I am sure that you have heard all about the banking industry and its crisis.  If you have not, the cave you are in must not have cable or internet in which case you are not reading this.  In the following post I will go into the reason for this crisis from the basis of a simple economic principle of Risk and Reward. 

 In the beginning god created the mortgage payment (part of terms of the agreement was the last payment was to be personally delivered to god himself).  The person who lent you the money for the mortgage was also on the hook if you decided to spend your mortgage payment on lottery tickets instead of paying him.  So he had a self interest to ensure that he did not lend you money, that you could not payback.  There was a self interest on both parties not take too big of risk.  After living on the street because you paid too much for a home you could not afford was your risk, the reward was some place to go when it rained.

All was right in the world, unless of course you lived in California but then again California is fantasy land anyway.  The rest of the world see periodic increases and decreases in home values but they were generally because of real factors, not because you want to live near where Brad Pitt gets his Starbucks. 

So what screwed this all up?  Well the federal bank, which by the way is not run by the federal government lowered interest rates after the dot com bomb to help jump start the economy.  In addition rules(created by the government to help those less fortunate) in the mortgage industry pushed them to help those that had shady or no-credit.  Well with the low fed interest rates the industry was able to offer lower mortgage rates.  These rates were substantially lower then what they were previously and dramatically lowered the monthly mortgage payment made by the average person (most people judge what they can get by the monthly payment and not the actual price).  They could now afford a bigger home.  Since they could afford a bigger home the demand for a bigger home drove the prices for bigger homes up.  This in turn drove the prices for every other type of home also.  After all people still need to live somewhere.  Caves can get musty after all.

So the price of homes began to move up.  Since the price of homes was going up the risk of the loan was lowered since the home was the collateral.  If you had an outstanding balance of 100K but the home was worth 200K you could get out of loan by selling the home and still have some money to find something smaller or less expensive.  In addition if you defaulted on the loan the bank could do the same.  So in essence the risk was lowered.  No matter what happened everything worked out.

With the risk of the these loans lowered the banks were able to start selling these loans to other banks filling their coffers with the sale and then use that same money to offer more loans that are then quickly sold to the next etc..  And here is where the problem started.

The person offering the loan only had a short term exposure to risk but a large reward.  They held it for a few months and sold it.  Very few people fail to make the first year of mortgage payment.  Soon the prices of houses began to get higher and higher, even with the low rates they became unaffordable.  But with the prices still going up and the advent of the “house flipper” mortgage companies got creative (there were always scams out there, these new ones just got rediculous).

So how creative did they get?  Since they were dumping the loans on someone else after a few months, they began to make mortgage terms that kept the price of the loan low in the beginning so they could get the person the mortgage.  Now that they have someone making payments they needed to get rid of it before the terms of the mortgage made the payments too high for the person to afford and they defaulted.  So they packaged all these bad loans into more traditional loans and sold them to bigger banks that could deal with a bad loan here or there.  The first guy selling the mortgage effectively had a big reward with little risk.  This led to more and more risky loans.  People could sign up with no proof of income or negative amortization of the loan (you had a higher balance each month despite making payments). 

It does not take a genius to figure out that this was set to fail.  It depended on three things; home prices rising, dumb people to sign the mortgage, and dumb banks to buy them.  If anyone of these failed the dominos would fall.  And it did.

Everyone knew the game, and they all went along with it.  Except for a few people just looking for a home they could afford,  but most of them were smoking their cigars and drinking their brandy laughing all the way to the bank.  Of course the bank they were walking to eventually collapsed right after they took out their money.  Falling on the guy who just signed up for a loan.

A whole lot of crap was out there basicly poisoning anything it touched.  The whole sham was about to fall in.  Unfortunately those that benefited from this whole thing the most are not going to take a brunt of this mess. They had golden parachutes.  These were all the executives of the banks that knew this crap was going on and authorized it.  After all one year’s salary for these bastards was enough to live for the rest of your life.  So screw it if in two years it all collapses they were safe.  So they did not have any risk.  See a pattern here.  The person benefiting most held no risk.  Therefore they only looked at the reward and the reward was an incredibly high salary and bonus.  Their future well being was not wrapped in the future of the company/bank they were heading it was in the huge bonus they were set to receive in one year.  Year two be damned.

Now here we are.  A bunch of fat cats have beaten the system.  And we are left holding the bag.  And the bag is full of dog crap.

I will go in what to do about it later.  Good luck and make your mortgage payment.