I sincerely hope I'm being civil here.
I will quote what a member wrote:
"Let others worry about your problem"? Seriously????????????????????????????????????????????????
Isnt that what got the US into this problem in the first place?"
End of quote.
I take it you are referring to the latest serious economic crisis (housing bubble)..Why should you let others worry about your problem? Because the problem began as a social upheaval fueled in great part by the investment sector, which tried to get what they are supposed to try to get: profits for their owners and their clients. And this was a spectacular opportunity. And you could not have solved this collective problem all by yourself.
We have the profit motive throughout the whole of the event. Profits is not a bad thing. Imagine you bought a house and it's market value started increasing by 10% per year. You could pay back your whole mortgage, sell your house at a tidy profit and buy another one, maybe snazzier. Profits are good, aren't they?
Please understand I cannot write a treatise in a blog, so many things will surely not be mentioned. This is a general idea.
Banks, as all lenders do, to put it shortly, lend you money IF you have money. Or if they have confidence that, in a specific time in the future, you will have money (plus the honest intention to pay back your loan).
Some very high ranking political authority felt this was somewhat unfair. There are thousands and thousands of Americans who were denied the American Dream because the risk officer at many banks denied them mortgages because they estimated that they would not have the means to pay them back in some future, distant or short., time.
Now, this is common sense to any lender. If you're not reasonably sure the lender will pay you back, you don't lend the money. I mean, you don't want to make the bank lose money. It has to be profitable. Your own wages depend on that. The owner didn't decide to put his money in building a bank, which is something most societies consider useful, to lose all his money plus all the money he borrowed to build his bank. This is business, so you don't lend money to people you consider not to be reliable. Of course, you can't be sure 100% of the time, so to cover possible losses (besides making a profit) you charge an interest on your loans.
Then comes this well-meaning politician and dictates, for example, that 10% of the loans the risk officer rejected have to be made available to minorities and other financially distressed people. After all they are Americans and should see their American Dream come closer.
It helped that Alan Greenspan, at the Fed, to fight the dot-com bubble had lowered interest rates considerably, and for reasons only this mysterious man who spoke in riddles understood, (that's why some people thought he was a genius I believe) he kept the interest rates low for an unusual amount of time. A word of caution here. The Fed does not set the interest rate by just saying "this is going to be the interest rate". It does so by manipulating it through the purchase and sale of bonds.
So the interest rates were low, making mortgages more affordable, and house prices were stable, so the banks said OK, we'll lose a little money but it won't be much.
Then, these minorities were "allowed" to get mortgages and at a low interest rate. Other people as well. And suddenly demand for houses started increasing. The real estate business was caught by surprise since they were expecting some higher demand but not as big as it became. Higher demand for your products is naturally seen in a good light because you can charge higher prices while, at he same time, you begin to increase house "production" to take advantage of the ever rising prices. Business is business and the prospect of higher profits are not the exclusive domain of Wall Street bankers. But, naturally, in a changing market, new profit opportunities arise. So the clever bankers found a way to climb into the bandwagon.
Now Alan, the wizard, found himself between a rock and a hard place. This had to be stopped before it ran out of hand. He began increasing interest rates but, alas, by very small amounts every month. If I recall correctly they increased from somewhere around 2% to 5% during the rest of his tenure. And mostly by 25 basis points only. Then Ben Bernanke appeared on the scene. I think it was because of his famous predecessor that he felt obliged to keep on increasing rates. Now from 5.0% to 5.25%.
This made mortgages more expensive every month and some people began to renege on payments. By this time the bankers' and investment houses' profits were going full steam ahead. You see, they invented a new investment scheme based on, what's more trustworthy, mortgages.
Until that time mortgage bonds were so safe they paid low interest rates and were classified as AAA investments. This was so because the vast majority of Americans who had financed their homes with mortgages, religiously paid their monthly installments. If not, the bank could take their house away.
But now the game was different. The banks had made packages of mortgages, each with a mixture of good, medium and hopeless mortgages. They took these to the classifying agents like S&P, Moodys or Fitch and argued that these packages should all be rated AAA. This is important for banks since they are allowed to hold, let's say, unlimited amounts of AAA rated investments, but very few of a lower standard. This is done to protect depositors.
The banks claimed that mortgages had always been good investments, that the AAA mortgages in the package would definitely be paid, some would have to renegotiate and defer the debt (at higher interest rates) and they would take away the homes of those who did not pay, because that was the collateral of the debt. And house prices were climbing. So these investments got classified as AAA. They were called collateralized debt obligations, where the houses were the collateral.
They were much better investments than mortgage bonds since the "bad" mortgages in the package paid higher interests. So the package, as a whole, became a very attractive investment and banks had a lot of these AAA investments.
And then things started turning sour. The real estate folks had built so many houses that house demand was struck in the head with a surplus of already built brand new houses. House prices began to fall. Ben Bernanke at the Fed saw he was being struck with another bubble and began lowering interest rates. But it was too late. People began noticing that the mortgage payments, that still were due, were higher than the value of the whole house. So they simply stopped paying, left the keys at the bank and said "take it back". All this added supply of housing made their prices go lower and lower.
Bankers began panicking because their collateral kept shrinking and nobody could know for sure how much the CDO's they had were really worth. At the end of each day, bankers must keep at least a fixed percentage of their deposits in the Fed to ensure that a run on the bank won't leave them without cash. At the end of the day some banks have more and some have less. So they borrow and lend themselves, at what is called the "interbank rate", in order to have the right amounts.
But with their enormous amounts of CDO's nobody knew what the real financial situation of the banks were. Something like: "you see, I can lend this bank the $ 500 million he fell short; but how can I know if he has enough to repay me tomorrow? If he has to sell CDO's to repay me nobody knows how much he'll get for that sale" So, maybe, I won't lend him the money.
If banks stop lending to one another the banking system starts to freeze and Bernanke's headache will get worse. The banks disguised their situation by valuing the CDO's in their accounts at purchase value, as if they were fixed assets. But what the Fed, the customers, the shareholders and the bondholders wanted to know is what they were worth at market value, which was getting lower and lower.
As the truth began spilling out it became known that many big fish were actually broke or quite close. And not only American banks but quite a lot of European banks also. The CDO's were such an attractive investment they spilled over worldwide.
If banks stop lending to each other the whole international trade goes belly up. When I sell a plane to Germany they draw up what is called a "letter of credit", which is a promise made by their German bank whereby, when they receive the plane, they will transfer the money to my American bank. If my American bank doubts if the German bank will be able to pay because they don't know how many or what is the market value of their CDO's, they will not accept the letter of credit and the deal is gone. CDO's began to be called "toxic debt".
In America, the Treasury Secretary Hank Paulson, former CEO of Goldman Sachs, with some aides, had to decide which banks were "disposable" and which had to be kept going at any cost. I won't go into details. They are classified information.
One last big problem remained. The world's biggest insurer, AIG, had insured a great number of institutions against losses on their CDO's. Now, when an insurer covers your house for fire, they have no problems because they collect insurance fees from the rest of your neighborhood which covers what they must pay you. But now, for AIG, the whole neighborhood caught fire. There was no way they could cover all the CDO losses of all who had taken the insurance, mainly banks. And if the banks did not receive their insurance they would go broke.
This is called a "systemic risk" because if it happens the whole financial system collapses. So AIG had to be bailed out.
And then we had the effect on GDP. Consumers, in light of the world bank disaster they were witnessing, stopped asking for credit and put away their credit cards. They began buying much less that what they were used to. The effect of consumer spending in the USA is enormous. 71% of the nations GDP is made up by consumer spending. And US consumer spending represents about 25% of worldwide consumer spending.
It was imperative to get consumers to borrow and spend again. But propensity to save had the upper hand this time. Despite the Fed having lowered rates to almost zero nobody was borrowing and spent the money they earned paying down debts.
I'll stop here. I believe the rest you know, like the increase in the Fed's balance sheet and so on.