Six things you need to know to understand the financial crisis
Financial calamities have come in waves during the past two weeks, each one sending another jolt through the U.S. economy.
These daily — sometimes hourly — developments have included continued declines in the housing market, government bailouts of troubled financial giants, and the disappearance of venerable Wall Street firms. Suddenly, Americans have had to become more familiar with financial terms and learn to navigate complex details about the inner workings of a U.S. and global — financial system that is in crisis.
Why mortgage-backed securities are a problem
During the housing boom earlier in the decade, many lenders relaxed standards and made subprime loans to homebuyers. These loans were risky and had interest rates that rose over the life of the loans, driving up payments. Wall Street bought up these subprime loans, put them into pools, repackaged them, and sold them.
Investors poured at least $1 trillion into these securities backed by subprime mortgages. Then the housing market slowed and home buyers defaulted in record numbers because they couldn’t keep up with mortgage payments. The value of mortgage-backed securities plummeted.
These losses are at the root of today’s crisis. As the housing market continues to decline and the economy slumps, losses are spreading to the traditional mortgage market and threaten to deepen the economic downturn. Investors -pension funds, hedge funds, mutual funds, and banks – have so far lost about $600 billion on securities backed by prime and subprime mortgages, according to Global Insight.
Credit default swaps: a time bomb like mortgage-backed securities
“Financial weapons of mass destruction” is what billionaire investor Warren Buffett called credit default swaps. These arcane financial products brought down the nation’s largest insurer, American International Group.
Credit default swaps are insurance contracts purchased by investors to protect them against losses on their debt-backed securities -AIG lost $18 billion because it had to pay up on policies on mortgage-backed securities.
Swaps became popular among speculators and hedge funds that did not own the underlying securities but used them to turn quick profits. Swaps are also backed by credit cards, car loans, business, and other loans, and a long chain of swap transactions links investors in this $62 trillion market. Many of these bets were made with borrowed money.
“It’s why we’re in this mess,” said Lance Pa, research director for Capital Advisors Group, a Newton money manager. “We understand how it works,” Pa said about the market, but “don’t know where the exposure could lie. That’s the problem.”
The financial market crisis leads to a credit crunch
As losses mounted, panic swept through the financial system. Loans to businesses, banks, and consumers become scarce and expensive, creating a credit crunch. Without loans, there is less spending, which causes the economy to slow.
Corporations are having difficulty tapping the credit market to fund daily expenses, from payrolls to truck leases. American Express reduced credit card limits for more cardholders. And one of the country’s largest auto dealers, Bill Heard Enterprises Inc., went out of business, because it couldn’t arrange financing for car buyers.
The credit crunch is the primary reason that Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke crafted a bailout plan, which Bernanke said was urgent to ease the credit crunch. A bailout allows the federal government to buy mortgages from financial companies. That in turn frees up capital in financial companies so that they can lend to businesses for investments and to consumers for purchases using credit cards and other loans.
“In light of fast-moving developments, it is essential to deal with the crisis at hand,” Bernanke told the Senate Banking Committee last week.
Bailouts could ease the credit crunch
The Bush administration devised a plan to spend $700 billion plan to buy back bad mortgages from faltering financial companies and investors. Add to that the $85 billion federal takeover of American International Group, the nation’s largest insurer, and another $200 billion will be injected into Fannie Mae and Freddie Mac, mortgage companies that support the US housing market.
In total, nearly $1 trillion could be the price tag on the taxpayer-funded bailout — that’s more than $3,000 for every man, woman, and child in the United States.
Nariman Behravesh, chief economist for Global Insight, a Waltham consulting firm, said the final cost will be lower, because the government will sell off many of the assets it is taking over. But even if the mortgage bailout costs $700 billion, that would be equal to just 4.5 percent of US gross domestic product, he said. By comparison, Japan’s bank bailout in the 1980s and President Franklin Roosevelt’s bailout of the US banking system amounted to 20 percent of each country’s GDP at the time.
Banking system remains a problem
The strength of the nation’s banking system -the foundation of the US economy -also is a chief concern for Paulson and Bernanke. Banks have been under severe strain as borrowers have defaulted on their mortgage payments, leaving lenders with portfolios of repossessed homes and rising losses.
While numerous lenders that made subprime mortgages began to fail in 2007, the problems accelerated in recent weeks as major banking companies failed.
IndyMac Bank in Pasadena, Calif., was seized by federal regulators in July. Last week, regulators seized the nation’s largest thrift, Washington Mutual Inc. in Seattle, which was teetering from its portfolio of subprime loans. JPMorgan Chase purchased the thrift for $1.9 billion. It was the biggest such failure in US bank history. Bank of America Corp., the nation’s largest banking company, also acquired Merrill Lynch & Co., the nation’s largest broker.
Going forward, there will be more market share in the hands of fewer financial institutions and less competition.
How bad is the economy: Recession vs. Great Depression?
While the events of the past two weeks were dramatic, they do not rival the Great Depression. Then, 1,500 banks went under, factories closed, and one in four Americans was out of work. The current crisis hit Wall Street hard but has not devastated the US economy. Unemployment in August was 6.1 percent, a historically low rate, and the United States is technically not in a recession, which is defined by two consecutive quarters of negative economic growth -the economy grew 2.8 percent in the second quarter, the latest data available.
However, many economists believe the country entered recession in the third quarter, and if the financial system does not stabilize the economy may enter a long, deep downturn. Next year, Global Insight predicted, the US economy would grow less than 1 percent, and the jobless rate could reach 7 percent -or higher.
Things could be worse without an injection of federal bailout money into the system, which would offset some of the negative impact of the credit crunch, Behravesh, the economist, said.
Kimberly Blanton can be reached at email@example.com.
By Kimberly Blanton