I realized after discussing the liquidity crisis today that I really hadn't read an explanation of the banking crisis that I thought was particularly good. Doesn't mean it isn't out there, but I hadn't seen it.
So, long story short, I gave it a crack. I'm no expert, but I have a basic undergrad background in economics and I think I basically get it. There are probably some details that I've screwed up so I welcome constructive/destructive criticism. If someone points out something substantive I can fix in the analysis, I will try to clean it up.
First, read this.
This page gives a good discussion of a liquidity crisis in corporate finance. A macroeconomic "high finance" liquidity crisis is essentially the same thing, only happening with large banks. As in everything in high finance, high-finance liquidity crises are more complex.
One key reason high-finance liquidity crises are much more complex and potentially disastrous than regular corporate liquidity crises is the meshed nature of the problem. When one big bank experiences a liquidity crisis, the bank seeks relief from its creditors in the same way a regular company would. But if the bank's creditors are close to a liquidity crunch themselves, they aren't really capable of making the calculation described in the linked example. The cost of forcing the illiquid firm into bankruptcy and allowing the illiquid firm to borrow additional money while you wait for them to shape up is the same - your own bank enters a liquidity crisis because you needed the cash from the illiquid firm to make your own debt payments.
Once this happens, the banking system has become a bag in search of a bagholder.
That bagholder in this case is the traditional banks, which are theoretically capable of absorbing the problem due to their tightly regulated debt-asset ratios that are much, much more favorable than those of the investment banks that are failing.
What Paulson and Bernanke are saying, and maybe they are right and maybe they are wrong, is that the traditional banking system may not actually be strong enough to absorb the fallout from a liquidity crisis that destroys the investment banking system.
If they ARE right, then it's correct for the government to step in, because the alternative is that they are on the hook as the bagholder for the ENTIRE banking system, unless they want to allow a whole hell of a lot of money to just disappear into thin air.
So that's the impetus for trying to bail out the entire investment banking system - because it's cheaper than bailing out the entire traditional banking system. Once again, of course Bernanke and Paulson could be wrong. But that's their argument, and at least in Bernanke's case he has no real personal stake in the call other than wanting to be right.
Now, that doesn't speak to HOW to step in. In fact, it doesn't even prove you SHOULD step in. There are other questions in that regard. One that's very important is "Is what we are doing going to work?"
On that I think there's great cause for skepticism. Even if Bernanke and Paulson think that there's very little reason to believe their plan will work, if they are worried that the banking system may fail they will obviously feel a strong subjective responsibility to try SOMETHING.
The Paulson plan does, on its face, make sense. If the investment banking system is failing, the problem is large but finite. All you have to do is provide enough liquidity to allow the failing firms to make it to the point where they've successfully taken enough of their "problem debtors" through the process described in the linked example that they've made it out clean on the other side.
The problem is, the original Paulson plan is not a particularly good deal for Treasury, because they are taking on a lot of risk and they aren't really on the hook to reap any windfall for that risk if the plan works and the banks recover. All they get in that case is the interest on the money they loaned out (which isn't nothing, but it's not commensurate with the amount of risk that's being taken on.)
The compromise the House Democrats cobbled together was a pretty good one in that regard – they are essentially buying a mix of toxic mortgage securities (which may be perfectly decent at the price they are paying, or they could be worth much less than the price they are paying) and stock options (which theoretically could wind up being worth a great deal of money, giving the government at least some upside in exchange for the big risk they are taking.)
The main problems remaining are tied up in the question of the actual solvency of the investment banks. If there are a significant number of INSOLVENT investment banks, meaning that they actually have more debts than assets, then there's not a heck of a lot that can be done.
The big problem for the next president is going to be what to do when the 700 billion allows the banking system to, say, limp along for a year before slipping into another liquidity crisis. If that happens, we'll be at a real crossroads because no one will want to accept that we wasted all that money, but you also have to draw the line somewhere.
Now that a deal has been reached, we'll never really know, at least anytime too soon, whether this deal was necessary. We'll know fairly soon whether it was sufficient.