The financial crisis: what is going on?

The events of the last few weeks are truly without precedent in the financial history of the United States.

We have witnessed the largest and supposedly most trustworthy institutions become financially impaired principally due to the poor decisions made by managers.

We have also witnessed the government become actively involved in the sector, putting its good name behind trillions of dollars in financial assets of dubious quality in order to prevent what could be the collapse of the entire financial sector. As if this weren’t enough, investors have lost over $1 trillion in equity around the world and markets continue to fall.

What caused this financial crisis?

The principal cause of this crisis is the U.S. housing sector.

During the boom period earlier this decade, millions of mortgages were approved for individuals who under normal circumstances would have never, ever been approved for them. These people did not earn enough money nor have sufficient assets to truly afford these mortgages. The collateral for these mortgages, the houses being bought, were really not worth the purchase price either.

Many people at the time benefited from this “open secret”. The buyer was able to live in a home that traditionally would be considered beyond their means. The mortgage broker and real estate agent earned a juicy commission. The bank that issued the mortgage charged higher than average fees and interest rates. Freddie Mac and Fannie Mae charged high fees to insure these mortgages for the bank.

Investment funds and other banks bought financial instruments backed by these mortgages that offered very high rates of return.

To multiply this return, they borrowed almost unimaginable amounts of money. And of course, executives at all of these companies received millions of dollars in bonuses for their “good work”. The shareholders of these companies were also rewarded with rising stock prices.

Even the government benefited from higher tax receipts and the good publicity associated with such a high percentage of the population owned their own home.

But all of this success was based on a key assumption that buyers and the ability to make their mortgage payments consistently on time. That of course, was not the case.

Everything has collapsed and the success has become failure.

Long-term and short-term effects

The effects of this crisis will be felt for many years. In the short term, our economy will enter a recession and interest rates on consumer debt like credit cards, card loans and mortgages will increase. It will also become more difficult to qualify for a loan.

The safest investments, like government securities, will pay very low rates of return as everyone rushes to buy them.

The government will also become far more active in regulating financial activity. If the past is a guide, they will over shoot and produce too much regulation which will stifle economic growth and lead to less job opportunities. We may even enter a period of deflation (the opposite of inflation) were prices fall due to lack of demand, which is very damaging for the economy.

Is the U.S. economy still strong?

Despite all of this, it is important to remember that the U.S. economy continues to be the largest in the world and in many respects the safest. It is bigger than any financial crisis, even this one. As an individual, if you try to save a little more, spend less than you make each month, and invest in truly secure investments for the long term, then this crisis will prove to be nothing more than a bad memory.

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