Economic 101 for Dummies

I know the word 'dummies' may raise your eyebrow but let me clarify that I am one of those dummies, or should I say, I am one of those who do not understand what is happening to the economy at this particular point in time. And also let me clarify that if you scratch your head trying to unravel the mysterious thread of the economy, you're not alone. And I really understand the frustration of trying to understand and read articles from Times or even The Economists which full of lingo and in the end, still leaving us clueless. Because of this, I took great effort to fathom this mayhem and initiated to write an entry explaining the crisis in laymen terms. So, for the clueless, enjoy it, but bear with me guys, I am not an expert but I hope this rudimentary explanation would, at the very least, give you the 'Aha'

First, let start with the heart of the problem: sub-prime mortgage. It is a loan that is given to unqualified borrowers, a loan that is not supposed to be given at the first place. When the housing price plummeted, the borrowers were running frantically since their house was not as valuable as before. Overall economy was performing badly as well, hitting the unqualified borrowers' ability to pay their mortgage loan. In consequence, mortgage company suffered from loss.

Second, Fannie Mae and Freddie Mac were those which were greatly affected by this blow. They were not mortgage companies, but they provided financing for banks who issued mortgage. The initial purpose of these companies was to boost people's confidence in taking loans and buying their own house, giving the impression that borrower's loan were safely backed up by the government,when in fact it was not. National Public Radio (NPR) describes them as a mortgage wholesaler for investment banks.

Again, because of the housing slump and borrower's delinquency, their capital were greatly hurt and the government decided to save them from going down. The reasons: they are the world's largest company in terms of the amount of debt issued. Thus, letting these companies go down will crush the financial economy into pieces. So, there you go, $200billion bailout.

Third, AIG's bailout. The reason why AIG was saved (while Lehman not) is because AIG sells credit-default swaps (CDS). This illustration will hopefully help you to understand. If you buy a bond from company A, you might want to protect your investment by buying CDS from AIG. With this, when company A fails to meet its obligation, AIG guarantees that you will get your money back. Put it simply, CDS is your insurance.

To make sure the system works, AIG has to post collateral and the collateral depends on rating given by rating agencies like Moody's and Standard & Poor's. What happened was the agencies sharply downgraded AIG's rating. This means AIG has to post significant amount of collateral - $250 billion in a night - which obviously AIG did not has.

The government realizes that letting AIG goes down means letting all the CDS holders (who think that their fund is protected) go down as well. The ripple effect is unthinkable; other firms will also fail which will lead to more firm failing which will then lead to a financial catastrophe. All hells break loose. Thus, there you go, $85 billion bailout.

Fourth and last point, if all the venerable investment companies were failing, is there any company big enough to withstand the blow? Apparently not, that is why the government was proposing a $700 billion bailout plan, which btw, was rejected by the House. So, what's the next plan? I don't know but the officials are, I believe, working around the clock to solve this problem.

But for sure, this is a historic moment guys, let's try to turn our attention to the news. I hope I have set some basic foundations to help you guys understand the issue further. For those of you who know better, please please please correct me for any wrong statement. I am indeed still learning about the issue and any comment / suggestion would be highly appreciated and anticipated. Lastly, I should give Cheap (aka Stephanus Saputra) the credit for answering my questions, and also to Time Magazine (The Price of Greed by Serwer and Sloan) and NPR's Talk of the Nation for their excellent coverage on the topic.