Understanding the Economic Crisis - What You Must Know to Prevent Foreclosure and Bankruptcy

Most of the folks in the country, and in fact most of the people in the world, are completely perplexed by the deep economic recession which faces us. You may be losing your job, fighting to protect your home, strugging to prevent bankruptcy, and all the while you may be wondering what went wrong. The truth is, understanding how and why we are in these dire economic straights will help you protect yourself and your family in the months and years to come.

The first step in understanding the problems we face here in the United States is to imagine that you are playing Monopoly. You know, the board game where you buy property and get $200 every time you make it around the board. Let's imagine you and some friends have been playing for a while, merrily rolling the dice and buying the properties you land on. Now imagine that someone reaches into the game and takes away half of everyone's money and almost all the money in the bank. Now you only get $50 when you make it around the board.

Imagine how your playing behavior will change.

• You purchase far less property because you have less cash.
• You really hate having to pay rent for properties you land on, because you have less cash.
• You really hope you'll get sent to jail, because at least there you pay no rent and your cash is preserved until (hopefully) the rules change again.

In effect, this is exactly what has happened to the United States and much of the world. A huge percentage of the "liquid money" available to consumers in the US and around the world has disappeared. Thus, the "rules" of our economy have changed, and not in the ways you probably expect.

Understanding the "Game"

When you went to school, at some point, they tried to explain to you how and why money is printed in the US. You deposit $100 into a bank, they keep $10 in cash and give the other $90 away in a loan. In effect, the bank tells the world you have $100 and the other guy has $90. In effect the bank just made $90.

That is how we used to make money. About ten years ago, we started doing something more complex and, as it turns out, more risky.

Imagine a 10 people, each of whom has borrowed to purchase a house that costs $1 million dollars ($1M). So, in effect, the bank has created about $10M. Actually, they've created slightly less than that, but lets just call it $10M.

Each of these folks pays what they owe with interest. Lets assume they pay $50K per year.

Someone, at some point, realized that, in effect, this was an income stream of $500K per year. And they turned that into an investment. They told investors, if you give me money to buy these loans, we'll get that revenue stream of $500K per year. Investors thought that was a fine plan. They bought into that investment, thinking it was safe. Investors used the stock they purchased as collateral for their own loans . . . just as they would have used any other "business income" to justify a loan.

And this "trick" of turning loans into investments wasn't just applied to homes. It was applied to credit cards, film production loans, car loans . . . Almost every class of loan was treated this way.

In effect you had loan payments being treated as investments which were used as collateral for other loans.

House Prices Shot Up But Wages Did Not

It will not surprise you to know that if loans are treated as lucrative investments that can be bought and sold, loans start being made very frequently. Credit becomes "loose".

When people buy a house, the amount they can afford to pay for the house has to do with how much they get paid in wages and how much they can borrow. House prices over the last decade or so shot up quickly because credit was easy to get.

Unfortunately, wages did not keep pace with the growth in credit. More and more folks used their credit cards and their home loans to buy things, because prices were going up and wages were not.

And Then Something Went Wrong

In order to turn a collection of loans into an "investment", especially a highly rated investment, investment managers would buy "insurance" that would guarantee that if people stopped paying the loans, someone else would pay instead. These insurance plans were called "credit default swaps" or CDS's.

AIG was a company who sold a lot of these kinds of insurance plans, and last year they found that people were not paying their mortgages at a much higher rate than they expected. It became apparent that AIG, and companies like them, really could not make good on their "insurance policies". And that meant that trillions of dollars of investment were now much higher risk than expected.

It also meant that banks were now confronted with millions of mortgages that might be bad. That meant they were insolvent. Banks stopped loaning one another money. After all, if you are a bank and you have a bunch of loans that may go into default, and a bunch of credit cards that might go into default, and you know the Federal Reserve will close your bank down if they find out you don't have the money and assets you are supposed to have . . . you aren't going to share your cash with other banks. You aren't going to make many new home loans. You aren't going to issue new credit cards.

Do You See Where the Money Went?

When banks don't make loans, house prices have to fall because the price people can pay for a house has to do with how much they make and how good a loan they can get. If they can't get a loan, the price they can pay for a house goes down.

Businesses can't get loans either, and that means they can't ride out this rough patch in the economy. They start firing people because they can't earn enough to pay them.

When people don't have money, they can pay even less for a house. And when millions of houses are in foreclosure, the price of a house falls even farther.

What Does This Mean to You and Your Family

The truth is, there's just less money around and that means the price of everything has to change. Some things will "re-price" faster than others. Wages are falling quickly, because people are frantically cutting what they charge for their time because jobs are disappearing. House prices are falling because house are cheap. Perversely, if you got a mortgage back when credit was cheap, you paid a lot for your home.

Loan Modification and Loan Renegotiation will let you bring your home loan back in line with reality.

If you've lost your job, or had to take a lower paying one, your credit cards may have been charged up to a point you literally can't repay. That is when credit counseling and debt consolidation can be helpful. Even bankruptcy can make sense when you just can earn enough to pay your mortgage, your living expenses and your credit cards.

A Final Note

It is very unlikely, if not impossible, for the credit and wage market to reset to what it was even three years ago. Contacting a cross section of professionals who can prevent foreclosure and protect your assets is the rational thing to do.