It’s a challenge trying to keep track of the events of the current subprime mortgage crisis. Compare it to an over laden cart gathering momentum on a steep and rocky slope – now it’s built up so much speed, it’s passing by as a blur.
When looking at the causes of this crisis we’re hit with catch phrases such as Banking Liquidity Crisis, Mortgage Backed Securities, Interest-only Loans, Subprime Mortgages, and as of late the dreaded Bailout.
We gather around the water cooler, absently nodding in agreement when a co-worker mentions how Hedge fund losses have contributed to the crisis, but what does it really mean?
Consider this your subprime mortgage cheat sheet, defining some of these terms and explaining their contribution to current economic climate.
Subprime Mortgages: An alternative to a conventional mortgage, subprime mortgages allowed people with bad or no credit history to buy homes with very little or no money down. Not only are these considered high risk mortgages, but history has demonstrated that these homeowners are most likely to default when times get bad. Subprime Mortgages are considered the primary cause of the housing slump; eventually spreading their infectious roots throughout the stock market and general economy.
Interest-Only Loans: Generally used in conjunction with a subprime mortgage, homeowners were offered a payment plan where for a pre-determined length of time, they paid off only the interest, and no principal on their home. The banks and lending companies found quite a niche and it wasn’t long before the market was saturated with borrowers that should never have received mortgages to begin with.
When their “interest-only” period expired, borrowers switched to a conventional mortgage, but monthly payments often rose to unaffordable levels and forced them to default, leading to widespread foreclosures. Adding insult to injury, housing prices began to fall and often, these distressed home owners owed more money than their house was worth.
Mortgage-Backed Securities: Banks, laden with high risk mortgages, bundled them into mortgage-backed securities and sold them off to Fannie Mae, whose sole purpose was to resell these mortgages to private investors.
Hedge Funds: These are a higher risk, investment fund not privy to the same controls and safeguards as mutual funds. Hedge funds have invested billions in Mortgage-Backed Securities – when this unlikely pair met up, the stock market was flooded with unstable investment funds.
Suddenly the effects of these irresponsible lending and investment practices were visible in the form of a nationwide housing slump and economic crisis. Huge financial institutions the likes of Washington Mutual Bank, AIG and Lehman Brothers were over-burdened by the weight of high risk mortgages they could no longer sell off, and the resulting flood of foreclosures. Existing customers reacting out of fear, closed their accounts, withdrawing their life-savings.
Instilled with panic, investors recently withdrew over $140 billion from their money-market accounts, transferring the funds to U.S. Treasuries, causing values to decline to zero.
Federal Bailout: In an effort to stabilize the economy, a $700 billion bailout scheme has been proposed and rejected by congress. However, a 2nd draft was in the works during the writing of this article. In the proposal, the government would eradicate these debts from the banks, Hedge funds and pension funds, and basically give them a clean slate.
Some feel that this removes any burden of responsibility from the corporate giants who saw an opportunity and exploited it, and instead transfer the debt to the taxpayer. Alternatively, experts say if we don’t instigate some sort of bailout, it will be next to impossible for the average consumer to get a loan or mortgage. On the surface, this doesn’t seem so bad, after all that’s how the trouble began, with shaky borrowers getting loans they couldn’t handle. However, considering the amount of employment and industry that just those two products alone support, and the negative effect on the economy if people stopped buying cars and houses, this may be the bitter pill Americans need to swallow.