Friday, October 3, 2008

What the Heck is Going On?

I was on Twitter briefly last night, and my friend Casey asked if someone could explain the bailout within Twitter's 140 character limit.

Um, not so much...

Thank goodness for chat. In about 140 lines, I think I helped her understand what's going on. Unfortunately, most of the people who are talking about it are either 1) talking over everyone's heads, or 2) heavily biased. I am going to try to talk directly to your head, using everyday language and borrowing heavily from last night's chat. And since I haven't decided how I feel about the bailout (I understand what they're trying to do, but I hate to see the government spend that kind of money bailing out companies who took advantage of people, however, I am truly afraid of what will happen if the government does nothing... So I'm going to let people who are smarter than I am decide), I'm pretty unbiased.

If you want a bottom line, before I get into all of it, I have to suggest that you take every dime that you have and put it into a credit union instead of a bank. We met with bankers from the CU where we have had all of our personal money for 10 years, and all of our business money for 5.5 years, and after talking to them I am sleeping much easier. They aren't at risk in the same way that the big banks are, because they've invested differently. They've invested differently because each of their customers is a member - they don't have shareholders who have demanded huge profits, so they didn't make the bad investments that got everyone else in trouble. So, I believe our money is safer in a credit union than it is in a traditional bank.

That said, let's get into this bailout thing.  Several years ago, the mortgage industry went insane, right? because the interest rate was low, and suddenly people who hadn't been able to buy homes before or had poor credit scores could get approved for mortgages.  At the same time, they came up with all kinds of screwy new mortgages - rather than the standard 15, 20, or 30 year fixed interest rate - where you buy your house at X% interest and that NEVER CHANGES so long as you don't refinance...  All of a sudden people were selling these crazy "interest only" mortgages, which basically allowed people to buy $300,000 houses when they could only truly afford the $100,000 house down the street.  Their payments were only a fraction of what they should have been, for a while.

Mortgages are backed by mortgage insurance - called mortgage securities - which works the same way that any other insurance works - basically part of what you pay per month is insurance for the lender (the person who gave the cash to the person who sold you your house) that says that they'll get the money back over the next 30 years, plus interest, or the insurance policy will come into play and they'll get their money that way.  

So what happened with the REALLY low interest rate AND all these goofy mortgages is that suddenly lots of people started getting foreclosed - because suddenly they had to pay principle and interest instead of just interest.  Their monthly payments went up a lot, and suddenly they couldn't afford their homes.

When you make your 1st mortgage payment, 99% of the dollars go to pay the interest, and 1% go to pay equity... So you own like one light bulb's worth of your house after you make Payment #1. Then, at the halfway point (usually 15 years) you finally start to break even and 50% goes to principle (or what you ACTUALLY OWN of your house) and 50% goes to interest (or what you're paying the entity that lent you the $100,000 in the first place to let you borrow their money).  Equity is the money you get back when you sell - if you still have a mortgage but you have $15,000 in equity you can use that $15,000 to buy your next house.  Or you can borrow against that $15,000, using it as collateral.
But there's an INSURANCE company that tells the lender, "Hey, for $10 a month, if Joe Homeowner doesn't pay his mortgage, I'll come in and pay you the difference."

Those are mortgage securities. They secure the mortgages so that the people lending the money don't get hosed.

The problem was that with these INTEREST ONLY mortgages, for the first 3 - 5 years the home"owner" was ONLY paying INTEREST - he had no ownership (equity) in his own house. He hadn't bought any of it... So, at 3 or 5 years the payment suddenly jumps to include both interest AND principle... And suddenly the payment is MUCH higher.

And people start losing their houses because they can't afford the new rate. And these mortgage security policies start having to pay out. And then they're paying out more than they're bringing in...

What happened was all these BIG banks (Lehmen, etc.) were buying up all of these mortgage securities as investments - because as long as people are paying their bills, they're making tons of money - $10 a month (or whatever) per mortgage to do nothing but say, "Um, yeah, sure,,, we'll pay you someday..."

It was really lucrative for these banks to own these policies... They had insurance payments (Just like the monthly premium you pay on your car insurance) rolling in...

But then people started defaulting... All at once, a bunch of them had to pay out more than they had in cash reserves - they went bankrupt. It's like if you had 200 maxed credit cards, and all of them said, "Oh, hi, we need the full balance yesterday, please."

So what the government is going to do is buy up all those securities (insurance policies). The government is going to come in and say, "We, as the Federal Government are going to guarantee, lender, that you will get your money, even if Joe Homeowner defaults on his mortgage." If the gov't buys the securities, the big banks can get the bad investments off their books, and then they'll be solvent again.

At this point, Casey asked, "So will any money go to Joe Homeowner to keep his house?"


Casey: But isn't that retracting on their original contract to pay the mortgage if people default?

The money will go to the banks, to buy up the bad debt, and to the banks, to pay them for the initial money they loaned out, if mortgages are defaulted upon.

Securities are traded, like stocks... If you have 100 of these policies, I can come and buy them from you as an investment (depending on the age of the mortgage and stuff, you can tell whether or not they're likely to be profitable - statistics, etc.)

The fed will buy the securities, and basically become a huge insurance company (for a while).

Then we talked about it in specific terms, with Moosh being the homebuyer, bank A being the mortgage holder, and bank B being the mortgage security owner...

Ok, bank A loaned Moosh $100000 to buy a house. And as part of Moosh's $1000 a month payment, there's a fee rolled up in there for the security... Where Bank B basically says, "Hey, bank A, if Moosh doesn't pay her mortgage, we'll make sure you get your $100000 back. All you have to do is pay us $10 a month..."

And so bank A says, "Hey, I don't want to lose my $100K, so I'll give you $10 a month..." Bank A is protecting its ass with that $10 a month, and Bank B is gambling that Moosh is going to pay her bills and own her house outright in 30 years, and they're going to get $10 a month for 30 years for doing NOTHING but promising that they'll give bank A $100000 if Moosh flakes out.

So, Bank B is in trouble, now, because thousands of Mooshes have lost their jobs and are being foreclosed on... So now the government is coming in and saying, "Look Bank B, we're going to bail you out. We're going to buy your committment to Bank A from you."

Now if Moosh defaults, the government has to pay Bank A. And Bank B gets out of the deal. Otherwise bank B will not have enough money to cover all of its debts, and it will bankrupt itself.

Casey: And that's a bad thing

me: YES

Because of credit. We have a rocket company, right? And if NASA comes and says, "Hey, we want you to build a rocket for us..." and we know we can do it for $250K, they're not going to give us a check up front. They want the rocket, first.

So businesses (particularly small ones) rely on credit, so that they can pay for materials, people, insurance, etc. in advance, and make products, and receive payment for those products later.

But those same Bank Bs that are having trouble with the mortgage fiasco are the banks that lend businesses money to do business. They don't have any money right now, remember? because all the Mooshes are out of work, or owe more on their mortgage (now that they're paying principle and interest instead of interest only) than they can afford.

Therefore, I can't build NASA's rocket. And neither can the other small businesses who don't have $250,000 sitting around in their checking account.  Big banks, like Bank B, loan money to small businesses. But now they can't, because they don't have any money.

So I can't build a rocket for NASA, and I have to fire everyone who works for me. If the government steps in and buys that bad debt, bank B has money to loan me, again, so I can build my rocket, and the gears of the great financial machine keep turning.

The government will pay bank A if Moosh defaults on her mortgage. Moosh no longer has a house.

It's gambling - the government is betting that most people won't have to default on their houses if they stop this from happening... Maybe 1 or 2% will, but not all of the $700-850 billion worth. So, eventually (over 30 years or so) the government will get back all that money it paid out. Or it will sell the securities back to the big banks, once everything is straightened out again, and (hopefully) make a profit that will eventually trickle back down to the taxpayers.

Casey: with the same $10 a month payment from moosh?

me: Yep, but there are thousands of Mooshes. Because if Moosh keeps paying her mortgage, that $10 a month is pure profit to the security owner...

Casey: so when a house defaults, the bank owns it and the govenrment will make up the difference until someone comes in and buys the house again?

me: I think so. I'm not sure who keeps the money...  I would think, if it were like regular insurance, that the homeowner would default, and the government would pay the bank, and then the government would own the house, but that doesn't make any sense. There's the cash payout on the security (insurance policy) and there's the physical asset - the house. I don't know who gets what, exactly, but the government doesn't NEED a whole bunch of houses.

It's going to be really hard to get any kind of mortgage for a while, or a credit card, or a student loan, because the people who normally have money to lend don't have it right now.

Casey: So can the Moosh who defaulted go buy another cheaper house or are they out on their ass?

me: No, they're out on their ass. Not only is she homeless, she's lost all the equity she had paid into the house (if any), and her credit is trashed...  It'll take years for her to build her credit back up to the point where anyone will loan her anything. It could even affect her ability to get jobs. I know banks don't hire people with bad credit, for example.

Casey: seems to me like the banks keep the houses. the government pays the bank the difference and the bank resells the house.

me: And then maybe the bank gives the government back the money... that would make more sense. I'm not really sure.

And I know it's some stupid accounting rule that's making the situation look a lot worse than it is, and BJ can help explain this... Something about the banks having to reconcile (balance) their books every night, so if you have X mortgages that haven't been paid that day, it looks like a loss, even though the money isn't due until the first of the month, or whatever. It had something to do with Enron, and all the rules that changed because of that disaster.

So, there you have it.  The Bailout/Financial Crisis in 140 lines and one picture.

I have to thank BJ for watching thousands of hours of CNN and listening to thousands of hours of NPR so that he could distill all of this down to the point where I can wrap my tiny head around it.  If I have made any factual or logical errors, please please please leave a comment and correct me, whether you're BJ or not.

Also, wikipedia is a great resource for understanding stuff like this, because it is written by regular people for regular people.  You can read more at the following links:

How mortgages work.
The bailout.  And here, too.  
How credit works.

And since I can't really get into all of this without at least getting into my personal politics, I must say that I think it is criminal (and I don't use that term lightly) that our congresspeople are attaching earmarks (like a $20 million tax credit for some company that makes bows and arrows!) to the bailout bill.  I understand that this is how things work in Washington - you scratch my back by voting for my earmark, and I'll scratch yours by voting for your earmark...) but COME ON!  If the sky really is falling, if it really is an emergency or a crisis, then can't we JUST ONCE pass a clean bill that doesn't include all of this pork?  I really believe that the representatives (who are supposed to represent OUR best interests) who have attached their special-interest projects to this bill should be tried and convicted of fraud.  Because they are perpetrating a fraud on every single taxpayer in this country.

I took my own advice this week, and spoke to the bank about our money (both personal and business) and this morning I spoke to one of our financial advisors (we have two).  I am assured that our money in the bank is safe, because our credit union never invested in these mortgage securities.  I am assured that Edward Jones, where we have our SIMPLE IRAs, didn't either, and so that money is also safe.  I still need to call our other guy.  I urge all of you, beloved readers, if you're still with me, to make similar phone calls over the next week to make sure that you make any changes that may be necessary to protect yourself over the next few years.

Again, this is what YOU need to do:
  1. Pay down your debt - interest rates are going to go up, regardless of what happens in DC.
  2. Keep paying your bills.
  3. Keep your job.  Don't show up late.  Now is the time to be Employee of the Month.  Be the least-fireable person in your organization.
  4. Do not assume any new debt - don't finance anything.  Maintain your cars and your homes so that you don't need to replace them for as long as possible.
  5. Save as much as you can.  Live within your means.  No, live below your means.
  6. If you can invest, do so!  Now is the time to "buy low."  This will end, the markets will come back up.  Remember that everything is a cycle.
  7. Talk to your parents, especially if they are retired or near retirement, about their financial portfolio, and whether or not they need to redistribute their investments to protect them.  Get the help of a professional financial advisor.  Get recommendations from people you trust to find a good advisor.
  8. Talk to your advisor about your own investments.  What do you need to do to protect yourself?  What is the appropriate amount of risk for your age and situation?  Should you be "buying low" or should you be buying things that almost never lose value - like gold and land?
  9. Relax, somehow we're all going to be ok.
  10. If you don't understand something, ask.  There are no stupid questions, and this stuff is really complicated.  Keep asking until you understand what is going on.  Get lots and lots of different opinions and weigh them each carefully based on what you know about the opinion-haver.
  11. And finally, for God's sake, VOTE!  Not just for president - the House and the Senate hold the purse strings in this country.  Research your local elections (I love for this, and I use it every year to decide who is getting my vote) and make an educated choice based on your own personal beliefs and values.
Feel free to leave corrections and questions and comments in the comments.

I have to go pick up the kids now.


Erin said...

I'm intrigued by your comment that you know that banks do not hire people who have had bad credit, for example, from a bankruptcy like you described. How do you know that? Did a banking representative tell you that or did you read it somewhere? That just seems like a blanket statement and I don't think it's applicable 100% of the time.

(No this is not a "poor Erin" moment...just fyi...)

My parents lost their farm and eventually their house back in the mid-80s due to a very nasty fight to attempt to reverse an earlier bankruptcy decision. I forget which chapter is which, but originally my parents filed bankruptcy in which the debt was wiped out, but we kept the house. However my dad decided that he couldn't bear the thought of someone else farming his land and hired a lawyer to reverse the decision. In the end, we ended up homeless. We moved in to my grandparents' house for a few weeks until we found a house in the school district to rent. Obviously my parents' credit was screwed for the next 10 years.

Guess where my mom worked during the next 10 years? A credit union, insurance & estate planning, lots of temp jobs, and eventually got on at a bank in '94 I think it was and she stayed there for about 10 years.

During that time that my parents' credit was in the toilet, was it fun? Absolutely not! But was it the end of the world? Nope. They basically had to rebuild their credit doing a lot of the things that you're encouraging your readers to do. I agree with you on a lot of what to do. It boils down to using common sense and not trying to live beyond your means.

However I wanted to make the point that bankruptcy does not necessarily hurt your ability to get a job even in the financial field. Well, at least it didn't for Mom.

My folks are doing great now, financially by the way. Mom's about to retire at the end of the month. We're all looking forward to that since my parents plan on doing some more travelling and hopefully coming down here more than once a year to visit. :)

Erin said...

You know me...I love to tell stories. :)

Amy said...

Erin - in my former life, I worked as a staffing supervisor at a temp agency (Express) and I had to fill a position at a credit union that required a credit check before they'd hire anyone. I guess they thought someone with bad credit was more likely to be tempted to steal.

Of course, if your mom explained the situation, or knew someone at the bank who was willing to overlook her credit situation because they knew she was trustworthy, the situation would've been different. Also, I know that farmers are, generally, regarded differently in terms of credit because nearly everyone who is in farming has to have loans in order to make ends meet in between crops. It makes more sense for a farmer to have a $100000 loan to buy equipment that he'll use to make money than it makes for anyone else to have a $100000 loan that they'll use to buy a sweet home entertainment system. Farmers, if I understand correctly, are treated more like businesses than your average individual.

So sorry that happened to your family. What a nightmare. I'm happy to hear that they're doing great now.


Anonymous said...

What should we invest in, if we can buy low right now?