Financial Crisis 2009

If you listen to the radio or have read any news recently, you’ve heard about the current economic issues. You may have heard something about a housing crisis. Maybe you read about the stock market crash or banks failing. But how did it happen?

The Basics: What You Need to Know
The bare bones of the situation tracks back to housing. Typically, when a person buys a house, he gets a mortgage–a loan where the property you’re buying becomes the bank’s as collateral for the money you need to buy the house in the first place.

In order to get a mortgage, banks will check a person’s credit to determine if that person is likely and able to repay the debt. The people that don’t have a good credit history, don’t get the loans to buy a home–at least that’s how it was supposed to be. But over the past ten years, more and more banks have been giving more and more loans to people who traditionally wouldn’t have qualified for them, people who were less likely to repay the debt.

This practice of lending to people with less than ideal credit ratings–”subprime” ratings, put the banks at risk. Those that are less likely to pay their mortgages, default more frequently, which means more foreclosures, which means more homes the banks have to repossess. Which is exactly what happened. More homes were foreclosed on, which meant less cash on hand for the banks.

Usually, when banks repossess a house, they just resell it to recoup any losses. But because of the number of foreclosures, the houses couldn’t be resold fast enough or at enough of a profit. So the banks lost money on the interest of the loans and lost bux in the value of the homes that couldn’t be sold.

Intermediate: A Tale of Double Dipping
Beyond the foreclosure risk banks saddled when making subprime loans, most banks are also publicly traded companies. So as banks lost money, investors did too. But that wasn’t the only way the foreclosures affected the stock market.

While banking institutions are traded publicly on the stock market, shares of companies, like Bank of America (NYSE: BAC) and Washington Mutual (NYSE: WAMUQ), aren’t the only securities that are traded. What else is traded on the stock market? Currencies are traded. Commodities–think gold, oil, sugar–are traded. And even futures are traded; based on future commodities (ex. quantities of available grain) or interest rates, speculators basically bet on the how much of a particular item will be available and how much it will be worth.

Make sense so far?
Well, there’s one more form of security that adds insult to injury with the financial crisis 2009 subprime issue: mortgage-backed securities. Mortgage lenders will package together a number of loans then sell them as securities, as investments, on the open exchange to mitigate their own risk. The value of these mortgage-backed items is directly related to how the loans are paid back. If the loans aren’t paid back, as is the case with foreclosures, the investors lose bux and the banks in effect lose multiple times: once on the bad loan, again on the inability to resell the property and another time on these failed securities.

Banks have been in a compromised position because of the subprime debt, and their value on the market has dropped consequently. When banks really get into trouble, when there’s talk of selling the company or of the bank failing, consumers start pulling their money out to keep it safe in the event of a bank collapse. After the Great Depression, the government began insuring personal bank accounts at a certain level, but that still hasn’t been enough to instill confidence this time around, as banks fail (Washington Mutual) and are sold off (Wachovia).