Thursday, March 27, 2008

The US economic problem explained

Okay, here's the short version of the American economic crisis, as explained to me by the GSM economic expert (Claire's father): Real estate prices were low in 1998. At the same time, mortgage fees were low due to the competition allowed as the mortgage business globalized. People were looking for the best possible mortgages for quick gain, and many people took out "subprime" loans hoping to quickly turn over their mortgages. These loans are intended for high risk borrowers and so they have high interest rates, although not at the start.

Okay, so we all understand this so far. Now, here's why the crisis goes so deep: the mortgages were then sliced up and packaged into Collaterized Debt Obligations, which were sold to investors, perhaps all over the world. The investors then used the debt they'd bought as leverage for other investments, higher risks bringing higher returns after all. But homeowners were also taking serious risks, all of them betting on the fact that American home prices had never fallen before. And they got so high that they had to fall. So, the combination of bad investments and highly leveraged investments explains why the crisis is mushrooming.

Hopefully, that's a coherent short version of the crisis. And hopefully for those of us whose finances are tied to the US economy (like all of Canda, basically), there won't be a long version of the crisis.


The Stash said...

here is an animated version of what you just tried to explain, only with more comedy.

The Subprime Primer

Hiromi said...

A big problem is that there has been continued resistance to the regulation of derivatives *despite* collapses of large banks in the past due to these financial instruments -- Long Term Capital and Barings, for instance.

This despite an unmistakable trend emerging in the past couple of decades: in addition to FDIC-backed low-return checking and savings accounts, more and more money is being invested in hedge funds administered by investment banks, which are not subject to the kind of regulation that commercial banks are, thus spawning what is being called the "shadow banking system" in the media. A fear that this shadow banking system will collapse is driving the bail-out of troubled investment banks.

Rufus said...

Stash- very entertaining. Thanks!

Hiromi- Well, they've been talking about more regulation here, along with "decoupling" from the US economy, which is a little alarming. I sort of think unregulated systems shouldn't ask the state to bail them out, which is basically what's happening.