Answers to questions about the credit crisis
Last week, it seemed as though you couldn’t pick up a newspaper or turn on the TV without hearing about the deepening U.S. financial crisis.
Suddenly, news once reserved for the business pages was making big, scary headlines.
In a tight economy – with real estate values down, food and gas prices up, and foreclosures in record numbers – we had already watched some of our biggest household-name financial institutions crumble.
Then, when the U.S. House of Representatives voted down a controversial $700 billion rescue plan Monday, investors lost confidence and the stock market took a historic tumble – the largest percentage drop since the days following 9/11.
Although the bill passed both houses of Congress by Friday, last week was filled with fear, anger, speculation and uncertainty in America. Adding to that mess was the confusion that comes with such a deep and complicated financial crisis.
Here are answers to some common questions asked about the ongoing crisis and its impact on Main Street America:
Q: How did the country get into this financial mess?
A: Simply put: subprime loans. An effort dating to the 1970s to relax mortgage standards and put homeownership within reach to more Americans eventually turned sour because of a surge in “exotic” mortgages.
Beginning in the late 1990s, banks increasingly began issuing risky adjustable-rate or no-money-down loans to borrowers with lower incomes or credit ratings. Wall Street got involved when investors purchased these mortgages in bulk from the banks.
The risky investments were desirable because they produced higher returns. Eventually, so many investors were tied to subprime mortgages that the value of the loans became severely over-inflated.
Then, around 2006, the booming real estate market headed south. Borrowers with exotic mortgages saw their payments increase while the value of their homes dropped. Upside down in their mortgages and unable to sell, homeowners fell into foreclosure in record numbers.
Suddenly, banks and investment firms weren’t making their money back and fell into serious financial trouble.
Q: How does this affect me?
A: If you have investments – including retirement funds such as 401(k)s – you’ve probably lost some money in the stock market. Anyone close to retirement may have to consider working longer to wait for the market to bounce back. Anyone who is retired and living off investments has seen a drop in income or net worth.
However, because the stock market is cyclical and will bounce back eventually, the biggest threat to consumers and the U.S. economy as a whole is what’s known as the “credit crunch.” Banks have drastically scaled back lending in response to the subprime crisis: They’re afraid people won’t be able to pay them back. That means it’s difficult right now to get any kind of loan – a mortgage, car loan, a credit card or a student loan.
Those with poor credit may find it next to impossible. Those with excellent credit may face higher interest rates than a year or two ago.
Q: What if I don’t plan to take out a loan anytime soon?
A: Because lending is essential to the health of the U.S. financial system, a credit freeze means serious consequences for the overall economy. Some experts say it could lead to deep recession – including job losses and business closures throughout the country.
The $700 billion federal rescue plan – or bailout, depending on whom you ask – is aimed at preventing such a freeze by buying the bad subprime debt from banks, which would free them up to lend once again. However, critics say the plan is too kind to people who made bad investments at the expense of regular American people.
Q: Where will the $700 billion come from?
A: It will be borrowed – U.S. Treasury bills would be issued and sold to foreign investors.
Q: Why would foreign investors want to buy American debt right now?
A: Although the national debt stands at more than $9 trillion, America’s high credit rating still makes it a very desirable borrower to the rest of the world. Also, despite the national debt, America’s debt in relation to annual gross domestic product is more favorable than most countries.
Q: Why not divide up $700 billion and give a check to every American taxpayer to stimulate the economy?
A: If the banks aren’t lending, it won’t matter how much consumers spend. The economy will still suffer.
Q: Will this financial crisis make it easier or harder to strike a deal with credit card companies?
A: If you’re planning to ask for more credit: harder. Credit card companies won’t be anxious to lend more money when there’s so much concern about ability to pay. You may still be able to negotiate a lower interest rate if you have a history of on-time payments, but the companies may not be as flexible as they would have a year or two ago.
Q: Should I stop putting any money into my fast-disappearing 401(k)?
A: Probably not. Most 401(k)s were never heavily invested in subprime mortgages. And as long you can wait until the stock market bounces back before retiring, the fund will eventually recover.
For younger workers, this dip might turn out to be a good thing. Lower stock prices will allow your 401(k) to buy a greater number of shares, which means more money in the long run when the stock market climbs.
No matter what, experts recommend contributing enough money each week to get the full company match, because that’s free money. But folks close to retirement may want to keep their 401(k) money out of the stock market.