The purpose of this entry is to try and explain the current Wallstreet and economic turmoil, in simple terms. <yeah, good luck with that, he hears through heavy sighs>. I am making this entry early, so that as your eyes glaze over, you can recover and enjoy the rest of your night, the last thing I want is to put you to sleep on your keyboard :o)
Investors, particularly foreign investors seeking higher yields as we have lowered interest rates, demand more options. Wallstreet answers with the development of Collateralized Debt Obligations (CDOs), which are complicated securities based on pools of mortgages. They were rated AA and AAA grade investments (this is good) by the rating agencies (this is an often overlooked aspect of this mess, we need rules and standards in this area as well).
With rising home prices over the last decade, financial firms not only create these CDOs, but leverage and load up, in the case of Lehman, borrowing at a rate of 30 to 1 to their capital reserves and assets. If you borrow 30 times your capital, and those investments rise in value 1%, you essentially make a 30% return. Conversely, if they lower in value 1%, you have a 30% loss.
American Insurance Group (AIG), and other insurers, sell Credit-Default Swaps (CDS), derivatives designed to protect investors from failures. Again, not a bad practice in a rising market, but when leveraged firms start losing money (due to the housing downturn), they can not cover all the losses. AIG is a $1 trillion company, and the government could not let it fail, hence the $85 Billion LOAN (not a bailout, the tax payers own more than 80% of this company now, and with patience and time, we will make money on this investment).
Last, supply of housing overwhelms demand, and the median sales price of existing homes falls 15% from 2006 to 2007. Mortgage holders, including the sub-primes, owe more than their homes are now worth, and with adjustable rates, they start to default in large numbers. These defaults cause the huge economic fiasco that we are in based on those leveraged companies, and as each percentage point of loss looms, the CDOs become worthless. Purchasing of securities and mortgages stop, and the government must again step in and put Freddie and Fannie in conservatorship.
Basically, in the short term, tax payers are bailing out the financial institutions, but in the long term, similar to the Savings and Loan fiasco, the taxpayers can end up ahead as the economy recovers, which it will.
Hope this long winded entry explains things a tad :o)
3 comments:
After reading this, and a little discussion concerning different terms (leverage, etc.), I think I have a fundamental grasp on this.
Seems like the borrowing took on a "gambling" aspect...taking a chance on winning big returns, but taking an even bigger chance on losing big. (Kind of like craps!) If you lose, you've lost everything.
It's all about greed, but frankly, I chalk much of this up to the current admin's attitude of a completely open market with no regulation. There has to be some oversight, or this will happen again.
Beth
I KNOW greedy in a big way trumps greedy in a small way as far as the effect on the economy, but the little guy is greedy too. HMMMM. Maybe too many people are greedy, & the guilt is expressed as anger? Just sayin. A long time ago, I wrote a tongue in cheek entry(though some did not see it that way) & at the end I mentioned loving(I don't remember the exact words) my passive income. Well, truthfully, my stock portfolio isn't passive, I work it all the time, & I feed it all the time, with money I have earned. Money I save instead of spending on me.
I got LOTS of emails from people wanting to know EXACTLY what they should invest in, what would go up, what would go up the most, & telling me I was "lucky," since they were not in such a good position. Huh? & I will never forget the person who wrote: I am borrowing this money from my brother & I have to pay it back soon, so this has to be quick. Uhm, OK!
~Mary
Thanks for the explanation. I'm on board with Beth, I think that the deregualtion , especially the practices and policies introduced during Regan's administration. set up this collapsing house of cards. As for taxpayers ending up ahead, that seems possible if you are not one of the people currently in the process of losing their home to foreclosure.--Sheria
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