The Bailout and Its Big Lesson

To understand why the federal government spent 700 billion dollars to “bail out” banks in the United States, one first has to understand how the financial crisis came about. The crisis has its roots in the home mortgage loan industry. In most industries in America, private companies owned by private individuals function in the free marketplace to provide consumers with good and services. But not the home mortgage industry. In the name of ensuring “home ownership” for every American the federal government created the entities of Freddie Mac and Fannie Mae.

These entities distorted the mortgage market in two ways. First, they directly loaned money to individuals that simply could not afford to make their mortgage payments. Second they “packaged” these loans into securities and sold them to financial institutions as investments.

The financial institutions obviously made, for lack of a better word, idiotic decisions when they invested heavily in these securities. However, part of the reason they chose to invest in these securities was that Fannie Mae and Freddie Mac advertised them as “risk-less.” That is, the government entities claimed that investors shouldn’t worry if some of the debtors could not pay their loans back because, as government entities, the return on the securities was guaranteed because the federal government would simply pay any shortfall.

But when the number of delinquent debtors was greater than expected, a domino effect took place that threatened to bankrupt the entire banking sector. When banks and other financial institutions realized the securities were worth much less than previously thought they were forced to write down those investments on their balance sheet. The enormous write downs decreased the value of the large banks in America. This decease in value forced the banks to refrain from taking further risks by loaning money to businesses and individuals. In effect, lending came close to stopping. Therefore the federal government stepped in with “the bailout” providing the money to keep the banks afloat. Now I believe the bailout was not the right move in the long-term because the government influences the banking sector more than ever. However, there is no question that America would have suffered significant short-term pain if the federal government had not acted.

So what can one conclude from the implosion of the mortgage market and the market’s subsequent rescue by the federal government? In essence, this is an expensive example of the failure of government involvement in commerce. Markets are efficient, sometimes brutally so, and they are designed to maximize efficiency and wealth. Governmental entities have very different goals. Their primary goal is to support constituencies that will, in turn, vote to keep elected officials in power. So while it made no economic sense to loan money to individuals who could not pay the money back, it made a lot of political sense to do so. Those individuals who received the loans were happy they received a nice house, at least for a time, and were happy to vote for the politicians that allowed them access to the loans, through Fannie Mae and Freddie Mac. When your goal is not to create wealth and make money, but to maximize votes it becomes very tempting to distort the market for political gain. Distortions eventually must be equalized and the collapse of the mortgage industry is the first, painful step in the correction of the mortgage market. Over time, the market will return to normal but not after great destruction of wealth and livelihood. Politics and the marketplace don’t mix, and when politicians begin to use an industry for the maximization of votes instead of allowing the free market to function as it should, bad, and this case, disastrous consequences are the result.

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~ The Conservative Guy