The major global issue today is probably unique in that the average Canadian citizen likely has no idea what it’s really all about. It’s not just Canadians either; people around the world are scratching their heads wondering why terms like subprime mortgages and credit-default swaps are causing hundreds of thousands of people to lose their homes and jobs. That’s because nobody is really explaining it.
The media seems to be forgetting something in covering this issue: regular citizens are not economy PHD’s. Calling the event the subprime mortgage crisis, without explaining what that actually means, not only doesn’t help but actually worsens the situation. When people get confused, they panic, and panic is a dirty word in economic circles because it becomes very difficult to predict how they spend money.
Explaining the economic crisis in clearer terms is the media’s job. So let’s start at the beginning. For that, we have to look to the U.S.A.
The media widely reported that the U.S Federal Reserve lowered interest rates from 6.5 per cent to one per cent between 2005 and 2007. What that means is that it lowered the price of borrowing money because there was so much of it. To the average American, that meant that mortgage interest rates had suddenly dropped more than five per cent. With cheap prices, the housing boom took off, and as a result housing prices begin to jump.
That was all good news for people who already owned a home. But for new home buyers, it meant that they needed to borrow more money from the bank, because even though mortgages interest rates were less than before, houses cost more overall. Of course, for banks there was a different problem. Low interest rates mean less profit for them. So, to counter this, they came up with a new strategy. Give out riskier loans, called subprime mortgages, because the people taking those loans have to pay more interest. And what’s more, banks decided to increase profit by making more loans.
So far, so good. But the whole process was littered with signs of its own undoing. First, the people receiving subprime mortgages were those who had a history of credit problems or low incomes. But the banks, optimistic about the housing boom, were lending them huge mortgages, sometimes for even more than their house was worth, because they assumed rising house prices would offset it eventually. Those people taking the subprime mortgages assumed that everything was fine, so they kept on borrowing. But banks don’t have infinite amounts of money. So, domestic American banks began to turn to foreign banks for loans. But banks lend money that regular citizens have deposited. Now all of a sudden someone in Canada or the UK could well have been putting money into a bank and having that money invested in an American one.
Now regular citizens were having their money put at risk, without even knowing about it. This is all usual business in the financial world. Except that these American banks and mortgage houses were lending out so many subprime mortgages that all that borrowing was happening without actual capital to back it up.
There are rules against this, but to go around it the bank sells off these mortgages to trusts and funds that are then bought up by investment funds or venture capitalists. This is dangerous because it’s extremely hard to regulate.
Of course, people also invest in things like investment funds or venture capitalist firms, so those shareholders, the wealthier investors on the other side of the spectrum, were all at risk now too. And all of these operations were backed up by reputable Wall Street firms, the same ones that would be in the news later getting bailed out by the U.S government.
When the housing market started to drop, houses started losing their values, and all of a sudden mortgages were worth more than the homes. No one wanted to buy mortgage packages that had no profit, so banks couldn’t sell them off. Suddenly people who had their money in the bank were losing it, because it was given to people who weren’t paying it back.
So the market crashes, and the world goes into what looks a lot like a recession. The media has reported this story many times. But they never seem to actually explain what any of this means. Some people will have gone out and talked to financial advisors to get them to explain. What seems obvious in the whole story is that the financial system has been less than prudent with citizen investments, and it should be up to the media to tell people what really happened.
If average citizens don’t really understand what is happening, they will either go on borrowing money, or panic and withdraw stocks, which causes the market to crash even faster. As world leaders, including Stephen Harper, move forward to address this issue, hopefully the media will take a second to remember that it’s worthwhile to explain exactly what is happening.