QOTD

UPDATE below:

Where I fear to tread, President Bush tries:

[H]ow did our economy reach this point?

Well, most economists agree that the problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions -- along with low interest rates -- made it easier for Americans to get credit. These developments allowed more families to borrow money for cars and homes and college tuition -- some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs.

Unfortunately, there were also some serious negative consequences, particularly in the housing market. Easy credit -- combined with the faulty assumption that home values would continue to rise -- led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.

Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages who had been planning to sell or refinance their homes at a higher price were stuck with homes worth less than expected -- along with mortgage payments they could not afford. As a result, many mortgage holders began to default.

These widespread defaults had effects far beyond the housing market. See, in today's mortgage industry, home loans are often packaged together, and converted into financial products called "mortgage-backed securities." These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.

The decline in the housing market set off a domino effect across our economy.

See also David Leonhardt in Wednesday's New York Times:

The first thing to understand is that a bailout plan doesn’t have to cost anywhere close to $700 billion, so long as it’s designed well. The $700 billion number that you see everywhere is an estimate of how much the government would spend to buy deteriorating assets now held by banks. Eventually, the government will turn around and sell these assets, for a price almost certain to be greater than zero. So this $700 billion is very different from $700 billion spent on a war or on Medicare.

"Much of the discussion of the cost of the bailouts is getting it wrong," David Colander, an economist at Middlebury College, says. "What matters is what price they buy the assets for and the price they sell them for. That’s where the real action is."

Figuring out how much to pay for the assets is the first problem. The drop in house prices and rise in foreclosures have made it clear that these securities are worth considerably less than banks expected. But there is enormous uncertainty about how much less.

Based on the underlying fundamentals (like the current foreclosure rate and the one forecast for the future), many of the securities appear to be worth something on the order of 75 percent of their original value. But thanks to the fear now gripping the market -- not necessarily an irrational fear, given that most forecasts have proven far too sunny over the last year -- very, very few of those securities are trading hands. Among those that have, the sales price has been roughly 25 percent of the value.

Which price is the government going to pay? As Mr. Colander puts it, that's where the action is.

It clearly shouldn’t pay 75 cents on the dollar, or anything close to it. That would mean the Treasury Department -- which, in the end, is really you and me -- was assuming nearly all the risk. But it probably can’t pay 25 cents. That might fail to fix the credit markets, because it would do relatively little to improve financial firms’ balance sheets. Firms might then remain unwilling to lend money to businesses and households, which is the whole problem the bailout is meant to solve.

The most obvious solution is to pay more than 25 cents on the dollar and then demand something in return for the premium -- namely, a stake in any firm that participates in the bailout. Congressional Democrats have been pushing for such a provision this week, and it’s one of the most important things they have done.

The government would then be accomplishing three things at once. First, it would take possession of the bad assets now causing a panic on Wall Street. Second, it would inject cash into the financial system and help shore up firms’ balance sheets (which some economists think is actually a bigger problem than the bad assets). And, third, it would go a long way toward minimizing the ultimate cost to taxpayers.

Other views from David Wighton at the Times (London) and The Heritage Foundation. Michelle Malkin, Jonah Goldberg and Newt Gingrich (plus blogger bobn) would kill the bailout. Last, but not least, see MaxedOutMama's take on Bush's speech.

MORE:

Andy Kessler in today's Wall Street Journal:

Taxpayers will get their money back on AIG. My models suggest that Fannie and Freddie, on the other hand, are a gold mine. For $2 billion in cash up front and some $200 billion in loan guarantees so far, the U.S. government now controls $5.4 trillion in mortgages and mortgage guarantees.

Fannie and Freddie each own around $800 million in mortgage loans, some of them already at discounted values. They also guarantee the credit-worthiness of another $2.2 trillion and $1.6 trillion in mortgage-backed securities. Held to maturity, they may be worth a lot more than Mr. Paulson paid for them. They're called distressed securities for a reason.

Now Mr. Paulson is pitching Congress for $700 billion or more to buy distressed loans and CDOs from the rest of Wall Street, injecting needed cash onto balance sheets so that normal loans for economic activity can be restored. The trick is what price he will pay. Better mortgages and CDOs are selling for 70 cents on the dollar. But many are seriously distressed (15-25 cents on the dollar) because they are the last to be paid in foreclosures. These are what Wall Street wants to unload the quickest. . .

You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans, suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion -- the greatest trade ever. Every hedge-fund manager will be jealous. Mr. Buffett is buying a small piece of the trade via his Goldman Sachs investment.

Over 10 years this could change the budget scenario in D.C., which can also strengthen the dollar. The next president gets a heck of a windfall. In the spirit of Secretary of State William Seward's purchase of Alaska for $7 million in 1867, this week may be remembered as Paulson's Folly.

(via Tom Maguire)