. government, making them the most secure investment possible. But if investors stop buying Treasury securities, then the United States will have to boost the interest paid on them to lure investors, raising the cost of debt financing to the American taxpayer.

How will this affect the budget deficit?

It depends. In the near run, it will increase the deficit as the government borrows money to meet these new obligations. But the government ultimately plans to sell the troubled assets it is buying from financial institutions; as in any sale, the government could make money. Or it could lose money.

The budget deficit hit a record $438 billion in the fiscal year that ended in September, according to the Congressional Budget Office, up from $162 billion last year. Eight years of war, tax cuts and now a faltering economy have doubled the national debt to $10 trillion. Running deficits in a time of economic distress is generally considered helpful, but over time chronic deficits are harmful.

Will China own everything?

China's economy is still going strong at 9 percent annual growth, and it has significant foreign reserves. China, in fact, holds about $1 trillion in U.S. debt, including about $400 billion in Fannie Mae and Freddie Mac debt. There are signs Chinese investors are diversifying, but at this point they appear unlikely to refuse to keep buying Treasury securities or dump much of what they have now. That's because such actions could reduce the value of the dollar and thus the value of their own U.S. holdings.

What does this mean for my retirement?

Perhaps the scariest statistic in the past week is this: The value of U.S. retirement accounts has declined $2 trillion in 15 months -- about $6,500 for every man, woman and child based on current population. For people nearing retirement or in retirement, their nest eggs have taken a real hit. Some of those gains were illusory in the first place, driven too high by the housing bubble. The increased debt load on the U.S. government will also make it more difficult to finance the Social Security deficits that will emerge as more baby boomers retire in the coming decade. That may require the government to cut benefits or raise the retirement age. Remember: It is important to diversify holdings beyond stocks before reaching retirement age so your portfolio will not be as affected by sudden market swings.

How long can this go on?

The market -- and the economy -- will improve only once investors have confidence in the political and business leadership again. Unfortunately, that may take months or even years. The United States has entered uncharted territory, and there are no easy answers or solutions.

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