Right around summer 2007, the nation started to hear about many people throughout America losing their homes because they had defaulted on their home mortgages. Instead of being locked in at a set interest rate for their loans, many of America’s homeowners received variable home mortgage rates, meaning the interest they would pay was subject to change. Without warning, millions of people found themselves paying hundreds, or even thousands more each month for their mortgage payment. With a family to raise, food to eat and other miscellaneous expenses, families found themselves moving with friends, family or apartment and condos.

An element that added to the mortgage meltdown was that banks were “lending happy”. Many banks didn’t even do credit checks on their customers, simply lending out anywhere from $90,000-$500,000. For your credit history, it’s not only important for you to have a good one, but it is the absolute number one indicator of financial responsibility which banks rely on.

Where The Hell Is My Money? Debt On The Open Market

One thing people should understand about banks is that there is a market for “loans” and “debt”. Say you go to your local bank and get a car loan for $15,000 at 11% interest. Your local bank turns around and sells that debt to a company, say Freddie Mac. Freddie Mac now has the right to receive the money you pay for your car loan, and you are legally obligated to pay Freddie Mac. Due to simplicity and the revenue element on the part of the banks, you continue to pay your bank. How do banks make money on this? The benefit to the bank? They sell the debt of $15,000 to Freddie Mac at 9.5%, and keep 1.5% interest for themselves while having the full $15,000 in their bank to loan out to new customers. The benefit to the investment firms? Getting paid the interest on the loan. It’s a market that’s win-win.

When you put money in the bank, that money is probably NOT in the bank. Money you deposit, for example, is in the bank account of your neighbor who just sold their house. How did it get there? The bank loaned it out to your new neighbor when they applied for a home mortgage. As a rule of thumb, take the number in your bank account and move the decimal over to the left one place. That’s how much of your money is probably still in the bank.

So what happened with AIG, Freddie Mac, Fannie May, Bear Stearns, Lehman Brothers and now most recently Washington Mutual (among others)?

Well, most cease to exist. These insurance, investment companies and banks had a heavy hand in the mortgage crisis, because they had been large purchasers on the open debt market. Without anticipating all these defaults prior to the mortgage crisis in 2007, they conducted business as always: purchasing debt from the banks and other financial institutions. One bank or investment company would purchase a “bundle” of debt, and in fear of their debt defaulting, they “repackaged” it by throwing some good loans in the mix, a bow tie and a stamp on the front that says “Guaranteed to Pay”.

At the end of the day, by the time it was too late for the companies to realize it, the bundles were nothing more than a bundle of… well, you know. Whoever was left with the bad debt instruments paid the price.

When a company owns a bunch of debt that won’t pay, the company will eventually fold. Unfortunately, thousands of people lost their jobs because these companies were stuck with bad debt. It’s tough to point fingers. For every finger you point, you have three pointing back at you. But I think the blame can fall on the banks, for their irresponsibility in lending to anyone and everyone, and poor regulatory oversight. Did certain criterion need to be met in order to give out a $400,000 loan? Apparently not.

As a side note, we received an e-mail here at CF101 last week about the interest rates of Washington Mutual rising to 4.0%. Considering the highest interest rate our sponsors offer is HSBC with 3.5%, I half jokingly laughed and said myself “WAM is next”. Two days later, they collapsed. What bank increases their rate from 3.3% to 4.0% in a weeks time? A bank that’s suffocating and in dire need of cash.

How do we fix this?

This is where you’ve heard about the bailout that President Bush proposed. Aggregate estimates of the bad debt that has made these companies crumble has been estimated to be in or around $700 billion dollars. $700,000,000,000. Seven-hundred billion dollars. At face value, the proposal seems absurd. The deficit would increase, but it may be a way out of the financial crisis. Plus, many people would still be able to keep their jobs.

Next: The Pros and Cons of the Bailout

More: about AIG, WAM.

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