News and politics, Pontifications

Financial Crises for Dummies, Part 1: Wu-wu-What just happened?

Lately, one of my favorite topics to rant and rave about while at family or friendly gatherings (so much so that I typically make everyone else uncomfortable) has been the Financial Crisis.  And with Washington and policy makers playing this giant smoke and mirrors act with the facts, most people don’t really understand what has happened that has led us to this point.  Just a couple of weeks ago, people were on the news saying, “Our economy is strong!  We’re not really in a recession!”  And now we’re on the brink of total economic collapse.  “What happened?!” is a very fair question.  So…here is a laymen’s explanation:

In the Beginning

To truly understand what’s happening here…we need to look at the precipitating causes of the Great Depression.  Now Ben Bernanke will tell you all kinds of things, but what he knows as a basic truth is this: people made really really really stupid decisions with their money.  Decisions that not only do we generally hold as stupid today, but decisions that there have been laws against, ever since then.  Basically, the stock market was booming.  It was seen as a “sure thing” investment, and many people, even your average Joes, decided to start investing.  And there was the problem…Joe Blow didn’t have much money to invest…but when he did put a little into the stock market, and saw those dollar signs…there was only one thing to do:  Take out a loan, to get more money, to invest.  With interest rates low, and returns high, it was pretty much a sure bet that he was still going to make gobs of money.

Credit can be a great thing, when used properly.  But it also increases the risk of any investment.  If the stock market tanks (which we know it did), then you haven’t just lost your money that you invested, you’ve lost everything.  People mortgaged their homes, and took our unsecured lines of credit, to invest in the stock market.  When it crashed, they lost it all.  Multiply this nationwide, and you see why the economic system collapsed.  People couldn’t pay their bills, 1/3 of banks failed, businesses went under.  It was bad.

Precipitating Events

Let’s skip almost 80 years into future, to about a year ago.  We have laws governing who can borrow for investing in the stock market, and how much they can borrow, to help prevent another similar scenario.  But when the .Com Bubble burst in 2000, and stocks fell, people began looking for other places to invest their money.  Because the economy was struggling, the Fed lowered interest rates (more on why this happened in another post), to help stimulate the economy.  Low interest rates makes it really easy and cheap to buy things on credit.  With 9/11 and the economic turmoil that followed, and rates hitting their lowest points in history, it became almost free to take out a loan and buy some property to resell.  The lower the rates went, the more people bought.  The more people bought, the higher the prices went.  The more the prices go up, the more people look at real estate as a great way to make some money.

What we then saw (as evidenced by numerous TLC shows, like Property Ladder and Flip that House!), was average Joe Blows, with no investment or Real Estate experience, deciding they could make money buying and selling property.  They took on massive amounts of debt to do so, and the real estate market began cooling.  What we have then, is a repeat of 1929.  People made really stupid decisions, took on massive amounts of debt in order to invest, and got screwed when the market started falling.  Only this time it’s the real estate market, and not the stock market.  People can’t pay back their loans, so banks start losing money.  Economic collapse will be forthcoming soon enough.

How did it Happen?

I recently used this example explaining things to a friend of mine.  Just to warn you, this is a very simplistic view of how the banking and monetary systems work, but it’s basically the way it goes.  Let’s say you have $100,000, your life savings.  You go put it in the bank to earn some interest.  The bank says they’ll pay you 3%.  The next day, Jim Bob walks into the bank, and requests a loan for $100,000, to buy a house.  Jim Bob has only mediocre credit.  But the housing market has been so great, the bank gets greedy and says, “Hey!  He may not be able to pay, but then we’ll just sell the house for a 25% profit!  Everybody wins!”  The bank tells Jim Bob he’ll have to pay 6% interest on the loan.  He agrees, and the bank gives him your $100,000, and he goes and buys the house.  Here’s the current situation.  Jim Bob pays 6% annually on the loan.  The bank pays you 3% on your deposit.  The bank gets the difference, 3%, as profit.  That’s how they make their money.

Now, Jim Bob was stupid, and got a variable rate mortgage…so as interest rates go back up, his payments begin to go up too.  Jim Bob can’t seem to get enough money to pay his bills, so he defaults on his loan.  The bank repossesses his home.  Poor Jim Bob.  But wait… the bank now has lost the income it was getting from Jim Bob, but they still have to pay you 3% on your money.  They try to sell the house, in order to get your money back, but the real estate prices have dropped, instead of rising, so they can’t get your full $100,000 back.  They can only get $80,000.  In the meantime, you’ve been watching the news, and decide that you don’t want to keep your money in the bank, because you’re scared it will go under . . . and you’ve got a little over the $100,000 FDIC limit in there now, so you better move quick.  The bank only has $80,000 of your money left, so they have to take $20,000 of their own money (or borrow it from another bank) in order to pay you all they owe you.  Imagine this happening nationwide, and you have what happened last Wednesday night.  The economic system freezes up . . . people won’t lend money to the banks, because they’re concerned about them collapsing, and the banks don’t have enough cash to pay out to their depositors.

And this brings us to today . . . the banks simply don’t have enough money to give their depositors their money, much less meet all the interest payments they owe, pay salaries of their employees, and stay in business.  They were greedy.  They made unbelievably poor financial decisions, and took on way too much risk, because they were betting on a booming real estate market.  They’re trying to get this bailout to happen, so they stay in business.  But this is America . . . a free market economy.  The possibility of total failure is supposed to help you make good financial decisions.  The Bailout is not the answer.  No one will get a home back, because of the bailout.  No one will be able to pay their bills, that wasn’t able to previously, because of the bailout.  The banks will basically just get to dump off the bad debt, and go back to business as usual.

I’m going to refrain from expounding on my opinions on that for now, and save it for another post.  But I hope this has helped shed just a little light on where we’re at, as a nation, and just how dire the situation is.  Make no mistakes.  We are on the precipice of a Financial Crisis.  Perhaps the worst in our history.  Bailout, or no Bailout, we are still on the precipice of a Financial Crisis.  The form it takes, and circumstances that happen because of it will be different, depending on how or if the bailout happens.  But nothing is going to stop this from happening.  Next time, I’ll be talking about what effect this bailout may have, and what effect doing nothing may have, as well.

On that note, have a nice day! 🙂

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