Who isaffected? Everyone.

How didit happen? Here’s how:

Thecredit crisis brings two groups of people together: home-owners and investors.Home-owners represent their mortgages and investors represent their money.These mortgages represent houses and this money represents large institutionslike pension funds, insurance companies, sovereign funds, mutual funds, etc.These groups are brought together through the financial system, a bunch ofbanks and brokers commonly known as Wall Street. Although it may not seem likeit, these banks on Wall Street are closely connected to these houses on MainStreet. To understand how, let’s start at the beginning.

Yearsago, the investors are sitting on their pile of money, looking for a goodinvestment to turn into more money. Traditionally they go to the US FederalReserve where they buy treasury bills, believed to be the safest investment.But, in the wake of the dotcom bust in September 11th, Federal Reserve chairman,Alan Greenspan, lowers interest rates to only 1% to keep the economy strong. 1%is a very low return on investments, so the investors say: “no, thanks.” 

On the flip side, this means banks on WallStreet can borrow from the Fed for only 1%. Add to that, general surpluses fromJapan, China and the Middle East, and there is an abundance of cheap credit. Thismakes borrowing money easy for banks and causes them to go crazy with leverage. 

Leverageis borrowing money to amplify the outcome of a deal. Here is how it works:

In anormal deal, someone with $10,000 buys a box for $10,000. He then sells it tosomeone else for $11,000, for a $1,000 profit, a good deal. But using leverage,someone with $10,000 would go borrow $990,000 more, giving him $1,000,000 inhand. Then he goes and buys 100 boxes with his $1,000,000, and sells them tosomeone else for $1,100,000. Then he pays back his $990,000 plus $10,000 ininterest. And after his initial $10,000, he’s left with a $90,000 profit versusthe other guy’s, $1,000. Leverage turns good deals into great deals. This is amajor way banks make their money. So Wall Street takes out a ton of credit,makes great deals and grows tremendously rich, and then pays it back.