An MP3 audio version of this article, read by Dr. Floy Lilley, is available here.
In one word, the market approach to the financial problem is bankruptcy. Firms go bankrupt when they do not have enough revenue to pay their bills. Banks make money by borrowing from lenders at a low interest rate and lending to borrowers at a higher interest rate. If banks make bad loans and borrowers quit repaying, banks go bankrupt.
Insurance firms help people avoid risk, collecting premiums to pay those who suffer bad luck. If the premiums collected by an insurance firm are less than what it has to pay, it goes bankrupt. AIG sold insurance policies to stockholders that banks and other firms would not go bankrupt and could not pay the policies when that happened.
Bankruptcy is a normal part of economic life, covered by laws that guarantee stockholders will be compensated as much as possible. More-efficient firms move in to take over what is left of bankrupt firms, buying what can be put to productive use. There is no crime in bankruptcy and, if handled quickly, little economic harm. When the largest US energy company, Enron went bankrupt a few years ago, there was not even a ripple in the energy markets, much less the economy. Bankruptcy is not criminal and should not be a surprise, but it can be unnerving if large, well-known firms go bankrupt.
Banks and insurance firms are careful when lending or selling policies because they want to ensure their revenue will pay their bills. Government involvement, however, provides a cushion for failure and allows banks and insurance firms to be careless. This carelessness occurred with the government-sponsored mortgage bank, the Federal National Mortgage Association.
Fannie Mae provides backing to mortgage banks, more or less encouraging them to make bad loans. Fannie Mae makes subsidized loans to mortgage companies when they are short of cash. Freddie Mac is a government mortgage bank that sells mortgages without the usual worry of making a profit, given its taxpayer backing. The government has taken over these two losing mortgage banks, and losses will be paid by taxpayers.
October 30, 2008
