Why the trouble
If one buys assets, one needs money to fund such a purchase. One can use equity (or capital as we know it) or borrowings (leverage as we know it) to fund the assets. If the assets move up in value, it is possible to sell them off, pay off the borrowings, and make a high return on capital. Lets say we put in Rs 10 as capital, borrow Rs 90 at 10 per cent and invest in an asset worth Rs 100. If we can sell it off at Rs 200 later, we repay Rs 110 to the lender, and on the Rs 10 of capital, we make a profit of Rs 90. This is the simple leverage benefit.
Now if this is too good to be true, heres the downside risk. If an asset can move up from Rs 100 to Rs 200, it can also fall off from Rs 100 to 0. If that were to happen, there will be no money to repay the lender. Therefore, for a structure to be stable, its capital has to be at least large enough to bear the loss in the value of the assets.
In the case of the failed institutions in the US, the values of assets have all dropped after the steep fall in housing prices. This means, they have Rs 10 of capital and Rs 90 of loan, but the asset value is now Rs 20. To salvage the situation, they are only three choices. One, hold on and hope that the assets will go back to Rs 100. This is unrealistic and lenders may not wait for eternity to be repaid. Two, ask the lenders for a write-off. This they will do to some extent, but a large default will require the borrower to declare bankruptcy. Three, bring additional capital to the firm, of say Rs 70, so the assets are transferred to the provider of capital, the loan is paid off, and the provider of capital waits for the asset values to go up. This is what we know as the bail-out.
In this case, the one who brings capital takes the hit of Rs 50 upfront, taking on assets worth Rs 20 while paying Rs 70 for them. He begins to make any money only if the asset value recovers, at least to Rs 70. The US Treasurys proposal is to take over the assets across the system. Lehman went bankrupt as it was unable to raise capital; Merrill got taken over; and several others are struggling to find buyers of the assets, now called toxic because of the rapid fall in value and the danger of a further fall.
Whom to blame
The simple question to ask is: Did the institutions not know that asset values can drop Why would they borrow such a large amount and invest the money is such shaky assets The answer to this question lies in the simple principle that borrowings are not always driven by a view on the value of the asset. They are driven by availability of money and the rate at which it is available. In 2001, the US began to reduce interest rates, to stall a possible recession after the massive meltdown in the technology sector. The low interest rates persisted for too long, well into 2003. The seeds of the current crisis were sown there. Everyone found money available and at very low rates, and there were happy lenders and happy borrowers. These happy borrowers kept buying the assets (houses in this case) and thus pushing prices steeply up. This created a virtuous cycle. More buyers of houses meant higher prices, appreciation in price meant more borrowers, who were now funding these appreciating assets with more and more borrowings. This is how the bloating of assets happened, and everyone believed that housing prices can only move up. When they fell, we are left with crumbling institutions and households that have more debt than they can ever repay.
What will be
When there was a crisis in the 1930s, the US allowed institutions to borrow and fund assets; investment banks that extended themselves materialised, and completely collapsed several years later. When the 2001 market correction threatened to spark a recession, interest rates were reduced; this led to everyone in the system extending their borrowing and creating an asset bubble that burst with disastrous consequences. We now have a take-over of assets and massive bailout as the response to the current crisis, which surely will have some completely unintended consequences. Hopefully we will live to discuss that another day, and with the benefit of hindsight, say what was wrong with the response to this crisis. Until then we shall live with happy conjectures and pet theories.