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Like most people, I have been totally baffled by our economic crisis, and why the fall in home values should have had such a ripple effect throughout. Recently on NewsHour, Paul Solman explained it all. Here is a summary of what he said. I found it incredibly clarifying:

The money you use to buy your house no longer comes from the local bank. It comes from investors, hedge funds, etc.

A Wall St. firm like Bear Stearns buys mortgages. It then sells slices of this mortgage pool in the form of mortgage-backed securities. The investors in these securities are in effect financing your house, and they make money on the interest payments from all the mortgages.

The rate of return on these securities is higher than normal, so they are extremely attractive to investors. And under normal circumstances these investments seemed very safe, since while one mortgage may default, mass defaults were considered highly unlikely.

So investors clamored for these securities, and there was tremendous pressure to lend in order to create them. So borrowers had to be found to put money into them, and people had to be encouraged to buy homes and take out mortgages. Thus lenders kept sweetening the deal, from 20% down on a house to 10% to 5% and then even to no money down at all. Then they offered “non-recourse loans” – where they don’t go after you if you default.

So with no down payment and no accountability, many homeowners found themselves responsible only for the loan’s collateral - the home itself. So if the value of the house falls below what the house was mortgaged for, and you’re stuck with a mortgage for more than the house is worth, you’re better off abandoning the house - especially since with non-recourse they can’t go after you.

If the value of the house falls and you’re a speculator, or you bought in over your head, you are better off just walking away, since you have almost no money of your own invested in the house yet - it is virtually all debt-financed. So you just mail in the key and walk (called “jingle mail”).

From this we get a domino effect, since everything is leveraged. The hedge funds borrow money themselves to lend it to you for your mortgage loan.

The leveraging created “arbitrage” opportunities: the mortgage-backed security pays you 6%, you can borrow money at 5%, and the investment appears to be a sure thing. This provides a powerful incentive to invest as much as you possibly can in these mortgage securities - they seemed like an inexhaustible gold mine.

So investors borrowed money like crazy from banks (CitiBank, JP Morgan Chase, foreign banks) to invest in these mortgage securities.

There is a proliferating chain of lenders. The home buyer borrows the money from a source, which borrows the money from another source to lend it to the homeowner, and on and on. Billions of borrowed cash become trillions. So if the end of the chain (the home buyer) defaults en masse, the whole thing collapses.

The danger now is that panic can set in, and everyone will want out of the system at once [kind of like the Bailey Building & Loan]. Bear Stearns collapsed because no one wanted to lend to it anymore. But then what about Bear Stearns’ outstanding creditors? The Fed Govt. had to do a partial bailout (Bear Stearns was folded into JP Morgan, and the government backed $30 billion of losses) to prevent a system-wide collapse. Because otherwise, Bear Stearns would have declared bankruptcy, its creditors would then also have had to declare bankruptcy, and the entire chain would have fallen like a row of dominoes. That had to be prevented, to save the economic system.

End of summary. Now here is where it gets interesting.

The “bailout” of Bear Stearns was necessary. In fact, it wasn’t really a bailout, since Bear Stearns as it used to be no longer exists. Something had to be done to save the system. Consider the following dialogue between Deborah Solomon of the New York Times and former Treasury Secretary Paul O’Neill:

Do you think it was appropriate for the Federal Reserve to lend a helping hand to Bear Stearns and save a private investment company from its own bad decisions? I would say they didn’t save Bear Stearns. They saved the financial system from a panic collapse. I reject the notion that they helped Bear Stearns. Bear Stearns was destroyed.

No it wasn’t. It was purchased by JPMorgan, which will keep it alive. They’re going to keep the book alive. But the institution of Bear Stearns has been destroyed. They’ve gone from $158 to $2 of equity. It’s wallpaper. It’s not even good wallpaper. It’s butcher paper.

It’s so hard to understand how the subprime mortgage crisis has triggered a financial crisis of global proportions. If you have 10 bottles of water, and one bottle had poison in it, and you didn’t know which one, you probably wouldn’t drink out of any of the 10 bottles; that’s basically what we’ve got there.

Instead of helping Bear Stearns, why doesn’t the Fed help out homeowners? It’s too late now. Going back a year ago, if the Fed and the Treasury had set out to help the institutions provide clarity and differentiate between good loans and bad loans, we wouldn’t have gotten to this freeze condition.

The Democrats are demagoguing the issue. They are playing on people’s resentment, saying that if the government can bail out Bear Stearns, it can surely do the same for the poor individual homeowner. But there is no legitimate comparison. The individual homeowner made a choice for which he/she is responsible. The government relieving homeowners and speculators of their responsibility does not help the larger economy. To the contrary, it only sends a message that you can keep buying things you can’t afford and the government will save you if you get into trouble. That whole attitude is what got us into trouble in the first place. At present the nation has a negative savings rate. We think we can keep on borrowing until there is no tomorrow, then we wake up to find the house caved in and the next generation holding the bag.

John McCain is the only candidate refusing to pander to the homeowners, and the only one who has acted responsibly in response to this crisis. Both Obama and Hillary have been ridiculing McCain for doing nothing about the common guy while advocating a “bailout” of big business. This is demagoguery. People must be accountable for the choices they make, especially when those choices impact badly on everyone around them.

Bailing out people who made bad choices and bought homes they could not afford, or who tried to make a quick buck by speculating with other people’s dwelling places, is not the same as intervening to prevent a panic collapse of the economic system. It supports the wrong values and is highly irresponsible. The Democrats should know better, but there’s no reason for them to care when there are votes to be gotten from pandering to greed and fear - and when they can hope the public will never understand this issue clearly enough to see through that.

The only ones who have reason to care are those who suffer from a rare malady, called integrity. Go John!