The Failing of the American Economy

Today, I'm going to talk about the failings of the American economy.

Contrary to popular belief, the free market did not cause this recession. I know that text isn't the best medium for expressing this sort of idea, but I have no video camera, so...I'll make do.

So. I've done a lot of reading on the subject, so I'll try to condense the main points into a couple paragraphs.

The Main Problem-Makers

From the eyes of the free market system, the main trouble makers in the financial crisis are Freddie Mac, Fannie Mae, Barney Frank, Chris Dodd, and The Federal Reserve. I don't have time to go over the entire thing today, but I'll start off with Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac

For those of you who don't know, Freddie Mac and Fannie Mae are GSEs, or Government Sponsored Enterprises. Basically, their entire purpose is buying back mortgages from banks. The theory is, the more they buy, the more money banks have. The more money banks have, the more loans they can make.

So, what can they do with these mortgages?

They sell them as mortgage-backed securities. How does that work? I'll show you.

Let's say couple A buys a $500,000 house. They put $50,000 in the down payment and get a $450,000 mortgage from Bank of America. I'll make up a rate, say....7.8% over 25 years. If the homeowners paid their monthly payments exactly right every month for 25 years, they would have paid the bank 1.024 million, after interest.

Fannie Mae, for example, would buy that loan from bank of America for $600,000, say. The bank makes money right away, a cool profit of 33%, they're happy. Fannie Mae now packages this mortgage with a whole bunch of others. For easy math, lets just make it a bundle of 100 mortgages with the same stats. So, Fannie Mae has now paid out 60 million for a bundle that will someday (assuming all the homeowners pay off the entire mortgage) be worth just over 102 million.

It seems like good business, and even a good way for everyone to come out ahead, right?
Well, if they had stopped right there, and used the money gained from that to pay off the deficit, it might have worked. Instead, they wanted instant gratification. So they sold shares in these bundles.

Again, seems like it would work. Why not sell shares? These shares were circulated throughout the market, and then the hammer dropped. When the housing bubble popped, people couldn't afford to pay their mortgages. So, the hedge funds and banks that had been buying up these shares of Fannie Mae's "mortgage-backed securities" lost money. So people pulled their money out of the hedge funds, and banks began to divest themselves of these toxic assets. So all of a sudden, Fannie Mae found itself in a massive amount of debt. And the government bailed them out. So now the people are being foreclosed on, the banks are shaken (which drives up rates and makes it harder to get a loan), and Fannie Mae can't afford to buy more loans (which makes the banks even more unwilling to lend).

Why could so few people pay their mortgage? More on that next time.