A half-assed simple explanation of the crisis

Note: I wrote this to a friend who was asking about the crisis a few weeks ago, I tried to explain it relatively simply, for someone without a background in econ. I don't vouch for the veracity of everything, it was just something simple so he could get the idea-

To explain what's happened, it's really important to understand the Federal Reserve and what it does. The Fed controls the money supply in the United States, most people know that. But most people don't know how it controls it, it doesn't print more-or-less money, it lends money to banks at certain interest rates. (It lends banks in a lot of different ways but that's the gist of it) As I'm sure you know, banks don't keep your money, they lend it out. The Federal Reserve is the organization responsible for most banking requirements. This is important to the current crisis in two ways. Basically, the Fed makes the requirements for what banks need to have on hand compared to what they loan out. (Reserve requirements) As such, when the Fed lowers their interest rate, banks can loan out more money and conversely if they jack it up a lot, the money supply will be tightened.

Also, the Fed can issue bonds, aka I-O-Us. The Fed is probably the most financially stable organization in the world, so people buy these by the truckload. It doesn't pay as much as more risky loans, but it isn't very risky and it pays consistently. So when the Fed wants to put more money out, they can also sell bonds. Basically taking debt on, and putting cash out there. Conversely, to restrict money supply they can buy back bonds which takes money out of the country. But the bonds aren't really the issue in this case.

That's essentially how it works. So what happened? Well, if you ask me, stupidity from all parties involved. But let's go to the beginning. There's a few ways to fight recessions, the main are fiscal and monetary policy. If you increase fiscal expenditures (Federal government) it helps mitigate it by putting money into people's pockets, directly or indirectly. The Federal reserve can also use its power to lower rates, thus pushing more money out there. (Fed govt= Fiscal, Feds= Monetary) So to combat the 2001 recession, the Fed cut rates to record lows. Like we're talking we've almost got free money here, 0.5% I believe was the lowest it went, but don't quote me on that. Typically it's somewhere between 2-5%, so this was low. So what happened? Well, banks had a lot of money to lend out, and rates were low.

It's no coincidence that the housing bubble started a few years after rates went down so low. Mortgages are huge loans, and so a few percentages has a massive impact. As such, people started getting bigger and bigger mortgages and banks kept lending them out. There's the issue- Democrats say banks were irresponsible and "predatory." True. Republicans say people were irresponsible and shouldn't have been getting such mortgages. Also true. It's both sides, but neither are honest enough with the full answer. These are the ones everyone's talking about, Subprime mortages, or basically mortgages to people with pretty bad credit ratings.

Just as banks don't sit around with your money, your mortgage isn't sitting there too. Investment firms buy into this kind of debt because it's generally steady income and it's lucrative. As the housing bubble started to pop, banks started to freak out that people weren't going to pay their mortgages. A rational reaction, considering savings rates are at all-time lows and credit card defaults are at record-highs. But that's not all of it.

Most of these people with subprime mortgages got adjustable-rate mortgages. Many loans are such by default. Basically, if the national interest rate goes up, you pay more interest. And vice versa. It takes inflation into account and Fed interest rate changes. But that's overtime. The Federal Reserve became worried that with oil prices spiking (they have a massive impact on our economy, because of transportation of goods and such) and this free money that inflation was coming. Inflation is not good. Not mega-inflation, like Germany post-WWI but anything over 5% is going to get the stock market and the Fed worried. So they started (slowly) over a few years jacking up the rates.

Well, people's wages are sticky and don't move as fast as they should, as in a perfect economy. Not to mention in the recession, people don't have as much money anymore. Because of this, their rate on their mortgages started raising higher and higher and higher, because they had adjustable-rate mortages. (On a side note, my sister-in-law locked in her student loans when it was record lows, her interest is like 3% right now. You can get CD's and money market accounts yielding that more.) If they had locked into a rate, they'd be fine. But they didn't.

So as I said, the banks started to freak out. Suddenly delinquencies were skyrocketing. A lot of these investment firms had bought up mortgages or underwritten these banks (financed) and started getting hit. After all, if someone can't pay their mortgage they can just leave. It hurts their credit rating immensely but more importantly the bank is left with a $100,000 loss. Multiply that times the 10s of 1,000s of mortgages that started (or threatened) to go belly-up.

As the crisis deepened, a lot of firms bet heavily on the fact that it would get better, and bought up more debt. I believe the Lehman brothers did that, and they just went bankrupt. 'Nuff said. Thus far most subprime home-owners have been getting owned pretty badly, but the Federal Reserve has been stepping in unprecedently to save some of these banks/investment firms. Left-wingers (sorry, it's true) have decried this, saying it's corporate bailouts and we're padding the pockets of Wall Street. Somewhat true, but they are missing the point.

The key power of the Federal Reserve is to affect monetary supply. If large banks (they loan first to big banks, who loan money to smaller, Fed works with Chase, not Fairport Credit Union) start to go under and cannot loan people money, then the Federal Reserve loses its' power to influence the economy, which as you can imagine is really, really bad. That's why they've been bailing out some of these massive banks, that and to restore confidence.

One of the further problems of this issue is called a "liquidity crisis or credit crunch." Massive companies all rely heavily on liquidity for a variety of things. Liquidity is just loans to finance stuff, sometimes to finance paying another loan. But if banks are getting hit hard (even if they don't go bankrupt) they are less willing and less able to loan out money. During a normal stock downturn, a company can borrow some money to cover its' costs when it's doing poorly. But since no banks are loaning out like they used to, a lot more companies are unable to secure short-term or long-term financing, and going bankrupt. That is what happened to Lehman Brothers, a Wall Street investment firm, they could not secure loans to cover their temporary losses.

The Fed hasn't bailed out all banks. And when they bail them out, they aren't really giving them free money. Most of the time the company is getting a major loan (The Federal Reserve has a lot of cash) to temporarily stay afloat, since no bank can do it right now. They are paying interest on it, and the Fed is getting collateral in return, aka a lot of mortgages and in general, some of the companies assets. Not ownership, but as collateral. Or sometimes. I'm not sure exactly what the Treasury is doing anymore, and I don't think anyone does. It's surprising to most people not because it's ridiculous, it's not like we're giving these companies free money, but a. because we're not really bailing out home owners (we sorta are) and b. the Fed has rarely done this kind of situation.

So because of the way the crisis is, with the liquidity problems or "credit crunch" the Fed needs to take more action than normal, otherwise they risk losing all of their power.