Oct 29, 2008

Financial Crisis Issues (complicated but necessary with 11/04 approaching :o)

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).

6 comments:

  1. Who knows if the bailouts are going to work, I can only hope my daughter's student loans are not affected!

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  2. I'm afraid that people are expecting the bailout to work overnight magic on the market, and that's just not going to happen. It's going to take a while to recover from this, and anyone expecting an immediate recovery is going to be disappointed.

    Sad, but true.

    B.

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  3. In the Uk the Credit Crunch has hit and we have also bailed out a number of financial institutions, and it's going to get worse and our saving are not even safe.

    Yasmin

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  4. Ken:

    I hope the bailout works, they say it worked way back when. But is just a theory now, I don't trust the analysts. A few years back they said if the barrel of oul ever hit $55.00 that the United States would be in a recession? We hit much higher than that, and they still say "We could be heading into a Recession" Excuse me I may not be the smartest person in the world, but are we not in one already? Possibly worse, but what do I know?

    I thank you for this entry, and think you spelled it out pretty good! I wish you both a wonderful day tomorrow!

    Blessed Be,
    Wes

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  5. I have been against the bail out from the beginning. Now, the government has their hands deeper in our pockets and our lives. I have to say, let the free market operate and those that fail will fail. Lesson learned. No, I'm so far from wealthy and I am in the same financial mess as most folks but I don't want big government. Take a look, the government just gave birth. :-)

    deb

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  6. Hmm ... same deal with your blog as well, anywho, this is financial mess is something that the smartest guys in the room cooked up to take advantage of the ensuing panic.

    The volitility(sp) makes everything uncertain. Stay in long term, and your investments could be up in smoke at the time you are looking for them. Pull out now, and you won't have what you wanted in the future, but the future-present isn't clear enough to rely on it being there in the end.

    I don't think that it is right, and that it is the retirement of the future paying for the greed of now. That money came from the leveraged future of young people, and what do they have to look forward to.

    (clink, clink) that's my two cents!

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Tell Me What You Think, Don't Make me go Rogue on you :o)