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Big Economic News: Financial Bailout $700 Billion HR 3997

Economics, Politics = Bad Mixture…what is really going on?
PART ONE

I’m writing this post and one to follow next week, to separate the politics from the truth. In other words; what has happened, how we got here and finally what will be the impact on our economy. My goal is to give you the “true” current status of our economy and how to position yourself as a real estate and/or mortgage professional so that you can take advantage of this great opportunity!

HOW DID WE GET HERE

In order to fully understand what has occurred we have to follow the timeline and events that caused us to get in this current financial crisis. After the popping of the “Technology Bubble”, Alan Greenspan did what every good economist would have done, and he supplied financial markets and the economy with “liquidity.” When I speak of liquidity I want you to think of it as the grease which allows a machine to run smoothly. In addition, liquidity can also be thought of as a way to jump start the engine of our economy. The best way to think about it is that it is the fuel that makes the economy run. Basically, it is how much money is flowing in the financial markets.

With all the liquidity (i.e. money/cash) pouring into markets, banks were flushed with cash. Banks were then able to lend and had some of the cheapest rates in recent history; Alan Greenspan had accomplished his goal. By supplying financial systems with liquidity he was able to entice banks to lend more to consumers as well as businesses, and this in turn jump started the economy. Moreover, we had one of the smallest recessions in American history.

One of the key innovations that came about during this time was the mortgage backed securities. Due to banks making so many mortgages to consumers, they had to come up with an innovative way to sell these loans to the secondary market to get them off their books. Once a mortgage is made, it is too small to be bought by big hedge funds; therefore, banks created mortgage backed securities which are a bundle of mortgages that is sold to the secondary market. By bundling thousands of mortgages together, banks had a large enough asset to sell to hedge funds. It is important to note at this time that this is how financial systems work in their simplest form. Financial institutions lend money and then either borrow money and/or sell assets to other institutions in order to raise more money.

HEDGE FUNDS AND THEIR ROLE

At this point we need to take a look at hedge funds because they played a key role in supplying the liquidity to mortgage companies. Hedge funds are large pools of private investor’s money. Basically, extremely wealthy individuals give large sums of money to money managers who used to work for large Wall Street firms. In turn, these money mangers make big returns for these investors by investing in various assets. During the mortgage boom, hedge funds moved into purchasing mortgaged backed securities.

Here is where one of the biggest problems came about. Hedge funds were making substantial amounts of money on the buying and selling of mortgage backed securities. The problem was that no one really understood what their securities were worth…and no one cared, because everyone was making a lot of money. So hedge funds would buy the mortgage backed securities, mortgage companies would be flooded with fresh cash to lend, and lending standards started to become ever more increasingly loose! At one point an executive for a major mortgage company realized that things had gotten out of control. Instead of trying to stop the “run away train”, he went and started his own hedge fund and bet that the mortgage backed securities would ultimately fail. He made billions!

As mortgage backed securities began to fail, hedge funds began to feel the pinch. Over the period of a year, hedge funds that were making billions are now losing money and closing down. Without hedge funds to buy the mortgage backed securities, banks end up having to keep these risky assets on their books. This does not appear to be a problem yet because banks still had access to money so they continued to lend to consumers in the form of Adjustable Rate Mortgages. This is where the trouble begins to become worse, but no one knows because everyone is still making big money.

MORTGAGES BEGIN TO FAIL

Banks now are unable to sell risky assets which were a key factor that had kept banks from ever getting into trouble. In other words, banks needed the hedge funds. However, they are making big money lending so no one is concerned that they are keeping these risky assets on their books. Finally, bad loans begin to go into default. This becomes an ever increasing problem because banks are required to keep a certain amount of cash on hand in order to cover any assets that fall in value. In other words, as the mortgage backed securities that are on a bank’s books fall in value, the bank has to raise more cash to cover the drop in value.

Banks begin to realize that the assets on their books are beginning to fall and they have no way of determining how far these assets could fall. By this time banks have made billions of sub-prime loans and decide that they need to exit this risky market. Overnight we have the sub prime collapse and mortgage companies begin to fail.

Follow up next week for part two.

Cliff Pape
Home Buddies