A Layman’s View of the Credit Crisis

I am not an economist nor do I have a business degree.  So, I do not really understand all the ins and outs of this current “Credit Crisis” that we’re in.  The funny thing is that I’ve got friends with MBAs who really don’t understand all the derivatives and complex debt instruments that made this problem so much worse.

I took a couple of real estate development classes when I was in college.  Our professor told us that real estate is a cyclical market, and that during booms, prices go up and credit is easy to obtain (low rates).  At the peak, homes become overvalued and people can not afford them.  Then defaults start, prices start to decline, and lenders pull back (loan less money at higher interest rates, to account for increased risk).  Then it bottoms out, and another boom starts.  Pretty simple, right?

Think about how that cycle was perverted during the last boom that ended in 2006.  Credit was too easy to obtain, and with zero down, interest only and teaser rates, people could afford a home that cost hundreds of thousands more than they could only 10 years before.  So the peak was pushed to an artificial, unsustainable peak.  Now, instead of a few people defaulting, there is a massive wave or foreclosures, and lenders aren’t just pulling back, but they’re failing altogether.

This same analogy can be used to describe our current financial system.  Normally, people would borrow to buy a home or maybe a car, or for some catastrophic event.  We used to save to buy things.  I remember my uncle who paid cash for a car.  How crazy does that seem now?  In our current state, we started using credit for buying cars, boats, or for items we really didn’t need, but wanted.  Instead of saving up for something, we just put them on credit.

During the last real estate bubble, banks were basically giving credit away.  You could use your house as an ATM machine and buy all sorts of frivolous things.  If you borrowed against your home at a low rate and invested it and made a good return, that’s one thing, but most people just spent the money.  

So now, we’re experiencing the downturn in the cycle.  But instead of lenders just tightening standards and pulling back, they’ve gone to the extreme of not lending at all.  This is the trade off for years of giving money away.  Lenders are so nervous that they will not get repaid that they won’t lend to even the most trustworthy borrowers.

Now is the time interest rates should be rising.  In order for a lender to take the extra risk of lending you money, they charge a higher rate.  Instead though, right now, rates are being cut.  There is no extra premium for lending money, so why would a bank right now.

The point I’m trying to make is that this whole mess needs to bottom out before we can move forward.  Currently, though, we are taking all sorts of measures to keep the bottom from being found.  Until the debts are all sorted out and liquidated, there will be the lack of confidence between parties and no one will lend money.

In the bigger scheme of things, the fact that credit is such an important part of our economy is disasterous as well.  Credit should be used to finance big purchases and that’s it.  Instead, businesses rely on credit to meet payroll and overhead costs.  Individuals use credit to buy groceries and gas.  Our reliance on credit for every day purchases has exagerated the problem as well.

We need a return to saving and thrift with the American people, and a government that will let the bottom be found.  Until those happen, we will only be propping up the house of cards and not rebuilding it with more sturdy materials.

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2 Responses to “A Layman’s View of the Credit Crisis”

  1. kanadianbakin Says:

    Rates will go up after the election, at least it has in the past. This could be different though, rates could bottom but the consumer will not see a penny of the move. Governments should learn from past mistakes. Nice post.

  2. Business news and reviews Says:

    Good post. I think that it reflects what alot of ordinary people are feeling at the moment. There has to b a return to savings and less consumer driven economics. No country can survive by being the worlds shopaholic, no matter how rich it may be.

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