Thursday, August 30, 2012

A Simple Explanation of the Cause of the Financial Crisis in the United States

Over the last several decades the private sector has taken on more and more debt, primarily in the real estate sector. Why has this happened?

The main reason is that many consumers don’t view debt as a problem as long as the servicing of that debt is within their budget. Furthermore, they don’t consider only their earned income when they assess their ability to pay service on their debt. They also consider the appreciation of their assets, and the possibility of refinancing these assets as their value increases to pull out money to service the debt. So asset appreciation becomes another source of income.

So, you might ask, are consumers really this smart that they can analyze their financial situation and come to these conclusions? The answer is that they don’t have to be. The financial sector will show them exactly how to do it.

The financial sector gets rich by making loans. As they compete to make loans they find ways to make them ever more accessible to consumers at lower servicing rates with schemes such as adjustable rate loans, balloon payments, securitizing the loans to hide risk, and pointing out to consumers that the appreciation of their assets will allow them to refinance over and over again to pull more money out of the assets to pay for servicing. This is the classic Ponzi scheme, paying servicing out of the appreciation of the asset, instead of out of earned income from a job.

The only problem is, eventually asset prices are bid up to way beyond their replacement value and the whole house of cards comes tumbling down as it did in the financial crisis. This can happen very quickly, but the cause builds very slowly, over decades. As more and more income is used to service debt, it is not available to create demand for consumer products. This results in businesses cutting back on expansion plans, research and development, and eventually leads to layoffs. The layoffs, in turn, lead to reduced ability to service debt, and a vicious downward cycle ensues.

Eventually, the financial sector gets in trouble as consumers default on their loans, or realize that their assets are no longer appreciating and income from refinancing disappears. This downward cycle accelerates and interlocking bank loans put the whole financial system in jeopardy. At this point the financial sector looks to government to bail them out, which it must, or see the whole economy come crashing down.

To be continued in future posts.

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