I’ve been reading the Wall Street Journal, Forbes, Bloomberg, etc, to get a concise view on the current economic crisis facing our nation. Since I have family members asking me to describe the current situation, I’m going to try to provide a simple explanation by avoiding terms such as “capitalizing assets”, “liquidity in the marketplace”, “securitized mortgages”, and so on… So here it goes:
For the past 15 years, the US government has subsidized mortgages for many people who really could not afford to buy homes. This increased the demand for housing, which also pushed up prices for homes. Meanwhile, mortgage companies and banks had financial incentive to provide loans to just about anyone, and since the price of homes was on the way up, speculators starting building or buying more houses. This further pushed up housing prices.
As in most cases when markets have artificially inflated prices, the bubble ultimately bursts.
People started discovering that there were many more homes than buyers (i.e., supply exceeds demand). This naturally pushed down prices. As the price of homes dropped dramatically in many markets, the homeowners (particularly those who were “living too large”) discovered that they owed more money on their homes than the value of the property. Thus, the banks and financial institutions ended up with loans that will never be repaid as expected.
This major drop in loan value leads to financial institutions going bankrupt. A bank going out of business is one thing, but it becomes really bad when all of the banks stop lending money. Remember, most people need to get a loan to buy a house. If people can’t confidently buy and sell homes, then home prices will get further depressed, accelerating a downward spiral.
The solution being pushed is that we taxpayers provide funds to help make up the losses for the banks. This isn’t directed to help specific financial institutions, but it is intended to ensure that enough banks are solvent so there is the flow of credit, and people can buy and sell homes (not to mention, cars, appliances, etc). Did you use cash the last time you went to the gas station? Similar to most people, you probably used a credit card.
You must not forget that a robust economy is based on the flow of credit to enable confident buying and selling.