What went wrong?

I am not a mom yet but got introduced to this blog by Sharmiladi. And ever since I came to know about this blog, I have been a regular visitor but this would be my first post. Although this post will be full of depressing things, but I think we should all know what’s going on in the world and how it can affect us and our future generations to come.

Well, no prize on guessing the topic…Its our economy. But as I mentioned, even though its boring to some of you, everyone should have some idea as to how things went so bad and what can it do to us?

I will try and be as simple in my explanations. First of all, what brought us into this mess. It all started with people who wanted to achieve the BIG FAT AMERICAN DREAM in a very short span of time. Lets take an example. There is an average American family who earns $45,000 to $55,000 a year. Given this earning, they wanted to have a house, and two cars. Lets assume that the family lives in San Diego and the average home price in San Diego is $500,000. They went to the bank to get a housing loan. Now comes the bank which plays an important role in this entire drama, perhaps the most important. The banks usually give loans on the basis of some co lateral which means that you have to show some documents or security which will go on to prove that you can pay the mortgage on a monthly basis. Lets say this couple went to Bank A, which, after some casual talking agrees to give them the loan at a very low interest rate and they also mentioned that the couple need not pay any down payment at all. Upon hearing this, the couple went elated and without reading the finer points of the loan agreement signs it and closes the deal. Now, on a $500,000 30 year mortage loan you are making zero down payment and the interest rate is 4.5%. What will be your monthly mortgage payment? Here comes the forgery done by the banks. If these greedy banks would have done their job in the right way, they would have denied this couple from buying a half a million dollar house with zero down payment and $55,000 annual salary. But the banks did not do so. Instead they gave away the loans to whoever came for it. Without checking any financial background, credit history, they just went on giving away these loans. What it did to the housing market? The home prices sky rocketed. People started bidding on the list price. The banks went on giving these loans. But now the question is what happened to these loans and where from the banks got so much money? Well, Uncle Sam was very generous that time to reduce the interest rate to near zero and the banks got lot of cash to give away these bad loans. Next, what will the banks do with so many loan papers? They became greedy and wanted to make more money out of this. So they went on to sell these loan papers as mortgage backed securities to different people and to different institutions.  The institutions like Lehman Brothers, Merrill Lynch also saw how lucrative they were and bought those. Then these institutions sold it to other investors thus creating chains of bad loans called, “credit default swaps”. These bad debts got swapped from banks to banks and institutions to institutions. Now, why will an investor buy such mortgage backed securities from a company like Lehman Brothers? For two reasons: 1. Lehman is a big company with great credibility (till then) and 2. These are insured by giants like AIG which means that if anyone defaults in the loop, your money is secured and insured by AIG…there you go!!! So everyone started buying (institutions and individuals) these mortgage backed securities thinking that it is insured by AIG and nothing will happen to my money.

So far so good……..

Then came the downturn. The housing market started to decline all over United States. Foreclosures started to pile up in the bank’s balance sheet. So, banks fail to pay the interests that it promised to the institutions. Frannie and Freddie went down followed by Lehman and Merrill. They all bought these mortgage backed securities and wanted to make big money. But as soon as the interest rate changed, people started defaulting–>banks defaulted. When people buying these investments went to AIG for their claim of insurance, they tried to pay up at the initial stages but when the size grew they could not afford to pay to the insurer. Uncle Sam had to come to the rescue of AIG because it would have been otherwise catastrophic (a word with which Mr. President seems to be in love with, and quite rightly so). By now, pretty much the picture came clear to everyone. Big investment giants like Merrill Lynch and Lehman Brothers bought these mortgage backed securities and they are left with no alternative other than declaring themselves bankrupt. Merrill was lucky, it got bought by Bank of America.

So, this was the problem of the present crisis in a nutshell. The root of the problem was the credit default swaps which went from one to the other, within the country and outside. I will write in my next post what has been done so far to fix this problem and how good they have been. I will also try and give an idea about what should we do in this economic situation, what stocks to buy, how to invest etc etc..

Enjoy reading!!!! Any suggestions will be highly appreciated.

Disclaimer: Right now, I am at work and typing really fast 🙁 so if there is some typo or something then please excuse me.

Thanks



7 Comments

  1. sarmila

    Really nice writing,, I like your topic! thanks a lot

  2. Yasmin

    Before I quit my job to take care of my twin boys, I used to work as a Collections Officer at a bank. Initially, I was appalled by the way an ‘Average American’ thinks about ‘spending’. He/she lives for today without regard for what may happen tomorrow, usually takes on too much debt and somehow cannot comprehend the consequences of overspending and carrying all that debt. If Americans don’t get their finances in better shape, credit card delinquencies / mortgage defaults will keep rising and banks will be afraid to lend, millions will lose their jobs and the recession will linger on.

  3. Khushi

    Great post, and in a very simple language. Thank you very much

  4. Anonymous

    Can’t wait for your next post.

  5. Pry

    Good Post..Hope the new stimlus package will help us recover…

  6. joysree

    Thank you for the post explaining in such a simple way. One thing is not yet clear to me is why the down turn came in the first place and housing prices started to fall !!
    Will look for a short reference to this in your next post.

  7. Malini

    Congratulations on your first post..Hope to see many more……..

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