Crisis on Wall Street: Why did it happen and how does it affect us?

This week, America has witnessed the greatest fiscal crisis to hit our nation since the Great Depression. Washington Mutual stands as the greatest bank failure in world history. The bailout of insurance giant AIG is the most dramatic government takeover of a private corporation in American history. The collapse of pseudo-government entities Fannie Mae and Freddie Mac and lending titan Lehman Brothers has stagnated the free flow of credit all across our nation.

These events surely have the empty suits, New York yuppies, and Wall Street fat cats scrambling to protect their vacation homes in the Hamptons, $5000/month leased BMW’s, and multi-million dollar estates. But what does it mean for the rest of us? How is Main Street, Schuylkill County, PA affected by this crisis?

Well, first and foremost, your job may be in danger. Many small businesses rely on small temporary loans from banks and lending institutions to make their weekly payroll. Since this crisis has frozen ALL credit flow in this country, from big city corporations to small town banks, most businesses will not be able to obtain the funds necessary to pay their employees. This means that those businesses will be forced to either lay-off some non-essential personnel or face bouncing some checks come next Friday.

Second, with the stock market’s recent nosedive, many of your 401K and pension plans face a substantial decrease in value now and in the coming weeks. This means that though you may have put thousands away for retirement, your stocks, bonds, and annuities may be worth bubkus very soon.

Third, because most banks don’t actually store all the deposits they receive in their vault, but instead use that money to provide loans and invest in paper securities, their inability to sell that paper and call in those loans can mean that in the near future when you go to use your MAC card at the local supermarket, it may be declined due to the institution not having enough cash to pay the bill.

All of this is scary. I know. But these scenarios go to illustrate that this crisis is not only one that affects day traders and bankers, but also can considerably affect your day to day life. However, the questions still looms in everyone’s (including my) minds: how did we get here?

Now, I am not an economist, but after days of researching the problem and listening to a variety of experts’ explanations, this is what I know for sure:

The problem started back in the early 1990’s in Congress. Congressional democrats and President Clinton started forwarding the idea that “home ownership is a human right”. They felt that it was unfair that the only people who could acquire the loans necessary to buy a home were people with the financial means to pay off the loan and a good credit history. So, they passed legislation mandating that banks and lending institutions start loaning a specific percentage of their funds to poor and minority borrowers. They told these banks to use factors other than credit score, debt ratio, and gross income to approve loans. They changed regulations to include welfare benefits, social security, and food stamps into a prospective borrower’s gross income to inflate their financial viability. Finally, they created a variety of programs that fixed the interest rate of these loans at a very low rate to allow these borrowers the chance to actually pay these loans off. Thus, the “sub-prime mortgage” market was created.

After lenders started issuing these loans, they then sold off bundles of these mortgages to other entities like Fannie Mae and Freddie Mac in order to obtain more cash to loan out more money. Fannie and Freddie would hold these mortgages until such time as they were paid off or increased in value enough to sell them to other financial institutions.

This system worked beautifully when the housing market was booming. In very short periods of time, people saw their home values increase dramatically. If sub-prime borrowers got behind on their mortgages, they would simply sell their property at a profit and obtain another loan for another property or take a second mortgage out on their existing property. To protect themselves possible foreclosure losses and to make some money on the deals, lenders would assign variable interest rates on the second mortgages of these sub-prime borrowers and on middle to upper-middle class borrowers, who they knew had the money to pay off the loan.

New homes construction skyrocketed. Millions of jobs were created. Everyone was happy. That is, until the real estate market stagnated. Too many homes were built in too short a period of time. Supply exceeded demand. The market shriveled. Home values started to decline. Once the escape valve (selling off the property when they got behind on their payments) was blocked for many poor borrowers, properties started going into foreclosure.

Since many of these sub-prime borrowers had re-mortgaged their properties at inflated prices, they owed two and three times as much on the loans as their properties were worth. In foreclosure, banks were losing their shirts. To recoup some of these losses, the adjustable rates on other more stable mortgages began to rise. Middle class families saw their rates increase from 4% to 16% nearly overnight. Soon these “stable” borrowers who had been paying their mortgages religiously for years saw their monthly payments double and triple. After awhile, many of these properties went into foreclosure. That is when the shit really started to hit the fan.

As I mentioned above, for years financial institutions had been trading these bundles of mortgage backed securities back and forth for cash. When home values decreased and foreclosures rose, these securities became toxic. Institutions like Fannie and Freddie and banks like Lehman Brothers and WaMu, who held billions of dollars in mortgages, couldn’t sell the securities they held in order to meet their own obligations, like paying their employees, keeping the lights on, and paying their investors.  Thus, they collapsed under their own weight. In addition, banks couldn’t come up with any cash to lend out to anyone. Thus, credit dried up. And finally, once executives were forced to report this to investors, people began selling off their stocks. Thus, the stock market began to fail.

This is where we are today. So, how do we fix it?

First, credit in this country needs to be turned back on. The only way that can happen is to infuse some of these troubled companies with cash by gobbling up the toxic mortgage securities that they are unable to sell. This is essentially what the government bailout is all about. Treasury Secretary Hank Paulson and FED Chairman Bernie Bernacke believe that the federal government has the ability to hold onto these securities for a longer period of time than normal financial institutions would be and would enable these troubled companies to gain the necessary cash to pay their own bills and start lending out money again.

Yes, the price tag is VERY high. 700 billion dollars to be exact. And the risk to the American taxpayer is great. If the value of these securities don’t increase over the next few years, keeping prospective buyers away, the crushing weight of this debt will force the government to either implode on itself much like Fannie and Freddie, ushering in an even greater crisis or force the government to pass along the bill to the people in the form of increased taxes.

However, the risk NOW is even greater. Look at Japan. During the late 80’s their economy was the envy of the world, but then a similar crisis in the 90’s caused their markets to plummet, credit to cease, and large corporations to fail. Put bluntly, their economy has been stuck in a holding patter for over a decade and their people have suffered greatly. The exact same thing can happen here.

It is clear to me that something has to be done and done quickly. The government must intervene. Now, I have many major problems with President Bush’s initial proposal, which I will address in another post. That said, it is imperative that the government act now to stabilize this economy why they still can or face a greater calamity.

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2 Comments

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2 responses to “Crisis on Wall Street: Why did it happen and how does it affect us?

  1. skittles

    wow what an awesome website!!!your the bomb!!!thanks
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  2. bookworm

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