Everyone has an opinion on whether the U.S. government should save these failing industries - wall street, main street, the auto industry, heck even playboy is looking for money. The strange thing although is that no one or at least most people don't understand what caused the U.S. economy to get this bad. Here's how it got so bad:
After 9/11, Alan Greenspan, the chairman of the U.S. federal reserve at the time, feared economic collapse of the U.S. economy, which was already in a recession. Alan Greenspan and the U.S. government felt that the country needed Americans to start spending. Hence Greenspan, who managed the interest rates, reduced the interest rates to point where getting loans became easier and cheaper. This in turn caused mortgage rates dropping to the lowest ever since 1971. These low interest rates attracted more and more people to buy a home. This in turn caused home prices to rise faster than people's income. Not a good sign since home prices are directly related to people's income. An increase in one should lead to an increase in the other and vice versa. Home prices since then kept rising and those who bought during this housing boom were eclectic about how much and how fast they built equity in their homes. Some homeowners even borrowed against this equity to fulfill their dreams - fancy vacations, in-ground swimming pools, whatever they could dream of.
Freddie Mac (FMac) and Fannie Mae (FMae) were two agencies created by Congress to increase home ownership. These two agencies would buy tons of home loans from mortgage lenders, giving mortgage lenders liquid cash to in turn dish out more mortgages to more people.
The mortgage payments that homeowners made each month hence ended up with FMac and FMae. They then pull all the money they receive from these homeowners and sell shares of them in an investment vehicle that is called a mortgage backed security. Their buyers - big institutions like pension funds and rich investors such as hedge funds. FMac and FMae were extremely selective with the mortgages they bought. They only bought those that they knew could actually pay their monthly payments.
Then some time in 2003, FMac and FMae got caught into accounting scandals and lost their dominance in the mortgage market. At this point, someone had to take over for these two agencies - and who took over - the big, bad Wallstreet; who was willing to bend the strict rules that FMac and FMae had established, so that more people could get into a home hence opening the door to subprime mortgages. The birthplace of the subprime mortgage was Orange County, California. Simply put, a subprime mortgage is a mortgage for the credit challenged.
Here's how it all worked (in laymans terms):
Millions of families (most of whom couldn't afford it) take out a humongous loan to buy a house; also knows as a subprime mortgage. The mortgage lender then sells that mortgage to Wallstreet in what is know as a Mortgage Backed Security (MBS). Wallstreet then takes chunks of these MBSs and creates a highly complex structured product called a Collateralized Debt Obligation (CDO). A CDO is categorized into tranches, each trench having a different risk level. The higher the risk, the higher the return and vice versa. Wallstreet then submits this CDO to a rating agency such as Fitch and Moddy's which analyzes these CDOs and slaps a rating on it; kinda like how JDPower and Associates rates cars and other consumer products. CDO ratings range from AAA(highly rated) to BBB (lowest rated). Once a CDO is rated, it's ready to sell. Wallstreet then takes this CDO and puts it in the market for investors - investors who have a boatload of cash lying around and are willing to put it to work for more. These investors include pension funds, municipalities (both U.S. and Ineternational) and filthy rich investors.
Fast forward to 2008, when homeowners realize that they can no longer make their monthly mortgage payments but even worse, the values of their homes are far less than what they had anticipated them to be - causing them to default on their loan and foreclosing their home. Here we are - 2009!
In the midst of writing this blog, a coworker sent me these YouTube links that drives the point home:
After 9/11, Alan Greenspan, the chairman of the U.S. federal reserve at the time, feared economic collapse of the U.S. economy, which was already in a recession. Alan Greenspan and the U.S. government felt that the country needed Americans to start spending. Hence Greenspan, who managed the interest rates, reduced the interest rates to point where getting loans became easier and cheaper. This in turn caused mortgage rates dropping to the lowest ever since 1971. These low interest rates attracted more and more people to buy a home. This in turn caused home prices to rise faster than people's income. Not a good sign since home prices are directly related to people's income. An increase in one should lead to an increase in the other and vice versa. Home prices since then kept rising and those who bought during this housing boom were eclectic about how much and how fast they built equity in their homes. Some homeowners even borrowed against this equity to fulfill their dreams - fancy vacations, in-ground swimming pools, whatever they could dream of.
Freddie Mac (FMac) and Fannie Mae (FMae) were two agencies created by Congress to increase home ownership. These two agencies would buy tons of home loans from mortgage lenders, giving mortgage lenders liquid cash to in turn dish out more mortgages to more people.
The mortgage payments that homeowners made each month hence ended up with FMac and FMae. They then pull all the money they receive from these homeowners and sell shares of them in an investment vehicle that is called a mortgage backed security. Their buyers - big institutions like pension funds and rich investors such as hedge funds. FMac and FMae were extremely selective with the mortgages they bought. They only bought those that they knew could actually pay their monthly payments.
Then some time in 2003, FMac and FMae got caught into accounting scandals and lost their dominance in the mortgage market. At this point, someone had to take over for these two agencies - and who took over - the big, bad Wallstreet; who was willing to bend the strict rules that FMac and FMae had established, so that more people could get into a home hence opening the door to subprime mortgages. The birthplace of the subprime mortgage was Orange County, California. Simply put, a subprime mortgage is a mortgage for the credit challenged.
Here's how it all worked (in laymans terms):
Millions of families (most of whom couldn't afford it) take out a humongous loan to buy a house; also knows as a subprime mortgage. The mortgage lender then sells that mortgage to Wallstreet in what is know as a Mortgage Backed Security (MBS). Wallstreet then takes chunks of these MBSs and creates a highly complex structured product called a Collateralized Debt Obligation (CDO). A CDO is categorized into tranches, each trench having a different risk level. The higher the risk, the higher the return and vice versa. Wallstreet then submits this CDO to a rating agency such as Fitch and Moddy's which analyzes these CDOs and slaps a rating on it; kinda like how JDPower and Associates rates cars and other consumer products. CDO ratings range from AAA(highly rated) to BBB (lowest rated). Once a CDO is rated, it's ready to sell. Wallstreet then takes this CDO and puts it in the market for investors - investors who have a boatload of cash lying around and are willing to put it to work for more. These investors include pension funds, municipalities (both U.S. and Ineternational) and filthy rich investors.
Fast forward to 2008, when homeowners realize that they can no longer make their monthly mortgage payments but even worse, the values of their homes are far less than what they had anticipated them to be - causing them to default on their loan and foreclosing their home. Here we are - 2009!
In the midst of writing this blog, a coworker sent me these YouTube links that drives the point home:
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