Understanding the 2008 Economic Crisis

The Subprime Mortgage Crisis

How does the economic crisis affect you?
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The 2008 economic troubles seem to be blamed on the subprime mortgage market. The subprime mortgage industry began to feel the effects of a looming crisis, and it spread across different areas of the economy. To understand the financial lessons from the economic slow down you need to understand why it happened. Why did this start and how will it affect you in the long run?

To understand how this really began you need to understand how the mortgage market works.

First a subprime mortgage is a mortgage lent to someone who would not normally qualify. This could be due to income, poor credit history or both. As a safeguard these loans usually have a higher interest rate. In addition many of these loans were made as adjustable rate mortgages—which means that the rates would adjust up over time and increase the monthly payments.

The subprime mortgage loans have a greater risk of default and so banks usually limit the percentage that they have on the books. However with the dropping interest rates of the last few years many more people who wouldn’t normally qualify for a mortgage took advantage of the lower interest rates and got mortgages. Many of these people stretched themselves to the limit, assuming that they would be able to refinance when their interest rates adjusted up. However the housing boom ended and many did not build as much equity as they were hoping to, and did not qualify to refinance their mortgages.

They found they could no longer make payments and began defaulting on the loans.

It is also important to understand the secondary mortgage market. The secondary mortgage market is the market where banks sell mortgages to other banks. They will package groups of mortgages together and sell the groups to other banks.

In theory this spreads the risk between multiple banks, and protects everyone if the housing market were to burst in one area. For example a typical bank would hold mortgages in several different locations: California, New York, London and Georgia. Chances are that mortgages spread over such a wide area would reduce the risk, but when the entire market drops there is not a safety net in place. 

Fannie Mae and Freddie Mac are key in helping the secondary mortgage market to function. They purchase the loans from the original banks, so that the banks will have liquidity to make new loans, and then sell them to other banks, often investment banks. The secondary mortgage market experienced trouble when investment firms, other countries and banks stopped wanting to buy these mortgages. They feared that they were no longer valuable because of the recent foreclosures and defaults on all the subprime mortgages.

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The United States government offered a bail out and agreed to back most of the loans that Fannie Mae and Freddie Mac hold currently. This happened on September 6, 2008. One thing that happened is that interest rates on mortgages dropped. The market seemed to rally a bit around the fact that these loans were guaranteed. However it means that the taxpayers are going to cover those that default on the loans.

The government agreed to cover up to $200 billion in loans so that the market could remain liquid.

The Fannie Mae and Freddie Mac bailout was not enough to save the two biggest investing firms in the United States. Lehman Brothers declared bankruptcy the following week, and Merrill Lynch was sold to Bank of America. This caused a crisis on Wall Street and resulted in plummeting stock market prices in the United States and around the world. Consumer confidence was shaken as AIG faced a crisis as well.

AIG got into trouble by offering insurance products that guaranteed the loan amounts to investors when the loans went into default. With the recent increase of default the company found that they no longer had enough to cover all of the defaults. The United States government again stepped in and backed up AIG so that it would not go under as well.

It has taken many years for the housing market to recover.

Many people ended up losing their homes, and the banks began to be much more cautious about lending money to people. The prices of homes fell, but are beginning to see an increase in value again. However, banks are much more cautious about lending money to people.

The bailouts and the use of golden parachutes for the executives that led their companies into needing bailouts led to the Occupy Wall Street movement in 2011.

The movement focused on the inequality between the world's wealthiest and the other 99% of the world's population. many people who graduated during the economic crisis had a difficult time finding jobs. The bailouts may have save a few companies, but did not seem to have the hoped for effect on the economy as it continued to struggle for several more years. 

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If you are wondering how this affectedt you personally, you should begin by taking a look at your personal finances. You may find that it is a little harder to qualify for a mortgage. The numbers of subprime mortgages are going to decrease dramatically. You will need to have a sufficient income and decent credit history to qualify for your loan. You should also plan on having a good down payment saved up for your home.

You should also take a look at your debt load. It is a good idea to reduce the amount of debt that you have. Many people are looking at all types of credit and feel that the crisis might spread to the credit card market as well. You can protect yourself by living within your means and focusing on getting out of debt.

Your savings and investing strategy should remain the same. You should continue to save and invest your money. The FDIC should be able to handle any other bank collapses. The stock market will recover eventually and your money will continue to grow. Remember to spread your investments so that you do not have them all in one company. An easy way to do this is to invest in Mutual Funds.

You may also need to build up your emergency fund, because it can become more difficult to find a job during a recession. Usually a recessions leads to layoffs, which in turn leads to a bigger recession, which then leads to more layoffs.

It is a vicious cycle. It can lead to a period of deflation, which is even more difficult to recover from. Do what you can to prepare yourself to remain competitive in the job market.

It is important to be prepared to handle an economic crisis. Good basic money management with a budget that allows you to get out of debt and build your savings can help you handle an economic crisis much better.

Take the steps during good economic times to prepare for the bad ones. 

More on Personal Finances and the Economic Crisis