Financial Crisis: How Did We Get Here? By Jeffrey Stoffer CFA, CFP At Isnare.com Ezine Articles

How did we get here…on the verge of the biggest financial crisis since the 1930's? So much has happened in the last few weeks that I felt it was important to step back and try to get a handle on what has transpired. We experienced a real estate bubble and as with most bubbles throughout history, they result from too much of a good thing. Credit is that thing. At the time, it all seemed so wonderful. More and more people were living the American dream of home ownership. Those already owning homes were pleased to see their value rise and happy to tap into the equity to purchase cars, vacations, and bathroom remodels. This story played out in so many countries.

But ingredients were coming together in the financial markets that make for a bad recipe. Too many people were getting loans that would likely never be repaid. The big financial institutions were lending more and more money to questionable borrowers as a route to quick profits. They could "package" these mortgages and sell them to someone else. The rating agencies blessed them and they were sold, across the globe.

This makes me think of a Warren Buffet quote, "Only when the tide goes out do you discover who's been swimming naked." The tide in our case is home prices. As home prices decline, these packages of mortgages depreciate in value. Then the financial institutions holding these risky packages have to devalue them on their books.

Now the pendulum of easy credit has swung too far back in the opposite direction. Every player in the markets has gotten more conservative, in fact down right stingy, with lending. We need qualified buyers to step up and buy homes, thus supporting prices. But lenders have become so strict that this is not happening, and home prices continue to decline. Mortgage securities decline in value, the strength of the financial institution weakens, so they lend less, and home prices continue down in a self-perpetuating vortex.

This reluctance to lend is what brought us to the current crisis. Credit and lending are the red blood cells of the financial circulatory system. Think of them as carrying needed oxygen and nutrients to sustain the body. What Fed Chairman Bernanke and Treasury Secretary Paulson saw in mid September was a credit contraction of unprecedented proportions. The recent take over of Fannie and Freddie and the rescue of AIG, were supposed to restore some sense of order and keep credit flowing. But it wasn't enough and markets were at a tipping point.

Though unpopular with most citizens, final passage of the $700 billion bailout plan will be vital to restoring confidence in the financial system. Just as the markets breathed a temporary sigh of relief, trouble was emerging overseas.

Fortunately, the Euro nations and Great Britain unveiled a bailout plan that was perceived to be more comprehensive than the US plan. Investors believed it could be even more effective because it guaranteed bank deposits and injected capital directly into ailing banks.

These actions will likely avoid the very real threat of a depression, but is seems likely at this point we are entering an economic recession. Things will get better, but it will take time for the economy and financial markets to heal.

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