Why we are where we are NOW, Good Read
This is pulled from a thread on HT called "the impending 2nd Great Depression"
it was started over a year an a half ago. Scary, but its dead on why we are where we are today. LONG READ but if you really want to understand the economy, read it.
*WARNING* LONG READ *WARNING*
First off, this is all my work except for the chart which I found via a google search. I have a similar thread in the investments section but they're all about P/E ratios, trading charts, etc which are nice and useful to an extent, but they're not so much about fundamentals and economics (see: reality), plus no one really posts in there too much so I decided to stir the pot in here.
Also, don't trust anyone who is currently working in the real estate or lending industry who says their will be a recovery soon in the real estate market, this is NOT going to happen. They are trying to make a buck before they go out of business/get laid off as the market collapses (comissions based salespeople never work in your true best interest, as always).
One more preface, this is NOT a left vs right debate, keep the partisan crap out of here please. Bill Clinton (NAFTA) and Bush (Budget defecits, pressuring greenspan to drop the fed rate so low) are both somewhat to blame with their various economic policies, as are lenders, and to an extent the average american consumer, but the MAIN culprit is Alan Greenspan and the fed.
Now wait you say, Alan Greenspan? The Fed King who presided for years over our economy, which has done, on the surface at least, very well for nearly his entire tenure.
However, in the early 2000s, the fed and greenspan decided that to stave off the 2001 recession that was started as a result of the september 11th attack. The dot com bubble burst and terrorist attacks occuring in such a short time frame (relatively speaking) were a lot for any economy to handle, so the fed made the fatal mistake of cutting interest rates to near zero. (interesting sidenote, many people funneled their profits from the dot com bubble into the real estate bubble, preventing the true effects from the 99 market crash from hurting the economy as much as they could/should have.)
Debt was inexpensive, and people and corporations started taking out loans all over the place. So now armed with cheap money, people could afford to pay more for a house without having a huge increase in payments due to the interest rates. Housing boomed all over the country, and people began to have issues buying a house with a traditional 30 year fixed mortgage. Interest rates had began to rise slowly now (2004), due to a fear of inflation after two years of very very low rates, rates not seen in 50 years. So now the rising housing prices combined with a modest uptick in interest rates made housing more expensive. The boom should have ended there, but it did not.
Enter in the adjustable rate mortgage, the interest only mortgage, 2/28s and 3/27s (2 years of a teaser rate, 28 years of variable, 3/27 is the same thing but with 3 years of a teaser rate etc., these are important) and other exotic loans. Suddenly people can afford to spend even more on housing, so prices continue to go up, and up, and up, investors get involved, as do speculators, driving up prices even further. Many of these 2/27 and 3/28 and other exotic mortgages originated between the spring of 2005 and the late summer of 2006 (also important).
It was also during this run up, which started in 99 but really gained speed in 2002, that lenders started abandoning lending standards, and going predatory. No down payment? No problem. Bad credit? No problem! No job or insuffecient income? No problem!!!!! Enter in a number of new homeowners driving up prices and demand even more. Lending institutions were banking (literally) on real estate continuing to boom, with the theory that as these loans reset and people couldn't afford the payments and were forced out of their homes, the bank could swoop in and sell the property at a profit over the original loan plus interest collected in the interim. They would loan to anyone for any property, why not, wait a few years, collect interest, foreclose, sell property at a profit, or if people could afford the loans the banks would make a killing on the payments anyway.
Prices went up and up and up and up, and an interesting thing began to happen, people began to feel wealthy as their house appreciated in value, so they began to cash out some of their newfound equity through home equity loans, a loan against the value of your house exceeding what you owe on a mortgage. This money was funneled into consumer spending (which accounts for 70% of our economy) which was a boon to growth. Lots of retail companies did incredibly well, prosperity rippled across the economy due to influxes of spending from the home equity loans and other debt which had been made cheap by the fed. Not only this, but the housing boom was fueling huge profits in REITs (real estate investment trusts, almost like a mutual fund based off of real estate, and yes I know thats a basic summary of how REITs work), and at homebuilders, and places that did business with homebuilders like home depot and lowes (more stock bubble build up). Profits went up, stock prices went up, mutual funds went up, everyone was happy.
Which brings me to the corporate and investing side of the bubble: leveraged buy outs (LBOs), merger and aquisitions (M&A) and collateralized debt obligations (CDOs).
Quick explanation of the 3 acronyms. LBOs are where a company will take out a loan (cheaply due to the low interest rates) and buy back outstanding issues of stock, as it was cheaper to pay interest than it was to pay dividends, plus it drives stock prices up which is great for those who have options (CEOs, etc, no conflict of interests there). So this drove the stock market up artifically, as did M&As.
M&As were made cheaper because hey, loans were cheap, interest rates were low, just issue some corporate bonds and buy or merge however you want, this, once again, has been driving stock prices sky high.
So now we have a real estate bubble, and a stock market bubble. Enter in hedge funds and mutual funds and the CDOs. CDOs are debt obligations made up of several buckets of loans of varying qualities, the idea behind them being they could increase profitability by bundling risky subprime mortgages and other exotic financing in with prime (less risky) loans of the variable and fixed type. Higher profits from the higher interest payments from the subprime loans, no increase in risk as the majority of the loans in a CDO are prime, sounds perfect right? Not only this, but the banks who created these securities made a killing selling them, driving up their stock prices as well!
In theory this is perfect, which is of course how the sellers and buyers of these loan packs have priced them until recently (more on that later). Hedge funds and mutual funds have bought several TRILLION dollars worth of these securities. Hedge funds and mutual funds that lots of people are invested in directly or indirectly. As the subprime loans go bad, they start to eat into the other parts of the security, damaging the value. How badly? Bear Stern recently had two hedge funds worth 9 billion dollars become essentially worthless as the subprime tranches of their CDOs made them unsellable. Creditors called looking for money and Bear couldn't sell the securities on the market, their theoretical price for the security, which they paid in actual money, was completely irrelevant. 9 billion out of several trillion, a tip of the iceberg.
So now we have a housing bubble, a stock market bubble, and trillions of dollars of securities in the hands of hedge funds and mutual funds that are becoming nearly worthless.
Enter in higher interest rates (starting in 2005 the rates went back above 3% and plateu'd at 5.25% in mid 2006 and has remained there since, also aprox 18 month lag for full effect to be felt economically in normal times without the housing mess) and the impending crash.
The higher interest rates were called into play by ben bernake to attempt to fight off inflation from rising oil and food prices, he had to do this, things were beginning to spiral out of control as the dollar weakened significantly.
The effects? We'll start with the adjustable mortgages, which are playing a big part in whats going on. These mortgages have become significantly more expensive as payments go WAY WAY up with the rising interest rate, and this is just with normal prime adjustable rate mortgages. People with 2/28s and 3/27s are in an even worse situation, remember how I mentioned the peak of hte housing boom being spring 2005 through late summer 2006 . . . . thats when tons of these loans were made, so now they are all resetting with an even greater price shock than an adjustable rate ARM. 2005 + 2 = 2007, 2006 + 3 = 2009 . . . . 2007 through 2009, thats how long this housing crash is going to last, 3 years at a minimum. The below chart shows only the subprime arm resets, not the prime, which are "safer" and "less likely" to go into default ("" denotes heavy sarcasm). It may last even longer than this as the higher interest rates, tighter lending standards and regulations and millions with ruined credit histories will place even more downard pressure on demand.
So suddenly, large numbers of people are going into foreclosure because they can't afford their loan payment resets, houses are flooding the market, pushing prices down. This flood of homes onto the market has been exacerbated by home builders building huge number of homes to ride what they incorrectly assumed as an almost never ending housing boom. Making this even worse is now interest rates are higher, people can't afford to pay as much for a home. And housing begins to unwidn at the end of 2006. As 2007 begins loans reset and people begin to miss payments and foreclose, dozens of lending companies have been wiped out, with more to come. The result of this has been a huge tightening of lending standards as lenders realize they've royally [freak]ed up, causing even fewer people to be able to afford a house. Prices begin to plummet, houses are vacant, people who can afford their mortgages are suddenly upside down on their loans, i.e. they owe more than their house is worth (due to the price drop, or due to the price drop and a home equity loan). This is a widespread issue, not localized to socal or florida, a national collapse of housing prices. Not only does the huge reduction in prospective buyers hurt prices, but the vacant and foreclosed properties severely damage the value of surrounding homes as well.
A much less mentioned side effect of this collapse is people have been using credit cards more and more often to try and stay afloat as their mortgages reset, and when they default on those payments as well the credit card companies are going to take a biggggggg hit, yet another stock market bubble popper.
Now on to how the rising interest rates and defaults hurt corporate america and the stock market. So housing collapses, and people can no longer take out home equity loans, people feel much less wealthy, tons of people go bankrupt, and consumer spending, the biggest factor in our economy, and economies around the world who export to the united states, sees a HUGE reduction. Corporate profits, GDP, employment, are ALL going to suffer as people tighten their belts through choice or by bankruptcy. Losses are on the horizon for lots of companies, and its going to cause the stock market to come crashing down (as it has already sort of), causing people to be even more fearful of spending money (vicious cycle). All you have to do is look at the earnings forecasts and guidances being put out by retailers, things are not looking rosy and we're not even fully into the housing crash yet. People have gotten leveraged to get into the market as well, more bankruptcies! weeeeee!
The M&A and LBO activity has also really dropped off as a result of the interest rate hikes and tighter lending standards. Deals can sour for corporations too, and lenders are starting to be fearful of defaults at higher levels. So M&A and LBO activity which has driven stock prices sky high over the past 3 years is now almost dead, bye bye stock bubble.
And the banks, god, the banks, oh man, the banks the banks the banks. Banks are going to disapear, big well known banks and investment houses WILL be wiped out by the foreclosures on mortgages, Credit Card losses, CDOs going bad, etc. Rates and standards are going to be high for years, putting even more of a damper on growth and recovery.
This is not an instance where the gov't can step in and bail people out, trillions of dollars in actual obligations are at risk, we can barely pay for a war costing 100 billion a year.
This economic collapse is going to lead to big time layoffs, which is going to just make things even worse in housing, which gives us yet another vicious cycle on the whole.
I can go on and on and on, but basically, we're at the spring that feeds shit creek and we don't even have a boat, let alone a paddle. The crash is going to be ugly, and the recovery could take a decade or more. If people want me to expand upon specifics or ask me questions about other effects this will all have let me know.
cliffs: We're about to see a collapse in the housing market, stock market, a bank crisis and an economic/credit crisis all at the same time. Think 1929 style but worse.
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