Economic Crisis

This post is a bit of a deviation, from the traditional topics I blog about, but I find it to be a topic of interest.
I am NOT qualified to analyze this. This is from light research and I plan to edit\fix this over the next few days. This should provide some overview on the situation, but treat this as possible misinformation for the moment. Please comment with fixes to the analysis, and I am writing this to help clarify it to myself and provide some understanding as to what this mess we are in is. This is simply food for thought.

The Economic "Crisis"

The year is 1998, we want to stimulate the economy so Mr. Greenspan lowers interest rates. This stimulates buying. Great! Consumer spending! So people go out and buy houses, but few can actually pay for the entire house so they get a loan\mortgage. Times are great, so banks decide to start "sub prime lending." Sub prime lending is when a lender gives a loan to a customer with a higher than normal chance of default. then you have a mortgage crisis. Suddenly many of these borrowers default on their houses; because they are not able to pay for them, and they cannot turn a profit\sell the house to pay it back since the value of the houses has fallen from oversupply of real-estate and over purchasing by buyers. This creates a cascade of effects.

"Liquidity Puts" and (Securitization)
Banks use securities. What does this mean in relation to mortgages? Well basically what banks did is collected all these mortgages and loans together in a package. This package was called a C.D.O. (Credit debt obligation). They then let investors invest in these packages, this is the aspect of what the securitization of the mortgages\loans is.
Now the risk of the loans and mortgage are distributed amongst the bank and the investors in the C.D.O. (collection of the mortgages and loans). Then some banks decided to guarantee the money of the investors, this is called a "liquidy put". This allowed the banks to hand out more mortgages and loans at lower rates, and increase sub-prime lending practices. Well as you can see this isn't what we would call a stable practice.

Now you have a situation where the borrowers are defaulting, so the C.D.O is not a very attractive option for investors. So what investors do is pull out. They take advantage of the "liquidy put" options and suddenly banks have borrowers who do not pay, and investors who are pulling out their money. This leaves banks with a bunch of debt and no one willing to buy the C.D.O. This is where the federal bailout comes in. The government buys these securities, and provides banks with stability where as otherwise the bank would collapse.

Consumer spending and Business
Now we have creditors who are calling in their money, and holding what they have. The puts a crunch on many consumers and affects businesses with loans. The consumers now have more trouble getting good loans for items. This means less demand. Less cars, less optional things. So now we have stores like Circuit City getting in severe trouble, because of falling\negative profit margins. Car makers get hit harder. The Detroit Three (GM, Ford, Chrysler) feel a strangle as the market struggles to regain stability. GM now needs federal assistance. If GM fails many of the parts factories the other companies benefit from will also fall. This creates a problem for Ford and Chrysler who are already in trouble. GM's failure would cause unemployment rates to soar several percent.

Federal Bailout - Where does the money come from?
The money for the bailout is paid in part by taxes, and in part through bonds. A bond is a loan from a party to the government. The government then pays the bond plus some interest back at a later date. Many of these bonds are bought by the PRC. Peoples Republic of China. This is where "our children will pay for it." originates from, since it is them who will be paying for the bonds. The fact China is buying these is not a bad thing is some respect. We offer China's economy a lot of benefit from all the products we buy from them. If we suffer they suffer. It is in China's interest for our economy to do well.

If federal assistance is not offered to the companies it is possible a large portion of several industries would collapse. Unemployment rates would soar, not to mention another cascade of effects. So this is why out government decides to intervene in the economy; which is controversial, because it brings forth the question of how involved the government should get.

Nov 16, 2008