What is going on with the economy?

Okay, I looked around for a bit in GQ and GD, but still couldn’t really get a handle on the situation. I won’t pretend to be an economist, but I am (I think) a fairly smart college student, so you don’t need to dumb things down too much. I’m sure there are others on SDMB wondering the same thing.

Here’s what I know. I know that some of the country’s biggest banks and lenders are very short on cash, and have been bailed out by the government (for better or for worse, I’ll leave that for GD). I know that they’re short on cash because the housing market is shitty. Why the two are related, or why the housing market is in such crap, I have no clue. I know the stock market is down (maybe?). I know the dollar has gone down in value dramatically (at least compared to the euro). How are all these things related?

Can someone give me a general overview of what’s going on? How much is it like the economic situation that led to the depression? What are the likely scenarios that could unfold from the current one? How will I, as an ordinary person just out to get a job and live life, be affected by the current climate, and by anything that plays out?

This will no doubt end up in GD, but here’s my take on the problem. I’m no economist, but I read and think I have a general handle on the problem:

[ul]
[li]Laws passed during the 1990’s–particularly the Gramm-Leach act–tore down some of the regulatory walls erected between the various financial sectors in the wake of the Great Depression. This allowed banks, for example, to sell financial instruments based on revenue they received on loans, such as the common home mortgage.[/li][li]Banks (and anyone working in the housing finanace market) now have a greater incentive to sell mortgages, so credit in general becomes easier to come by. This has a threefold effect: (1) more borrowers with poorer credit ratings receiving loans–particularly adjustible-rate loans, which ratchet up the interest rate after some introductory period–(2) an increase in average home price–if credit is easier to obtain, sellers can increase the price on homes they put on the market–and (3) more speculative purchases in the housing market, i.e. people are buying properties they don’t intend to live in or borrowing on terms that assume the property is easily disposable.[/li][li]The credit risk starts to catch up with reality. ARM rates ratchet up and suddenly that cheap loan doesn’t look so cheap anymore, or changes in the job market cause a loss of the personal income required to maintain the mortgage. By this time the original mortgage has been cut up and resold a few times in the securities market (in ways that often hid the original credit risk), so the connection between the person making the payments and the person receiving the income is tenuous at best. In any event, more people begin to fall behind on their loans, or outright default, and are finding it difficult to renegotiate because the paper isn’t held by their local bank any longer.[/li][li]As the easy-credit assumptions behind many of these securities is exposed, credit starts to tighten, which means housing prices must fall because buyers can no longer get the money they need to purchase expensive homes. This causes speculative investors to bail–exacerbating the problem further–and even those who own their home are in danger of being underwater and facing a hiked ARM payment, indicators that increase the likelyhood of a future forclosure. Defaulted loans is basically what did in Fannie Mae and Freddie Mac, as these companies disproportionally serve the sub-prime lending market[/li][li]Because many of these securities are not traded on an open market–i.e. they are traded on an unregulated market–the requirements to reveal the details of the capital supporting them aren’t as stringent as, say, on the stock or bond market (in short, they are easier to undercapitalize). So it’s easier to hide the losses for a period of time. This means that when losses are reported, they often have a devastating effect on what market there is. This is what knocked out the major investment firms like Bear-Sterns, Lehman Bros., etc.[/li][li]By law (and common sense) investment firms are required to carry insurance against these types of failures. These insurance contracts–you can thank Gramm-Leach again for this–can also be divvied up and traded as unregulated securities, hiding their potential risk. AIG is being forced to pay off on more of its policies than expected; the losses are mounting, and there is even more worthless paper being held by investors.[/li][li]The US federal government has decided that some of these firms are just “too big to fail”; if AIG filed for bankrupty, the amount of worthless paper in the hands of investors would likely crash more investment groups around the world in a domino effect. Thus the Fed is “loaning” AIG some $80 billion dollars to cover the losses and receiving 80% of the company in return. Similar logic is behind the earlier bailouts of Fannie Mae/Freddie Mac and Bear-Sterns[/ul][/li]Again, I’m no expert, so please feel free to correct.

That’s a pretty good summary of what’s happened.

The Gramm-Leach-Bliley Act.

Source: http://en.wikipedia.org/wiki/Phil_Gramm

Contrast Gramm’s legacy to that of Jim Leach.

This pdf of a transcript from This American Life http://www.thisamericanlife.org/extras/radio/355_transcript.pdf, I found an easily understandable summary. It blames the current trouble on rating agencies.
Also see: http://www.washingtonpost.com/wp-dyn/content/article/2008/09/16/AR2008091602877.html for a description of how principal transactions and leveraging contributed to investment banks going bankrupt.
The Gramm Leach Bliley explanation is controversial.

There’s both rising unemployment and rising inflation, along with skyrocketing food and energy costs, and a weak dollar*. Can any of this be directly tied to the housing/financial crisis, or are they happening concurrently and only exacerbating each other?
Either way, how do these things interact?

Everything CJJ said seems correct, but there is an overarching problem behind it. Everyone is too highly leveraged. Let me explain. Suppose you buy stock and put up 10% cash and borrow 90%. Now you can buy ten times as much stock as you could if you paid cash. The result is that all gains are multiplied by ten (great), but so are all losses (not great). Worse, should the sock happen to go down by 10%, your lender will want you to put up more cash. If you have it, fine, but you may have to sell not only that particular stock but also others you own. Since the sale is forced, this makes matters worse by depressing the price even more. Of course, one person will have no such effect, but tens of thousands or more will.

Now the SEC regulates what percentage you can borrow on stock. I was unable to find the current rate; google gives nearly a million hits on margin rate, but none of the first ten seems to be the actual rate.

Anyway, stocks aren’t the real problem. It started with real estate and has now moved to AIG, which insures against losses. Someone told that the have guaranteed about 30 times their actual cash reserves (sorry, I don’t have a cite, but it is the principle that counts).

Now what happened to the old conservative banker, insurance company, etc.? What happened was that old Zeke lost his job because young Steve down the street was making his bank down the street twice the profits. Old Zeke was replaced by Steve’s kid brother Scott, who started making twice the profit Zeke was. Now both banks are out of business.

Tangentially related, rising global demand for oil and ethanol have caused oil and food prices to go up. A weak dollar causes firms that import to do worse and firms that export to do better, higher unemployment is the result of this transition. More unemployment and higher oil and food prices cause some people to have a hard time paying their mortgages on time. Mortagage defaults are the reason for this finance crisis. However, because of collapse of the housing bubble and the misunderstanding of the risks involved there would have been a mortgage crisis anyway. The oil price shocks and weak dollar have probably made it slightly worse.

I want to add one thing to CJJ*'s post, which he just touched on. The amount of capitalization a bank has and needs depends on its assets. Many of them are traded, so the value will change regularly - but not by much, it is hoped. However, the market has collapsed for a lot of these mortgage backed instruments,so auctions for them fail. Say you offer a bond for $500, but no one even makes an offer for it at any price. How much is is worth? Maybe it is worth $200, or maybe everyone is so uncertain that no one wants to bid. This situation has meant that the value of a lot of assets for the banks, especially those that took big risks on these, is unknown. Which also means that no one wants to lend them money, since their credit is unknown, and that no one wants to buy them without help from the government, since their value is unknown. This uncertainty just makes things a lot worse.

That’s interesting. Don’t you just love that arrogance - “We don’t need these common-sense safeguards that those fusty old Depression-era guys came up with!” Yeah. Nice thinking…

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