Please help a finance newbie

October 8, 2008 1:20 AM

Can someone help me understand the current financial crisis?

Hi,
I am complete ignorant when it comes to finance. I feel bad about it and I feel really dumb that I have no idea of what is currently going on in the world. I don't understand why stock prices are plummeting, why those banks went bankrupt...and how that impacts all the rest. Can anybody recommend a website or a book where I can read up some basics so that I can understand at least the headlines? Please keep in mind that I live in Europe so ideally I would need something not too US-centric.
Thanks!

posted by annapanna to work & money (16 comments total)

Have a look at The Money Meltdown.
posted by slightlybewildered at 1:54 AM on October 8, 2008 [1 favorite]

This American Life has a couple of very good podcasts you might want to listen to.

Episode 355: The Giant Pool of Money
Episode 365: Another Frightening Show About the Economy
posted by flabdablet at 2:19 AM on October 8, 2008 [7 favorites]

Look at mefi user Mutant's post history.
posted by rodgerd at 2:44 AM on October 8, 2008 [2 favorites]

I've been asked this question by several people who seem to think I might know, with my only qualification being that I'm the only person they know who reads The Economist.

That said, clearly mutant or Wikipedia will be better suited, but I'd like to try a stab at an explanation of the crisis as I understand it.

Caveats: I'm a 23-year-old college dropout with absolutely no financial education under my belt but with an active interest in the markets and banking and such. I got a C in macro-economics, but I think that's just because I really hated college. Point being, if anyone else sees any MASSIVE fails in my logic, please feel free to correct me.

A good chunk of the underlying cause started with the housing bubble. In 2005-2006, housing prices in certain already-rapidly-growing markets started to skyrocket. I live in Gilbert, Arizona, which has the curious quality of being one of the fastest growing municipalities in the US. In 2005, people were paying $20,000-$40,000 over asking price on a $200-$300,000 house, just so that they could snatch it up before it hit the market.

Why? Because when prices start to increase at a faster than normal rate, a lot of strange things begin to happen: People think they can get in on the action, as a good "investment," so they buy additional property with the intent of flipping it a few months later. Speculators impact the market some, but an influx of people and the growth of communities that appeal to a broad range of upper-middle class income families build a whirlwind of "just gotta have it" locations that people find themselves willing to pay any price for. More, still, when they see that the price has gone up 10-20% in the last year alone—no matter what you're paying, it's a steal!

Banks see the action and see inventory flying off the shelves; houses are snatched up like crazy, so they begin to loosen their lending rules and lowering their risk aversion, because when things are trending up, people still pay their mortgages.

The issue is that the bubble was just that—a bubble. Prices began to outstrip anything resembling sanity and people started to realize this. Speculators started to see the winds change and shifted to pull out. Ridiculously low interest rates started to climb some and people with variable rate mortgages started to see a bad moon rising. Essentially, they watched as the value of their home, which they just paid $20,000 OVER ASKING PRICE just dropped 3% in a single month, say. This is terrible enough, but not for the fact that they weren't exactly an ideal mortgage candidate—no, they were a subprime candidate. Because of this, they were locked into a terrible variable rate mortgage with bad terms and the ability to ramp up in bad times.

Except that as they watched their mortgage rates ramp up (ALWAYS GET A FIXED RATE!) and their house value drop, they realized they'd fallen upside-down on their house. Now this is a depressing fact, not least of all for individuals you thought they might be able to see some returns in the short-term, instead of looking at a house as a long-term, steadfast investment. Seeing the value of an investment drop so soon after buying it is bad. Seeing it drop with what looks to be continued payments for something you're completely upside-down on (upside-down meaning you owe more than you could get at market value) is just plain depressing. So what happens? People quickly cannot or will not pay their mortgages.

Well, shit. This royally hurts the banks some. The same banks who had wildly relaxed their credit lending rules started to hit maturity on mortgages that weren't getting paid on. This is bad news because they're selling and seeking liquidity through Collateralized Debt Obligations or CDOs. These are essentially collections of mortgage-backed securities and other assets, the cash-flow of which can be portioned off through equity notes and a bunch of other technical terms that I hardly understand. The issue with the crisis was made significantly worse because of how CDOs were rated, assembled and how their complexity lent itself to terrible risk management and shrapnel-spreading damage, that impacted far more groups than a single security should have.

When the banks realized that they weren't going to be getting paid by the many, many, many new homeowners who realized THEY were getting screwed with their new house purchase, a few bad things happened: They realized they were nowhere NEAR as liquid as they needed to be in order to extend new lines of credit. And they panicked their customers by telling them they weren't liquid. The first such case of this being an issue occurred in Britain with Northern Rock, a bank that ran into massive liquidity issues because, basically, none of their "accounts receivables" were coming in. (Wild oversimplification, that, but you get the idea. Beaucoup cashflow issues.) People panicked and started to pull their money out of Northern Rock. Exactly what a damanged bank does NOT need to have happen: have all their depositors pull out whatever liquidity they have. (Liquidity, btw, is basically how much cash or quickly saleable assets a bank has on hand that's theirs to distribute out to depositors. Sort of; again, oversimplifying.)

Now, the government graciously backs our deposits to keep this from being an issue, but a lack of regulation has allowed banks to otherwise become FAR too overextended with their loans and lines of credit. When people stop paying those bills, they're not able to meet their obligations, to depositors or to their own creditors. So what we're seeing here are a series of liquidity crises, banks holding on to EVERY LAST DROP of their cash and no longer extended loans out to (almost) ANYone and people losing their homes because their mortgages became toxic, basically both to them and the lender.

Since things were trending up so magnificently, no one really cared about the risks associated with lending to, well, people the banks shouldn't be lending at. Worse still, at rates and under terms that targeted the "subprime" nature of these people. And now the banks are shocked, shocked I say that the same people aren't paying their mortgages. Their high-risk chickens are coming in to roost.

You're seeing the market move to reflect these concepts because financials are publicly traded. Fannie and Freddie are government-secured-sorta-but-still-freely-traded mortgage companies that back entirely TOO much of the country's mortgages. They were originally founded to allow lower-income people secure safe, fair mortgages and get into houses. Except that Freddie and Fannie dumped the profit from their deals into the shareholders, since they were traded publicly, and took on additional, higher risk assets, only to find themselves in the same position.

AIG had a bunch of these bad securities as well and it wasn't made any better that they have a LOT of dealings with insurance for commercial and industrial insurance, and that the divisions were too closely mated to let AIG itself fail. So AIG tanked, and the government extended some credit-liquidity to them, to get them by. (In exchange, they've taken a giant ownership stake, and the liquidity is backed by AIGs assets.)

The rest of the market is seeing a whirlwind of fail occur: Because people are upside-down on their homes, they don't have any equity in them, which they'd normally use to take out a home equity line of credit, or HELOC. People use money like that to buy improvements on their home or to spend additional money. It's relatively revolving cash, and if the value of your home goes up, you can tap into that increase without selling. People are also seeing gas prices go up and hearing of other companies having trouble and "possible recession" and so they tighten their purse strings. When they do that, consumer confidence goes down dramatically and volatility goes up on the market. So the stock market reacts by punishing EVERYONE as people become scared that the situation STILL hasn't hit bottom yet, the government's bailout is NOT going to go into immediate effect anytime soon, and dammit, that's my retirement fund, but I'm not going to let it go to nothing. So I sell, at whatever price a "greater fool" is willing to buy at. And I sell into a dip and further precipitate the dip.

So we're watching markets take significant hits, even though the intrinsic values of the companies at hand haven't shifted, and even though the situations for those individual companies haven't changed significantly enough. People are worried consumers will spend less this holiday season, so Apple takes a huge beating, even though they continue to be popular and do very well. When people see large companies falter, they get scared and pull their funds and the panic results in giant dips like you saw today and yesterday.

Now in theory, there should be large swaths of individuals smart enough to buy in, because a lot of stocks are at the price of a lifetime. Google is a good example; it's taking a ridiculous beating, down to $338 from $500 in mid-August. Why? Because people perceive that companies will slow down their advertising. Now, they probably won't slow it down on Google's front first, since Google is measurable and effective. But people (read: the stupid market) think things and get them in their head and then punish companies arbitrarily because the market is going that way anyway and it, to them, is a sign of greater failures to come. Google hit $747 in the last year. It will probably hit that again at some point in the next 5 years. You can double your money if you're willing to hold GOOG for 5 years on that assumption. But buying into a dip like this is not for the squeamish.

So what you do as an intelligent investor (which I am not), is you dollar average in. You take the total chunk of cash you want to spend on a stock, say, $50,000, and you buy it in chunks, no matter the price, over the course of, say, a week or two. This way, you get the smoothed-out, average price, instead of buying it ALL at $338, then watching it bottom out to $300 in the next two days and saying "well, damn". Instead, you buy a bit at $338, a bit at $345, and a bit at $320 and a bit at $330, and it averages out and absorbs through your purchase into the dip.

Warren Buffet says it best: "Be greedy when others are fearful." It's important to remember that things aren't looking great right now, but there's a LOT of smoke in the air and a LOT of uneducated people with money in the markets that aren't sure what any of this means, except that they're seeing red and don't want to see any more red.

The bail-out will help banks start to be able to lend again. It's essentially a loan to the banks to tide them over while they work on the mortgage issues at hand, and it's backed by those mortgages. This will let them loan money back out to companies who need to make payroll, say, and individuals who need to buy things. Since it's not an instant-on switch, the credit markets are still seized up, like an engine without oil. We'll start to see some movement, if the bail-out is executed with any intelligence, which I have some confidence it will be. Too many rich people's money is at stake here.

In the mean time, read The Economist, if you have stock, sit back and relax if you don't need the money for 5-10 years, and if you do, well, get engaged more. If you don't own any stock but have some money lying around, now is when money is made.

Good luck. As for me, I got punished by Freddie and Apple, and lost about 35% in the past two weeks, even though I averaged in some. (I had no earthly clue Apple would continue its fall into the abyss; it's dropped from $135 to $85 in like... two weeks, for no good reason.) But I'm holding it long, long-term, so I'm not panicking, because selling would just hurt me when the turn around comes. Averaging in more would be nice and a way to absorb some of the shock, since, if I believe it'll bounce, I should be buying into that belief, but because I'm fully leveraged on my money I'm willing to put into the market, that will not come to pass.
posted by disillusioned at 4:19 AM on October 8, 2008 [19 favorites]

This explains it all in comic form.

http://www.businesspundit.com/sub-prime/
posted by the_ancient_mariner at 5:35 AM on October 8, 2008

The best down to earth explanation I've read - if you like Reader's Digest type first-person summaries - is Cityphilia by John Lanchester. It was written back in January, but more accurately explains the problems - it's not all about sub-prime, but also about derivatives, hedge funds, and the like, all of which are explained in a very down to earth way.
posted by wackybrit at 6:04 AM on October 8, 2008

15 things you need to know.

Here's a conversation going into the background leading up to it -- mortgages, etc.

Freakonomics tried to break it down into bite-size form (but I couldn't even understand that)
posted by Jaltcoh at 6:08 AM on October 8, 2008

Mutant just explained it to me about 30 minutes ago.
posted by nax at 6:14 AM on October 8, 2008

nthing the podcast from This Modern Life, The Giant Pool of Money. I listed to it a few weeks ago on my ipod, and now I feel that I have a very good grasp of several of the contributing factors, even the global aspect and the "Chinese money" that was mentioned several times in last night's debate.
posted by raisingsand at 6:56 AM on October 8, 2008

ehh, This American Life.....
posted by raisingsand at 6:57 AM on October 8, 2008

....Is it me, or have there been other questions like this in here too?
posted by EmpressCallipygos at 7:08 AM on October 8, 2008

An explanation from the children's BBC.
posted by kmennie at 7:16 AM on October 8, 2008

NPR also had a daily podcast on this stuff called Planet Money, which is a "no jargon" zone. It's good because things are moving so fast that today's problem you don't understand may be different than last week's problem that you do understand.
posted by smackfu at 7:40 AM on October 8, 2008

Google is a good example; it's taking a ridiculous beating, down to $338 from $500 in mid-August. Why? Because people perceive that companies will slow down their advertising. Now, they probably won't slow it down on Google's front first, since Google is measurable and effective. But people (read: the stupid market) think things and get them in their head and then punish companies arbitrarily because the market is going that way anyway and it, to them, is a sign of greater failures to come.

Disillusioned's explanation is pretty good, but this is one major thing I disagree with. The market is not always perfect, but it is by no means stupid. The stock prices are falling due to realistic re-evaluations of company earnings potential. Google's stock rose so high because the market was expecting them to grow at a very fast rate. If the current economic problems result in less advertising spending, which is what the current collective best guess is, then Google will perform much worse than what was previously expected. The old price made sense because there was a relatively low chance of a major economic crisis like the current one, and now that the crisis has appeared the new price is also reasonable. If the market really did make obviously incorrect price moves like this, it would be much easier for experts to consistently beat the market, which doesn't happen very often in practice.

So what you do as an intelligent investor (which I am not), is you dollar average in. You take the total chunk of cash you want to spend on a stock, say, $50,000, and you buy it in chunks, no matter the price, over the course of, say, a week or two. This way, you get the smoothed-out, average price, instead of buying it ALL at $338, then watching it bottom out to $300 in the next two days and saying "well, damn". Instead, you buy a bit at $338, a bit at $345, and a bit at $320 and a bit at $330, and it averages out and absorbs through your purchase into the dip.

This isn't really dollar cost averaging, and the benefits of dollar cost averaging are debatable anyway. Dollar cost averaging is supposed to take place over a period of months or years, not weeks. The point is to buy the same dollar amount in good times (like the years leading up to the crisis) and bad times (like right now). It's kind of a gimmicky strategy, because it really doesn't have any effect on returns, and in fact if you have $50,000 today that you want to invest it's easily proven* that investing it all at once will give you better net results. The important point is less that you should always invest the same amount at set time periods, and more that you should come up with some sort of plan and stick to it, rather than following the daily news headlines and trade out of excitement or fear.

* Explanation for the skeptical: You should only be investing money in the stock market if you think that it will produce positive returns over time. That means that any time you do not have money in the market, you are losing out on the money you could have earned in that time. For an extreme example, think about investing $100k today versus $10k a year for ten years at an average yearly gain of 9%. The lump sum investment would result in well over $200k at the end of ten years, whereas the yearly strategy would only be worth a little more than $150k.
posted by burnmp3s at 8:53 AM on October 8, 2008

RE: dollar cost averaging burnmp3s says "it's easily proven* that investing it all at once will give you better net results."

Your "proof" only holds for the case in which the returns are constant over the period which is never the case in the real market. Academic studies based on past history have been able to show that investing a lump sum beats dollar cost averaging about 65% of the time. This indicates that lump sum investing is generally a better bet, but there are no guarantees. As a case in point, anyone who was unfortunate enough to make a lump sum investment one month ago most likely will not fare as well as someone who started a dollar cost averaging strategy one month ago. You are making much too strong a claim that lump sum investing always gives better results than dollar cost averaging. It depends on the luck of the timing, which you cannot know in advance. Results cannot be "proven." You can only make conclusions indicating what would have happened in the past, not the future.
posted by JackFlash at 11:37 AM on October 8, 2008

Might want to read:

http://www.iwillteachyoutoberich.com/blog/10-links-to-walk-you-through-todays-financial-crisis-and-make-you-smarter-than-99-of-other-people
and http://www.iwillteachyoutoberich.com/blog/the-truth-what-obama-and-mccain-wont-tell-you-about-your-money
posted by bbyboi at 1:47 AM on October 9, 2008