Tuesday, October 21, 2008

Economic Downturn: Part III

The most talked-about topic over these last few weeks has been the 700 billion dollar bailout/rescue plan that was proposed by the President and passed by Congress. I must admit, I have been dreading this post because I have yet to make clear sense of it in my own mind. Even my dad, to whom I look at times to glean economic and financial wisdom, said "Good luck with that one".

The first question is, what is the need for the bailout/rescue plan? What would happen if no plan were put into place?

I should preface with the fact that the amount of money a bank is able to loan out is regulated by the Federal Reserve System (The Federal Reserve System, or The Fed, is the central banking system of The United States, headquartered in Washington, D.C.) based on the amount of cash and the value of assets owned by that bank. As I mentioned in previous posts, the value of investments held by large investment banks has fallen dramatically, largely due to foreclosures and declining home values. Therefore, banks are not able to loan out as much money as they try to balance their assets to loan ratio. When banks become more strict in their lending policies, it becomes more difficult for someone to purchase a car, get a home loan, or receive a small business loan. You can imagine how this effects the auto industry and home construction industry. But this also keeps new businesses from starting or expanding, resulting in fewer jobs being available and so on.

Add to this the general fear that people had about the future of the economy. People were wanting to pull a lot of cash out of their bank accounts just for safe keeping. Cash is an asset for banks, and when their cash levels decline, it only worsens their lending ability. This is why one of the first things done by the Federal Reserve was to increase the Federal Deposit Insurance Company's (FDIC) limit on insured cash at a single bank from $100,000 to $250,000. (Basically, what it means to be FDIC insured is when you have a savings or checking account, and the bank is shut down or collapses, you are guaranteed to receive your cash up to the FDIC insured limit.)

Without the proposal of some sort of market protection plan, the financial markets' rapid decline mixed with increased fear would have sent our country straight back to 1929.

That brings us to the second question: What do we do now, and/or how should this $700 billion dollars be spent? That question is why I have taken two days to write this post. I have been reading opinions and recommendations from all sides and have yet to form a solid argument. Generally speaking, it has been determined that the majority of these funds will be used to buy up bad mortgages. The government will hold on to the rights of these properties until the values of the homes increase and they can be sold [ideally] at a profit. But how all of this will be played out is yet to be determined.

Phew! I think tomorrow's post will be a little lighter.

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