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).

Some want to Outlaw Subprime Mortgages.. I Have a Better Idea.

Umm, let’s not and say we did.

The American Prospect, one of those high-brow magazines you see in the doctor’s office that you don’t bother picking up, has a suggestion on how to avoid the subprime mess going forward. They want the Federal Government, (who brought you the amazing Katrina response and the Walter Reed medical story last year) to help you sub-primers out there. They want to stop those bad ol’ loan-sharking lenders from ever giving out those stupid mortgages again—by banning them.

While it sounds great on paper, I think this is yet another time where we should not let the government step in and try to “save” grown adults from themselves. Usually, nothing good comes from such moves. Most people got into the subprime (adjustable rate) mortgage market to start with because they were (a) looking for a cheap and temporary teaser rate and were planning on preparing for the adjustable part “later on,” or (b) looking for a low rate because the fixed rates at the time were too high to get into a home. For the future, buyers should beware of such temporary fixes.

The blame doesn’t completely rest with the borrower though—some of the lenders who wrote out these “bad” mortgages were receiving excellent commissions to keep the debt pile growing. Eventually, someone had to take care of it; now bank after bank continues to write down billions (yes, with a “B”) of dollars in debt

Stay away from adjustable rate mortgages (ARMs) and interest-only mortgages because you never know what the future holds in terms of your ability to pay. Stick with the fixed-rate mortgages, and you’ll be less surprised (if at all) about how much you’ll be paying five, ten or fifteen years from now. And above all, don't depend on the government to bail you out of poor decisions--it creates a culture of dependency that usually allocates more power to the feds, and usually that's not a good thing, no matter how good it may sound.

Renters Not Escaping the Mortgage Meltdown

From USA Today, there's word that the mortgage meltdown (correction) isn't just affecting the homeowners, but those who are in the rental market are feeling the pain as well:

Already, one in four renters are paying more than half their income on rent — the highest level in at least two decades — according to a study being released Thursday by the Center for Housing Policy. That's up from one in five renters in 1997.

As a renter, all I can say is "Yay, just great.." I personally have locked in my rental rate for the next two years, but I can definitely see it happening. My rent went up about 15% over last year, which did put a significant dent in my budgeting. "Well," you make ask yourself, "How would it affect me, in the future?"

Rents are projected to rise about 4% this year and next. In part, that's because of a shortfall in apartment construction. At the same time, more renters are renewing their leases because they can't qualify for a mortgage. And rising foreclosures are turning some homeowners back into tenants.

I think this 4% number is a bit low. As the mortgage industry continues to shake out those who made a poor choice by buying homes too soon, people will move into rental units in larger numbers. I've also spoken against a bailouts for Wall Street, lenders, and homeowners alike--and actually in support of foreclosed homeowners downgrading to rental units until they can get back on their feet.

I know there are those who may disagree, but I think it definitely will go a long way in preventing this debacle again. What happened is Wall Street took sub-prime mortgage lender debt which are comprised of and sold it on the world markets--often with AAA ratings (meaning that the loans were guaranteed on the same level as the US Treasury). Then, they were astonished when the borrowers, many who weren't saving and overusing credit couldn't pay the lenders, and of course the lenders bombed (and so did Wall Street, at least until they got their bailout).

Long story short--unless you locked in a fixed rate as a homeowner, you may feel the burn of the sub-prime correction until it shakes out. Renters should brace for impact--it won't hurt as much as homeowners feel, but you'll feel it nevertheless.

Tax Freedom Day and Subprime Bailouts

So today is Tax Freedom Day, the day where most Americans have worked off their tax burden for the year. In other words, because the "average American" falls in the 25% tax bracket and assuming you receive relatively equal check payments across the year, all the money that you've made up to this point is about the amount you owe the government. For the remainder of the year, all the money you make is "yours." (A quick note--Tax Freedom Day varies by state because some states have state taxes as well, so in some areas it's later than April 30, in others its earlier, but generally it falls about 1-2 weeks before or after April 30.)

Of course the government already knows that if cannot send you a bill for three-month's salary. The reason is because the government knows that most Americans cannot budget. (Most of us don't know how much money we spent last week, let alone how much we spent in the past month). So, the government gets its cut upfront by taking three months worth of pay from you but they spread it over the whole year.

In other news, some words on the "subprime meltdown." There is word that US Senator Chuck Schumer (one of my Senators, no less) is out to craft a bill that would "bail out" those who received bad loans from subprime lenders. Luckily, it appears not to be gaining traction. From the Washington Post:

"I'm not interested in (a bailout) at this point. I think this problem can be addressed without going down that route," said Sen. Chris Dodd, the Democratic chairman of the committee.

Sen. Richard Shelby, the most senior Republican on the panel, said he would be "unalterably opposed" to a costly federal program to rescue troubled mortgage borrowers and lenders.

"I believe the subprime problem will go on for several years," Shelby said, but added that market forces would be corrective.

Perhaps the spirit of bipartisanship in government isn't completely over. Personally, I think there is too much emotion wrapped up in the debate here. Some feel that they were "tricked" or "teased" into an introductory rate (from adjustable rate mortgages) that went up too high, but I also think it's the responsibility of the person receiving the loan to know what they're getting into. I'm sure the emotion of owning your own home is great—however, as home buyers we should jump into home ownership with caution—saving a couple years for a down payment and buying a home within you means is still the best way to go. Don't be in a rush to buy a home, otherwise you can end up in over your head. They'll still be making homes in the years ahead—I promise.

I also don't think the government should bail out the businesses who made these loans either. Lenders who lent to people with bad credit at teaser rates probably knew exactly what they were getting into. Bailing out either the lenders or the borrower is a bad idea because it sends a message that its OK to buy a house out of your range or to extend loans to those who most likely can't pay it back. It's a tough lesson for many, but it's necessary.

What are your feelings on bailing out those who chose sub prime loans? What about the lenders who issued them? And do you think our tax system is fair? Speak your mind!