How did we get into this mess; Answers to the how and why of this global financial recession.

Most of my readers come here for simple to understand answers to their questions. Thus, the following is not a comprehensive answer, however, it should be simple enough to understand for the average adult, without a college degree.

The most simple explanation to why we are in this current financial crisis is because of this so called “sub-prime mortgage” mess, and everything that followed it. Now, what does that mean? Our Federal reserve is responsible for setting monetary policy, in other words they indirectly set the rates banks use for lending. The banks then sets the standards for individuals to borrow. When the Federal reserve dropped the prime rate of lending to banks from nearly 7% to 1% in the early 2000’s, this set off a lending frenzy by the banks. The banks new that their was very little cost to their lending, so they could make money off of anyone, even those with poor credit, or so they thought (as long as demand kept increasing). Wall Street bought in on the action too, packaging up these sub-prime loans and selling them to investors, whom in turn were making a killing off of them in the beginning. As more and more people were able to qualify for loans (when they shouldn’t have been able to), they drove the prices of all homes, because as the supply of homes grows smaller, all other home prices would go up as people competed to buy them.

Then, when these people with poor credit and sub-prime mortgages started to default on their mortages, the investments started losing money, and people started selling them off in record numbers. Moreover, the banks profitability began to plummet as well. When wall-street saw this happen, everyone started pulling their money out of the market, to protect from losses.

Now, at the same time all of this “sub-prime lending” was going on, you have a bunch of good credit homeowners, who saw their home prices sky-rocket, and they began taking out home-equity loans, and spending that money on anything and everything, thinking their home value would continue to rise. Basically, they were taking artificial gains and spending it, and in turn artificially inflating companies values. When investors realized too, that these companies that were making a ton of money, were only doing so because of this “artificial boom” and that the future wouldn’t be so bright, as future profit estimates dropped, doom and gloom overtook the market.

To compound the problem, normally rational people, whom didn’t participate in any of this, decided they too should protect themselves, and so they started pulling their money out of the stock market and hoarded it, or bought up government bonds, and they still are.

Now, the banks, in trying to correct their bad investments, have tightened credit standards on consumers to the point that people aren’t able to continue to maintain their lifestyles. The banks have not only tightened consumer lending, but also business lending. With consumers unable to spend, and businesses unable to borrow, the opposite phenomena is occurring. Businesses are laying off people, as they don’t need to produce as much to meet demand, and they are stopping expansion plans and new product development as well.

When will this all work itself out? Well,  the market is irrational right now, just as it was when we were on this mega spending/lending frenzy. The market will correct itself in time, and those people hoarding their cash will eventually buy back in, helping unfreeze credit markets and get people buying products and services again, and allow businesses to pick back up spending and hiring. The last major recession in the early 2000’s lasted nearly 3 years, and witnessed a near 50% decline in value. My opinion, is now is the best time to buy as the market is still unreasonably low due to consumer confidence, and these companies are worth more than they are selling for.

Be Sociable, Share!

Leave a Reply