Economy Not Quite Ready For Recovery

in Economy

Tough times? You bet! I don’t know anyone who hasn’t been affected by the down turn in the global economy. People who can’t make their mortgage payments, pay their credit card debts, and those still managing to get by through the use of retirement savings and other fiscally responsible actions are all feeling the pain and wondering when the end may be in sight.

The sad reality is that it is going to be a long protracted period before we begin to see any signs of recovery. Our economy has been displaying symptoms of a larger problem far longer than most mainstream media and other resources close to the problem have proclaimed. No matter your opinion of how we got into this mess, one thing is certain; it will take a collective ratcheting-down on the American way of life and exactly what the American dream means to everyday, ordinary people.

I have watched in amazement, the bailouts of AIG, Bear Sterns, The Automakers, and other meg-money financial institutions and have sat stunned as to how people who are a hell of a lot smarter than I am couldn’t see this coming down on us like an global ticking time bomb. I am a forty-six year old woman and I live in one of the six worst hit states as a result of the most recent housing bubble burst. Florida. I have owned five houses since the mid-eighties and have experienced two significant real-estate booms here in Florida, with the latter that started in the late nineties and ran all the way up to the big burst starting in 2007.

I remember debating with friends and real-estate professionals regarding the stability within the housing market and most everyone was of one mind. Real estate never goes down, at least not in Florida. To me, I have always been of the mindset of that which goes up will always, always, always come down. Well, we all know that to be true now, but how did we get here? To understand what has happened with the housing market, you must have a baseline understanding of economics, banking, risk, and simple mathematics. This presupposed understanding by even the most general of news accounts has been the impetus, in part, to the problem. Terms like collateralized debt obligation, securitization, and write-downs are familiar to those with a financial background but are foreign to the vast majority. This article will provide a simple explanation and introduction to the basis of our current crisis.

To begin to understand the problem lets first start with a simple example of how banks have functioned historically. Throughout history banks took in deposits from savings account customers and then loaned money to homebuyers. In our simple example, they paid 1% interest to the account holder, guaranteeing the savings customer access to his or her money and a small rate of return on their savings. The bank then loaned the money to other customers for mortgages and collected 6% interest on those mortgages. The spread, in this simple example of five percentage points is more than enough to compensate for any homebuyers who couldn’t pay their mortgages. Again, this is a very simple explanation of how banks historically loaned money.

Then, as any account of the “sub-prime” crisis explains, banks began to re-sell or securitize mortgages. If you have owned a home within the last twenty years or so you have probably made your monthly mortgage payments to different lenders (banks) who “purchased” your loan from the first bank you got your original mortgage from. This is securitization. Bank A loans you the money for your mortgage, bank B buys your mortgage from Bank A for the “stream of payments” thereby collecting the principle and interest you pay every month. Bank A merely essentially makes their money by the various fees collected though making the loan. In most cases, Bank B is typically an investment bank who will securitize your mortgage with thousands of other mortgages of similar type based on criteria like creditworthiness, loan-to-values ratios, interest rates, and other measurable factors.

Let say for example you have a pool of 10,000 mortgages with approximately $10 million in monthly payments streams coming in from mortgages (borrowers) each month. That entire pool has a price. The entire price being how much someone would pay for the risk associated with that pool to get all of those particular payment streams. In a securitization, the investment bank divvies up the pool into many small slices, lets say 1000 for this example. Each slice can be bought and sold separately and each slice entitles the owner/buyer to 1/1000th of the payments streaming into that particular pool. The riskier the slice, the lower the price for the payments streaming into that pool.

Now using this example and assuming a trend in housing to continually rise and appreciate in value, your return on your investment becomes very profitable. One can see how easily this can compound exponentially as long as market conditions remain favorable.
In our next post we will expound upon this concept and delve further into the current problem within the financial and banking sectors and sub-prime mortgage lending.

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