What is happening now in the financial markets is no different than what happened to the old Bailey Building & Loan in the famous movie, "It’s a Wonderful Life."
Every Christmas, we watch this movie and shed a tear when George Bailey, played by Jimmy Stewart, realizes he does love his life. His friends and neighbors rally around him in his time of need, and even Clarence the Angel gets his wings.
But do you remember what caused George Bailey to regret his life in the first place and contemplate jumping off the bridge? It was a run on the Building & Loan, whose customers heard rumors the Building & Loan was in trouble and then started pouring in demanding their money.
Now in the movie, the Bailey Building & Loan was in trouble because Uncle Billy "lost" the payment the Building & Loan owed to Mr. Potter’s bank. In today’s economy, there are numerous banks in trouble (though fortunately none here in Wisconsin), not because they "lost" their payments to Mr. Potter, but rather because they invested heavily in high-risk loans. These high risk loans are what you hear described in the media as "subprime" or "mortgaged backed securities."
Several years ago, banks lowered their credit standards, making it easier to borrow money to buy a house. Other financial institutions began buying these subprime loans or just portions of these pooled loans (mortgage backed securities). Financial institutions doing this made lots of money because of the high interest rate charged on these loans. And as long as housing prices were rising and the economy kept going up, everything was OK. In fact, it was the existence of easier credit that spurred housing purchases, which in turn drove up housing prices.
But when the economy slowed – as it always does, as every economy goes through cycles – high-risk loans started to fail. When enough of those high-risk loans started going bad, investors started pulling their money out. Eventually this led to runs on several banks and other financial institutions: Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual (WaMu) and others. These bank runs are the modern day equivalent of the Bedford Falls town folk racing in to take their money out of the old Bailey Building & Loan.
So how do we solve this? Our government has passed a bailout package. Treasury Secretary Henry Paulson, Congress and the President are all in the same position as George Bailey was when he stood behind the counter trying to convince customers to not take their money out of the Building & Loan.
The goal of the bailout package is to calm everything down – restore confidence – stop the bank runs and get the economy going again.
So how does the bailout package work?
- Banks with these bad loans can sell them to the government through a reverse auction process. The government is given $250 million at first to use in buying back bad loans. To get more, the Treasury secretary has to go back to the President and Congress.
- As banks’ balance sheets look better, the theory is this will help banks be able to themselves borrow money and in turn make loans.
- With more money for loans, the economy, which depends on businesses and people buying and investing in order to succeed, will start moving forward again.
- Taxpayers get stock in those banks that sell off bad loans, and the banks again prosper after shedding such bad loans.
- There are limits on executive pay. And to get Congress to approve, there are certain tax breaks, as well as rules prohibiting insurance companies from treating mental health illnesses different than other illnesses.
If the bailout works, banks will be in better financial condition, confidence in the markets will be restored and there will again be access to credit. And the folks in Washington will debate over who deserves credit for the bailout and who should get special tax breaks – in essence fighting for who gets to be Jimmy Stewart playing George Bailey in our national time of need – unless the bailout is just too little, too late.
John Kirtley is a shareholder in the Milwaukee office of Godfrey & Kahn’s Litigation Practice Group. He also is the firm’s marketing partner and a member of its board of directors.