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).