I would like to think I have a reasonably good understanding economics and finance. I am not specifically educated in this area but I have read a number of books about the subject. I am open to being called a niff or simpleton here if someone can explain in full how this bailout works other than what follows.

My real thoughts on this bailout are; what does all this money actually achieve?

My understanding is that the US Government will raise 700 billion from their ability to lay tax on the citizens of the USA. They will then have the US Federal Reserve (who are owned by private corporation ‘member’ banks – remember this) to create this money. Once this money is created (no it is not sitting in some vault somewhere) the government will purchase or insure 700 billion dollars worth of troubled mortgage backed securities.

Mortgage backed securities are the crux of this issue. These little beauties are only as good as the people who create them or loan them. In very basic terms if you, Joe Homebuyer, wants to buy a home or commercial property. You go to a bank to borrow money from them to buy said property. They lend you lets say for example $100,000 for this property. Now in essence the bank owns the property and will get interest from you every month to pay for this property.

The bank may have thousands of similar loans that they carry on their books and are at risk too. So they bundle these loans together (with the help of Fannie May or Freddie Mac) and they sell these loans as a ‘mortgage backed security’ (lets call them MBS’s from now on) in a form very similar to a bond. The people who buy these MBS’s vary from super funds to investment banks to anyone really but the major purchaser of these MBS’s is a little group of investment banks that seem to be in trouble at the moment.

So what is causing the issues here?

One problem is the loaning practices of the people lending the money in the first place has slipped greatly in recent years and a lot of the Joe Homebuyer’s out there can’t afford these loans. The people lending money haven’t effectively screened their clients to make sure he or she can afford what they are trying to buy. In the end Joe Homebuyer struggles along for a period and eventually succumbs to the pressure and defaults on the loan.

Not a problem you think, the MBS’s owner still owns the property? True but what happens when there are thousands of defaults and thousands of extra homes/properties available for sale? Well the old simple rule of supply and demand comes into play and the value of these ‘securities’ starts to drop significantly. Suddenly the MBS owner is not getting his interest anymore and the value of the security is dropping, bad darts in anyone’s language.

The second problem is that these investment banks that have bought the majority of these MBS’s have been able to borrow money against them. Yes, they have a security that they ‘sort’ of own and they are able to borrow heavily against it to buy, well, whatever the hell they want to!! And what happens when you borrow against a security that suddenly starts to drop in value? Welcome to house of cards, population investment banks.

Back to my original question, what does this all this money actually achieve?

The government will have the US Federal Reserve (A private corporation remember) create this money to buy these troubled MBS’s from a bunch of investment banks. The concern is that more than likely a large percentage of these investment banks are also the same owners of the member banks that own the US Federal Reserve. You can see how this could look bad to a lot of people and may explain why this wasn’t voted through this morning.