The Credit Crisis: What It Means and What You Can Do About It
by The best explanation of the Credit Crisis this author has heard was by “South Park.” Why Kyle was right to extend credit, and how you can understand this without watching “South Park” – or listening to talking heads screaming at each other on the financial networks.
Even lenders who didn’t want to play this game of hot potato found themselves making difficult decisions. They either relaxed their underwriting standards, or they lost their loans to lenders who would refinance with relaxed lending standards. Either the lenders had to play, or lose their assets.
What Happened – Part IV
Demand-Push Housing Price Inflation – Then Deflation
What the quants didn’t factor in, nor did their Wall St. bosses mention (flooded in profitability as they were), is that by increasing the demand for houses to include squillions of people who would have never qualified for mortgages under the old, archaic rules, prices would be pushed up to unsustainable levels. It’s in Econ 101, and it’s called demand-push price inflation.
For those of you who live productive, fulfilling lives without having taken (or remembered) Econ 101, if you increase the demand for a thing, the prices will rise until demand equalizes. Unfortunately, before demand equalized, the result of lax underwriting standard produced the inability for many of the people who took loans with newly relaxed standards to actually make payments. And the unthinkable happened.
Those houses all went up for sale, and housing prices throughout the U.S. fell at the same time.
No one knew exactly what percentage of all those loans that were packaged together were the bad ones. They weren’t all bad, but definitely some were. So how much were these packages worth?
No one knew, so no one was buying. The widows and orphans who owned these things, along with banks, insurance companies, hedge funds and zillions of other investors that owned them, had no buyers.
We lost faith in these things. We became non-believers.
What Happened – Part V
Depressing, But Not Depression
Housing is a big part of the economy. It’s generally the largest asset owned by a family. When our house is worth a lot, we’re worth a lot. No matter that if you actually sell the house, you’ll have to buy another one that’s also worth a lot.
We feel rich.
Housing prices are falling. AND, Wall St., a party to this housing problem, also fell, in part because it had sold assets, those packaged mortgages, on which nobody could set a value. Two big parts of the economy went ppppppfft. Our 401(k)s and our houses are both worth a lot less now. Unemployment is over 8% – and climbing. In some parts of the country, it’s over 10%.
We feel poor.
Back when we felt rich, we were fixing up our houses, going on vacations and going out to dinner. Now, we are putting off spending because we’re scared. Banks are scared to lend money, and we’re scared to spend it.
Back at the beginning of our discussion, we said
A lender lends because she believes that the person to whom she extended credit will repay her at a fair return for the risk she takes in lending money. A creditor believes that the cost of borrowing money is less than the potential return on the investment he makes with that money. In other words, the lender believes in the creditor and the creditor believes in the economy.
Why did we stop believing? We felt poor.
What’s Happening Now – Part VI
Renewing Belief
How do we start believing? We look at the facts.
Ninety per cent of us who want a job are still working. An enormous amount of money has been allocated to banks by the Treasury, in order that they start lending money again. These are hard times, to be sure. But the world is not coming to an end.
A huge financial stimulus package is on its way into the economy that is designed to create jobs.
As soon as we start believing that this will work, and behaving in accordance with that belief, the economy will strengthen. Generally, about six months prior to an economic recovery, the stock market will move up. Chairman of the Federal Reserve Ben Bernanke says that he forecasts the beginning of economic recovery at the end of the year. And, we’ve recently seen a 20% upswing in the stock market from its lows.
There are signs that buyers are coming into the housing market, with interest rates at historic lows and lower prices.
All is not lost.
Do you want to help the economy?
Start believing in the recovery, and acting accordingly.
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Post CommentBrian Belefant
On April 7, 2009 at 1:40 pm
There you go again with the widows and orphans.
Kitty OKeefe
On April 7, 2009 at 3:20 pm
Just call me a bleeding heart liberal.
You may use that descriptive term liberally, as it applies to me.
Frances Merritt
On April 10, 2009 at 1:08 am
Kitty O’Keefe, you have done it again, made the complicated understandable – I think you should write a book, your knowledge and your wonderful sense of humor are a slam dunk. Now if you could help me rustle up a couple of those Quants and a few Standard and Poors so I can line them up and slap them a couple of times it would really help me in starting to believe.
On another issue, I am confused about mark to market. Some economists are against changing the practice for banks, while others think it will make banks assets more in tune with what is true. Wasn’t mark to market initiated so banks couldn’t cook the books about their assets? Okay, good idea – let’s keep the banks truthful. On the other hand, as you said, many of the mortgages are good, and people continue to pay them down etc, but since there are many that are bad the bank then has to lower the value on the mortgages even if the homeowner continues their regular payment. So say the loan is $300,000 – the homeowner keeps paying, is not moving, has a steady job but comparable houses have fallen to $250,000 so the bank is then required to lower it’s assets by $50,000 on that one mortgage, even if it is a good loan. The market always goes back up eventually so, let’s assume eventually the house regains it’s value. So I am puzzled as to what is the best answer. Can we trust the banks not to cook the books and remove restrictions of mark to market? Hmmm?
Kitty O'Keefe
On April 14, 2009 at 11:03 am
Great question, Frances. Theoretically, any policy that makes a financial transaction more transparent is a good idea. The problem with mark-to-market is this. What if there is no market? If one cannot attract a buyer, the price must be lowered to the point where buyers are willing to take the risk. But, what if risk aversion in a difficult economic environment is such that there are no buyers at a reasonable price?
In that event, marking to market may cripple a company to the point of driving it to bankruptcy.
A difficult situation, to be sure, and one that FASB addressed adequately with replacing market price with cash flow. With respect to these packaged securities, cash flow, or the amount of payments actually being make on the underlying loans, seems a much more reasonable way of valuing these securities.
Frances Merritt
On April 14, 2009 at 3:34 pm
Yes, it is a difficult question and we shall see how replacing market price with cash flow works, I guess it will all take time to work out. I wish they would value the loans in the securities the same way – resulting in the banks not having to lower their assets as much.