Learn From History - The Anatomy Of An Economic MeltdownOver the last couple years, many consumers were burned badly by the state of the economy and the failing of many of the banks people have relied upon for generations.
At the beginning of 2007, the United States had five investment banks, through which a lot of investment transactions occurred. By the end of 2008, there were zero investment banks in the United States. The investment banks that did not fail outright, changed their charters to commercial banks, thereby eliminating all investment banks in the U.S. by the end of 2008.
Where people got hurt the worst in the recent economic meltdown was when banks stopped loaning money to consumers and businesses.
Banker fears turned our economy on its ear, erasing positive growth and replacing it with recession.
Bankers started to question the viability of their competitors and stopped loaning money to their competitors. Suddenly, when major banking institutions were no longer able to get money to loan to their own clients, banks began to turn off the business credit and consumer credit tap.
We knew the gig was up when General Electric could no longer get loans to float their production cycles. We also knew that the situation was getting bad when banks started freezing credit lines to the automakers. And when the State Of California could not get loans to carry the state through the course of a single economic year, we knew it was ready to hit the fan.
Economic Contraction Has Deep Roots
The lack of business credit is not what killed the auto industry. What brought the automakers to their financial knees was the inability of consumers to get auto loans for new vehicles. This started to happen nearly a year before the commercial credit began to dry up.
When consumers could no longer get loans for major purchases, the economy began to contract significantly, as manufacturers could no longer sell products already in inventory.
As major manufacturers begin to fall by the wayside, the ripple effects hurt hundreds of other businesses, employing thousands.
For every automaker that falls, there are companies that produce tires, car seats, carpet, radios, and automotive parts that will also have to lay off people. The automaker is the easiest example to show the ripple effects of a crumbling economy.
When auto sales fall, car dealerships begin to shut their doors. Dealerships provide hundreds of additional jobs in small towns across America, providing employment for sales people, mechanics, supplies and support. Once you get past the jobs supplied directly by the dealerships, then one must realize that local detail shops generally contract most of their work from car dealerships.
If General Motors fails, jobs are not lost only in Detroit, but in Oklahoma City; Lansing, Michigan; Doraville, Georgia; Ontario, Canada; Spring Hill, Tennessee; Moraine, Ohio; Flint, Michigan; Pittsburgh, Pennsylvania; Ypsilanti, Michigan; and Portland, Oregon. (This list is actually derived from a GM plant closing list from 2005.)
In 2008, GM also closed plants in Grand Rapids, Michigan and Janesville, Wisconsin.
As 2009 approached, GM announced further plant closings. When the announcement came in December of 2008, there were 20 more GM plants on the cutting block for temporary shutdown. This round of plant closings will affect plants in the U.S., Canada and Mexico. Specific states affected by these plant closings include plants in Delaware, Maryland and Texas.
Consumer Credit Dried Up One Year Before Commercial Credit Ended
I mostly respect Bill O'Reilly's view on the world, but one day, he went on a rampage about the economic meltdown, stating that he pays attention to things and did not see the economic meltdown coming. He was complaining that no one warned us of this happening.
I wrote to O'Reilly that day, for the first time ever. I told him that if he watched his own news channel - we knew it was coming. If only he had turned on Neil Cavuto once in a while or watched the Saturday morning business block, then he would have seen this mess coming too.
It all started with a real estate bubble that we all knew was there.
When the real estate bubble began to pop in remote areas of the country and banks started to realize that home foreclosures where on the rise, banks reacted by stopping consumer loans for big ticket purchases, such as homes, cars, furniture and electronics.
The economy began to contract, as consumers could no longer drive the economy unimpeded.
It took business a little while to notice the contraction of business. Most assumed the contraction in sales was more related to the price of gasoline, without noticing that the problems ran deeper than that.
Most business managers assumed that once the price of gasoline dropped back to its historical threshold that all would recover. But gasoline prices only masked the real problem - the lack of consumer credit.
The Roots Of The Real Estate Bubble
The roots of the real estate bubble and subsequent implosion began in the 1990's. Interestingly, both G.W. Bush and Bill Clinton opposed the policies that created this mess, but both were either ineffective or unable to change the course of government policy in this matter.
Bush and Clinton seemed to agree that the credit practices of Fannie Mae and Freddie Mac were bound to create problems that could not be overcome easily. In the discussion I was listening to about this issue assumed that both Bush and Clinton were "unable" to fix this problem, although both spoke about it regularly.
I tend to find it hard to believe that any President of the United States is "unable" to do anything... but then again, Bush was "unable" to address the political hot potato of Social Security in his second term.
In the early 1990's, the role of Fannie Mae and Freddie Mac was changed from helping the underprivileged to buy a home, to guaranteeing banks that wrote loans to anyone and everyone who wanted to buy a home.
Fannie Mae and Freddie Mac began buying loans from banks, packaging those loans, and selling them to investors. Ah... you see the connection... you have heard about that stuff on the news... Good.
Since bank interest rates were so low, banks and mortgage brokers soon realized that they could not make their money collecting interest. So, they began the transition to selling loans to consumers based on closing costs. So long as the consumer could meet and pay for the required closing costs, then the bank would be able to write a loan to the consumer.
If that loan to the consumer was for a home, then the bank could sell those loans to Fannie Mae and Freddie Mac, who would then package a group of loans to sell to investors.
Here is where the story goes south.
Since banks were selling loans only for the closing costs and selling the loans to a third-party investor, banks stopped looking at whether an individual could afford the loans being given to the consumer.
You know, if I can only afford $900 per month on my mortgage, what makes anyone believe that I can repay a mortgage worth $1200 per month?
Within the system as it was constructed, the bank could care less if I could afford to pay $1200 per month. They only cared that they could sell me the loan, get their closing costs, and then they would pass the liability of my problem loan to a third-party investor.
Because the bank had no financial interest in my ability to repay the loan, they did not concern themselves with writing loans that could be afforded by consumers.
As a result, banks lined up to write consumer loans that consumers could not afford to repay. (We can also slap the consumer at this point, because the people who took those loans also knew that they could not repay them.)
The Contribution Of The Consumer
Each consumer who took a mortgage they could not hope to repay contributed to our current economic meltdown.
I know that many felt strongly that they could repay the loan or that they could get a salary increase to help ends meet. But when consumers are struggling to get by, it only takes one unexpected car repair or other large expense to bring the house of cards tumbling down. The end of the road could also come as soon as one got sick enough to miss a couple days of work.
The consumer should have known better than to take the loans they were offered. But many people also expected that banks still worked the way they did in the 1970's and 1980's - making sure that consumers could afford a loan, before offering that loan.
Lining Up The Dominoes
Consumers had taken loans that they could barely hope to repay. But when an unexpected expense came up, people began to get behind on their mortgage payments. Eventually, the added pressure of being behind on payments pushed consumers to cut their losses and default their home mortgages.
Of course, this process was accelerated when the real estate bubble burst and homeowners began to realize that they owed $120,000 on a home only worth $100,000!
As consumers began to default on their home mortgages, banks started to tighten up their credit policies on other large consumer loans such as cars, furniture and electronics.
As consumers became unable to get loans for the things they desired to purchase, manufacturers and retailers began to struggle under slowing sales.
Slowing sales further complicated the issue, because banks began to realize that their business clients were having a harder time paying back business loans.
At this point, the banks worried about their business clients, but they did not close all commercial credit just yet.
Like you and I, banks borrow money from each other, in order to enable ensure that bank liquidity is maintained. In the banking industry, the government requires that a bank always has cash-on-hand to match 10% of the total loans it has in the marketplace.
On days like payday, banks will often borrow enough money from another bank to help them cash all of the checks that will be brought to their bank. They borrow that money to be able to meet their cash needs, without tapping into the money in their safe that is required to meet federal lending standards.
Of course, banks will cash a check on Friday and they will have that money back in their own coffers by the following Wednesday, when the employer's bank is able to send the money back to the bank who cashed the check. Within the banking industry, few-day loans and one-week loans between banks are common for this reason.
It did not really hit the fan until banks stopped loaning money to each other. When the investment banks began to fall, other major banks also began to fail. With banks failing everyday, bank managers began to wonder about the banks to whom they loan money.
Fear crept into the bank-to-bank lending cycle, and bank-to-bank credit came crashing to a halt.
This is the point where commercial credit died. It was September of 2008 - only weeks before the Presidential election. John McCain handled himself badly during this time frame, ensuring that he would forever be only a footnote in history. "I am suspending my campaign to focus on this problem," - John McCain, famous last words of the top dunce of 2008.
When banks stopped lending to each other, other banks had to freeze commercial credit lines. When General Electric's top lender was unable to get bank-to-bank loans, it was unable to loan money to GE, regardless of their belief in GE's ability to pay back the loan.
The Fallout Is Wide And Painful
When GE can no longer get loans to finance the manufacturing cycle of their products, then GE is forced to lay off workers.
When the automakers customers cannot get consumer loans and the automakers cannot get loans to keep them afloat during this economic downtown, the automakers are forced to lay off people. Along with the automakers laying off people, part suppliers and dealerships also have to lay off people.
When the State Of California cannot get loans to keep the state operational until tax payments start coming in, Governor Schwarzenegger has to make some hard decisions, stopping certain government services and stopping production of development projects. Of course, Schwarzenegger does not have the political courage to fix the problem, but only to survive the crisis. Either way, money stops flowing in California from government coffers, leading to taxpayers receiving IOU's from the California tax agency and people losing their jobs in state construction projects.
The Downward Spiral
Consumers cannot borrow money to buy consumer goods, which in turn slows sales at major manufacturers and major retailers. Slowed sales leads to more layoffs and fewer jobs. Slowed sales also leads to lower stock prices and fewer stock dividends.
Sometimes the pain felt at the business level leads to business failures, which in turn leads to more lost jobs. Fewer jobs leads to more defaulted loans and home foreclosures.
It is a cycle that is hard to break.
According to a story by the Fox Business Network last week, American consumers have lost $11 trillion dollars in their net worth over the last one year.
Is there a light at the end of the tunnel? Certainly there is, although it is a bit hard to see right now. Every down cycle in an economy ends with an up cycle. It is just that we have yet to discern a bottom in this economic downturn, so it is hard to predict when recovery will come.
I am an optimist by nature. I see good days ahead, although those good days will necessarily be preceded by some pain.
The best advice I can give anyone in this current recession is to only spend within your means, until this economy recovers its vitality. At my house, we are still spending, but we are not doing it with credit. Instead, we are paying cash for what we want and making darn sure not to increase our debt load during this down cycle.