I'm going to go a little off topic here, but trust me, I'm going somewhere with this.
Most of you have been affected by the downturn in the economy over the past five months. Even if you were not directly affected, I'm sure you know someone who has either lost their house, lost all their equity in their house, or has lost a significant amount of money in their savings. What I'm talking about is the American sub-prime housing fiasco, which is quickly becoming a worldwide financial concern.
For those who are not financial junkies like myself, let me give the brief version of what has happened in the financial markets in recent years. As usual, it has a lot to do with greed, subterfuge, and a lack of foresight.
In 2003, banks and financial institutions realized that the only way to keep the housing bubble inflated was to keep people buying homes. The problem was that most of the eligible market had already been serviced in the previous few years and the market was threatening to dry up.
Luckily, they identified a huge untapped market of potential home buyers: people who could not afford homes. These people would never get a bank loan under normal circumstances, but these were not normal circumstances because the banks had a great plan. They would just hope that the good times would never end.
Taking all of the best parts of "historically low interest rates" and combining that with the traditional "low payments for three years" with just a dash of "don't worry, we'll figure that out when it happens", they created a new financial tool called the subprime mortgage. This deal allowed home buyers to pay only two percent interest on the first few years of a mortgage with the interest rate jumping to a variable rate afterwards.
It's amazing they never thought of this before. All they had to do was figure out a way to convince people with poor credit to lock themselves into longterm financial quagmires. So it was like shooting fish in a barrel.
Suddenly, people who would normally have been renting were able to buy a starter home. People who should have been in the $200,000 market were buying $400,000 homes. And the wannabes started buying McMansions when they should have been living comfortably in a house half the size. These loans started to get extremely popular because when the friends of these new home owners stopped by for a visit, they were amazed by the grandeur and the low payment so the friends got into the market too and bought using subprime rates. And so on and so on.
What wasn't explained to these people (or what they conveniently ignored) was that your mortgage payment - for the first few years anyway - mainly consists of paying down your interest. And if the current rates are "historically low", then they can only go up. Once they passed the subprime phase of their mortgage, they were going to be on the hook for mortgage payments that were up to 50 percent higher than they had been paying before. If they were having trouble coming up with $1,500 per month, how were they going to find another $600?
Now, you might ask why the banks would take on such risk. Good question.
Answer: They didn't care because somebody had figured out a way to make even more money off the situation.
Enter the wolves. Wall Street saw this this situation and went to work selling snowballs to the Eskimos. They started pooling all these subprime loans together and selling them off to banks and other financial institutions. The idea was that as long as the real estate market was thriving, there would always be value in holding these securities. But the real estate market could only keep thriving because of these ridiculous loans.
See the circle?
In essence, it was a glorified pyramid scheme perpetrated by Wall Street and kept hidden by low interest rates. And nobody cared because it was one of those gr