Over the past week, the landscape of American Finance has
been changed forever. We’ve all been
reading about the impending recession and the failures of major financial
institutions, but many of us here in the Hip-Hop nation still do not have a
full understanding of how we got to this point.
With our Government finally reaching an agreement on a plan
to use more than 700 Billion of our tax dollars to get Wall Street out of this
mess, it’s important that the Hip-Hop Nation be ahead of the curve in
understanding exactly what they’re doing with our money. Before we talk about
getting out the current crisis we should be on the same page in understanding
how we got here. Let’s go behind the
numbers and discuss the financial principles that set the stage for all of
this.
For decades, as Americans, we’ve been told that the key to
building wealth and financial security is home ownership. Historically, purchasing a home provides
better returns, over the long haul, than any other investment one can make –
better than a 401k, better than any savings, better than any stock. Additionally, there’s the added security that
in times of need, you can borrow against appreciation of the home’s value. After years of prosperity during the Clinton
administration – from the late 1990’s through the early part of this decade,
more Americans began getting their piece of the American Dream by purchasing
homes. Cities like Atlanta,
North Carolina and New York saw their property values double
and sometimes triple in less than a decade.
Banks and Mortgage companies all profited from lending money. Home values steadily increased and it was seemingly
a win for everyone involved.
When you purchase a home, normally, you take out a long term
loan with a bank or mortgage lender.
That loan creates a steady source of income – through your monthly
payments - for the lender. With so many
houses being bought, the lenders began selling those loans - for cash to give
out more loans - to Investment Banks.
For example, you get a 30 year Home Loan from HSBC. Bear Sterns, an Investment Bank, might go to
HSBC, Washington Mutual, and Bank of America and purchase your loan, and loans
just like it, at a discount. HSBC and
the other banks get the cash, which they can use to give out more loans or
invest in other markets.
Bear Sterns would then take all the loans they purchased and
package them into what’s called a Collateralized Debt Obligation – or a
CDO. What they are essentially doing is creating
a single asset out of many loans just
like yours. This is Securitization. Bear Sterns can then sell all of those
loans, as one item, to another investment bank or Hedge Fund. Again, the seller gets the cash to do other
stuff with, and the buyer gets your monthly payment – for 30 years.
The problem with securitization is that it eliminates
responsibility. If I’m HSBC, and you
come to me for a loan – and I know I’m going to sell your loan to an investment
bank – I’m not going to take all the necessary steps to insure that you will be
able to pay your loan. Good Credit, Bad
Credit, No Credit? – No problem. None of that matters because HSBC is not going
to be on the hook if you default on your loan.
And that’s exactly what happened. For the first time in years, home prices
stopped rising and in some parts of the country, they actually began to
fall. At the same time, people began to
default on the loans they’d taken out.
Some of these were no money down loans with adjustable interest rates
that rose after the first couple of years (known as ARMS). Some of the loans
were given with only stated, not verified sources of income. As these loans began to default, the value of
the CDO’s discussed above began to decrease dramatically.
Remember the thousands of loans just like yours that Bear Sterns
bought and packaged - imagine if 10% of the people who are paying those loans
ended up going into foreclosure. That
CDO loses millions of dollars in value.
Investment Banks and Hedge funds were buying, literally billions of
dollars of these types of investments, and often, they were borrowing money to
do so.
When the number of people defaulting started to increase,
and homeowners could no longer borrow against their equity, or sell their homes
for a profit, those investments lost value and the billions of dollars in
subsequent losses led to the disaster we’re in now.
