The Financial, Credit Crisis - explained with visuals. By Quicken.

Quickenbeam.com The financial crisis. How did this all happen?? Let’s start with the Borrowers, from their point of view… Things were going swell with the US economy. With low interest rates people can borrow money easily (it’s cheap to pay it back) When people borrow money, that puts lots of money in the system, lots of ‘liquidity’ There was a general shift. The banks feel OK offering lots of people a loan….even those that may not normally qualify. These are called Sub prime borrowers. Banks offer more loans, with lots of different terms. Adjustable rates, interest only for a while, etc. The buyers were encouraged by mortgage lenders, the terms were doable, at least until the rates adjusted, and overall, people were confident. When House values go up, my house increases in value. I will be able to renegotiate my loan for a better rate from someone else.. The economy is still growing! The buyer isn’t worried about their mortgage. Interest rates were historically low.

Banks usually make loans, and pay it back with the deposit money from their other customers… What do they do with this deposit money? They loan it out. to make money. But the banks aren’t silly. They know they have to insure this loan. So they ask insurance companies to protect them if the buyer decides he can’t pay. Banks are happy, this frees up money, reduces their risk and allows them to make more loans. Investors saw an opportunity to help banks make more loans and curb their risk. They grouped a chunk of these loans, and, bought them from the bank.. (Pooling of loans is called securitization) Now, more money moves. The investors want to turn around and sell these off in ‘secondary markets.’. A company, like AIG, insures the loan. The Bank pays AIG a small sum of money regularly, to insure the big sum of money.. The insurance company invests this money that the banks give them, in places like the stock market. But…many of the loans were too risky to do this. So there came to be a rating system which helped expand the pool of potential buyers, to people all over the world. But this stuff is expensive.. How do banks even afford it? Well…these investors would get short term loans. What does that mean? They pay a lower interest rate (price of borrowing) on this short term debt, than what they earn from longer term mortgages that they invest in.. So they make money. Because these are short term, they have to be “rolled over,” Meaning that in a short while, you get a new rate on the loan. When interest rates are good and people are paying their mortgage…this works out. But when things change… From the lenders point of view… These levels, categorized by risk, are called traunches You have a rating system which instills confidence, and lots of sophisticated and unsophisticated investors bet on these ‘safe’ investments. Quickenbeam.com

Quickenbeam.com So what happened? So things were good. The economy was growing fast, and then 2 things happened. The Fed decided it was time to raise interest rates. They wanted to prevent inflation, which happens as a result of lots of money in the system. So it went from 1% to 5.2% over a period of time. And…overall the number of people (or the demand) for houses went down. So less people bought houses,. With less people buying houses, the price of homes fell. People who had these loans out and thought they would be able to refinance their home, when the value of their home went up, were stuck paying a much larger payment than they agreed on. And subsequently…couldn’t make their payment. So lots of people defaulted,. When the borrower doesn’t make payments …someone still has to come up with the money. . 1 2

. These loans were no longer with the banks that had made them. Instead they were held by investors around the world. And because these banks can’t borrow, they are left needing money, and wanting to sell their securities..* But…no one really wants to buy these.. Here’s where it gets sticky. Remember the bank.s…: In this case, the fear that drives the word “crisis” is that no one will lend money (bank to bank, or otherwise). People are afraid of the default risk…and it simply becomes ridiculously expensive to borrow money. … And we have a credit crisis. Hence the necessity to give banks money…or Bail them out with money. Bankers didn’t count on this perfect storm, everyone defaulting at the same time. There were big models of risk…none of which predicted this. It became harder for banks for borrow. The impact wasn’t just the mortgage market. It trickled into the corporate market and overall drove down the appetitive for investment. SO….the price of borrowing went up and the value of debt goes down. What this means is that Banks had to write down their assets. How much? People were unsure. When people don’t know, they don’t trust. And when you don’t trust someone, you’re not going to want to lend them money. This is called a liquidity crisis.. Imagine if you had a gold necklace that you thought was worth mega money., and you bet it in a game of poker. You lose. Then, the next day, you find out the necklace is worth a lot less. Yikes! You still owe that person money, but now can’t sell the gold necklace to get the money. The banks had a lot of gold necklaces they couldn’t sell, and needed money *Securities.. are any form of ownership that can be easily traded on a secondary market…bonds, stocks, mutual funds. Quickenbeam.com

That borrower (that the bank got an insurance policy for) stops making paymen..ts…he defaults. The Bank, having insured against this possibility, asks AIG for money. The insurance company doesn’t have this money in their back pocket. They invested it. So the insurance company pulls out some of their investments…in order to pay the Banks back., so the house can be paid for. Stock prices go down. … And we have a stock market crisis Now remember the insurance guys? Overall, confidence in the market is going down. with a lower investment appetite, and general economic downturn… Lots of people default Quickenbeam.com

What does it mean???

The fear of various banks not having enough cash, or get short term loans to cover their debt) is increasing the risk down the entire chain

Relatively "safe" investments are being seen as risky.

Moving money isn’t a bad thing…as it may seem from the story. It is important for money to move to where it will be most efficiently put to work. Important projects, businesses and the economy get starved of necessary cash.

Two fears with the liquidity and credit crisis, and one big reason the government felt the need to come to the ‘rescue’ immediately:

- Businesses will have trouble getting loans…. And the result can be layoffs.

Government bonds are harder to sell….the result is less or canceled government projects.

The system was built on a lot of complex risk models that said that this perfect storm wouldn’t happen.. The rating system then enforced the safety of these investments. For things to get better, many say it’s dependent on trust being able to be restored in this (or a) system.