Panic of '08 - Part 1

Someday the financial problems we face today will be called the Panic of 2008. The first question is why? What happened to create this panic? The second question is how can the government turn this around? And the final question is how can we prevent this from happening again? This posting is going to look at the first half of why this happened with the rest to be tackled in later posts.

For years now, banks have had difficulties being profitable. They normally make a lot of money from the margin: the difference in the rates they get from loans minus the rates they pay out on CDs, Money Markets and Checking with Interest. Basically they need to have high rates on loans and low rates on what they pay on deposit accounts. However, the extremely low prime rates over the past decade have hurt bank’s ability to be profitable.

If the profit from a loan is much less than in the 90’s and 80’s then one solution is to make more and more loans. Very simply, let’s say you use to make $5,000 profit on a loan and today you only make $1,000 profit. In order to maintain your profit then you need to make 5 loans. And that is what these financial institutions did. They ended up giving loans to people who barely qualified and to accommodate customers who didn’t qualify they gave them adjustable rate and subprime rate mortgages. Another means of showing higher profit was to put aside less money to cover potential bad loans. Think of it as putting away money for any emergencies then raiding that fund to pay for a vacation. Six months later when you are fired your emergency funds are gone. This is what happened with financial institutions. At the same time they are making riskier and riskier loans they have less and less in their funds to cover bad loans.

In addition to making loans, financial institutions could also invest their money. Desperate to make up for the low rates on their loans, they began to invest in things like derivatives and other high risk investments. The big institutions thought they knew what they were doing while the smaller ones simply blindly followed the big firms. Both were wrong and ended up with bad investments. Next: Part 2 - How it all came apart at once...