So over the last year, we have watched with confusion and dismay the fall of the critically acclaimed American economy. But just what the heck happened? The Delasol Group offers its humble version of events below for the learning and reading pleasure of busy folks everywhere.
1. Credit is (was) the lifeblood of our economy. You and I use credit to buy cars, houses and education, and governments and businesses use it to finance new projects, maintain payrolls and expand. Without credit, we'd be forced to buy a car when we had the $20,000 saved up to do so. The cost of the privilege to use credit is the interest rate.
2. In the late '90s and early '00s, jobs were abundant and people had money to spend, invest and save. Credit was easy to get then, and one result was that more people were able to purchase homes. More people purchasing (demanding) new homes drives the price of a new home higher and higher.
3. Businesses benefited from easy credit too. They could invest in equipment and new projects and could afford to hire and train employees. Investment banks on Wall Street were getting paid too, because they trade the loans that people and businesses take out to finance their demands. Over the past decade, credit was increasingly "securitized." As an example: an investment bank may purchase a bunch of mortgage loans and sell them to an investor who wants to get in on the action within the American real estate market. The key is that the loans are only as good as the payments you and I make on our mortgages. Trading these mortgage-backed securities makes immediate cash for the bank. At the end of the first quarter of 2006, the mortgage-backed securities (MBS) market was valued at approximately $6.1 trillion. Whoa. These securities were good for a lot of people's wallets, even if they weren't well thought out investments.
4. It soon became obvious that houses were overvalued and too expensive for less-sophisticated borrowers to maintain. People began to default on their mortgages and in turn, mortgage-backed securities lost a ton of value. Investment banks that got rich quick off of MBS products went broke even faster. If people aren't making payments, the loans are worthless, and banks are stuck with bad debt. Bear Stearns was the first to go under in March 2008. Powerhouses Merrill Lynch and Lehman Brothers followed a few months later. The largest insurance company in the world, AIG, was forced to accept corporate welfare in the form of a multimillion dollar bailout from the government.
5. Everybody is broke; no one has the money to cover their debts and no one wants to lend money out because no one believes anyone has money (duh)! This is the essence of the credit crisis. Without credit, everything stops. Businesses and governments cannot expand, hire new people, or support the people they already have, so they lay people off.
6. So that brings us up to speed, Busy People. On February 17, 2009 President Obama signed into law the American Recovery and Reinvestment Act of 2009 to combat the chaos in the economic markets. In short, he's jump starting a new trend in spending since no one else is willing to. The goal of this is to get people engaged in economic activity again so we can move ourselves out of this mire and start doing business as usual. In a future post we will indulge ourselves on the details of the President's plan to save the world (literally) and explore if it's a boom or a bust idea.
What are your thoughts and questions on the Credit Crisis?
