The whirlwind of news surrounding the current financial mess we’re in has my head spinning.
First it’s foreclosures, then it’s Fannie and Freddie and then it’s Merril Lynch and AIG - when will it stop?
But more importantly than that, this rapid destruction of the American financial system has many people wondering how it got started to begin with?
That’s why I decided to write this week’s article in response to this question on TickerHound:
How did this financial mess get started in the first place?So let’s go through it step-by-step, from the beginning until this weekend when the Government announced a $700 billion bailout of the financial services industry. It’s our tax dollars that will be financing this bailout so I think it’s important that we all understand how and why it happened.
I. It all started in the housing and mortgage market:
Basically, lenders were loaning money to whoever wanted to buy a home. Credit score, income and assets became irrelevant terms as brokers and local lenders rushed to issue new mortgages.
It seemed like a relatively “low risk” strategy at the time to many banks. Reason being, they figured that even if people stopped paying their mortgages, the housing market was doing so well that folks could just sell the house for a profit and pay back the remainder of the mortgage.
And that’s really where the trouble started.
II. Then the Investment Banks Got Involved:
Mortgage Backed Securities (MBS) are nothing new on Wall Street. They’re sort of like bonds, meaning there’s a “principle amount” (the amount being loaned) and interest coupons (or payments) that would be paid monthly on the loan. However, MBS’s aren’t single loans.
Instead, these loans were really thousands of individual mortgages all pooled together to create a single, tradable security.
This is another reason why many lenders were happy to keep giving out mortgages to folks (even if they didn’t qualify). Local lenders knew that they’d be able to package up all those mortgages and just sell them right to the big investment banks and not have to worry.
The banks then turned around and would trade these Mortgage Backed Securities like they would a stock or a bond - trying to pocket profits in between each trade.
III. Bubbles
The basic assumption in this whole mess was that housing prices would continue to rise each year.
In fact, that assumption turned out to be pretty accurate. According to the S&P Case-Schiller Index, home prices nearly doubled across the country from 2001 - 2006.
That’s because it was so easy to get a mortgage, everybody wanted to buy a home. Thus spurring demand and in turn driving up prices further.
