Booming Housing Market Was Really a House of Cards:
Part 1
First part of a simplified explanation of the credit
crisis that has overtaken our economy
By Jeffrey D. Voudrie, CFP
March 31, 2008 - The current credit crisis has
impacted multiple sectors of our financial economy. Home foreclosures
are on the rise. Credit-worthy consumers struggle to secure mortgages.
Investment banks are brought to their knees. Foreign and domestic stock
markets experience gut-wrenching volatility. The Federal Reserve is
forced to take historical steps to maintain liquidity. And the list goes
on.
In an effort to help the ordinary investor make
sense of it all, heres the first part of a simplified explanation of
the credit crisis that has overtaken our economy. Hopefully youll come
away with a better understanding of the situation, along with some
lessons you can apply to your own personal finances.
As with all true disasters, a series of mistakes
are made that culminate into a full-fledged crisis. History provides us
with many examples, including the sinking of the Titanic, the stock
market crash of the 1920s, and more recently, 9/11 and Hurricane
Katrina.
In each case, a series of circumstances, along with
multiple human errors, combined to bring about a true disaster.
Such is the case here. We cant just blame the
banks, or the mortgage companies or the housing market or the Federal
Government. This was a real group effort and theres plenty of blame to
go around in this chain of events.
Lets start the story at the beginning of the
chain, with the American homebuyer. We all know how to buy a home. If
your income and credit score are high enough, and your outstanding debts
are low enough, you can get home loan from a bank or mortgage company.
And many people do.
But as home prices continue to rise and the supply
of credit-worthy consumers dwindles, a way has to be found to keep the
mortgage profits flowing.
So loan requirements are relaxed. Adjustable rate
mortgages, with low initial teaser rates, are introduced. Down payments
are lowered or eliminated altogether. Documents proving credit
worthiness, like income tax returns, are no longer required. Loans for
more than the price of the house are given.
Suddenly almost anyone can get a loan for more
house than they can really afford. But thats no problem, certainly not
in the middle of one of the hottest housing markets in recent memory.
House prices are going up like a rocket and everyone wants to go along
for the ride.
Once a bank or mortgage company gets a loan, they
turn around and sell it to investment banks, freeing up capital so they
loan even more money. The investment banks, believing that these
mortgages have been given to credit-worthy consumers, in turn sell
groups of mortgages to shell companies they create.
This way these mortgage loan assets are off their
books, freeing up capital they can reinvest to earn even more profits.
The shell-companies dont have the capital
requirements that banks do, so they can leverage these loans even more
by issuing short-term commercial loans to institutional buyers and hedge
funds.
They are earning more off the mortgages than they
are paying on the commercial loans, so they make a profit. The rates
offered on the commercial loans arent high because the mortgage bonds
collateralizing them are AAA rated.
The institutional buyers like AAA ratings of the
underlying bonds, and buy large amounts of the short-term loans theyre
based on as a secure source of income. Everyone believes that these
groups of mortgages are well diversified and are from credit-worthy
consumers, hence the AAA rating.
As long as house prices keep climbing, everyone is
happy and keeps making money.
So far, our chain of events is all about leverage.
The homebuyer leverages a small (or no) down payment and monthly house
payments to fund a substantial mortgage.
The bank or mortgage company leverages the profits
from these loans to loan even more money.
The investment banks that purchase these mortgages
from the original lenders are able to move them off their balance sheets
and into shell companies they create, leveraging them even further.
The shell companies leverage them yet again,
allowing them to make even more loans and helping institutional
investors increase profits.
In our next article, well see the tragic
consequences when all this leverage is turned on its head and the house
of cards based on a booming housing markets collapses.
If you have a specific question or would like more
information, give me a call toll-free at 1-877-827-1463 or you can also reach me by email at
jeff@guardingyourwealth.com.
I will answer your financial question FREE.
About Guarding Your Wealth:
Guarding Your Wealth is a
nationally syndicated weekly personal finance column written by Jeffrey
D. Voudrie, CFP. Mr. Voudrie is the President of Legacy Planning Group,
a private wealth management firm that employs sophisticated proprietary
strategies designed to protect and grow its clients' investments. Visit his website,
www.guardingyourwealth.com to read past articles under the Guarding
Your Wealth Article Archive that may not have appeared in
SeniorJournal.com.
Guarding Your Wealth for Seniors, on
SeniorJournal.com, is
a collection of columns by Voudrie that deal with issues of particular
interest to senior citizens.
Click here
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In addition to being a nationally
syndicated columnist and Certified Financial Planning Practitioner, Mr.
Voudrie provides personal, private money management services to select
private clients
nationwide.
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March 31, 2008 - The current credit crisis has
impacted multiple sectors of our financial economy. Home foreclosures
are on the rise. Credit-worthy consumers struggle to secure mortgages.
Investment banks are brought to their knees. Foreign and domestic stock
markets experience gut-wrenching volatility. The Federal Reserve is
forced to take historical steps to maintain liquidity. And the list goes
on.