Simple Explanation for Hard Times

I came across this AMAZING article (alright, so my dad wrote it) that very succinctly sums up what the combined causes are that have carried us into the economic crisis we are currently facing. I usually have a hard time wrapping my head around economics, but this explains it very well. And if you're too thick to hang in there for the full thing, at least be sure to catch the joke at the end!:

What is going on with the Economy??

What now? We have heard a lot about sub-prime mortgages but many don’t understand exactly what that means and more importantly what caused it. So a definition is in order. Most of us can remember when you had to save to get a down payment, keep your credit rating in good shape and have a work history of at least two years to qualify for a mortgage. If you qualified for a loan you were a prime borrower, meaning that you were a good risk for the bank to loan money to you.

Then in the 1990’s a wave of ‘everyone should be able to experience the American Dream of owning your own home’, especially those that were poor swept the country. The government then passed legislation mandating that lending institutions relax the criteria for making loans to poor. These loans were sub-prime loans meaning that the borrower qualifications were sub-standard and therefore higher risk.

Banks lent money to everyone and were making tons of money. Many may remember that you could get a loan for 105% of the value of the home. This worked very well for some families who were having trouble making the down payment or coming up with closing costs. Many people who would have otherwise been unable to own their own home suddenly qualified and they were home-owners. But with every program, abuses immediately surfaced. Because the housing market was skyrocketing pushed by the increased demand for housing, many thought the best way to take advantage of this situation was to buy a home they were totally unable to pay for – hold it for three years and sell it for a profit. Hence came the ‘creative payment structures’ such as interest only payment, balloon payments etc. This all worked well as long as the housing prices were going up and the market demand was still increasing.

Some of the banks were a little worried about the risk they were incurring with these sub-prime borrowers so they bundled these loans and sold them off as a package to large banks and mortgage institutions. These banks and mortgage companies then leveraged these loans or securities using them as collateral to make even more loans. When the bubble finally burst the houses came back to the bank and in turn eroded the collateral of the large banks putting them upside-down. The greed of the bankers took advantage of the mandate of the government to make risky loans –the banks for money and the government for votes!

Now the government is intervening again not with lending regulations but with bailout packages to keep the large banks afloat. With the housing market flush with an over supply of houses in foreclosure, it will be some time before the market can right itself and use up the supply of houses. This will take place if the markets are allowed to work independent of outside forces; The down-side is that many people are going to get wasted in the transformation and bailing out the banks and homeowners is going to but forestall the inevitable. The market will solve the problem but many are going to be hurt in the process.

The sub-prime mortgages are only one of the problems whose roots lay in the 1990’s. Many will remember the trade agreements the government made with foreign countries to boost the global economy. We were racing head-long into the global market forgetting the idea of fair-trade and trading it for free-trade. As these trade agreements started to flourish, the USA found that not only were our import versus exports numbers going upside down, but that with cheap imports, our US companies could not compete. Made in China was on everything! Unable to compete with these cheap imports, US companies were forced to set up operations in foreign countries to take advantage of (1) lower taxes, (2) cheaper labor, (3) cheaper input costs, (4) lower quality standards and (5) less regulation. With that came the erosion of the industrial base in America leaving the economy to turn to the service sector. Even Levi’s are made overseas – who could have imagined that something as American as jeans would no longer be made in America.

The problem with a service-based economy is the fact that when things get a little rough, the first sector to be hit is non-essential services. i.e. when money gets tight, you mow your own lawn instead of hiring it done. The ramifications are that all businesses slowdown.

It is hard to make mortgage payments when you have lost you job so the combination of these two unusual circumstances have crossed paths sending us into a spirally downturn the seeds of which were planted in the 1990’s but have taken fifteen years to mature.

We experienced similar problems in the great depression of the 1930’s and the government decided then to dry up the credit markets which plunged us deeper into depression. The war brought us out of that. Not willing to have that happen again, the government is throwing money at anything that moves in order not to fall into the trap of no money available such as was the case in the 1930’s. People are wary of spending money right now because they are uncertain about the direction the economy is headed and although it might be good for the whole for everyone to spend money now – it might not be good for the individual. So the fear is that if you personally start spending, you might be the only one – better to see what happens first. I predict that we will be numbering bailouts and stimulus packages by the end of the year. The government is already talking about another stimulus package which will make three in as many quarters. It will not work because the market must ground itself first which means that everyone is going to wait and see where the bottom is before they start spending again. The backlash is that if we continue to throw trillions of dollars at the problem, we will have inflation or hyper-inflation to look forward to in the coming years.

So what now? I don’t know but as the joke says, what is the difference between a Tennessee divorce and a tornado, - I don’t know but someone is going to lose a trailer. I think most of us will be hunkering down until this blows over.