What caused this mess?

Years ago, mortgage giants Fannie Mae and Freddie Mac began offering sub-prime loans to low-income borrowers. Those high-risk loans were packaged together and sold to various financial firms as mortgage-backed securities. When people began defaulting on their homes, many firms found themselves with securities that were worth less than they thought they were, forcing them to revise their estimates of how much they had in assets. Lehman Bros., for example, had to write down $4 billion in assets and eventually declared bankruptcy.

Did anyone see it coming?

In 2004, several books were published that predicted a crisis as a result of the proliferation of mortgage-backed securities. Congress debated regulating the industry more closely and tightening restrictions on Fannie Mae and Freddie Mac, but the initiative was killed.

What’s being done about it now?

Lawmakers in Washington, D.C. have negotiated a $700 billion bailout package. The plan would allow the government to buy risky mortgage-backed securities from financial institutions and replace them with virtually risk-free U.S. treasury bills. The government would then own large amounts of risky assets. If those assets turn out to be worth more than was originally thought, the government will make money, but if they are worth less, the government will lose the money.

What will the bailout do?

The bailout’s architects believe that if firms are left with mortgage-backed securities on their hands, they will be forced to extend less credit to people and businesses that need to borrow money. A credit freeze could send the economy into a recession. Thus, a bailout that replaces risky assets with treasury bills will allow firms to continue extending credit and prevent a recession.

Is the bailout a good idea?

It depends on who you ask. Some economists argue that firms that engage in risky behavior should be allowed to fail. If the government bails out these firms, they say, it will encourage similar behavior in the future. Others argue that the risks associated with recession are too great to allow firms to fail.

— Meredith Simons/The Daily

Source: Mike Garrison, OU Ph.D student in economics