Clear and Concise: Decoding The Meltdown

I've seen plenty of questions floating around on Yahoo! Answers and elsewhere from average investors or other individuals asking for clarification of why the recent meltdown is occurring. Questions range from:  "Why are the world markets going down?" to "Why is this happening?" I'll do my best to provide a relatively non-technical/financial explanation of what's going on, both domestically in the U.S. and abroad to bring individuals up to speed.

Basically, banks became greedy a few years ago and started selling blocks of mortgages together as assets which others could invest in. (So if you owned a mortgage, it might be sold as an investment to a number of different people/institutions). The problem was twofold in this regard. First, these packages that were being sold were extremely complex so most people buying them couldn't see what they actually were. A single mortgage could be sliced into many different portions, repackaged, and then have that package sold again and repackaged, etc. The common analogy is that the "bad debt" was like rotten meat thrown into a grinder, so that the banks only knew if they had it after they were already sick.

Secondly, the banks were greedy in that they were giving out mortgages to people who shouldn't have normally been able to afford them. So, the "sub-prime" was basically giving away teaser rates to individuals who wouldn't be able to afford the "normal" mortgage payments. For instance, if an individual had $2,000 they could allocate to their mortgage, a bank would issue a mortgage to them at a teaser $1,800 payment, knowing that the real payment would be around $2,500 after a few months. So in essence, the banks knew that the individual would not be able to afford it, but they would get a few months worth of payments, then reposses the house, and sell it again to make a profit.  That practice was supported because all the housing prices were so high (so the banks never really lost money).

However, when the housing prices fell, all of a sudden the banks couldn't resell the houses for what they paid for. There was literally trillions of dollars of "bad debt" in these packages - holdings which were worth nothing that the banks had to write off. Because the packages were so complex though, it was hard to tell which banks were holding which bad assets (think of a horrific game of bank Russian roulette, no pun intended, with the status of the Russian markets). So, as they discover them, and have to write off hundreds of millions (or billions) at a time, the banks are being forced to go out of business - hence all the collapses recently. This creates an environment where no one trusts each other. The banks typically loan a significant amount of money to each other in their normal day to day operations, but now that they feel each other might go out of business overnight (which is very possible), they aren't loaning anymore out of fear, which locks the credit lines up. That in turn makes it harder for average individuals to get loans for mortgages, cars, etc. Of course, this creates a panic and the rapid swings/sell off which we have been seeing in the last seven days.

As for a macro-world view - not only was the "bad debt" packaged and sold here in the U.S., but much of it was sold abroad. So you might have Taiwanese, German, or Brazilian banks/companies which are having the same problems. This, plus a generic fear of the markets, and the fact that many markets are pegged fairly largely to the U.S. economy, has created the global financial meltdown we have seen. The entire country of Iceland has had to shut down their banking system and suspend trading on their stock exchange. The Russian stock market lost 19% of its value, and most major markets are having extremely severe declines as well.  One great place to see how the world economies are doing is a startup called Emerginvest. It has intuitive heat-maps of the world so even if you're not familiar with markets, you can see how specific regions, sectors, or the world as a whole is responding.

Many people have been questioning whether or not the U.S. was to blame for the current economic meltdown. One opinion is: absolutely not. The subprime practice became a world-wide trend with many banks selling mortgage securities to one another for profit. The other is: yes is definitely is - the U.S. started the practice and sold the vast majority of securities to foreign investors.  

That being said, I personally think the U.S. is to blame on account that it was the U.S. who first started the practice because of the extremely high domestic housing prices which supported it. I recognize that the trend caught on, but the U.S. did initiate it. I certainly feel that many international individuals will see the U.S. as having caused the crisis, and especially as the U.S. sold the bad debt abroad. Is the U.S. entirely to blame? Absolutely not. Do I personally feel like the U.S. was much more largely responsible than any other party? Yes.

I hope this goes a long way to clearing up any gaps of understanding.

Disclosure: Emerginvest is an international finance portal, helping investors find investments from around the world. Emerginvest provides impartial information about world stock markets, and does not have any holdings in foreign equities.

Comments

[Steve B:]

Clearly Biased & Concise Spin: Decoding the Apologia

“banks became greedy”, “banks were greedy”, “banks knew that the individual would not be able to afford it” BAD BAD BANKS!

“Do I personally feel like the U.S. was much more largely responsible than any other party? Yes.” BAD BAD USA!!

No mention of Community Redevelopment Act, Fannie May, Freddie Mac, ACORN?

Informed readers will make their own decisions on your which gaps you filled and which ones you created.

2008 Oct 12 08:06 AM

[Insiderman:]

Well said, Steve B. Barney Frank, Chris Dodd, Chuck Schumer, and Barack Obama created legislation to fund ACORN to the tune of $500 million per year to help them MAKE banks give loans to low-income and minority borrowers that couldn't afford them. Banks complied, but couldn't offload the loans to legitimate MBSs, so the Democrat-led agency regulators told FNMA and FHLMC that they MUST accept more bad paper. FNMA and FHLMC complied, but Wall Street needed a way to offload the risk of the bad paper and created CMOs to tranche the risk. Lehman Brothers took a lot of the risk in the credit swaps market. Whoops! You missed the big picture, Jon!

2008 Oct 12 09:52 AM

[raising4dau...:]

Nice job, Jonathan, in spewing the DNC talking points. Of course bankers were greedy.....they've been greedy since, well, forever. Greed in banking has been a constant through time. Pick up a Bible or some other book from Greek or Roman empire times. Welcome the real world young man.

The problem is that the politicians and regulators put in place to govern against the excesses of banker greed were asleep at the switch or, worse yet, in cahoots with the bankers.

We're suffering from an evil deal in force between the Dem's and Rep's since 2003. Since then, the Dem's have agreed to look the other way on Iraq; in return, the Rep's have agreed to look the other way on programs invented to pander to Dem constituents.....Commu... Reinvestment Act, Departments of HUD and Education, etc.

Both parties are complicit, and anyone that votes for a single incumbent is a fool.

2008 Oct 12 10:44 AM

[BerkeleyBob:]

There is plenty of blame to spread around, and some long hard thought needs to go into how to increase home ownership and have long term and predictable interest rate stability. (It helps not to get embroiled in expensive military efforts or run large deficits.) That being said, Fanny and Freddie were not the prime movers in the present disaster, and the CRA, reviled by some free-market types, was not on the same scale as Lehman or Countrywide, or AIG. Also largely unmentioned is the role of the rating agencies in abetting the fiscal fraud packaged as CDO's, etc. etc.

2008 Oct 12 12:41 PM

[StateofConf...:]

After nearly eight years of the Bush adminstration and six years of the republican led congress, you would think those that voted for this mess would learn something. I guess not. Every election the Republican lie machine cranks up to put fear into the brainless base. Its everyones fault but their own. As an independant I don't like either party much but the garbage I hear every election from the Republicans, the NRA and any brain dead person they can get to do a commercial tells me I would not be a part of that bunch.

I have to hand it to McCain for standing up to his rabid dog audience in a town hall meeting but Bush has been a lying SOB from the first. He wanted no regulation and he got it. He has fought to repress and modify any report that said Climate change is real and mostly man made. He has cost us trillions of dollars with bad policies. Our workers are supposed to compete against people making a dollar or two a day and living in dorms.

After Obama is elected, we still must stop illegal immigration, and have national health care, get rid of the 41,000 lobbyists in DC, start a massive project for energy independance and get rid of our crazy tax system. The reason most countries have lower business taxes is they use a VAT system on consumption. We need to stop the income tax and use VAT so people will save and invest.

2008 Oct 12 05:39 PM

[Bwilson:]

You're all wrong! You're looking at the symptom, and not the disease. The banking problems are only a symptom of the real problem: the American consumer is broke...run out of "cash", and to make matters worse, owes $15,000 on his/her credit card(s). If we are to keep the fractional reserve banking system, the only way to fix the problem is to reduce the size of government and drstically cut government spending - enough so to abolish the IRS. The American worker/taxpayer/consum... could then keep all of their hard-earned wages to spend into the economy. There are 153 million taxpayers in the US who pay an average of $9,000 a year in income tax. Do the math.

Keep up your conferencing about the symptoms and the patient(s) will soon be dying from starvation. And when people are having trouble putting food on the table, they start asking questions and demanding answers. When they find out who's pushing all the buttons and pulling all the levers behind the curtain, they begin to organize - like the Colonists did before the American Revolution.

One way or another, we have a bright future ahead, because wherever there's a growing dark shadow, the Light is getting closer.

2008 Oct 12 06:23 PM

[Moon Kil Woong:]

Trust me, in Taiwan they don't allow people to hide 40 to 1 dervivatives bets nor issue orders like the SEC did yesterday letting companies declare any arbitrary value they want for paper that no one will buy. As far as Asia is concerned, US bank values are worth less than Russian bonds. 0% transparency, 0% accountability, 0% regulation, 0% fiscal restraint. The US is looking a lot like the USSR.

2008 Oct 13 12:05 AM