Our financial system currently faces a severe crisis created by years of lax lending standards and inaccurate predicted default rates for borrowers.

When a borrower takes out a loan to buy a house, their creditworthiness is analyzed by the bank to see what their risk of default is. Prime borrowers pay the lowest interest rate for borrowed funds while subprime borrowers, who bear the highest risk of default, pay the highest interest rate. Borrowers pay down part of their mortgage each month. Mortgage backed security bonds take thousands of mortgages from similar credit demographics (think prime/subprime) and bundle them together.

With bundles of mortgages, the law of large numbers diversifies the risk of default to mirror historic levels. In other words, historic default rates for various credit demographics can be used to predict how many people will be unable to pay in the future. Based on this information the buyers of the bonds can know how much cash to expect and pay an appropriate price for the bond.

A bond is a security which pays a fixed amount of money to the holder. Bonds are sold to the holder in order to raise money. In this case the money is raised to finance real estate purchases.

Like many things in life, the system always works perfectly-except when it doesn't. The recent decline in housing prices has led default rates, especially on subprime mortgages, to skyrocket. When people don't make their monthly payments, the owners of the mortgage backed security bonds don't get paid as expected.

Currently defaults are climbing at unpredictable rates, causing many bondholders to sell. In what seems to be a mirror image of the "irrational exuberance"-fueled dot-com boom, fearful sellers are driving prices of these bonds down. Many experts believe the bonds are trading well below intrinsic value.

In terms of a bond, the intrinsic value is the present value of all future cash flows. Another way to look at it is today's value of all the checks which the bondholder will collect over the life of the bond.

Market value is simply how much money you can sell your bond for at a given point in time. In a world with perfect information, where cash flows are accurately predicted, intrinsic value equals market value. In our world, market value does not equal intrinsic value since people have no idea how many defaults will actually occur.

Banks previously saw these bonds as safe investments and used them as collateral to borrow excessively. When the value of their mortgage backed securities declined sharply, many banks were unable to pay all of their liabilities.

In the wake of Bear Sterns, Lehman Brothers, AIG, Freddie Mac and Fannie Mae-all having severe liquidity issues, the credit markets have frozen up and loans are very hard to come by. Since borrowed funds are crucial to business being done in our financial system, lack of liquidity in the credit markets threatens the stability of our economy.

The bailout package pushed through Congress will use about $700 billion to buy distressed bonds from banks. With the toxic securities removed from their balance sheet, banks will be able to pay off their debts and start lending more freely again. Some experts believe that a financial meltdown will ensue if the bailout is not executed. As Warren Buffett put it last week, failure to pass the plan would trigger an "economic Pearl Harbor."

The government can buy this stuff because, unlike banks, they don't need to pay off any debts in the near term. Checks from the bonds can be collected over time, making (irrational) market prices irrelevant.

In a worst-case scenario, defaults may continue to spiral out of control leaving the value of these bonds below the price paid by the government. In this case the taxpayer will not be hit since the bill states that the president must call for legislation which charges the financial industry for the loss.

While losses are possible, many experts believe that fear in the marketplace is currently driving prices below intrinsic value. In a best-case scenario, the bailout will result in taxpayers gaining a return on their investment. If the government collects checks for more than the bonds cost in the open market, taxpayers will be making money.

In any case, banks will hopefully be freed of their toxic waste and able to once again drive our economy by lending.

Tags: FINANCIAL BAILOUT