It's no easy task to keep up with all the intricacies of the housing crisis, the credit crunch and the rest of the economy's doldrums. This week, the Federal Reserve stepped in to negotiate the sale of one of Wall Street's big investment banks, Bear Stearns, and lowered a key interest rate yet again.
To help explain what's going on, Laurence Meyer, vice chairman of Macroeconomic Advisers and a former Federal Reserve governor, and Adam Davidson, NPR's international business and economics correspondent, answer listeners' questions.
I'm still puzzled at how the downturn of the subprime mortgage market has had such a dramatic effect on big financial institutions like Bear Stearns if the subprime mortgages are only a small portion of the American housing market and an even smaller portion are in jeopardy of default. How is this problem causing so much financial difficulty for banks and investment companies? — Jason Burt, Maple Valley, Wash.
It's true that housing altogether makes up only 5 percent of the economy. Subprime mortgages are a much smaller chunk of that, and those in danger of default an even smaller percentage. But one of the explanations is something called leverage, Davidson explains.
Here's how it works: Big banks like Bear Stearns might have, say, $1 million, but they borrow $30 million and invest that in securities backed by the subprime mortgages. It's a great way to make money if the market moves up, because you get $30 back for every dollar you make, Davidson says. But that can also work in reverse: If you're in debt $30 for every $1 you own and the market goes down even the slightest bit, you're in trouble.
So why would banks put themselves in that position? It made sense a few years ago because housing prices on average across the economy had never gone down in the history of the United States, Davidson says. When that did happen, the banks were so exposed — and that exposure was multiplied so many times — that the tiniest downtick in housing prices and the tiniest uptick in the foreclosure rates collapsed the entire system.
We hear endlessly about all the money that has been "lost" due to the subprime debacle. Could you please elucidate where this lost money has gone? Certainly it didn't fall into the sea. — Mary Lynn Buss, Vashon Island, Wash.
Well, in a manner of speaking, it did. Here's an example: Let's say you purchased several shares of General Motors, and you paid $1,000. Every day in the marketplace those shares are revalued, Meyer says. If something happens and you can only sell the shares for $500, there's nobody on the other side. You lose $500. Nobody gains $500. "The value of the total equities in the economy is lower," he says. "The wealth of the private sector is lower."
The news about the economic fallout seems to be getting scarier and scarier each day. Are we headed for another Great Depression? — Arthur Blake, Alpharetta, Ga.
To put things in perspective, during the Great Depression, the unemployment rate rose to around 25 percent, Meyer says. Today, the unemployment rate is only 4.8 percent. So there's a long way to go to reach that kind of economic catastrophe.
In addition, the country now has deposit insurance, which wasn't around then, so the potential for runs on banks is reduced. Also, the federal government, which accounts for 20 percent of the economy, won't reduce its spending during a recession, Meyer says, so that also cuts the risk.
Other safeguards? "We have a very activist Fed who really understands now how to support the economy in times like this, and we have government policy that will certainly come into play if it turns out to be a severe recession," Meyer says.
At the same time that the Federal Reserve is cutting interest rates, mortgage rates continue to rise. There's a lot of confusion with homeowners over the relationship between these two.— Ann Puffer, Haines, Alaska
There are two components to mortgage rates, Meyer says. One is the rate on safe assets, like a Treasury security of the same maturity. Then, you add on a risk premium, because private debt is riskier than government debt. What happened was that as the Treasury rates fell, the risk premiums rose, and the net impact on mortgages was to push them up, even as the Fed was lowering the funds rate, he says.
Where does the Federal Reserve get the money it's loaning to these big banks? Are they printing it? Is it possible to have a bank run on the Federal Reserve? — Brent Griffith, Golden, Colo.
The Federal Reserve isn't printing money, but that's not far off, Meyer says. When it loans money to a bank, for example, it sets up a deposit at a Federal Reserve bank — a deposit the Fed just creates. The Fed can create as many deposits as it wants, to lend as much as it wants.
The constraint is that the Fed does want to get its money back. So it does assess the credit-worthiness of the collateral put up.
"I can't think of any way you could have a bank run on the Fed," Meyer adds. "Remember that the Fed has infinite resources to create as many deposits as they want to. The only thing like a run would be that everybody wants to borrow and the window is simply not going to open for everybody, and catastrophe sort of happens."
What will the effects of the government's economic stimulus package be on the value of the dollar? Won't printing or borrowing more money to inject into the economy only weaken it further and reduce its value abroad? — David Scott, Eagan, Minn.
Several things are weakening the dollar right now, but many economists say this is a healthy and important way for the United States to make up for the many years in which it borrowed more money than it made, Davidson says. Every year, the United States — including citizens, the government, businesses — has been borrowing 5 percent or 6 percent of its income from foreigners to pay for its consumption.
Just like with credit cards, at some point that debt needs to be paid back. One way to do that on a global scale is for an entire economy to pay back the rest of the world by having the value of its currency weakened. It can be painful, but it's also necessary in the long term, Davidson says.