Financial Markets--What Just went Down Last Week?

AND WHY IT IS EXPECTED TO CONTINUE...

I want to keep this one simple this week. The following is my attempt to explain what's going on with the government bailouts and explain if it will have a direct effect on you. This week, I hope to explain how everyone--the mortgage borrowers, the mortgage lenders, investment banks, and even the federal government have some of the blame in the debacle we have now. it almost reads like a script with the way all the pieces to this issue fall into place:

The Backdrop
It started when the government started to put more pressure on lenders to help increase home ownership among Americans and end borderline racist processes like redlining (where lenders couldn't give you loans if you lived in certain zip codes). The government also promised to guarantee (co-sign) on the loans. Lenders then aggressively started seeking ways to give our risky loans and to make nice profits while spreading the risk. Thus you saw the re-emergence of adjustable-rate mortgages, intro (teaser) rates, and sub-prime mortgages among buyers. Also, construction companies begin to build lots of homes in anticipation of buyers filling them.

The Ingenious Plan
Buyers applied and refinanced for home loans they couldn't possibly afford, and lenders were eager to give them out. You see, financial engineers had a genius idea: local banks could collect all the loans they gave out (good and bad) sell them to investment banker firms who would "package" and sell them as an investment. Buyers of these packaged, of 'securitized' loans were then sold on the secondary market--businesses like Bear Sterns, AIG, Lehman Brothers, Freddie Mac, Fannie Mae, and Eula Jean (well, maybe not that last one) spread the risk of these securities among investors (remember, they are a collection of mortgages). Investors would make money as people paid their mortgages, and as people sold their homes for a profit (because housing prices ALWAYS go up, right) investors got paid too. These securities were sold everywhere. Investment banks. Businesses. People who owned mutual funds bought them if their mutual fund invested in it.

Trouble
Then, problems started to arrive. Anticipating a sharp rise in the number of homes needed, contractors and construction companies built. And built. And built. And you know what happens to the value of product if the market is flooded with it right? Prices fall. And people were not about to move out of a house that's losing value right? So houses continued to fall in value. No one was moving/upgrading to newer houses because the prices were too expensive and the housing inventories got larger. Then, those teaser rates expired. The adjustable rate mortgages..adjusted up (they were already at 40-yr lows and had nowhere to go but up). Suddenly, people couldn't afford those mortgages they had anymore.


The Perfect Storm Develops
More trouble developed--the economy started to slow down and companies began to cut jobs in manufacturing--people then got under-employed and still couldn't keep up with house payments. They tried borrowing against the increased value of their home, but remember there were too many houses on the market so it wouldn't go up much. Up the chain, those people who were holding on to those mortgage-backed securities saw that people were not paying up, and so they began to bail. However, some of these companies were so heavily invested in these securities that they didn't have the cash on hand to pay everybody who wanted their investments back.

Remember how a bank works? Simplified, a bank takes the money you deposit and keeps maybe about 10% and lends the remainder to other banks and business. So if you deposit $100, they may keep $10 on hand and lend $90 to another bank, who keeps $9 and lends $81, and so on. So your $100 in this could easily turn into $1000. Back to our story.

What happens when a bank can't cover all it's deposits? Who do banks, keepers of money, turn to? Other banks. As long as they trust each other, banks can borrow money from other banks so they can continue making loans to people and businesses and (by extension) keeping the economy going. So we're cool, right?

Trust
Except that the trust was beginning to disappear. Soon banks stop believing other banks would pay the loans back after customers and businesses--even big businesses began filing for bankruptcy because they couldn't pay their loans back. Banks started raising the interest rates (the cost of lending out the money). Some banks stopped lending money altogether, which is bad. The federal reserve stepped in and tried to calm things by lowering the interest rate, but the problem continued to worsen.


And Now?
Well, last week we dodged a huge bullet. When you hear people talk about the "credit tightening up in the market," it refers to money banks lends to corporations (and each other). Basically, companies large and small go to banks all the time to get money to run their everyday operations until the money they get for their transactions come in. Companies depend on banks extending these lines of credit, called commercial paper, to start new businesses and ventures. Well, last week, the banks ran out of this commercial paper. The federal reserve stepped in at the last minute and (ahem) "made more money available." without it, US company operations would have started shutting down pretty quickly.


So I'll leave it there for this week. Next week, we'll get into what's next and the ideas people have on how to fix this problem. If you need a funny summary of this issue, click here (warning, there is strong language there).

Corporate Socialism: More Camel Straw...

The corporate conga line continues this week as more companies continue to line up to ask the federal government to bail them out, er, to provide temporary funding in an unsteady market. You may have heard the term corporate socialism, which has been defined as the phenomena when companies reap profits and socialize the losses (meaning when the market is bad to them they look to the federal government to cover the losses).



How does this affect you? First, a quick reminder of what the heck is going on. I think the blogger from Electoral Vote has a pretty good look on this:

Decades ago, when you wanted to buy a house you went to local bank and applied for a mortgage. If the mortgage was less than three times your annual income and you had a good credit history, the bank would loan you the money and you would pay them interest and some principal every month for 30 years. Then Wall St. got a bright idea: buy up all the mortgages from the banks, collect a few thousand into a pool called a CDO (Collateralized Debt Obligation) and sell shares in it. The owner of each share would get a pro-rata share of the incoming monthly mortgage payments…



What happened? It sounded like a great idea and soon all mortgages were sold and repackaged into shares. It didn't take long before the banks realized that they could issue mortgages of five, six, even eight times the buyer's annual income or sell them to people with terrible credit histories. After all, the shaky mortgages would soon be somebody else's headache. That's what happened. Lehman, Merrill, and others bought billions of dollars of mortgages that the homeowners had no hope of ever repaying on schedule and nobody wanted to buy shares in these worthless CDOs, so the brokers got stuck holding the bag with billions in worthless loans.

So essentially,

Remember earlier this year when Bear Sterns had the Fed bail them out (with the help of the federal government). That was only the start apparently.

- Then there was the nationalization of mortgage companies Fannie Mae and Freddie Mac which own a large percentage of the mortgages held in the U.S.



- This week, Lehman Brothers filed for bankruptcy protection,

- Bank of America, who bough Countrywide financial has now bought Merrill Lynch.

- Washington Mutual is in a danger zone,

- And so is AIG, which was "helped" by the State of New York, who not only let AIG lend $20 BILLION to itself, but apparently has a lot of money they haven't told us New York Residents about.



Basically, it almost seems if you have a commercial on TV, you've got problems.



…and not too far behind these guys is the three major car companies from Detroit, who are all looking for help resolving their debt but haven't come hat-in-hand..yet. All these companies are now asking for help from an over-burdened government which already has a $400 BILLION dollar shortfall. For our sakes, they'd better pick their battles. Because in the end, it's not "The Government" that will pay these bills. They will either print more money to pay the balance off (really bad) or just spread the costs among the taxpayers (bad, but not so much in the eyes of the government).

Don't Teach Financial Education? Are you crazy?

I recently read up on an interview CNN Money had with law professor Lauren Willis on the importance of teaching financial literacy, or rather the importance of not doing it. I was actually puzzled about some of the reasoning behind the idea. To wit:

Lauren Willis, an associate professor at Loyola Law School in Los Angeles who specializes in financial products regulation, says that's the wrong move. She argues that trying to teach consumers to make wise money choices is not only a waste of time and resources, it may be dangerous.

Dangerous? Let me be clear: I think we should approach the teaching of personal finance very carefully. If there are classes that focus directly on this topic, it should probably be carefully evaluated. But to not include it at all in high school or college curriculum raises concern to me. However, here is the point in the interview that concerned me the most, a back-and-forth on budgeting (and shouldn't it be taught):

Q. But aren't basics such as budgeting always applicable?

A. Teaching them is a waste of money. Studies show that sending people to either high school personal-finance classes or adult retirement seminars does not result in better financial behavior.

It may do the opposite. Financial literacy classes give people the illusion that they can successfully manage their finances. So rather than seek help, they end up making worse decisions.

Q. Then what should we do?

A. Stop trying to turn everyone into a financial planner. Instead, try to get everyone to understand that the people selling you financial products often don't have your best interests at heart.

The strange, almost contradictory language I see here is striking: You shouldn't teach people to budget because they may (heaven forbid) try to manage their own money instead of seeking (often overpriced) help, yet you should make sure to tell people seeking help is risky because they may be overcharged.



Here's how I feel about it. Teaching someone how to budget is not difficult. It's pretty simple addition and subtraction. Take out a sheet of paper (or spreadsheet), add up your income and subtract your outgo per month. If you're in the red, that's bad. Avoid that (by increasing income or decreasing spending.)

I would question the studies that determined why teaching people to manage finances don't work. Is it the way it's taught? Is it because most high school kids don't have to shoulder the burden of paying rent or a mortgage and a set of bills?

Bottom line—I think it's the lack of teaching and awareness that causes people to make risky mistakes. The biggest example being the housing debacle the country is still feeling right now. Many people signed on to risky mortgages that have affected the entire market and have caused many banks to fail (and of course, lenders were complicit in these behaviors). Now, we have the government stepping in this week and assuming the debt of big lenders Fannie Mae and Freddie Mac because they are "too big to go under."

This is all because of shady lending practices and consumers who took on the debt without being more educated on the associated risks of such loans. Education is important and counts. At minimum, I think budgeting should be a base minimum teaching for children and adults. Shoot, I still have a lot to learn.

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Hot Links for the Week

Hi guys, sorry for the slowdown in posts, but with the Conventions going on the past 2 weeks, I've been quite occupied. Check out some of these posts of the "Best of the Web:"

* Everybody thinks that we need to put financial education in the schools. Free Money Finance explores the real question: Is it a waste of time?

* Get Rich Slowly lists 5 basic steps for handling credit better. [My suggestion: If possible, avoid using credit ;-)]

*Need cash in a hurry? The Frugal Wench has some ideas.

* And the Harvard Business School blog has a very interesting article up on Indulgence Vs. Regret.

And as far as it comes to me getting my posts together, I will do better!