The housing bubble
At a time of rising home values, the seed for the crisis was sown when risky borrowers were able to obtain home loans from mortgage lenders, which pooled mortgages together and sold them for a fee. The banks hired investment banks to package the mortgages as securities with different risk layers. To sell desirable risk loans, banks kept significant amounts of less-desirable loans -– typically lowest-return, highest-risk loans -– for themselves. The investment banks sold the rest of the securities to a wide variety of investors. In some cases, banks parked the securities in off-balance-sheet funds, called Structured Investment Vehicles, which the banks themselves sponsored. The securitization of these assets allowed banks to transfer credit risk to capital markets and focus on generating fees rather than interest income.
Insurance was purchased to enhance the credit rating, or hedge the value, of securities. The role of insurance companies, like AIG, in providing credit enhancement or protection made asset values on bank balance sheets dependent, in part, on insurance company solvency. For this reason, regulators viewed the potential bankruptcy of AIG as posing a systemic risk.
After peaking in October 2007, home values began to decline, with the pace of that decline accelerating through the summer of 2008. At the same time, over-extended home buyers began to default on their mortgage payments, and foreclosure rates began to sharply climb.
The Credit Crunch
Increasing mortgage defaults and excess housing supply led to the collapse of real estate values, which underpinned mortgage security values and caused a crisis of confidence in bank solvency. As the values of mortgage securities fell, banks recorded losses, now totaling more than $660 billion. The losses required them to raise new equity capital to reduce leverage as well as to tighten credit, which has forced down spending.
Consumers, tapped out on credit with declining home values and a lack of savings, have stopped discretionary spending.
In September 2008: Treasury Secretary Henry Paulson announced the federal government takeover of Fannie Mae and Freddie Mac. Bank of America acquired Merrill Lynch. Lehman Brothers filed for bankruptcy, the largest of its kind. The Federal Reserve lent AIG $85 billion in exchange for nearly 80 percent of its stock. Washington Mutual failed, representing the largest bank failure in U.S. history.
Secretary Paulson proposed a $700 billion rescue plan.
The Dow plunged. The bailout begins.
In October 2008: The President signed the $700 billion bailout bill into law. Wachovia agreed to be purchased by Wells Fargo for $15.1 billion. Hedge fund and mutual fund redemption's led to massive selling of equity securities.
While it may be too soon to know whether the bailout of the nation's financial institutions alone will solve this crisis on a global scale, be assured that there will be volatility in the markets. If your are five or more years from retirement, this is the time to hang in the market, and keep following the practice of monthly purchases. Over the long run, you may come out ahead. If you are closer to retirement, or already retired, you need to watch a little more closely, the last thing you want to do is to panic, and lock-in recent losses. If you have a year or two cushion, then I recommend watching the market on a regular basis, and sell only when it makes sense (the market is so volatile, that watching the market daily if you have assets at risk can be beneficial).