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

Last night I happened to catch an episode of “Larry King Live” which included a feature on the current housing crisis along with a panel of participants including Robert Kiyosaki, author of ‘Rich Dad Poor Dad’, and Donald Trump.

While the stats by now are known to most people – The Shiller Home Price Index was down 15.5% for April ‘08 vs April ‘07, and over 1 Million foreclosures have been filed with many many more expected, the real overarching questions were a) is this a good time to sell and if you have to sell then what can you do to sell, b) what do you do if you are a homeowner facing foreclosure, and c) is this a good time in terms of opportunities to buy and invest?

The unanimous consent amongst the parties was pretty much as follows

a) This is not a good time to sell obviously and if you do not have to sell then you shouldn’t. If you do have to sell then you can sell if you price your property appropriately. This means first of all IGNORE what other homes are listed for, the only thing that matters is what homes have actually SOLD for recently as a valuation bench mark. If you must absolutely sell then discount your home 20% below current market value and you will find that it sells very rapidly. The bottom line is that it is not that there are no buyers, it all boils down to the numbers.

At our business we have been working diligently for the past 2 years, communicating to our sellers that the one thing that is more important than anything else in determining whether or not a listing will sell is price. We have some listings that have lingered without activity for a year where sellers simply refuse to face the realities of the market, and then other listings that are selling in a week, because in those cases the sellers are realistic and follow our advise. The Sarasota real estate market is what it is and if you ignore market realities then you simply will not sell.

b) If you are a home owner in trouble the resounding agreement was that the very worst thing you can do is ignore the lender when you get your notice. Lenders do not want to own your home, and they are willing to work out loans with home owners and today you have a lot of leverage as a owner in renegotiating your loan. The only predicament today is unfortunately that lenders will not discuss your loan until you are at least a couple of months late. Once you are late however you will find that you have the ability to get the lender to agree to work with you so you do not lose your home.

In our business we are working with a lot of short sales and I do see many lenders making amazing concessions. Some lenders are of course better than others. The worst unfortunately in terms of communicating is Countrywide and it is well possible that Countrywide’s own internal upheaval is contributing to this. Hopefully once the acquisition by Bank of America is finalized this will change.

c) Is this the time to buy? The panelist were in full agreement that we are either at or very near the bottom of the market. And yes, this is a great time to buy, as the best time to buy in any market is when prices are down and everyone is selling.

That being said, the days of real estate as a get rich quick scheme is over. You have to know what you are doing. Just because something is a foreclosure or bank owned property and priced at a seemingly amazing price does not mean that it is a great investment.

I tend to agree. If you are looking to buy a home as your residence then definitely now is the time to strike. Sellers are super motivated and there are a lot of opportunities to snap up a property that simply was unheard of in the past. And 5 years from now your property will certainly be worth more than you are paying today. If you are an investor then you need to understand how to evaluate a property as an investment. If you buy something in hopes of a quick flip then you will get most likely hurt. This is not the time to flip properties.

Overall I felt this was a very informative segment with a lot of optimistic view points. I would love to hear your views on the aforementioned 3 points, particularly with respect to the Sarasota Real Estate Market.

All the best…

Thomas Heimann, President & CEO
Bravo Real Estate Solutions
http://www.bravobrokers.com/

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Housing Market Crisis Opportunity?