Full disclosure; I am not an economist or an accountant, nor do I play those parts on TV. The opinions expressed below are mine and are based on observation and reading.
Treasury Secretary "Tax Cheat" Geithner finally unveiled his plan to get the credit and banking systems moving again by getting the federal government and private entities (backed by the federal government, including the Fed) to purchase the toxic assets (loans and mortgage-backed securities, or MBS) stuck on the books of many of the top U.S. banks. Many have noticed that with some minor (yet significant) exceptions, what Geithner put out is basically a rehash of what former Treasury Secretary Henry Paulson was originally going to do with TARP last fall before Paulson and the Bush administration decided on bailing out failing banks, insurance giant AIG, and two of the Big Three American automakers, which has continued under the Obama administration (see Dafydd ab Hugh's excellent comparative analysis).
Whether Geithner's plan will work or not remains to be seen. And although I am not an economist, I am very skeptical that it will.
Let's start with a little background; again, this is based on observations and on what I have read. Much of this you may have heard before, but it is good to make sure everyone knows what happened. We have to start with where the toxic assets came from. Back in the 1970s, as we already have seen, the Congress passed the Community Reinvestment Act (CRA), signed by President Carter, which encouraged banks via legislation and regulations to lend money to people normally not able to get mortgages so that those people could buy homes; charges of systemic racism against poor black people by the banks were made in order to get the law enacted.
In the mid-1990s, during the Clinton administration, there was an alteration in the regulations that further hardened the CRA, tying banks' increased lending to the poor (through subprime loans) with good ratings by federal regulators, regardless of whether this was good banking practice or not. Also during the Clinton era, the Gramm-Leach-Bliley Act (GLBA) allowed for greater competition amongst companies in the financial services industry (banks, lending companies, securities firms, insurance companies), as well as end the the Depression-era Glass-Steagall separation of commercial and investment banks; the new law also kept the majority of provisions of the CRA in place, with few modifications. With the CRA and the GLBA, institutions were able to expand into the subprime lending market.
The government sponsored entities Fannie Mae and Freddie Mac, the former being a private company that had been a part of the federal government, with the latter being created as a competitor to Fannie Mae (the government has great input into whom would serve on those corporations' boards, and the financial activities of Fannie and Freddie are backed by a line of credit from the Federal Reserve), purchase the loans in order to keep liquidity in place for the lenders, and in turn sell the loans in the form of securities (the MBS assets). They have great leverage over the loans that they are willing to purchase, able to direct lending institutions who they should be lending to. With the CRA regulatory changes, the GLBA, and pressure on Fannie Mae to increase home ownership to low-income consumers, subprime lending took off, whether they be by banks regulated through the CRA, or through other lending institutions. Housing prices rose in levels not seen in the past, encouraging people and lenders to make riskier and riskier ventures.
Like any other corporation, Fannie Mae needs to keep its accounts in order and pays out bonuses to its high-ranking executives for good performance. However, it turns out that Fannie Mae's leaders had long been "cooking the books" in order for those leaders to garner well over $100,000,000 in bonuses (former Fannie CEO Franklin Raines was charged and fined for his actions, although the charges were dismissed, but the Fannie Mae insurance company, through taxpayer money, actually paid the fine).
But by then, the housing bubble was about to burst as people couldn't pay back the loans they made, and put the survival of banks, other institutions that had made the loans, and homeowners themselves, at risk.
One other subtle, yet important, wrinkle was added into the mix. The Fair Accounting Standards Board (FASB), which sets the accounting rules enforced by the SEC, did the following in late 2007:
The U.S. Financial Accounting Standards Board Rule 157, which is effective for fiscal years that begin after November 15, 2007, will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, the wire service reported.
In effect, the SEC forced MBS assets to be valued at mark-to-market rules, meaning they had to be valued at what their estimated selling price would be instead of what they were purchased at. With the housing bubble burst and the value of homes dropping, the loans and MBS assets on those homes were suddenly worth much less, and those involved with these home loans, including Fannie and Freddie, had to readjust the values of their assets; they found out their assets weren't worth as much as they had been, and nobody wanted to make things worse by further lending; the credit market froze up solid. The SEC has yet to rescind FAS 157.
In addition, the companies themselves weren't worth as much, and shareholders dumped their stocks in those companies. Then the government moved in; things were about to get much worse.