Our economy is in a crisis, according to every morning talk show and news program. The problem is so complex, it is nearly impossible for the average person to understand it.
I thought I would take a moment to simplify it. This way, we each have a common understanding.
Let's begin.
1. What is the problem?
One word - credit. Banks and lending institutions are reluctant to lend money to anyone, including each other. Unlike the Great Depression of 1929, where the problem was liquidity (the availability of cash) , this economic crisis hinges on banks unwilling to make loans.
2. Why is this a problem?
Credit allows out economy to grow. Let's use your family car as an example. The average American can't afford to pay cash for a $20,000 car so they borrow the money. Now let's say the average credit score in the United States is 620 (which is considered "good") but banks are unwilling to lend money to anyone with a credit score less than 720.
Now the average American can't buy a new car which then spills over to General Motors and Ford. They sell fewer cars, which leads to layoffs and plant closures. They also cut contracts with suppliers, like Pretty Products for floor mats. These suppliers, in turn, have to layoff workers and close plants. Now the laid-off workers can't afford to shop for groceries or Wal-Mart items, which lead to reduced sales for retailers. The economy starts a tail spin downwards, banks won't lend money and the economy grinds to a halt.
3. Why are banks unwilling to lend money? What caused the problem?
Two words - real estate. For example, a bank has $2 million to loan out. It will use 50 percent to make home loans and 50 percent for other loans (car, business, credit cards, etc.). So it makes $1 million dollars in real estate loans, each worth $200,000, for people to buy five homes at 6 percent interest. The bank then bundles these five loans and offers to sell it to an investor who is looking to make a 5 percent on his investment.
The bank keeps 1 percent to pay employees and other expenses. The investor buys the mortgages and gives the bank $1 million dollars. Thus, the bank has another $1 million to loan out.
Now, let's say one of the five borrowers goes into default and stops paying. Now instead of making $60,000 in interest per year, the interest is now only $48,000. The investor is unhappy because they aren't making what they were promised.
In the past, banks would seize the property and regain the money by selling the house. Banks now offer a new loan with the proceeds of the home sold to anyone who will pay.
However, compound the problem with real estate properties falling. In our example, the bank has lent $1 million to buy houses. But as real estate prices drop, the bank now owns five properties worth $800,000. So if they had to sell all five properties, they would lose $200,000.
Then compound that with the subprime problem, where loans were made to people who should not have received them. These people bought homes which were too expensive. Let's say these people borrowed money with an adjusted rate; and their payment rose after two or three years, making their house payment nearly 66 percent of their income.
They would default because they can't make their payment. They also can't refinance because they owe more than the house is worth and they don't qualify because they shouldn't have qualified in the first place. That's a mouthful, but it is a complex problem.
So now the banks have these bad mortgages and cannot package and sell, thus, they have no money to lend and they are reluctant to lend any money because they are short on cash to lend.
4. What does the $700 billion bailout do?
What the government does is come in and buy these loans from the bank, giving them the money needed to make new loans. Since no one else wants to buy them, the government becomes a "rich Uncle Sam" and buys them. They use taxpayer money to buy these mortgages and that is why there is some fuss on Capitol Hill. It is costing every American taxpayer in the United States about $5,800. So if you are a family of two taxpayers, you now owe the U.S. government about $11,600 in taxes to help fix this credit crisis.
No, you will not get a bill from the government for this amount. But less of your tax dollars are available for other programs like the military, roads and schools, and the government may need to raise your taxes over a 10-year period to make up the difference.
The last time the government did this was the Savings and Loan Crisis of the 1980s when they created the Resolution Trust Corporation (RTC).
5. Are there drawbacks by doing the bailout?
Yes. By making $700 billion available to the economy, you are now increasing inflation. Inflation is too much money chasing to few goods. And if you increase the amount of money while the amount of goods remain the same, inflation follows. I have heard conservative estimates of 7 to 12 percent inflation in two to three years from now due to the bailout. Ouch! It also decreases the value of the dollar overseas, which we have seen effects oil prices.
6. Does it solve the problem?
Yes and no. Yes, it gives banks more money to lend, but if home prices continue to fall, it does not solve the problem of a deteriorating mortgage environment. The government needs to also offer incentives to home buyers. Increasing interest in home ownership will stabilize housing prices and help solve the problem. But it certainly staves off a complete collapse of the U.S. economy, much like what happen in Russia in 1998.
I hope this oversimplified explanation helps you understand where we are at. There is no comfortable landing on this crash, but hopefully we have managed to keep from breaking every bone in our financial bodies.
...Shane Pyle, chartered market technician with Raymond James Financial Services.
The following edited blog entry is courtesy of Shane Pyle and can be found at www.coshoctontribune.com.
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