Monday, September 22, 2008

The best simple, plain-English explanation of the credit crunch

I've been fielding questions from various friends and relatives about the credit crunch. I guess they see me as some kind of business expert! At any rate, I've been casting about for a good plain-English explanation of the current crisis. Well, I've found it:

Here’s the problem with having lots and lots of debt and no savings, whether in the form of passbook savings or equity in your house: Sooner or later Tuesday comes around when you happen to have had a bad week, and the guy who sold you your hamburger wants his money, but you don’t have it. Once home prices began to decline (or for the most over-leveraged homeowners, simply stopped rising fast enough), therefore, it was a big problem when Tuesday started to come around and lenders and vendors started to ask to get paid for the hamburgers.

Normally this would have been bad for both the homeowner and the guy who wanted to get paid for his hamburger, which might very well be the mortgage lender, but not really a big deal for you or me. (If enough of this occurred, of course, it could lead to a general slowdown and hurt pretty much everybody.) But this impact was magnified by the fact that most of the mortgage lenders sold the right to the payments under the mortgage to third parties. These third parties broke up the rights to the payments from the mortgages into lots of little pieces, combined these pieces with the rights to payments for little pieces of lots of other mortgages, repacked these in “creative” ways, and re-sold them to fourth, fifth and sixth parties. Four, five and six then used these promises as their own equity in order to raise further debt of their own. This would be like you using an IOU from your neighbor as your down payment for a mortgage. So when lots of these over-leveraged homeowners started to miss mortgage payments, parties four, five and six had less money than they expected, and they had problems making their own debt payments if they themselves had taken out enough debt. Oh yeah, many of these debt contracts are in fact between parties four, five and six.

Unfortunately for you and me, parties five and six are the financial institutions where we have our life savings deposited.

That's what many bloggers seem to miss when they complain about bailouts for billionaires...if the financial system goes down, all of us go with it.

3 comments:

Alex said...

So, what solution would you favor? Admittedly I haven't searched much, but it seems like I've yet to find a well thought out, pragmatic solution.

So far I've seen "It sucks, but may be the only option" and "no bailouts for billionaires".

Alex said...

Also, this video is a simple but good english (heh) explanation. Funny, as well.

http://ca.youtube.com/watch?v=SwRFoxgEcHc

Dedric said...

So the mortgage lender had no business selling hamburgers to people who could only afford gruel.

The term Sub-Prime should be a warning sign already.

Sub = Below
Prime = Best

Below Best = Lending money to people who are unlikely to pay it back...

shoulda woulda coulda seen it comin'