By SCOTT MAYEROWITZ
ABC NEWS Business Unit

Is your head spinning these days trying follow what is going on with the economy?

Subprime. Collateralized Debt Obligations. Liquidity.

Every day it seems as if these words — which nobody you knew was using just a few months ago — are being thrown around.

The stock market is down. Government officials are scrambling to find ways to help the economy. And a lot of people are talking about a recession.

So what does it all mean? And how did this all begin, especially when just a few years ago the economy was booming thanks to the red-hot real estate market?

Well, that’s where the problem starts.

A combination of low interest rates and aggressive new lending practices in the late 1990s and early 2000s led to a buying frenzy.

Many banks were enticing first-time home buyers into the market with pitches of “historically low interest rates” and “no down payment required.”

In June 2003, the Federal Reserve had lowered its key Fed Funds interest rate to just 1 percent. Mortgage rates were of course higher, but were still considered a relative bargain.

Banks had also changed the way they made loans, opening up the American dream of homeownership to a whole new group of people who had always considered themselves renters.

The Mortgage Boom

With rising home values, almost everyone believed they could get rich just by buying a home. And pretty much everyone — even those with terrible credit histories — could get a home loan.

Many got adjustable-rate mortgages with low, introductory teaser rates that made their mortgage payments affordable. Those rates would eventually reset to higher ones, but many owners planned to sell first or refinance.

Even high-risk borrowers — if they made their mortgage payments on time and built up a good credit history — could refinance into a more traditional fixed-rate mortgage before their interest rates reset.

And since the home would undoubtedly be worth more than it was just a few years ago, the banks were willing to lend out more money because the collateral for a loan — the house — would theoretically be worth even more in a year or two.

How Wall Street Profited

To facilitate some of these new loans to riskier borrowers, lenders and those on Wall Street came up with new ways to package them up and sell them off to big pension funds, private equity firms, mutual funds, foreign investors and any other investors looking to profit from the housing boom.

Gone were the good old days when everything was simpler, where a local bank manager who knew a borrower for years would issue a mortgage.

The idea behind these investments, known as collateralized debt obligations — or CDOs — is that by grouping hundreds or thousands of mortgages together the risk of loss because of nonpayment is significantly reduced.

In one group of mortgages — say 1,000 homes — 40 or so might not be paying on time. But the profits you make off the other 960 mortgages will offset any losses you suffer from those 40 bad loans.

So what was once considered an undesirable mortgage to somebody with poor credit — a so-called subprime borrower — was now deemed a safe investment. Wall Street rating agencies gave the investments their blessings, and investors started buying them thinking there was little risk and high reward to buying these mortgages.

But then things changed.

As adjustable mortgages started to reset to higher rates, more people started to default on their loans, making investors uncomfortable.

Two things started to happen. First, banks and other lenders started to tighten their lending standards, realizing that they had been too liberal in who they lent money to.

Second, the value of these investments started to fall as more people defaulted. Many banks and investment firms had these investments on their books as assets. They had taken out various loans using these assets as collateral. But as these bundles of loans declined in value, the banks decided to make fewer loans.

Simply put, lenders became more cautious. Not only were they lending out less money for mortgages, they were lending out less money for pretty much everything else.

So if a manufacturing company needed to borrow $10 million to add a second assembly line to grow its business, it now found fewer banks willing to lend it the cash. The same held true for large corporations that wanted to borrow money to buy out other companies.

Starting in September 2007, the Federal Reserve has tried to make it more affordable for individuals, banks and companies to borrow by lowering interest rates, which also makes it easier for banks themselves to borrow money directly from the Fed.

But there have been many bumps along the way.

Just last week, investors started to question the health of Wall Street brokerage firm Bear Stearns and pulled their money out of investments there. As everybody pulled their money out at the same time, the investment bank collapsed.

Home Prices

While all of this has been occurring on Wall Street, home prices across the country have been falling.

It started with the rise in foreclosures, which created a surplus of homes on the market.

Further compounding the situation, lenders have now tightened the standards of who can borrow money to buy a home. So there are more homes now available for purchase and fewer people who can buy them. That causes prices to fall.

Real estate agents suffered. So did mortgage lenders, real estate appraisers and everybody else involved with the sale of a house.

Developers stopped building new homes because the demand was no longer there and they couldn’t get the same price for their products.

But it didn’t end there. The home improvement industry also suffered. With homes worth less, homeowners no longer have as large home equity lines and can’t afford to put in that new deck or buy that new refrigerator.

Additionally, since fewer people were buying homes, there was less renovating. So that meant decreased sales of paint, new sofas or whatever else people typically buy when moving into a new house.

Recession Watch

So that’s the housing market and the world of Wall Street. But why are we now talking about a full-scale recession hitting all parts of the economy?

It all comes down to consumer confidence.

Americans have much of their savings and their sense of wealth tied up in their homes.

When home prices start to fall, that feeling of wealth disappears. Whether they are really worse off today than than they were a month ago doesn’t matter. What matters is that they feel poorer, which in turn leads them to spend less.

While many economists believe that we are already in a recession, the official determination of when a recession begins and ends comes from a committee of the National Bureau of Economic Research called the Business Cycle Dating Committee.

The group’s definition of a recession is: “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.”

The widely held maxim of “two quarters of negative growth” is not a requirement for a recession, but that is often the easiest attribute to see when a recession occurs.

Falling wages are not always part of a recession, and inflation-adjusted income has not fallen substantially during five of the past nine recessions.

This was true during the most recent recession in 2001, when fast growth in productivity and declines in the price of imports, especially oil, raised purchasing power while employment was falling.

It has been almost seven years since the last U.S. recession, which was from March to November 2001. Before then, there was a recession from July 1990 to March 1991, and a previous one beginning in July 1981 and ending in November 1982.

Read more from the original source:
ECON 101: Credit Crunch for Dummies

- Sandra Simmons

Does the current economic crisis have you worried? Are you wondering how achieve financial freedom so you can protect yourself and your family from the coming financial crash? Here is what you need to know.

The first thing you need to understand is what the word economics means in terms of thinking about your family, and how you can use what it means to your financial advantage.

Forget what the media says about economics when they talk about the roller coaster ride of the stock market, supply and demand, inflation, banking industry mortgage defaults and the unemployment rate. Those are ‘economic characteristics’ that measure an area much larger than you can control.

What you can control is your own household economics. The definition of economics I am using is the original one; meaning “the art or science of managing a household or business.” And that is something that you, as an individual, can control.

There is an art to managing a household. It takes having certain skills and abilities, like organizing things so they run smoothly. There is a science of managing a household, especially in the area involving money. Here is what you can do to make sure that the economics of your household are strong and stable, even though the economy of the country may be on the slippery slide to financial disaster.

1 – Spend Less Than You Make

Take a lesson from your parents or grandparents who made very little, but lived very well. Keep expenses down to a level below what you bring home in your paycheck after taxes. The fastest road to financial disaster is spending more than you make. It’s possible to maintain your quality of life while cutting optional spending. This can be done by doing something as simple as renting a movie and making popcorn at home instead of going to the theatre, to buying a new used car instead of a brand new car.

2 – Pay CASH

Every time you purchase something using credit cards that you cannot pay off as soon as the statement arrives, you are committing your future earnings to the credit company. Those future earnings will be needed to pay your regular household expenses, so you end up in economic slavery known as the credit trap. The exception is purchasing property that increases in value, such as buying a home or investing in a commercial building that puts more income in your pocket.

Tip: When paying with cash; negotiate a cash discount. When the economy is sliding down and credit is harder to get, the guy with the cash is king. In addition, find out how to buy wholesale instead of retail to further lower your cost.

3 – Make the Money BEFORE Spending It

If there is some large purchase you need to make or want to make in the future, start putting small amounts in a savings account towards that purchase and keep that up until you have the cash to pay for it. If you have 10 years before your child enters college, then find out what the tuition will be and figure out how much you have to put away every week to have the cash the year they graduate from high school. Plus apply for every student scholarship, grant or financial aid package you can locate.

4 – Stash Some Cash for Emergencies and Living Expenses

Nothing will make you sleep better at night than financial freedom of having some cash tucked away for emergencies like having to get the car repaired, needing some unexpected dental work or losing a job. When you have a cash cushion you can get your hands on immediately, then magically, you stop worrying about money, your attention goes back on living life and enjoying it, and making money suddenly gets easier.

The only thing you have to fear in an economic crisis is not having some cash reserves in a savings plan you can immediately get your hands on. Did you know that more millionaires were made during the Great Depression in the United States than during any other era in our history? How did that happen? In that time, the economy crashed, the stock market crashed, inflation took prices of everything through the roof, the unemployment rate went sky high as businesses closed, and people who lost their jobs also lost their homes.

The people who had cash stashed away were able to buy houses, property and whole companies for pennies on the dollar. They ended up being millionaires because they had enough cash to weather the storm called the Depression.

Out of every bit of income that comes in the door, immediately carve off 10% and put it in a savings account that you have designated for your cash cushion. Even if you have to work an extra job and cut expenses on top of that, JUST DO IT! As the weeks roll by you’ll find you sleep better at night and walk through life with a lot more confidence knowing you have achieved financial freedom and protected yourself from the economic crisis looming on the horizon.

Sandra Simmons, President of Money Management Solutions has years of experience helping business owners and individuals manage their money to reach their financial goals.

Read the rest here:
How to Protect Yourself in an Economic Crisis

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• how to protect yourself in a crisis
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South Asian Journalists Association (SAJA) presents a talk radio show on 24 Sep, discussing the various aspects of the turmoil in the current U.S. economy.

Speakers includes:

• Vikas Bajaj, business reporter, The New York Times;
• Anirvan Banerji, co-director of research at the Economic Cycle Research Institute;
• John Laxmi, co-founder of a New York-based private equity firm with $4 billion under management (and SAJA treasurer);
• Sudeep Reddy, economics reporter and “Real Time Economics” blogger, The Wall Street Journal.

 

BlogTalkRadio: US Economy Turmoil

  - Ben Stein

Now for some reassuring words. Of all of the columnists writing in this space, I suspect I am the oldest. This means I have seen the most economic fluctuations. This also means I am less terrified about them than younger heads.

Let me put this differently. I read recently in The Wall Street Journal that the stock market was at the time of that writing almost in “Bear Market Territory,” which is to say, down roughly 20% or more from its high. This, said the author of the piece, shows that we are about to have very bad economic times. The author helpfully noted that the market has been down into “Bear Market Territory ” some nine times since the mid-1960’s. Without doubt, this author was trying to do his best, and to serve his readers.

But here’s a relevant addendum: yes, the market may have fallen 20% or more nine times since then. But there have only been five recessions since then.
That is to say, the stock market predicts 10 out of five recessions. Not such a great record.

The truth is that while the economy is clearly slowing down we are not yet in a recession. There has so far not even been one quarter of negative economic growth, nor even a break-even quarter. We may well have one soon, but two in a row are required for the classic definition of a recession. And as I keep saying, if anyone can call anything a recession, the whole subject loses all intellectual or factual meaning. This too could happen-a real recession-but it has not happened yet.

There are still reasons for hope. Exports are phenomenally strong. Minerals and agriculture are strong. Medical is strong. The government sector is large and robust. Sadly, military must remain strong indefinitely.

The government is running an immense deficit, and this is stimulative. True, finance is in tatters, as is transportation, refining, and home building. These are large sectors. They may fall so much that they bring the economy into recession.

But think about this: somewhere out in the big wide world, there is voracious demand for minerals and commodities. That (along with speculation) explains their major price increases. It would be extremely rare for there to be a spectacular worldwide demand for commodities along with a serious fall in demand for other factors in an economy. That is, it would be rare for demand to be both rising and falling at the same time. It could happen, but it would be rare.

However, let’s assume we do have a recession. I hope we don’t, but we might. What do we do about it? What can we do about it? Just keep plugging along. Just keep buying broad indexes. Just keep a good chunk of liquid assets. None of us can control the economy. Thus, we just have to keep swimming in the roiled waters.

As we cling to our life jackets, please remember this: no recession lasts forever. I can well recall so many times in the past when every single headline in The Wall Street Journal was about some record growth of sales or profits. Then time passes and every single headline is about horrible news. Then time passes and there is mixed news, and then it’s all good news again.

Economies go through cycles. But the long-term trend is up, and people who buy broad indexes when the news is bad, if they live long enough, live to be happy about it.
Besides, what alternative do you have? If you have money to invest, yes, keep some in cash. But cash loses its value in inflationary times. In fact, holding cash over long periods – beyond what you need for peace of mind – is a surefire way to make yourself unhappy. You will lose money on it over long periods as inflation nibbles at it.

The best bet usually is what has gone down the most, and that, for now, is real estate. I got a letter from a thoughtful reader saying he was going to wait until real estate had reached its all time low before he bought. But how will he know? And how rarely does he find a home he truly loves? Even when homebuyers buy at the top of the cycle, if they love their homes, and if they can hold on, they always end up delighted.

Yes, there will be news saying housing will not recover THIS TIME. But in fact, except in really depressed areas, housing recovers EVERY TIME and goes on to pass its prior record. The real story of real estate, as my brilliant money manager friend, Phil DeMuth, says, is of failing to buy, not of staying away successfully.

The plain fact is that you don’t know when real estate will be at bottom until it’s too late. If you see a home you love, buy it now if you plan to be in it a long time. And know that the headline writers want to whip you up and make you crazy about the economy. They sell fear. Stay calm and stay well to do.

Excerpted from:
Don?t Panic – Buy Index Funds and Real Estate