mage67 (mage67) wrote,

Mortgage Crisis explained so far

This post was inspired by trying to answer this post by shesingsnow. It became a long explanation and I have been asked this before, so I hope others can get some benefit from it. Some of this is obvious, so please forgive me if I state things you already know. I tried to make it easy to read.

The mortgage market was a system-wide failure, and there is plenty of blame to go around.

Lenders: Their philosophy of lending was that they could compensate for a bad risk by charging a higher interest rate. However people were bad risks usually because they couldn't pay back money at lower interest rates. So they were even more likely not to pay back at the higher interest rates. Since lenders could potentially make more money with a high interest rate loan, they gave much larger incentives to their rank and file workers to write bad loans rather than good ones. They also purposely mislead borrowers to make them think they could borrow what they couldn't afford to pay back.

Borrowers: Many of them knew better than to borrow money they couldn't possibly pay back. For example, a nurse made $50,000 and borrowed $500,000 for her new house. An educated person should realize that they're extremely unlikely to be able to pay back a loan that is TEN times their annual salary or more. Lenders sometimes fooled people by showing lower payments at first, and then they balloon out of control. However borrowers should have looked at the payment schedule and used some common sense.

Investment Companies: They bought high risk mortgages for a fraction of what they were worth (since they were in danger of defaulting), and counted them as assets and borrowed against them. They figured any defaults could be written off as a loss and be tax deductible. This was the same thing they did in the Junk Bond era, and they should have known it couldn't work by that example alone. So when much of these "assets" turned out to be worthless, they lost those assets and had to pay back the massive loans they took out on now valueless or questionable assets. This was money they didn't have, since their re-evaluated asset value wasn't enough to pay back these loans comfortably.

Regulatory organizations and government: They trusted that it was in a bank's best interest not to lend money to bad risks. After all, they'd lose money if a loan was bad. So they didn't regulate or watch banks nearly close enough to ensure this. However the people writing the loans didn't care about the health of their companies, and just cared about the extra money they'd earn by closing on such deals. Regulatory organizations and government now admit that more oversight is obviously necessary. However they saw many many danger signs and just ignored them and hoped the market would benefit forever from these bad practices. Some of these people might have even been bribed or influenced.

The Solutions:

1. Bear Stearns' failure happened so fast (literally overnight), that the government didn't have time to evaluate the potential damage to worldwide markets. So they backed JP Morgan's purchase in case Bear Stearns investments were more toxic than anyone realized. JP Morgan had a no-lose situation now, since they could buy Bear Stearns at a small fraction of what it was probably worth and if the worst happened, the government covered almost all of the potential loss and would pay JP Morgan back for it.

2. Lehman's incompetence wasn't so bad that it would affect others. Bear Stearns had written so many derivatives that were bought worldwide and their incompetence was so great, that if Bear Stearns wasn't backed by the government, everyone investing in their derivatives would have suffered greatly. Derivatives are basically leveraged investments. So if you buy $10 of derivatives, you could lose many times your $10 investment. This is unlike a stock where you only risk the money you actually invest. Lehman wasn't saved because no one but Lehman would get hurt by letting it fail.

3. The AIG takeover by the government is actually a good investment for the government. They bought almost 80% of the company for a fraction of what it's worth and loaned them money for very high interest rates. AIG is the largest insurer, so every business and individual insured by AIG and their investors were at risk. So by the government taking this action, everyone wins.

4. Freddie Mac and Fannie Mae are the Nation's largest lenders by far. So to have them fail and would also have world-wide consequences since the incompetence was so great.

5. Since more financial institutions are likely to fail soon over this incompetency/corruption, the government has to step in or everyone world-wide will be hurt. Confidence has been so shaken that there seems to be no safe harbor for money. If most people try to get their money and hide it under their mattress or such, then the entire financial system will probably collapse and it would cause world-wide hardship.

How it effects average people: Since financial institutions have less money, they can't lend out nearly as much as before. So expect much higher interest rates on credit card debit and credit harder to get. Since there seems to be few safe investments, you will get less interest in your bank account. Any money the government uses to bail out the system will have to come from taxpayers eventually. A lot of jobs and companies will be lost, so the government will lose a lot of revenue from that, that has to be replaced eventually by tax payers. Also any assets you have probably decreased significantly, since almost all assets depend on financial institutions' health. Companies will have to shed expenses and jobs to deal with this. This will also cause higher prices and inflation for almost everything to make more profit to pay for the problems and higher taxes.

How I hope it will play out: Extreme incompetence/corruption cannot be rewarded. If it is known to be rewarded, then it might become more profitable to have a failed financial institution than an successful one (Anyone who has seen the movie The Producers knows how well this idea works). So hopefully the government will buy out failed financial institutions for pennies on the dollar and actually make a huge profit on it, like they did with AIG. With this profit, it's possible to even pay off some of the national debt. So it's a case where two wrongs do make a right.

What is being talked about is just bailing out these companies without making a profit from them to save the system, since the entire system is collapsing so rapidly. This would be a bad move, but since it's all being revealed so fast, it may be unavoidable.

Is the handling of this fair or just? Of course not. However pursuing justice in every case here would hurt almost everyone even worse. Fixing the problems and stopping people from getting hurt is taking priority over justice here.
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