14 Sep Global Financial Crisis
An Explanation Of Why We Are Currently In The Shit part 1 Global Financial Crisis
Firstly let me start by stating that I am not a financial guru. But seeing as it is all the financial guru’s that have got us in the shit, I take that as a positive. I am going to try and explain the 2007/2008 global financial crisis as I see it in layman terms. As lets face it, it is confusing. How is it that problems in the US housing market have affected us all. So bear with me. It is quite complex but interesting.
What started the Global Financial Crisis?
It started about 15 years ago with Alan Greenspan who was in charge of the American Federal reserve. To stimulate the American economy he kept interest rates low and then made them even lower, all the way down to 1%. This is the rate that banks borrow money from the Federal Reserve bank. Thus making debt very cheap. Interest is the penalty you pay for borrowing money. If that penalty isn’t large, then banks borrow large. If the potential benefits are massive compared to the risk, as they were, then banks borrow massively.
This was the case with Lehman Brothers. They borrowed money from the Fed at 1% and then lent it out to sub-prime lenders (other banks) at 3%. This 2% profit they were making might not seem like a lot but when they collapsed they owed 500 billion dollars. One of the sub-prime banks that Lehman Brothers lent to was American West. American West then lent the money to consumers at 8%. A nice 5% profit margin. Why such a high and profitable margin? Because the people that they lent to were risky lenders. These lenders they call sub prime lenders. So they weren’t great people to lend to. That is why they had to pay the higher interest rates as they were considered risky.
So why did this become a problem and turn into a global financial crisis? How did the house of cards come crashing down? Firstly those sub prime lenders were given 100% bonds on their properties. So the property cost 000 and they were given the full 000 to buy the asset. This was not a problem as long as the value of the asset/house was increasing each year as it did for a number of years in the US. Then the bubble burst and property values started to fall. What this meant is that if a bank had loaned you 000 to buy a house in 2006. Property values dropped and now that same house was only worth 000. So now the house that was used as security of the loan, is worth less than the amount that was originally loaned. Uh Oh!! Still not a major problem as long as the person you loaned the money to doesn’t default on their payments. But this is exactly what started to happen. People defaulted and banks had to repossess their houses. Houses that are now worth less than the original loaned amount. As more people default, more houses are repossessed. Suddenly their is an over supply of houses. Banks can’t even sell the houses at the reduced prices. Plus due to the oversupply, housing prices drop further.
In my next post we will discuss how this problem turns into a global melt down. Hope you enjoyed my first post on the global finacial crisis.