Wall Street is going crazy, but how can you make sense of it all? Here is plainmoney.com‘s simplified guide in ten easy steps:
1. It starts with the old-fashioned savings and loan association, like the Bailey Building & Loan in the classic movie It’s a Wonderful Life. That savings and loan association would accept deposits from people, loan them out on mortgages, and all was well. (Stay with me; this is going to be easier than you think.)
2. That is, until people lost confidence in the savings and loan association. Then if they all tried to withdraw their deposits at once, the savings and loan wouldn’t have the money — literally. The money was tied up in mortgages. The mortgages were sound, though, and all would be well if confidence could be restored.
3. So, if there was a run by depositors, it would take an inspiring speech by a George Bailey character to restore confidence. In time, federal insurance of deposits was an even better solution. People wouldn’t have to run get their money out if they knew federal insurance was there.
4. Backed by federal insurance, the old-style savings and loan association still had two main problems: 1.) It could only draw savings from a limited area; and 2.) Its requirements for credit-worthiness left many people unable to own their own homes, especially poor and minority borrowers.
5. The answer was to open up opportunity, both by making mortgage finance national and by easing requirements for home ownership. This was accomplished largely through the packaging and sale of mortgages to investors everywhere, enabled by the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac.”)
6. In the housing boom of the early 2000s, Fannie Mae and Freddie Mac encouraged truly risky mortgage finance behavior — lending money to people who wouldn’t have qualified in the old days. It was an over-correction to the earlier practices that had restricted home ownership.
7. As long as the housing boom continued, the risks didn’t seem very big. If a homeowner with poor credit stopped making payments, then refinancing or even getting kicked out wouldn’t be much of a risk on that mortgage money. Why? Because reselling the house at an even higher price would allow the lender to get repaid.
8. But when the housing boom stopped, everyone then realized there were thousands and thousands of homeowners who owed more on their houses than the houses were worth. They were “upside down,” so to speak. Now if the owners stopped paying, the lender might lose money.
9. There’s a lot of money tied up in mortgages that are likely to go bad. And unlike the days of the old federally insured local savings and loan association, failures don’t just hurt one local institution. In fact, lots of financial institutions had made huge gambles on mortgages not going bad — not only with their own money but with borrowed money too.
10. Because of bad mortgages, we’re back in the old movie (It’s a Wonderful Life) again. People have lost confidence in the relevant financial institution, but this time it’s a huge network instead of a single savings and loan in quaint little Bedford Falls. Any solution will have to restore confidence, and it may be very expensive to get that done.
There’s the problem, in ten easy steps.