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UWRF professors weigh in on economic bailout

October 9, 2008

The U.S. Senate passed a revised version of the $700 billion bailout Oct. 1 in an effort to alleviate financial burdens that bad mortgages have placed on banks.

“The purpose of this [bill] isn’t to bail out Wall Street,” UW-River Falls economics professor Glenn Potts said. “It’s to keep the credit markets moving.”

The credit markets, the place where people get mortgages, loans for cars and where students get loans for college, froze up because of an increasing lack of trust between banks.

According to Dawn Hukai, an accounting and finance professor, the banks were selling pools of mortgages, called mortgage-backed securities (MBS) to each other. Some of those MBS contained mortgages that were in default or in foreclosure.

“The banks didn’t know what they were buying from each other anymore because they couldn’t trust the securities,” Hukai said. “So banks figured, why should they go buy a security where they don’t know what the price is because it might be underlined with fraud, and at that level these MBS stopped trading.”

Once banks stopped trading amongst themselves, they also were hesitant to lend to small businesses, college students and working adults because the banks began to value cash over lending.

“As soon as it becomes a problem, and you had all sorts of institutions with these bonds [MBS] on their books with questionable value, they have to start raising money to cover it,” Potts said. “So whenever an insurance company or a bank gets a dollar into their hands, they keep it, and they start quitting the lending to each other.”

MBS are littered throughout the economy after being bought and sold by banks all over the country, and the world. After the trading seized up it had a strangling affect over the entire economy, not just the housing sector.

The seizing of the credit market led to unprecedented volatility in the stock market along with the failures of banks like Wachovia and Washington Mutual. To avoid a colossal amount of bank failures, the federal government intervened in late September, as President George W. Bush announced a $700 billion “bailout” for banks.

“With large financial crisis government feels it can’t do nothing,” Hukai said. “The problem is that with financial crises, generally what the government does doesn’t fix the crisis.”

It is too soon to know whether the revised $700 billion bill that passed through congress Oct. 1 will fix the problem. The treasury will sell bonds to foreign investors to raise the $700 billion they will then use to buy the MBS from banks.

“Over the next couple of weeks the treasury will begin the sale of these bonds,” Potts said. “Probably sometime by the end of October you will see the treasury begin to purchase some of these MBS and hopefully the markets will unfreeze.”

The plan is simple enough on paper: an initial $250 billion spent on buying the bad MBS from banks and another $350 billion to be used at the president’s discretion. But as the stock market continues to lose ground and speculation becomes bleaker, the government perhaps cannot stop the problem, they can only hope to contain it.

“It is very possible over the next couple of weeks there will still be some financial institutions in trouble,” Potts said. “But hopefully it is a relatively small amount of trouble and the Federal Reserve System will be able to take care of it with emergency lending.”