This post was written by Allese, Wesabe’s Community Manager.
After yesterday’s failed bailout vote, the ominous headlines are everywhere:
They’re big, bold-faced and downright scary. But what does it all mean?
After reading a few articles over at Yahoo! Finance and scanning Google News, I get that the situation is bad and it’s been bad. From the fall of Freddie Mac and Fannie Mae this past spring, to Washington Mutual’s failure last week and yesterday’s failed bailout, it’s clear that the American economy is in trouble. Outside however, these headlines seem far away — the stores are still crowded, the banks are still open, and restaurants and bars still overflow. Granted, I live in downtown San Francisco, an area where most people I encounter say that they are thus far unaffected by the economic crises.
Walking home last night, I wondered how long it took for the Black Tuesday of 1929 to affect the worker. If we’re headed into economic depression, how do we respond to it? How does one contextualize this crisis to make it hit home?
Trying to make sense of how this all happened for the non-financier (someone like me) is really difficult, as it is so complex. Lacking a degree in Economics, all this can seem like scary jargon. Attempting to answer my questions, I have read a lot and talked to several people about this crisis. Here’s my breakdown in layman’s terms.
It all started with mortgages. Banks were lending money to people who were qualified to get mortgages. These mortgages were very profitable for the banks. Investment firms and banks liked these mortgages, packaged a whole lot of them together, and sold them to larger financial institutions. In turn these financial institutions would repackage these into larger packages sell them higher up and so on. This was very profitable for the resellers, increasing the demand for mortgages, and causing banks and brokers to start lending money to less and less qualified people. At one stage, the bar got so low that you didn’t need to show any income or even have a job to get a mortgage (these were called NINAs – no income, no assets).
Now all this was being financed because home prices in the U.S. kept going up. The individuals who took out these mortgages began using their houses like piggy banks and borrowing against them. However nothing goes up forever. Eventually, the party came to an end, and house prices stopped going up and people needed to pay back their mortgages. But because loans were made to people who did not have the resources to pay them, they were unable to pay them back.
As people could not pay back their mortgages, these loans or pieces of paper, became worthless. Suddenly commercial banks that originated these loans and investment banks that repackaged these loans were left holding worthless (or toxic) pieces of paper. Worse still, investment banks leveraged these pieces of paper compounding the problem. As a result, investment banks such as Lehman Brothers, Bear Sterns, Merrill Lynch and commercial banks such as WaMu and Wachovia could not pay back these loans.
Back to my question, how does this all affect the average American citizen? These dramatic headlines are the beginning of a domino effect. The stock market is generally an indicator of market sentiment, or the way people feel about the future economy. When the market is down 8% in one day, as it was yesterday, there is clear concern and fear.
Banks are now less inclined to lend money to each other because they are concerned that the other bank will fail and not pay back their loan. Subsequently they have less money to lend to businesses and individuals, be it the American corporation looking to expand all the way down to the person trying to buy a car, the student trying to pay for college, or the Mom and Pop sandwich shop. As there is less money to be lent, corporations downsize and people lose their jobs, the Mom and Pop sandwich shop goes under as it is simultaneously unable receive loans to pay for its expenses and people begin to pack their lunches, the eighteen-year-old can’t go to college as he is unable get that student loan and so on.
Kiplinger has an interesting article titled “10 Things That Will Change,” spelling out what they think the economic and financial landscape will be in a few months. According to the article, “In reality, the change isn’t to a new environment. It’s a return to traditional norms of the past, before cheap money inflated asset values, undermined lending standards and encouraged excess risk. It’s bitter medicine, but it’s necessary.”