The US Financial Crisis for Dummies :)

Well, we have been reading up about the whole financial crunch and investment banking getting a blow! I really had no idea what the whole  fuss was about, and was trying to understand the entire situation.  The more I understood it, the more I got hooked! I have tried to summarize the entire situation, from what I understand. I also took the help of my cousins BN, AN, NH who gave me their insights about the problem. I have re-organized the mail thread and tried to come up with a coherent flow here. As I said, this is a very layman view of the issue:
Sub-prime loans: The most commonly used term here is sub-prime loans. This word is basically the root cause of the entire problem. Sub-prime loan is basically a loan given to a person who has a bad credit record OR someone who might NOT be able to repay the loan amount. The rate of interest is usually very high in this case.

So, why would a bank give loan to someone who cannot repay it? Normally, when a person wants to buy a house, he walks to a bank and applies for a loan, mortgaging his house. Like what I have done. Now, if your credit record is bad and the bank feels that you will not be able to repay the loan amount, then it gives you a sub-prime loan.

Now what is the problem here?
Take this example:

1.    If I have a bad credit history and wish to buy a house, I borrow some money from a bank. This would come under sub-prime loans.
2.    In the face of general recession, if I lose my job (Outsourcing), then I shall not be able to repay the loan amount.
3.    Since I am not able to repay the loan amount, the bank can seize my house and auction it. On a magnified level, as the banks acquire more houses, the demand decreases as there are not too many people to buy it. As a result the real estate values fall.
4.    Since the real estate values are falling, the banks cannot retrieve their loans.
5.    Now, most of these banks run on the money invested by these investment firms like Lehman Brothers etc. So, when the banks are not able to retrieve the money, they are not able to give these investment banks their money!

The common understanding that everybody had was, “Housing market will improve. Housing prices will adjust itself in couple of years”. These were some of the big-wrong assumptions that were made by these sub-prime lenders and borrowers. They did not see the simple supply demand funda here. As they acquired more and more houses, there were lesser and lesser people to buy the house. And the cycle was set in motion. As a result, the house value dropped. The drop was very steep and it varied from place to place. This caused the big hit. Why should the consumer pay back a loan when the underlying collateral is not worth that much? Foreclosures started. People said, “take my house, leave me alone!”

Credit Cards and the Credit System in the US:
The basic problem is this… In the US, the system pretty much mandates you to have a credit card. And it’s based on the card’s usage that your credit history is determined. Some of the factors taken into consideration are 1. How long you have had credit. 2. How regularly you pay your bills (which indirectly translates to ‘how frequently do you use your card?’) 3. How many established credit accounts you have (not too many, but definitely not too less).  Basically, the country advocates you to have a credit card, gets you into the habit of spending on credit. Banks makes money by offerring you loans at exorbitant interest rate, because you they know that you cannot repay it. They themselves have been spreading the evil right?
The logic behind this system is in order to give someone a loan, one needs to know if the person has capacity and willingness to repay the loan.  In US, the way this is checked is not only looking at the income (capacity to repay) but also willingness to repay by seeing if they have already taken a loan in the past, and have they repaid it.
So, to get a new loan, the rule is that you must have already taken a loan and repaid it.  So the question becomes, how do you get your first loan?  It is difficult to get the first loan.  The simplest form of loan is to apply for a credit card with a low credit limit, and ensure that you promptly pay the bills on time.  Each time you use a credit card, you are in effect taking a small loan that you repay within a month (next credit card statement).
Thus, by making people take these small loans, and get the habit of paying back on time, one builds the culture of honoring one’s loans.  Then, if you really need to take a big loan such as for buying a car or a house, then the bank can see your history and decide how good you are at paying back.
But, what happens is that Banks indulge in predatory lending.  It is no different from baniya lending in India.  You lend to a person who is going to find it very difficult to repay the principal.  An example of this is to introduce 0% interest for 6 months on consumer goods items.  People will take the loan thinking that they will repay the loan in 6 months, but often don’t.  They may not be able to afford it as some other expense might come up.  The banks hope that the debtor will keep repaying only interest for a long time, and Banks make money by increasing interest rates based on several factors to such customers.  From their point of view, there is nothing unethical here, as this is their business model.  It is how Baniyas make money in India as well.
Or was this due to a lack of self regulation? At this point I think it is.
I am reading about at the 700 billion dollars bailout, and its implications, and why it failed. As of now, I have an understanding that it was not good for the people. But in what way, I am looking at it.