A lot of my friends have asked me how this whole financial crisis came about. I've decided to try and explain it in layman's terms because it is pretty complicated but hey, Life is Complicated right? First of all, I'm not a financial guru and don't claim to be any kind of expert in this area but I do have a pretty profound interest in personal finance and I am always on the edge of the economy to make sure I understand how screwed up or corrupted CEO, politics, or even neighbors affect my financial life. Well, believe it or not, the financial crisis today will affect you, mostly negatively but sometimes positively if you know what you're doing.
So, How did this all Happen?
The best way to explain is to make up an imaginary family, the Adams family, and a scenario.
In 2004 Bob Adams got a job in Phoenix, Arizona making $35,000 a year. The Adams Family were living in an apartment. The Real Estate Market started to rise in value, the average home prices in his area went from $150,000 to $200,000 in 6 months and Bob Adams started to worry that if he didn't buy a house now he would never be able to afford one. He decided to jump on the boat.
The Adams family found their dream home at $210,000 and went to their Mortgage Broker, Joe. Joe told Bob that his monthly payment will be $1,430 a month plus taxes, insurance, and PMI which could run up to $1,550 a month. This is more than half of Bob's monthly paychecks. Joe tells Bob about some other options he has such as an ARM Loan with the option to pay only the interest for 5 years which will drop the payment down to about $900 a month. Bob Adam figures that the home value will keep rising to about $350,000 in two or three years so he takes the loan with a plan to sell the house in a few years to make some major profit.
So the Adams Family moves into their new home and enjoy their cheap monthly payment of $900 a month. Their home value increased $20,000 in 3 months and they are thrilled! Bob gets this idea that if he remodels his kitchen the value will increase even more! So Bob takes out a $10,000 loan using his home equity line of credit to start the remodeling project. Another two months pass and their home value increased even more! You get the idea here.
2006 the Adam's Family home is now worth about $300,000 and the Adams Family owes about $230,000 because they picked the Option ARM loan they did not pay off any interest. Plus they went a little wild with their equity line of credit. Suddenly, home values were too high because most people's income were not increasing the same rate houses were. So people weren't able to sell their houses as quickly, then came the drop in home values. Investors saw the drop and started to panic then everyone wanted to sell their homes to make a profit. Now there are too many homes for sale and not enough people with money to buy. So home prices dropped significantly.
2007, The Adams Family panicked, their home value is now at $250,000 so they put it up for sale. Months after months no one bought it so they dropped their price to $240,000 the exact amount they owe. Still no one bought it. Bob, lost his job and now he was desperate. He had to sell his house or lose everything. After 3 months Bob still couldn't sell and could not make his payments so the bank seized the house and Bob was forced to move out and his credit was crunched.
Now, the bank owns a house worth less than they loaned to the Adam's Family. The Bank finally sells the house at an auction for $180,000 losing $50,000.
Now, what happened to the Adams family happened to millions of families, they were forced to bankrupt their homes and the banks had no choice but to sell the house for far less than the amount the bank loaned the family. So now the banks were losing billions of dollars because of bad loans. This hurt the banks pretty badly so other banks.
Now about banks, the economy requires money to flow from one bank to another, they borrow and lend money to each other to keep the system running. So, as an example, Washington Mutual was in trouble, they lost billions of dollars and needed more money to keep the cash flow in their system, the problem was, other banks knew they were in trouble so they wouldn't buy loans from Washington Mutual. Washington Mutual was pretty much dead and failed. This had a domino effect on other banks in similar troubles. Many banks failed because they made bad loans and no one wanted to buy them.
To sum it all up, the financial crisis is here because of greedy banks giving out way too many bad loans to people who couldn't afford it.
What happens now?
Well, the government had to intervene to make sure banks stop giving out bad loans, to people who wouldn't be able to afford it. Banks got greedy during the real estate bubble, they thought that home value was going to keep rising and it was going to make everyone rich, especially the banks. I don't think they cared if they thought the housing market was going to failed because they were counting on people to pay back the loan regardless. So now the government is figuring out whether they should pump in $700 billion or more into banks to get the cash flowing again. Once property values start to rise again (it will but much much slower this time) then banks will get back on their feet again. The government will also make lending much more stricter, so people like the Adams Family won't get loans they can't afford. This is where it affects all of us. Over the next few years it will be harder to sell our homes because it will be harder for potential buyers to get a loan. Businesses will also have a harder time getting loans, if small businesses can't get the loans they need to operate, they may go out of business and that can mean job losses.
How can this be positive for those who know what they are doing? Well, the stock market is down, certain stocks are cheap and that means that if you pick the right stock and get in the right time it can really pay off. For example, Fannie Mae, Freddie Mac, and AIG stocks has made some people a lot of money! My brother knows someone who bought FNM stocks at .50 cents and sold at $2.50 he made 5 times the amount he put in. I wouldn't invest in those stocks now, its too late but the concept is to watch, now is the time to find those opportunities.
Anyway, thats basically how I see this financial crisis. My 401k was with Merrill Lynch and my funds took a nose dive, thats how I've been affected so far but I'm hanging in there because I'm confident that the market will come back, it always has. If not, well, then money will be worthless anyway and I'll wish I owned gold. Life moves on.
Feel free to correct add comments if I've missed anything. My goal is to explain the problem in a way that helps people understand. The more educated we are about this the better prepared we can be.
Lance
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