Earl Chua

How the Economic Crisis Started

So I was talking to my financial advisor the other day and of course, one of the main topics that we talked about was the economic crisis that the United States is going through. Obviously we’ve all watched the news, read the newspaper, or at least heard people talking about the economic crisis and the $700 billion bailout plan. Although I didn’t pay as much attention as I could have, I felt quite foolish when I had to admit to my advisor that I really didn’t know why all of this was happening. It turns out a lot of people do not know as well. So I will try to explain it as best as I can.

This whole crisis started because of mortgages. A lot of qualified people were jumping on the hot real estate market and borrowing money from banks to get mortgages. These mortgages were very profitable and caught the attention of investment firms that realized that they could make money off of these loans as well. The investment firms and the banks ended up packaging a bunch of these loans and sold it off to larger financial institutions at a slightly higher interest rate, making a profit on the interest gap. These larger financial institutions would then repackage them into larger packages and sell them higher up and so on. This was very profitable for these financial institutions which also increased the demand for mortgages. The increased demand for mortgages then caused more and more banks to start lending money to less and less qualified people.

This was actually possible because although a lot of these people couldn’t afford to pay off their mortgages, home prices and the value of these buyers’ homes kept going up. The people who took out these mortgages began using their houses and borrowed against them. But nothing goes up forever and the party eventually came to an end. The housing prices stopped going up and these buyers still needed to pay off their mortgages. But because these loans were made to people who did not have the resources to pay them, they were unable to pay off their loan.

As people were not able to pay back their mortgages, these loans became the debt of the institutions that loaned the money out. Suddenly commercial banks that originated these loans and the investment banks that repackaged these loans were left to take on the debt of their faulty borrowers. As a result of all of this, a good amount of investment banks such as Merrill Lynch and commercial banks such as Washington Mutual could not pay back these loans.

The accumulated debt was so high that they needed $700 billion of hard earned tax payer money to make up for these millionaire bankers who messed up. Hope this helped.

Avoid the credit trap

Lately I’ve been hearing a lot more of people who are getting themselves into debt which actually inspired my “how to not be broke” series. Anyway, it’s very disturbing for me to find out that people I know and associate with have put themselves in the situation that they are in. While some have reasonable and manageable debts of $1-2k, I actually know of some one with over $100k in bad debt and not showing any signs of changing. Scary.

While there are good and more understandable debts such as student loans, business loans, or even home loans, I will be talking mainly about bad debt. Here are some things that can get you into debt quick.

Credit Cards

Everyone knows the benefits of having a credit card. Having a credit card provides a convenient way to pay for things and comes in handy during emergencies. Credit cards are convenient, but that does, of course, come at a price. What seems convenient at first can also get you into a situation that’s not only inconvenient, but emotionally disturbing as well – in debt.

Unfortunately we now live in a time where the consumer culture has a hold on us and easy access to credit is what causes overspending. Credit makes it way too easy for us to make large spontaneous purchases that we would not normally make if we had to pay with cash. These days, it seems like everyone is using their plastic to not just buy the things they need, but everything else on their wish list. Whether its an iPod, a plasma tv, or even vacations, people are purchasing things that they cannot afford.

The sad part about credit card debt is that for a lot of people, the more money you make the more in debt you become. The person who makes more money will just use his credit card to buy even more expensive and extravagant things that he cannot afford as well. It’s people in all classes living beyond their means which creates this vicious cycle of the debt trap.

Financing

I was talking to an associate who works at the BMW financial department the other day and he was telling me that less than half of the people who buy cars at BMW could actually afford it. And by affording it, I mean that the car is less than half of their yearly income. He laughed as he told me of young “ballers” making $30k a year and purchasing $50k cars and how they felt after getting the car. They feel that because they signed their life away to finance the car, people will think they are rich and important, and I guess that makes them feel better.

I would never be able to justify financing a car that costs more than my yearly income. That means that if I worked a whole year and didn’t have to pay for anything else…I still wouldn’t be able to pay off the car. What more if you have to pay for gas, insurance, rent, food, and I’m pretty sure credit card debt as well. At this rate, the debt will just continue to pile up and it will never end until he or she becomes bankrupt.

These days they make it way too easy for broke people to purchase cars. They will finance anyone and they even have deals which don’t even require any money down. As long as you have a job, you can walk into a dealership and drive the car away, with no money. This gets people to believe that they can afford things that they really can’t which in turn gets them into deeper debt.

Why do I think people get themselves into these situations? You’ll have to wait for the next post cause I need to go to sleep.