PRINT
EMAIL
COMMENT
BUZZ UP
DIGG THIS
1. It all began with cheap money. To prop up ailing economies early in this decade, central banks in the U.S. and Japan kept interest rates unusually low, which encouraged speculation. In the U.S., the Federal Reserve Board lowered the federal funds rate -- the rate that banks charge each other for overnight loans and a barometer for the cost of borrowing money on a short-term basis -- from 6.5% in 2000 to 1% by mid 2003. Cheap money quickly ignited a sharp rise in home values in virtually every corner of the country.
RELATED LINKS | |||
 |
SLIDE SHOW: 10 Things That Are Going Right | ||
|
|
How to Cope With the Financial Crisis | ||
2. Financial magicians made subprime loans golden. Banks and mortgage companies fed speculation in home prices by offering cheap credit to all comers, including those who would not normally qualify. What to do with these subprime loans? Package them with thousands of high-grade loans to sell to investors. To make the subprime loans attractive, underwriters bought insurance policies guaranteeing that the loans would be repaid. With insurance on the loans, credit-rating agencies stamped such paper as triple-A-rated debt.
3. The global economy became infected with poisoned debt. The loans came to investors as collateralized-debt obligations, or CDOs -- huge packages of loans sold in assorted tranches that varied by level of risk. Buried inside the least-risky tranches were those subprime mortgages masquerading as triple-A-rated debt because of their insurance policies. Insurers assumed that default levels would be minuscule.
4. So much for those assumptions. Home prices tipped downward, setting off a chain reaction. All bubbles eventually burst. The Fed began raising short-term interest rates in 2003, eventually boosting the federal funds rate to 5.25% by the summer of 2006. As a result, adjustable-rate mortgages (particularly the subprime variety) began to reset at far higher interest rates, and in July 2006 the rise in home prices abruptly stopped. In fact, home values began a descent that continues to this day, in many communities averaging a loss of 15% to 30%. As borrowers realized their homes were worth less than the amount owed on their mortgages, defaults shot up.
5. Rating agencies lowered their assessment of those subprime loans to junk levels. The investment and commercial banks, pension funds, and other institutions that had bought the supposedly safe, triple-A-rated CDO tranches woke up to find their investments tainted by those poisonous subprime loans, which began to default at alarming rates. Holders of these CDOs found it all but impossible to sell them, because there were few buyers -- the beginning of a seize-up of U.S. debt markets.
6. A wave of write-downs on the value of those loan packages commenced. Financial accounting standards require banks and investment companies to Òmark to marketÓ the value of their assets each day. If it's impossible to value a security because there is no market for it, too bad -- make a smart guess. Starting in 2007, one financial institution after another announced a series of quarterly write-downs of hard-to-value and unsalable CDOs that turned into a financial tidal wave.
7. Financial institutions were revealed as vastly undercapitalized. As the quality of their debt portfolios deteriorated, investment banks wrote off billions of dollars of bad assets each quarter, causing their reserves to shrivel. Commercial banks are leveraged with perhaps ten times as much in assets as capital. But some investment banks leveraged themselves more than 30 to 1, to the point that should anything go seriously wrong with those assets, they could fail. Also overextended: Fannie Mae and Freddie Mac, which stand behind $5 trillion in mortgages.
POSTED BY: Loretta (November 07, 2008 05:56 PM)
as a retired widow i don't see much hope for the economy. government has sold their souls to the devil thru greed. the spending must stop! entitlements will only drag us further down. and no one is adressing this and much more. we need to get our budgets under control. no increases. i have to live within my budget and so should the government.give taxpayer money to private business that fails??? get rid of the top guys with no golden parachutes and then MAYBE i'd consider it with many rules and regs. and oversight...
POSTED BY: arjaybee (November 09, 2008 08:16 PM)
A substantial portion of the equities and bond markets' decline occurred after the polls showed Obama leading by MORE than margin of error (approx. mid-Sept.). Are markets forward-looking or does Kiplinger think this is entirely coincidental?
Reprint Article
