Friday, October 17, 2008

What's going on?!

In light of the recent economic downturn, I felt it necessary to return to this blog and help out those who are seeking to make the most of these times. More so, I was encouraged today when I found out that a gentleman I had just met yesterday has been following The Dave Ramsey plan with his wife--all because of this blog.

Some may be wondering how our country has gotten into this situation, why the stock market keeps falling, who is Freddie Mac and Fannie Mae, and how will one be effected by all of this if he does not own a single share of stock.

Let's start with Freddie Mac and Fannie Mae. Say I have some money that I want to invest, while at the same time, you are looking to buy a house. I know you, you have a decent job, and you seem relatively trustworthy. I decide to loan you $150,000 at the going interest rate. You make a payment to me every month, and we are both happy. As you probably know, with every investment comes risk. I am taking on the risk that you might not make your monthly payments. Maybe you lose your job or come down with a fatal illness. In order to reduce my risk as an investor, it would make more sense for me to invest in 10 homes instead of one. If one home defaults, it isn't the end of the world.

Essentially, this is what Freddie Mac and Fannie Mae do. They are both government sponsored enterprises which mean they were charted by the government, but are actually privately owned. A mortgage company will sell its signed mortgages to Freddie Mac or Fannie Mae, who will then package them together (say 100 of them), and then sell them to investors in the secondary market. They refer to these investments as "mortgage-backed securities" because they are worth the values of the homes they represent.

Naturally, some of the mortgages in the pool of 100 will default, or at least be behind in their mortgage payments. But, the decline of Freddie Mac and Fannie Mae started when more and more people fell behind in their payments than usual and foreclosures became much more common. Add to this the decline of home values. For so long, home values were on the rise. $150,000 was paid for a home that is now worth only $125,000.

For a while, interest rates were so low that everyone was buying a new home (or 2 or 3). There were also mortgages put into place that start the home buyer at a low interest rate, only to increase that rate to 8 or 10 percent after three years. (These are referred to as Adjustable Rate Mortgages, or ARMs) And on top of that, government policies were put into place that made it possible for people to buy a home with little to no money down for a deposit.

Unfortunately, this was all spotted too late in the game. The government paid a large sum of money to help Freddie and Fannie during this time. If the government did not do this, a snowball effect would have occurred, and the entire financial system would probably have tanked by now.

I just hope we have all learned our lesson on this one.

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