Economics

This week Frank and I have been talking about the headlines and what all the economic craziness could mean for us. Frank knows a lot more about the economy and investing than I do. But I was trying to get my head around what has actually happened. What caused the mess? I listened to some news commentators, but they talk like I should already know what's going on. It was over my head. I felt like I walked in on the middle of a movie. So I decided to do some research online and then break it down into simple terms that I could understand myself. My grandfather taught me how to think about the stock market on a small scale like this, in order to get the bigger picture.

I'm posting my "scenario" and my conclusions so that anyone else who is wondering doesn't have to do as much reading as I did. This is simplified, but if I have any major errors, feel free to comment on them.

IF you make it to the end.

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A Home Mortgage
I want to buy a baseball card that costs $.50, but I don't have the money. You are willing to lend me $.50 if I agree to pay you $.10 every day for the next ten days. Since I get a small allowance every day, you're pretty sure that I will pay you the money. You're not taking a lot of risk. It benefits me, because I get the baseball card NOW. It benefits you because ultimately you'll get $1.00 - double the money you loaned me. If I don't pay you, then I have to give YOU the baseball card. You can either keep it or sell it.

This is a basic home mortgage. The bank gives the money, knowing that I will almost certainly be able to pay back the loan. If I end up not making my payments, then the bank gets the house, and they can re-coup the loss by selling it to someone else.

The Way Banks Used to Loan Money
You realize pretty quickly that this is a great way to make money. You start loaning money to other kids to buy baseball cards. But you have two limits: 1) You only loan money to kids who will most likely pay you back - kids who have a steady allowance coming each day. 2) You only loan money based on the cash you have in your pocket.

This is how banks used to make loans. 1) Low risk. 2) They could only loan as much money as they had in the bank on deposit.

Sub Prime Mortgages
You've made a decent amount of money making loans for baseball cards. Since you have extra profits, you start to loan money to kids who are a little riskier. They have good intentions to pay you back, but it isn't a sure thing. Since you have a small cushion - and you like the profits - you decide to try it anyway.

Banks started breaking the "low risk" rule, and loaned money to people with questionable credit, or loaned money for a bigger house than they really could afford. This is a subprime (not ideal) mortgage.

Going Beyond the Bank with companies like Fannie Mae and Freddie Mac
Business is going well. You realize that if you just had more cash on hand, then you could make more loans and see more profit. So you go to your dad, and ask him for a $50 loan. You agree to pay him back, with interest. It cuts your profit slightly on each loan, but since you can make so many more loans, overall you will make more money. Basically, you will continue to run your business the same, but your dad is "buying" the loans. If people stop paying you (meaning you can't pay back your dad's loan) your dad will end up owning a lot of baseball cards. He is assuming the ultimate risk for your business.

Banks were looking for a way to expand their profits, so they went to larger companies who could loan them more money to make more loans. These companies (like Fannie Mae and Freddie Mac) assumed the ultimate risk for the subprime or "riskier" mortgages, because if the homeowner can't pay the bank, then the bank can't pay them either.

Into the Larger Economy
Business is booming. You are making money. Your dad is making money. You borrow as much money as he is willing to loan you. Your dad decides to ask a few of his friends to invest in his business. He doesn't tell them EXACTLY what he is investing in (i.e. baseball cards) because he is invested in other things too. Since he has a record of good profits, they decide to give him some of their money to invest. He continues to make good money off of your little business venture, so the people that invest in him continue to make money. More and more of his friends see that this is a good idea, so pretty soon he has a large group of people that have given him money. He, in turn, gives a large portion of that money to you to make more loans. This is turning into a huge operation.

Larger companies like Fannie Mae and Freddie Mac loaned money to banks or loaned money to banks who have loaned money to other banks (this is where it gets confusing in a big hurry). These larger companies get their money from shareholders - some of them are other large companies, but some of them are small investors like you and me (if you are invested in a mutual fund that has invested in one of these companies). So everyone has a stake in whether or not the bank's mortgages pan out - essentially, whether the bank has made a good investment or not.

The Crisis
Bad news. Those kids that you loaned money to - the ones who were kind of risky - they aren't able to pay you on time. Some of them aren't able to pay you AT ALL. Because you were a little too cocky, you loaned money to WAY TOO MANY kids who can't pay you back. That's a problem, because you can't pay your dad. And he doesn't want the baseball cards instead of the cash. What would he do with the baseball cards? So now your dad can't pay the guys who have given him money to invest. Not only are YOU in trouble, but YOUR DAD is in trouble. And so are the guys who loaned him money because he isn't able to give it back. The only thing left are all the baseball cards - and they aren't worth enough to pay everyone back... even if you could find someone to buy them. And it seems baseball cards aren't as popular as they used to be.

After the housing boom, interest rates went up and other things happened in the economy (rising fuel costs, etc) and people weren't able to pay their mortgages. Because of the way the system works, that doesn't just affect the bank that made the loan. It affects the company that invested in the bank AND the people who invested in the company.

Bad Reputation
Your dad is getting a bad reputation. People are starting to wonder about the kinds of investments he's made. No one is willing to "buy" his business, because it isn't worth as much as they thought. Your dad can either bail out of everything (bankruptcy) and no one gets paid back. Or he can go to HIS dad and beg for some help (cash). HIS dad (the government, haha) is willing to give him some money for the sake of his son's reputation and to calm everyone down.

There you have it. Government bailout. No one wanted to buy these companies, because they had way too much bad debt. Who wants to pay for something that isn't going to bring a profit? But the government knew that if they didn't step in, a lot of people were going to lose money in the deal. That, in turn, would cause more and more problems since the economy is intricately tied together.

Panic
Now that your dad's friends have been burned by a bad deal, they are much more cautious about investing in anyone else. Everyone is holding onto their money, instead of investing it in other business ventures. This really hurts the kid down the street who has been selling candy bars. Even though he has been doing business very responsibly, he still needs someone to loan him money or he will have to scale back his business. It isn't his fault, but he has to deal with the consequences of what happened in your baseball card business.

The issue goes from a tangible issue to an intangible one. TRUST. Everyone is afraid of bad investments, so everyone is holding onto their money. The economy needs money from investors to keep growing, but no one knows which companies are being managed responsibly and which ones are not. When investors are not buying, then it is harder to sell shares in a company. The value drops. That's where we are today.

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I can't believe you read all that.