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The current credit crisis has impacted multiple sectors of our
financial economy. Home foreclosures are on the rise. Credit-worthy
consumers struggle to secure mortgages. Investment banks are brought
to their knees. Foreign and domestic stock markets experience
gut-wrenching volatility. The Federal Reserve is forced to take
historical steps to maintain liquidity. And the list goes on.
In an effort to help the ordinary investor make sense of it all,
here's the first part of a simplified explanation of the credit
crisis that has overtaken our economy. Hopefully you'll come away
with a better understanding of the situation, along with some
lessons you can apply to your own personal finances.
As with all true disasters, a series of mistakes are made that
culminate into a full-fledged crisis. History provides us with many
examples, including the sinking of the Titanic, the stock market
crash of the 1920s, and more recently, 9/11 and Hurricane Katrina.
In each case, a series of circumstances, along with multiple human
errors, combined to bring about a true disaster.
Such is the case here. We can't just blame the banks, or the
mortgage companies or the housing market or the Federal Government.
This was a real group effort and there's plenty of blame to go
around in this chain of events.
Let's start the story at the beginning of the chain, with the
American homebuyer. We all know how to buy a home. If your income
and credit score are high enough, and your outstanding debts are low
enough, you can get home loan from a bank or mortgage company. And
many people do. But as home prices continue to rise and the supply
of credit-worthy consumers dwindles, a way has to be found to keep
the mortgage profits flowing.
So loan requirements are relaxed. Adjustable rate mortgages, with
low initial teaser rates, are introduced. Down payments are lowered
or eliminated altogether. Documents proving credit worthiness, like
income tax returns, are no longer required. Loans for more than the
price of the house are given. Suddenly almost anyone can get a loan
for more house than they can really afford. But that's no problem,
certainly not in the middle of one of the hottest housing markets in
recent memory. House prices are going up like a rocket and everyone
wants to go along for the ride.
Once a bank or mortgage company gets a loan, they turn around and
sell it to investment banks, freeing up capital so they can loan
even more money. The investment banks, believing that these
mortgages have been given to credit-worthy consumers, in turn sell
groups of mortgages to shell companies they create. This way these
mortgage loan assets are off their books, freeing up capital they
can reinvest to earn even more profits.
The shell-companies don't have the capital requirements that banks
do, so they can leverage these loans even more by issuing short-term
commercial loans to institutional buyers and hedge funds. They are
earning more off the mortgages than they are paying on the
commercial loans, so they make a profit. The rates offered on the
commercial loans aren't high because the mortgage bonds
collateralizing them are AAA rated.
The institutional buyers like the AAA ratings of the underlying
bonds, and buy large amounts of the short-term loans they're based
on as a secure source of income. Everyone believes that these groups
of mortgages are well diversified and are from credit-worthy
consumers, hence the AAA rating. As long as house prices keep
climbing, everyone is happy and keeps making money.
So far, our chain of events is all about leverage. The homebuyer
leverages a small (or no) down payment and monthly house payments to
fund a substantial mortgage. The bank or mortgage company leverages
the profits from these loans to loan even more money. The investment
banks that purchase these mortgages from the original lenders are
able to move them off their balance sheets and into shell companies
they create, leveraging them even further. The shell companies
leverage them yet again, allowing them to make even more loans and
helping institutional investors increase profits.
In our
next article, we'll see the tragic consequences when all this
leverage is turned on its head and the house of cards based on a
booming housing markets collapses.
Nationally-syndicated financial columnist and Certified Financial
Planner(R) Jeffrey Voudrie provides personal, in-depth money
management services and advice to select private clients throughout
the USA. He'll answer your financial question for FREE at
www.guardingyourwealth.com. |
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