What is This Credit Crisis You Speak Of? And Why Do I Care?

I thought it might be useful to follow up on Casey's post regarding the credit crisis and its recent impact on the student loan market. The events of the past nine months have been a sobering statement about what it means to be able to borrow money. From the most complex transactions at the largest banks in the world to your grad school loan or home mortgage, all the way down to the woman in rural Vietnam taking out $35 for a six month loan so that she can buy a pig, the wheels of economic mobility are greased by - better yet, completely stuck without - someone being there to lend you the money.

We borrow money every day: from the credit card company when we go to the grocery store or the mall, from Dell when we buy a computer, from the dealership when we buy a car... the list goes on. We also lend money every day.... to the banks where we keep our savings. They pay us a little interest on that money so that they can lend it out to other people for their home mortgages, cars, etc. Importantly, banks also raise money by selling off their loans to investors in packages (think of it as putting 1,000 loans in one box and shipping it to someone else), so that they can use that money make more loans.

What happened that messed everything up? Well, at its core, borrowing and lending money is not just a legal contract, it's a social contract, a chain where all the links in the chain must be solid in order for the system to work. If someone takes out a loan they can't afford; when lenders push inappropriate loans on borrowers in order to generate origination fees; when banks don't explain to borrowers that in two years their interest rates will increase and their mortgage payments could double, then the links in the chain start getting pulled pretty tight.

When you can't afford your mortgage, you can try to sell your house and bail yourself out, but what if it isn't enough to pay back the mortgage? What if this started happening to thousands of people? Well it did. And when enough people can't pay back their loans, then a link in the chain breaks. Housing prices start decreasing, the packages of loans the investors bought from the banks is worth much less, and somewhere, whoever the investors borrowed money from to buy that package of loans wants their money back yesterday. That's when things get really dicey.

[As a detour, I would like to point out one market that has not failed: The microfinance market. In developing countries around the world, women (and a few men) are borrowing small amounts of money in numbers unimagined even a decade ago...and paying it back! When five women get together and say to each other, "if one of us fails, we're all responsible," that means something. There are many microfinance organizations to which you can donate, or even lend, money, but I will save that for another time.]

The social contract of borrower and lender in the U.S. has faltered, and as a result the trust we depend on that makes lending money possible has been severely impaired. And that is where we are today, an accelerating lack of trust: no trust for home mortgages, no trust for student borrowers, for Fannie Mae or Freddie Mac or the U.S. dollar. What is the U.S. dollar backed by? Not gold. Not diamonds. Not Warren Buffet. Our currency is backed by the full faith and credit of the United States Government.

Take note, because those words, "faith and credit," they go hand in hand. In order to believe in our economy, we must believe in our government. So, Government, pretty please, give us something to believe in.

Will the credit crisis reduce people to laundering money?

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