ECON 101: Credit Crunch for Dummies

March 20, 2008— -- 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.

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.

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.