WhatistheCreditCrisis.doc

What is the Credit Crisis? It is a worldwide financial fiasco involving terms you’ve probably never even heard. Sub-Prime Mortages Collateralized Debt Obligations Frozen Credit Markets Credit Default Swaps Who is Affected By The Credit Crisis? Everyone How Did It Happen? The credit crisis brings two groups of people together. Homeowners and investors. Homeownwers represent their mortgages and investors represent their money. The mortgages represent houses, and the money represents large institutions like pension funds, sovereign funds, insurance companies, and mutual funds. These groups are brought together through the financial system normally known as WALL ST. How is Wall St. connected to Main St? Years ago investors were sitting on piles of money looking for a good investment, to turn into MORE MONEY. Traditionally they would go to the Federal Reserve, where they would buy treasury bills. However, in the wake of the dot com bust and the attacks on 9/11 . Federal reserve chairman Alan Greenspan lowered the borrowing rate to only 1% to keep the economy strong. 1% is a very small return on investment so investors said “No thanks.” On the flip side this means banks can borrow from the bank for only 1%. Now add to that a large surplus of money from China, Japan, and Europe, and you have an overwhelming abundance of cheap CREDIT. This makes borrowing money easy and causes them to go crazy with LEVERAGE. “Leverage is borrowing money to amplify the outcome of a deal.” How Does Leveraged Investing Work? In a normal deal someone with 10,000 dollars buys a box for 10,000 dollars. He then sells that box to someone else for 11,000 dollars, making a $1,000 profit. Using leverage someone who has $10,000 will go and BORROW $990,000 instead. Using the original $10,000 as collateral. He now has $1,000,000, and he can buy 100 boxes. He sells them to someone else for $1,100,000. Now he has to pay back his 990,000 plus 10,000 in INTEREST. After you subtract the initial $10,000 he is