What does it mean to you?

Let’s break it down to understand.

What is this crisis exactly, and how could it cause another Depression?

First let’s start with explanation of what a depression is:

Depressions are marked by mass unemployment and a sputtering economy. As Frank Chodorov put it, “A depression is a halting of production. Production stops when people cut down on their consumption.” People want to work, but can’t find it. People want to borrow money, but no one lends. People can’t pay their debts. They lose their homes, their cars, their businesses, their jobs.

Do you know why depressions happen?

Depressions happen because resources get put to bad uses.

People have gone to work in industries that provide “goods and services” that other people no longer want. For example, a few years ago everyone was becoming a real estate agent. Today? Real estate agents now drive around looking for more homes to list with no buyers. These people have had to find something else to do. In 2006-early 2007 real estate agents were making a killing. In a Depression a lot of people are looking for something else to do all at the same time.

“How the economy found itself in the state that it is in today?”

Here is the core thing you have to understand about where we are right now.

We’re experiencing a credit crunch of monumental proportions in the credit markets. The credit markets are the places where borrowers and lenders meet up to exchange money for promises. A borrower takes money from a lender, and in exchange for that money gives a promise – to pay back the money with interest.

What’s a credit crunch?

Banks do not trust other banks, therefore they don’t lend to one another, if they don’t lend to one another then the banks don’t lend out to the rest of the public. Instead are holding onto their money to make sure they survive another day.

How do you know when a crunch is on? Do you have to ask the lenders? The borrowers?

No. Just watch interest rates. You see the signs of a credit crunch anytime interest rates suddenly go way up. Especially when interest rates raise within a matter of days.

Why do they go up in a crunch?

Because there’s not enough of the money to go around for everyone who wants it, so the people who are “selling money” have a lot of potential customers bidding for it.

The supply and demand effects money as well. When demand is low and supply is high, interest rates are low. When demand is high and supply is low, interest rates are high.

In the last couple of weeks, short term interest rates – specifically, the rates at which banks lend each other money overnight – shot up around 200%.

The crunch borrowers are experiencing right now is primarily in short-term money that companies need to borrow.

Notice I said need to borrow, not want to borrow. If they don’t borrow, bad things happen.

Many companies borrow money for short periods of time to cover expense or pay for things they need immediately, like inventory or payroll, because don’t have the cash right now. This is called “commercial paper”, companies like GE and Intel trade this “paper or credit” everyday.

They can get a short-term loan because they’ll have the cash later. Because they will have the cash later, someone will lend them the money they need right now and get paid back, with interest, a little later.

So right now the big worry is that there’s a shortage of this short term money for borrowing, and it’s putting companies under so much pressure that they might have to shut doors, stop delivering services, and lay off people.

If you don’t have product to sell because you can’t finance it, then you can’t make a sale, can’t turn a profit, can’t pay your people, your rent, your long-term debt, your light bill, etc.

This is what is happening with Wachovia, Lehman and other large institutions. They didn’t have enough credit to stay open and pay their short-term debt. They can’t make your reserve, they can’t pay their employees.

What happens if you can’t pay your people?

They can either work for free, or they can try to get another job. Either way, it’s a hardship. Their mortgages have to be paid. Their kids have to eat. It’s incredibly disruptive. Mass layoffs means mass defaults on consumer debt (they have credit cards and cars that they bought on credit), which means consumer lenders tighten credit, too. And it spirals downward.

See, in the business world, people often don’t “pay off” debt with cash in their bank account – there isn’t any cash there. They pay off one loan by going and getting another. This is called “rolling over” debt.

People can’t roll over their debt, and they can’t get cash for their short term needs. So they’re being threatened with having to close their doors and lay people off, all because they can’t roll over this debt.

These are often great companies, profitable companies, companies with customers and demand for products.

So we know what’s happening. But why is it happening? Why can’t good companies get short term debt?

There are two reasons lenders get afraid to lend.

1) They’re worried they won’t get paid back on the loan.

2) They’ve also borrowed money to lend it back out, and they’re worried they’ll have to pay it back before they have it.

When you borrow money, it doesn’t come without strings attached. There are certain ways you agree to run your business and certain standards you agree to keep. There are also collateral values you agree to maintain so that in case you don’t pay the loan back they can take over something of value, sell it, and recover all or part of the loan loss.

There are many individuals that are losing their jobs and have no money to pay back their debt.

But something else is going on. Even on loans that are getting paid back, the assets (the collateral values) attached to the loan are dropping in value as a collateral.

Borrowers and lenders both are becoming INSOLVENT.

Being insolvent means you are unable to meet your debt obligations. You owe more than your asset is worth and you can’t pay your loans back. Insolvent means “negative net worth”. It’s de facto bankruptcy.

Who wants to loan money when the person receiving it (the counterparty) might not be able to pay it back and whose collateral is so cruddy, losing value, that you might not be able to recover any of it? What would any reasonable person do? Hold their cash close to the vest.

Right now the threat and fear of insolvency (fear of permanent and/or significant loss) among counter-parties is causing hoarding by lenders.

Why are companies suddenly becoming insolvent?

The problem is two fold – DEFLATION and ASSET VALUE WRITEDOWNS

Deflation:

The housing market just busted. Housing prices have plummeted. Banks that lent against homes, using those homes as collateral, are seeing the value of that collateral plummet. Who wants to make a loan in an environment like that?

Writedowns:

The bank lends you $200K to buy a house, and you buy a $200K house. So you owe 100% of what the house is “worth”. Let’s say you have an interest-only mortgage (that means you only are paying back the “cost” of the money you borrowed – and not actually paying down the money itself) and pay $1000 a month in interest.

But then a recession hits, homes are overbuilt, etc., and the price of your house in the market drops to $160K. Then let’s say you lose your job and can’t pay your interest payment. You want to sell the house, but you’re $40K “underwater” (your house is worth $40K less than you paid for it). And you can’t even make the monthly payments.

See, the value of that home has to be “written down” by $40K. But it wasn’t your money that was put in the home. It was someone else’s money that they lent you. Someone else was out $200K and thought they’d get it back from you some day, plus interest.

Since you can’t pay the debt, you’re insolvent. The bank takes the house back, but now that $200 “asset” on their books has to be written down to $160K. That’s a $40K loss for them. That’s real money the lender lost because the loan wasn’t paid back and the home couldn’t be sold for the value of the loan.

Prices are dropping on homes, people can’t afford them, so banks are having to take them back for fractions of what they’re worth. As they write down the value of the home, they are finding that they themselves – the banks – are becoming insolvent. See, they borrow money, too, then lend it to you . . . and when you don’t pay them back, they can’t pay back the people they borrowed from, and they go bankrupt, too. It’s like dominoes.

A really smart guy named John Hussman explains how write-downs and deflation lead to insolvency. He’s specifically talking about banks, and he’s showing how deflation leads to write-downs, which leads to customers making withdrawals from banks, which leads to more stress on a bank. There are some words in there you might not understand, but read it anyway, just in case.

1) As the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;

2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;

3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;

4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.

So deflation and write-downs can be very bad, because they often wipe out the equity value of assets and leave just the debt. The Debt ends up being more than the equity value, that means UPSIDE DOWN.

So what causes deflation?

Busts.

But what causes the bust that causes deflation?

INFLATION.

To be precise, inflation is an increase in the money supply, which then raises the prices of goods and services people are selling.

One of the evil things about inflation is that can make you feel richer – for a while – without actually making you richer. And when you figure that out, you feel poorer.

If I get a raise at work and my salary is doubled, I now make twice as much money as before. But if, at the same time, the price of everything in the economy doubled, well, I’m just where I was before. If I make a buck today and a coke costs me a buck today, but tomorrow I make two bucks and a coke costs two bucks, am I really richer?

There are different kinds of inflation, but the one we’ve just seen in our economy is one that has been very, very, very bad. It’s called “asset inflation” and it manifests itself particularly in the inflation of home prices.

When there’s too much money in the market chasing goods (supply of money increasing), it drives up the price of things.

Think about houses. When lots of people wanted to buy homes in 2005 and 2006, there were more and more buyers bidding up the prices of homes.

When you realize that borrowing on credit increases the money supply, and that reducing the amount of money lent in the economy decreases the money supply, you understand that the prices of goods follows – simple supply and demand.

More money chasing a fixed amount of goods? Inflation (rising prices).

Less money chasing a fixed amount of goods? Deflation (falling prices).

So what caused inflation and why did it [inflation] have to stop?

Cheap Money Lending: Money was so cheap to borrow, it was around 4% at some point in time. You could go the bank, show them your drivers license, and get a loan for $250,000 and only pay 4% interest only. It didn’t matter if you had a way to pay the loan back or not.

The government puts money into the economy until the supply and demand for money meet at the interest rate they’ve targeted.

It’s sort of a “cart and horse” thing. If there’s a lot of money in the system, rates will be cheaper. If people think rates will be cheaper, there HAS to be an increase of money in the system to have them actually be cheaper.

Here is how the system works: Money is cheap to obtain (low interest rate), more people can afford to buy a more expensive home, more people are able to buy homes, this will increase the amount of homes being built which will allow for more jobs to be created. *Great—booming economy.

Now everyone wants a home and can obtain a loan for unreasonable prices. They’re getting into “bidding wars” and the prices of homes are going higher and higher.

During 2006-2007 I heard over 100 times, “Real Estate is the best investment you can ever make, **HOMES NEVER DECREASE IN VALUE!!!”

That isn’t the case in 2008 is it?

People with really low incomes are buying really expensive homes.

People who have no business buying homes (people who months earlier were struggling to make rent on their apartments) are now getting the money to buy a Mansion.

Alan Greenspan has called this situation: “IRRATIONAL EXUBERANCE”, concerning the asset values that were being placed on homes and the stock market. Also later in 2005 he stated his concerns over “FROTH” in the housing market and pointed to a big increase in speculation in homes.

An example of the asset value escalation:

Just imagine that there are two dollars in the world and they are owned by one person, and two other people in the world each want to borrow a dollar. The guy who has the dollars gives them each a buck and they agree to give it back to him in a month along with 10 cents (to pay for the “rent” of the money). So it’s a 10% monthly interest rate.

They pay the guy back, with interest at the end of the month.

Now, a year later, the two borrowers go back to the guy, but this time he’s only got one buck, and it’s the only dollar in the world. He says, “sorry, I’ve only got one, so I’ll rent it to the highest bidder.” The two borrowers start bidding, one after the other. Money is in tighter supply, harder to get, so this one, scarce dollar is now more valuable to each of the borrowers. Finally, one of them bids 20 cents to rent it for the month (20% monthly rate) and the other guy says, “Fine, you have it. I’m not paying that.”

Did you see what happened? The fact that money was more scarce drove up the interest rate. Once it got high enough, one of the borrowers dropped out.

The rate got high precisely because there was less money. That is what has happened with home prices and other assets that have been bought and borrowed against.

Misallocation of resources. (Hey, isn’t that what causes depressions? )

Lots of houses. Not a lot of buyers. Builders start to slash home prices to get out of this inventory of homes they’ve overbuilt.

The bubble bursts … deflation takes hold. All that equity created when the home prices ran up gets wiped out.

But, oops, a lot of people borrowed against that equity and replaced it with debt, and now their houses are worth far less than what they owe on them.

But, you ask, if the banks weren’t bearing the full cost of the loans, who was?

First of all, lot of disappointed investors that the banks sold loans to bore the cost. But you know what? That’s not too terribly bad because investors take on risk, that’s part of the deal.

So what caused this to happen? Why didn’t the government put a stop to this excess spending that out of control asset valuation?

Two Reasons: 1. Community Reinvestment Act & 2) Fannie Mae & Freddie Mac.

1 – The CRA allowed for the extortion and blackmail of banks so that they’d be put out of business if they didn’t make horribly risky loans to unqualified borrowers.

2 – The banks went ahead and made the risky loans because the government, through the organizations of Fannie Mae and Freddie Mac, agreed to back the risky loans, implicitly guaranteeing that if they went bad, the government (i.e. the US Taxpayer) would pick up the tab, not the original lender.

These organizations are authorized and implicitly backed by the government to make mortgage loans, buy mortgage loans from people who hold them, and also to insure them.

If a loan defaults – the borrower stops paying it – and Freddie or Fannie has sold insurance on that loan, then when the loan doesn’t get paid back to the person who made the loan Fannie or Freddie has to pay the outstanding loan amount to the guy that got stiffed.

As you have recently heard: The government had to bail out Fannie & Freddie by injecting billions of dollars. Whoops, we goofed, you told us to, now give me billions of dollars to get me out of this mess.

So, to recap the above.

**Depression is caused by economic failure, which is caused by markets freezing up, which is caused by deflation, which is caused by a bubble bursting, which is caused by the misallocation of resources and inflated prices, which is caused by inflation, which is caused by a lack of government discipline plus government intervention to create cheap money plus abuse of government laws, which are caused by aiding to voters and extorting taxpayers while simultaneously trying to stimulate an economy artificially to provide the illusion of wealth and progress.

Now the economy was bailed out by the government and this placed the government in debt. That debt has to be paid back (money doesn’t grow on trees).

Who’s paying it back? We’re paying it back. One way or another, we’re going to pay. We’ll pay now, we’ll pay later, we’ll pay for a long time, and we’ll get very little in return because the money has already been spent.

The government can make money in two ways.

It can create monopolies for itself and charge high rates while operating inefficiently, like they do with the post office.

Or it can take your money, with or without your consent, as it does through taxes.

So, pick your poison.

Don’t worry you couldn’t have controlled what happened. But you can control how you make your money, how the economy effects you and how to get tax breaks to not help pay back for the mistakes of the corrupt individuals.

University for Money provides you with the best asset in this economy. KNOWLEDGE!. Know what is affecting you and how to navigate through it.

Please return to learn.

Source: Drex Davis http://www.drexdavis.com/ & The economist www.economist.com