Steve Sturdevant explains the financial meltdown.
Back in September, when the market was starting to melt down and I found myself baffled by the press coverage, stymied by my C- in Macroeconomics and failing to grasp the exact nature of the problems, I wrote an email to my dad in Louisville, asking if he could lay it out for me in concise and easy-to-grasp terms.
This is what he wrote:
Here’s what I think happened.
Interest rates were low, and also there was plenty of money to be lent.
Homeowners were encouraged to buy houses perhaps larger than they could afford. Perhaps due to adjustable rate mortgages and lenders who offer adjustable rate mortgages were not so conscientious about making good loans.
So when interest rates went up, owners began to have trouble. This in itself is not a great problem; that’s happened before.
However, in the mean time, these mortgages were repackaged as securities. That means that the mortgages were made into financial instruments and shares were sold as if those were stocks. These shares were leveraged by allowing the buyers to buy om margin, i.e. the buyers could pay 3% of the value and repay the rest as the interest came in or the value went up, requiring that housing prices rise and that borrowers repay their loans.
So, if you buy at 3% and the loan is paying 6% interest, then you are doubling your money every year. However, if the homeowners default then you don’t make anything, and you still have to pay back that 3% — or, you can sell the shares. So many defaulted that housing prices began to fall. So remember that 3%. If housing prices fall more than 3%, then the shares are worth 3% less than you paid, and you owe more than it’s worth, and you can’t sell for what you have in it, and you don’t have any of the interest coming in. You’re bankrupt. Lehman Brothers.
In the mean time, in order to hedge your bets (you built a hedge around your property so that the foxes can’t get in and eat the chickens), the share holders such as Lehman Brothers bought insurance from AIG so that if homeowners defaulted the insurance would pay for the loans. So many defaults killed AIG.
I’m sure you’ve heard about the Federal Reserve raising and lowering to affect the economy and you’re thinking “Why doesn’t the federal Reserve just lower interest rates and every body’s happy/”
Because of course, that’s bullshit. There’s not enough money to be lent have an effect on these loans.
That’s where some of the $700,000,000,000.00 comes in. The US gov’t will buy up these loans and hope the homeowners pay some of it back. Some of them might.
So who came out the winners in this?
The guy who said “I can get such a good price for my house that I’ll sell it and use the money to travel around the world” He got a great price for his house, traveled, blew half the money on booze and broads and now can come back and buy that same property with the money he has left.
So was he smart or just lucky?
Dad
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