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Romie Has an Economics Degree
Oct. 2nd, 2008 12:02 amA few people have asked me what exactly happened to the stock market, and whether anybody predicted it. So here's a quick primer.
You probably already know that this has to do with the subprime mortgage crisis, and maybe something involving a housing bubble. What I'm hearing you don't know is how the crisis happened [Banks loaned money to people who couldn't pay it back, but why? And why all of a sudden?] or how it crashed into so many other areas [Okay, a bank is failing, but my retirement account is not at a bank, so what is going on?]. There's also a sense that it must be someone's fault, but whose?
Basically, it boils down to bad models that mis-estimated risks, and then mechanisms for selling off those risks to people who couldn't see the models. Marketplace and This American Life put together a great explanation here, and it's worth an hour of your time to listen to it.
The problem is housing bonds, which are the things that Fannie Mae and Freddie Mac make. Housing bonds are aggregations of lots of people's mortgages, and buying them has for a long time been thought of as a fairly safe way to store your money and make a little return on it - kind of in the same category as government bonds and certificates of deposit. When you buy a housing bond, what you are effectively doing is giving the bank extra money it can loan to people, and when the bank gets interest on the loan, so do you. It's low risk because the bank is also invested in the loan and you can trust that they've done all the background checks on the people they're loaning to. Aside from that, you, like the bank, are buffered by the fact that this is an aggregate - maybe some people get into trouble and default on their loans, but the majority don't, and so you can count on money coming in.
( unless something goes terribly wrong.... )
You probably already know that this has to do with the subprime mortgage crisis, and maybe something involving a housing bubble. What I'm hearing you don't know is how the crisis happened [Banks loaned money to people who couldn't pay it back, but why? And why all of a sudden?] or how it crashed into so many other areas [Okay, a bank is failing, but my retirement account is not at a bank, so what is going on?]. There's also a sense that it must be someone's fault, but whose?
Basically, it boils down to bad models that mis-estimated risks, and then mechanisms for selling off those risks to people who couldn't see the models. Marketplace and This American Life put together a great explanation here, and it's worth an hour of your time to listen to it.
The problem is housing bonds, which are the things that Fannie Mae and Freddie Mac make. Housing bonds are aggregations of lots of people's mortgages, and buying them has for a long time been thought of as a fairly safe way to store your money and make a little return on it - kind of in the same category as government bonds and certificates of deposit. When you buy a housing bond, what you are effectively doing is giving the bank extra money it can loan to people, and when the bank gets interest on the loan, so do you. It's low risk because the bank is also invested in the loan and you can trust that they've done all the background checks on the people they're loaning to. Aside from that, you, like the bank, are buffered by the fact that this is an aggregate - maybe some people get into trouble and default on their loans, but the majority don't, and so you can count on money coming in.
( unless something goes terribly wrong.... )
