Feb 262009What Happened to Our Economy – In Plain English

flatline

This is the first part of a three part series about our economy. It seems the economy is on everyone’s mind and on every news channel. I know many people are confused by how we got here and what is going to happen. In preparation, I was doing some additional research and one article likened our economy to a middle-aged man who had a heart attack. I didn’t really agree with their explanations but I thought the analogy was a good one.

heartThe Attack
Imagine our economy is a middle-aged man. He might appear relatively healthy on the surface but those close to him know he has unhealthy habits. That was our economy a little over two years ago. Wall Street thought we looked good. Retailers thought we looked good. But the mortgage companies and credit card companies knew we had some unhealthy habits. Then boom, 18 months ago the attack happened.

What Caused The Attack
Humans need blood circulating to survive. Our economy needs money and credit to survive.  When banks stopped lending money, consumers couldn’t get loans. Without loans, homeowners could not refinance their houses. Unable to pull out the equity in their homes, they couldn’t buy things. Thus no money was being spent. No loans + no consumer spending = blood clot.

french-friesHow Did the Arteries Get Clogged
When someone has a heart attack it isn’t because the arteries were clogged overnight. It is a long process. In this case there has been a series of events that caused the attack.

1. With so many people living beyond their means, the number of people with good credit who were able to qualify for a loan was slowly dwindling. Mortgage brokers needed to find more people that could qualify for a loan.

2. So mortgage backed securities came into the picture. This is basically an investment tool initially used by smaller banks to lend money to their customers. How they work is that lots of mortgages are bundled together into one lump. Then the bank sells this package to investors. It allows them to lend money without risk to them of customers being able to pay. They pass the risk to the investors.

house3. Banks were able to lend money to people that normally wouldn’t have been able to qualify because they could couple several riskier mortgages with a good one and be able to sell the mortgage backed security package. Since so many people were able to buy homes, home prices went up and up and up.

4. When home prices went up, many homeowners refinanced their houses. Two problems occurred here. First when they refinanced, they accepted an adjustable rate mortgage instead of a fixed rate because the ARM was cheaper. Many homeowners assumed that since house prices were escalating, they could refinance again before their rate changed to the higher rate. Then, second mistake, was when they refinanced their house instead of using the equity to make their payments lower, they took out the equity in their home and used it to pay off their credit cards or do a home improvement project.  And with balance-free credit cards, they felt comfortable running them up again because they assumed they could just refinance again and everything would be fine. Think of this as super-sizing your French fries.

5. The next problem is also two-fold. Firstly, many of those people couldn’t actually afford the original house payment because either they or their broker lied on their loan application about their income level. Then secondly, when the house increased and they refinanced and took out the equity, they REALLY couldn’t afford the new loan payment. So they began to default. This is when the blood starts thickening in the arteries.

foreclosure6. When people started defaulting on their loans, the investors who bought the mortgage backed securities started losing money. They weren’t buying new packages and credit came to a stand-still. With no new credit, no one can refinance and their adjustable rate mortgages adjust to the higher rate. Now more homeowners can’t make their payments and the situation snowballs as more and more people default on their loans.

7. Now you know the rest, it’s what’s been on TV. Mortgage lenders start failing; all the investors who bought the securities are failing. No one can get credit and either all your money is going toward your mortgage or you are saving it because you are afraid you will be laid off. Thus no money is flowing. Heart Attack.

Treatment
This is where we are now. Our government has out the defibrillator paddles and is attempting a jump start…or two or three. Keep in mind that many people don’t die from heart attacks but it does take lots of therapy and re-learning healthy habits to get back on track. Unless you take the necessary steps, you’ll have another heart attack. The same goes with our economy. So next week, I’ll address What Happens Next and the following week, How to Recession Proof Your Life.

Feel free to leave comments with observations or further questions. However, please note that this post is about the economics of the economy and not the politics of the economy. Any comments related to politics will be deleted.


Comments

  1. Wow Shellie. This was really helpful. Thanks for spelling it out in such a reader friendly format.

  2. I am out of debt now, but am scared to put any money into mutual funds and even the interest rates on Internet banks are blah.

    Although, they are much better than my old bank that’s “too big to fail” that I left last summer. I just read that their interest rate for savings is 0.01%. Yes. It makes even my credit union’s 0.3% look really good.

  3. Good read. For any of your readers that want a visual to back what you have shared, I recommend watching the Crisis of Credit Visualized video. It’s 11 minutes long but another helpful tool to understanding all this. http://www.crisisofcredit.com/

  4. Great post.

    And also — it’s not just when people lie on their mortgage applications when people get in over their heads. When we applied for a loan for our house, they quoted us some crazy high figure for the house we were able to afford — the amount we were approved for. There’s no way we would have been able to afford that… and we bought a house $35,000 under what they quoted us, and it was STILL a stretch some months.

    I have no idea on how they got to their numbers.

  5. Thanks Shellie- I passed this on to my friends who seem to be walking around in a fog, grasping for an explanation to this disaster.

  6. I followed this link from my guest post at Homemaker Barbi. Very good info. Thanks for sharing! Amy