The financial markets bailout package passed by Congress and signed by President Bush was intended to unfreeze the credit markets by re-instilling confidence in the American financial system and improving the balance sheets of US financial institutions. But in its current form it will not do enough to help the economy recover and get banks lending again.
The spark that ignited this financial crisis was the steep decline in the price of homes. A number of Americans purchased homes with mortgages they could not afford. Once they began to default on their mortgages, it pushed down housing prices. Depressed housing prices caused more Americans to default on their mortgages as the value of their mortgages began to exceed the value of their homes. And this downward spiral continues.
The decline in housing prices was important for the American financial system because most US banks owned large amounts of complex securities whose value was tied to the US housing market. Those securities became illiquid and plummeted in value once housing prices began to decline. The securities turned out to represent a very large portion of US banks' capital. So much so that many banks worried that the other banks were insolvent (assets were not enough to cover liabilities) and as a result stopped lending them money. If a bank cannot borrow money from other banks, it cannot lend money to other businesses or consumers, and therefore cannot stay in business (a bank's business is essentially borrowing short and lending long). This was then a problem for the US economy because without lending to businesses and consumers, consumers cannot afford to buy things (cars, houses, etc.), and businesses cannot afford to make investments or even produce items that require too much cash upfront.
The bailout package passed by Congress attempts to fix this situation by purchasing $700 billion of the bad debt from banks. The idea is this will improve banks' balance sheets and get them lending again and re-instill confidence in the banking system. Treasury Secretary Henry Paulson also announced the government will be buying small stakes in banks to give them some additional capital. Will this be enough to get banks lending to each other, businesses and consumers again? I say no because the package fails to address the underlying problem which is the continuing decline in US housing prices. Seven hundred billion is only enough to buy up a small fraction of the bad debt on the banks' books, so if housing prices continue to spiral downward (as they will) the banks' balance sheets will continue to decline and the financial crisis will continue. The NY Times has reported that banks are essentially sitting on the bailout cash.
So what should we do instead? FDIC Chairperson Sheila Bair has a good idea. She wants to lend money directly to homeowners to keep them in their homes, which might put a floor on the spiraling decline in housing prices which underpins the poor balance sheets of the banks and keeps them from lending. Without putting a stop to the decline in home prices, this recession may not end for a long long time.