As effects of the financial crisis ricochet worldwide, the number of taxpayer dollars involved in cleaning up the mess seems to grow by the minute. Stock markets go up and (mostly) down, and every day brings more news of trouble for financial institutions. All of that raises questions for anyone who thought that big rescue package passed by Congress was supposed to, well, rescue the system. Here are some answers:
Q. What's happening?
The world economy is tottering because banks and other financial institutions are afraid to make loans, which has created a credit crisis.
When home prices were soaring in recent years, just about any person or business could get a loan; if they had bad credit, they just paid a higher interest rate. More and more loans to more and more people helped send home values to unsustainable highs. This is known as a bubble, which is financially painful when it pops.
Rising home prices made people feel richer, so they borrowed against the equity in their homes. Banks bought up securities based on those loans. But when the housing market collapsed, those securities were suddenly worth much less and so the balance sheets of the banks were greatly weakened. Banks now are trying to strengthen themselves by hoarding their assets, rather than making loans.
So now you need a sterling credit rating to get a loan. This has a spiraling effect. Orders for new cars have fallen dramatically, which means auto companies are laying off workers. Those workers have less money to spend, affecting other businesses – and the problem just keeps getting worse. If there are few loans and little spending, the country could fall into a deep recession – if it's not already in one.
Q. Why did the rescue package pass but Wall Street keep falling?
The $700 billion package was approved by Congress but still needs to be implemented. Treasury Secretary Henry Paulson Jr. said this week it will be weeks before the government starts buying troubled assets from financial institutions. Investors have been spooked by the realization that the economy will take a while to improve. Also, European officials have been slower to respond to problems in their own banks.
Q. How much will this cost?
All told, the federal government is on track to spend more than $1 trillion to solve the credit crunch. And the price may keep going up.
Q. Where is the money coming from?
Three letters: Y-o-u. More precisely, the Federal Reserve and Treasury have assets, and Treasury will sell securities to investors to make up any shortfall. Treasury securities are backed by the full faith and credit of the U.S. government, making them the most secure investment possible. But if investors stop buying Treasury securities, then the United States must boost the interest paid on them to lure investors, raising the cost of debt financing to the American taxpayer.
Q. What does this mean for my retirement?
The value of U.S. retirement accounts has declined $2 trillion in 15 months – about $6,500 for every man, woman and child based on current population. People near retirement or in retirement have taken a real hit to their nest eggs. The increased debt load on the U.S. government will also make it harder to finance the Social Security deficits that will emerge as more baby boomers retire. That may force the government to cut benefits or raise the retirement age.
Q. How long can this go on?
The market – and the economy – will improve only once investors regain confidence in political and business leaders.