FISCAL FALLOUT: How Did We Get Here?

Over the past week, the landscape of American Finance has

been changed forever.  We’ve all been

reading about the impending recession and the failures of major financial

institutions, but many of us here in the Hip-Hop nation still do not have a

full understanding of how we got to this point. 

 

With our Government finally reaching an agreement on a plan

to use more than 700 Billion of our tax dollars to get Wall Street out of this

mess, it’s important that the Hip-Hop Nation be ahead of the curve in

understanding exactly what they’re doing with our money. Before we talk about

getting out the current crisis we should be on the same page in understanding

how we got here.  Let’s go behind the

numbers and discuss the financial principles that set the stage for all of

this.

 

For decades, as Americans, we’ve been told that the key to

building wealth and financial security is home ownership.  Historically, purchasing a home provides

better returns, over the long haul, than any other investment one can make –

better than a 401k, better than any savings, better than any stock.  Additionally, there’s the added security that

in times of need, you can borrow against appreciation of the home’s value.  After years of prosperity during the Clinton

administration – from the late 1990’s through the early part of this decade,

more Americans began getting their piece of the American Dream by purchasing

homes.  Cities like Atlanta,

North Carolina and New York saw their property values double

and sometimes triple in less than a decade. 

Banks and Mortgage companies all profited from lending money.  Home values steadily increased and it was seemingly

a win for everyone involved.

 

When you purchase a home, normally, you take out a long term

loan with a bank or mortgage lender. 

That loan creates a steady source of income – through your monthly

payments – for the lender.  With so many

houses being bought, the lenders began selling those loans – for cash to give

out more loans – to Investment Banks. 

 

For example, you get a 30 year Home Loan from HSBC.  Bear Sterns, an Investment Bank, might go to

HSBC, Washington Mutual, and Bank of America and purchase your loan, and loans

just like it, at a discount.  HSBC and

the other banks get the cash, which they can use to give out more loans or

invest in other markets. 

 

Bear Sterns would then take all the loans they purchased and

package them into what’s called a Collateralized Debt Obligation – or a

CDO.  What they are essentially doing is creating

a single asset out of  many loans just

like yours.  This is Securitization.   Bear Sterns can then sell all of those

loans, as one item, to another investment bank or Hedge Fund.  Again, the seller gets the cash to do other

stuff with, and the buyer gets your monthly payment – for 30 years.

 

The problem with securitization is that it eliminates

responsibility.  If I’m HSBC, and you

come to me for a loan – and I know I’m going to sell your loan to an investment

bank – I’m not going to take all the necessary steps to insure that you will be

able to pay your loan.  Good Credit, Bad

Credit, No Credit? – No problem. None of that matters because HSBC is not going

to be on the hook if you default on your loan.

 

And that’s exactly what happened.  For the first time in years, home prices

stopped rising and in some parts of the country, they actually began to

fall.  At the same time, people began to

default on the loans they’d taken out. 

Some of these were no money down loans with adjustable interest rates

that rose after the first couple of years (known as ARMS). Some of the loans

were given with only stated, not verified sources of income.  As these loans began to default, the value of

the CDO’s discussed above began to decrease dramatically. 

 

Remember the thousands of loans just like yours that Bear Sterns

bought and packaged – imagine if 10% of the people who are paying those loans

ended up going into foreclosure.  That

CDO loses millions of dollars in value. 

Investment Banks and Hedge funds were buying, literally billions of

dollars of these types of investments, and often, they were borrowing money to

do so.  

 

When the number of people defaulting started to increase,

and homeowners could no longer borrow against their equity, or sell their homes

for a profit, those investments lost value and the billions of dollars in

subsequent losses led to the disaster we’re in now.

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