What Caused the Credit Crisis – One Word “Foreclosures”

One of the questions I get frequently is why is the economy in such horrible shape and what does my mortgage or my foreclosure have to do with the “crisis of credit”

This is a great question and while the technical answer is very complex we can paint a broad picture of how greed, supply and demand and some bad decisions led to the economic time bomb that we are living with today and will be living with for decades to come.  And why it is harder than ever to get the banks to give you a mortgage to buy a new house.

So let me give you the very broad strokes of how the crisis of credit happened and then I’m going to recommend that you go watch a little longer video that is very well done that goes a little bit more in depth and between this and that video you’ll have a good grasp.

So the first concept that we have to understand is financial leverage.  It sounds complex, but it’s something we are all familiar with.  It’s basically taking a little bit of your own money, think of it as your down payment, and then borrowing a bunch of money from a bank or other investors, think of it as a mortgage, and then buying an investment, think your house.

You are able to buy an expensive item, your house, with only a little bit of your own money, your down payment.  Then if you sell the investment, i.e. your house for more than you bought it for you make a big profit on just a little bit of your own money, even after you pay back the bank or investors.

Now think of doing this on a huge scale with millions of houses, and you can see that as long as the price of houses is going up, everyone including the banks and investors, continue to make tons and tons of money making everyone along the line rich beyond their wildest dreams.

Now when people and investors are getting rich from a relatively simple and straight forward scheme like this, you can imagine that our old friend greed will begin to rear his ugly head, as you want more and more of these deals, so you can make more and more money.

Now this is where supply and demand come in.  As greed and wall street fat cats are saying give me more, give me more of these deals, unfortunately they exhaust the supply of these good deals, so they create a whole new type of deal that looks the same but when you really look at it, is a whole other creature.

To satisfy their demands they create the sub-prime mortgage where they make mortgages to anyone with a pulse regardless of whether it is a good deal and whether or not the homeowner has the capability to pay the money back.

And this is the big uh-oh that crippled our economy.  As soon as the individuals figured out they couldn’t afford the pricey payments for these mortgages and began to stop paying on them, the banks and investors began foreclosing on the houses, this in turn created an increase in the supply of available houses and in turn reduced the prices of houses everywhere.

Now if we go back to the beginning of the circle we remember that this whole scheme only works as long as the prices of homes continue to rise.  Well guess what, as soon as they stopped rising the scheme collapsed, the banks and Wall Street fat cats were sitting on billions and trillions of dollars of investments that are now worth less than they originally were, and there just isn’t any more fuel left to run the engine.

And finally, the worst part is that this is a circle that continues in both directions, so when home prices were rising everyone was making money, and now with home prices declining, it continues to move in the other direction, down just the same way.

Now I know this is a very broad overview with a lot of the fine details being left out, but if you understand these basics you will have the fundamentals to at least understand why the economy is in the dumps today.  And like I said, I’ve included a link to another great video that goes a little more in depth and is definitely worth watching.

Well that wraps up this post, and as always if you have any questions or comments about this explanation of the crisis of credit please feel free to comment below.

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About Anthony Candella

Anthony is the founder and Directing Attorney of YourCreditAttorney.com and has been helping consumers just like you understand and improve your credit and financial situation since 2003.

  • Don S

    what caused the credit crisis… Three words. Mark to Market