ECON 101: Credit Crunch for Dummies

Is your head spinning these days trying follow what is going on with the economy?

Subprime. Collateralized Debt Obligations. Liquidity.

Every day it seems as if these words -- which nobody you knew was using just a few months ago -- are being thrown around.

The stock market is down. Government officials are scrambling to find ways to help the economy. And a lot of people are talking about a recession.

So what does it all mean? And how did this all begin, especially when just a few years ago the economy was booming thanks to the red-hot real estate market?

Well, that's where the problem starts.

A combination of low interest rates and aggressive new lending practices in the late 1990s and early 2000s led to a buying frenzy.

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Many banks were enticing first-time home buyers into the market with pitches of "historically low interest rates" and "no down payment required."

In June 2003, the Federal Reserve had lowered its key Fed Funds interest rate to just 1 percent. Mortgage rates were of course higher, but were still considered a relative bargain.

Banks had also changed the way they made loans, opening up the American dream of homeownership to a whole new group of people who had always considered themselves renters.

The Mortgage Boom

With rising home values, almost everyone believed they could get rich just by buying a home. And pretty much everyone -- even those with terrible credit histories -- could get a home loan.

Many got adjustable-rate mortgages with low, introductory teaser rates that made their mortgage payments affordable. Those rates would eventually reset to higher ones, but many owners planned to sell first or refinance.

Even high-risk borrowers -- if they made their mortgage payments on time and built up a good credit history -- could refinance into a more traditional fixed-rate mortgage before their interest rates reset.

And since the home would undoubtedly be worth more than it was just a few years ago, the banks were willing to lend out more money because the collateral for a loan -- the house -- would theoretically be worth even more in a year or two.

How Wall Street Profited

To facilitate some of these new loans to riskier borrowers, lenders and those on Wall Street came up with new ways to package them up and sell them off to big pension funds, private equity firms, mutual funds, foreign investors and any other investors looking to profit from the housing boom.

Gone were the good old days when everything was simpler, where a local bank manager who knew a borrower for years would issue a mortgage.

The idea behind these investments, known as collateralized debt obligations -- or CDOs -- is that by grouping hundreds or thousands of mortgages together the risk of loss because of nonpayment is significantly reduced.

In one group of mortgages -- say 1,000 homes -- 40 or so might not be paying on time. But the profits you make off the other 960 mortgages will offset any losses you suffer from those 40 bad loans.

So what was once considered an undesirable mortgage to somebody with poor credit -- a so-called subprime borrower -- was now deemed a safe investment. Wall Street rating agencies gave the investments their blessings, and investors started buying them thinking there was little risk and high reward to buying these mortgages.

But then things changed.

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