Now, consumers are asking: “How do these guys live with themselves? It is so obvious that this is a Ponzi scheme which will eventually explode.”
Well, maybe not so obvious.
One of the reasons that the bank executives were willing to lower the credit requirements of consumers was that they knew the average person wouldn’t default for five years (five years is just an example). At that time, the bank would take possession of the house, and resell it, to recoup its losses. By that time, the bank would have collected five years of mortgages plus the value of the resale of the house. So, the money could be repaid.
The bank calculated the probability of selling the house, and what the value would be, and it looked like a safe bet. If Jorge and Rosalinda defaulted, there would be 100 other buyers, willing to buy the house at its appreciated value. The banks bets were covered.
This next bit is an extremely simplified example, so if you know deeper economic theory and banking procedures, please don’t rip me apart. This is just a way of explaining it so everyone can understand it.
Five years down the road, the CEO retired, taking his millions with him. Jorge and Rosalinda defaulted on their mortgage, and the bank took control of their house. Jorge and Rosalinda lived in a housing development which was all financed under the same set of loans, with the same diluted credit policies as Jorge and Rosalinda’s house. So, the same week, 70% of the houses in the development defaulted. Now the bank is sitting on a ton of foreclosed houses.
They try to sell the houses, but in the mean time, the convenience store, the auto-repair shop, the restaurants…every business which was serving the housing development has closed because 70% of the people are gone. Prospective home buyers drive out, take one look at a deserted neighborhood, with no businesses close by, and they decide not to buy. So, the houses get harder to sell.
Let’s say that they do decide to buy anyway. They apply for a loan. Since the bank is getting slammed with foreclosures and lack of income, they decide to raise their internal credit policy back up to the previous, more stringent rules. Now, instead of 100 qualified buyers for these houses, they only find 10. So, 90 homes are now on the bank’s balance sheets. They are unsellable assets. The laws of capitalism basically say, if you can’t find buyers at $100,000 you drop the price to $90,000 and then to $80,000… The price of the house keeps dropping till it finds a market of buyers willing to buy it.
Now, remember that these houses were being carried on the bank’s balance sheet to secure major loans the bank took. But, the houses are steadily dropping in value. In a simplified example: The bank carried a house at $120,000 and borrowed $120,000. Now the house is only worth $90,000. The bank’s creditors come in and say, “You have to give us $30,000 in cash to make up for the shortfall of your collateral.” The bank doesn’t have $30,000. So, they can’t pay their creditor.
The creditor can take the house from the bank, but the creditor will now have a loss of $30,000. And remember this didn’t happen on one home loan or in one bank. It was across the industry, which means the companies who extended credit to the banks are now in danger of collapse. The banks are also in danger of collapse.
The buyout package which has been in the news, from what I can see, will be loaned to banks, to pay their creditors, so banks and their creditors can stay in business.
How does this affect you?
If you have large amounts of cash in a bank, FDIC insurance will protect up to $100,000 worth of cash. So, if the bank went belly up, your $100,000 would still be safe.
IMPORTANT! Not all money stored at banks is FDIC insured. If you have mutual funds, IRAs, or money markets they will probably not be covered. Check with your banker and make sure your money is in an FDIC insured account.
As a side note: credit unions and S&Ls are not banks. They often are not covered by banking regulations and are not FDIC insured. If you have money at those types institutions, or money in a cash account at a brokerage house, check with your representative and find out if you are covered under FDIC.
If your money is FDIC insured and the bank dies, your money should be fine. BUT if there is a credit crunch, which there is, this means that some banks are failing and others have no money to lend, this will send ripples through the whole economy. Certain types of business can only stay open if they have access to nearly unlimited credit. For example, a car dealership or a taxi company, or car rental business often does not own the cars on the lots, they are all financed. If there is no cash available in the finance system, these businesses cannot buy or lease cars, which will ultimately mean they will have to close.
The employees will lose their jobs. So, if you are an employee of these types of firms you will be directly effected. If you work for a company which sells services to these types of firms, you will eventually be effected, because your company will lose its customers.
Construction, real-estate, and land development is another sector which is completely dependent on the availability of credit. If credit dries up, all of these employees stand to lose their jobs. People who sell good and services to these industries or their employees will lose their customers and possibly have to close.
All of these employees will suddenly lose their income, which will mean defaulting on their personal debt and home mortgages…
On a global note: The US is one of the largest consumer nations in the world. If millions of Americans lose their jobs and lose their access to credit, they will stop their consumer spending. There are entire manufacturing companies in China, for example, who only sell products to Wallmart. Any foreign country with a positive trade balance with the US (meaning countries selling products to the US) will lose their customers, and eventually have to close.
The flutter of a butterflies wings in New York becomes a typhoon in Asia.