Over the last few months as the subprime lending situation has grown increasingly worrisome, a lot of people have written to me asking some very fundamental questions about what’s going on. I’ve decided to collect all of these responses into a single post.

Please note that this is not a be-all end-all explanation of how the United States economy works, nor does it capture all of the nuances. This is intended as a layman’s explanation so that an individual can hear a news report in the mainstream media about the Federal Reserve or about the subprime crisis and know generally what’s going on. It’s also based on my own understanding of macroeconomics and a ton of research I’ve done lately – I don’t claim that it’s infallible, and I’m quite sure that someone will correct or expand on a detail or two in the comments.

So, let’s dig in.

The Federal Reserve and The Subprime Crisis

1. What is the Federal Reserve? What do they do?

The Federal Reserve (sometimes called the Fed) refers to the central banking system of the United States. It basically serves as the interface between the government and private banks, like Bank of America or Citibank or your local bank.

In the words of the Federal Reserve Act, the law that authorizes the existence of the Federal Reserve, the purpose of the Federal Reserve is:

To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

The primary reason the Federal Reserve was created was to avoid banking panics. Banking panics are pretty familiar to anyone who has ever heard stories of the Great Depression, when all of the customers of a bank would line up and try to take out all of their deposits at once. If the bank didn’t have that much cash on hand – and often it wouldn’t – the bank would be forced to close and simply not return deposits to investors. This caused some serious mistrust of the banking industry, for obvious reasons – I can say, for example, that my grandfather still refused to use a bank as late as the 1980s because he was so jilted by banking panics in the 1930s.

The recent mess with Bear Stearns was a near-miss of a banking panic, for example.

2. What power does the Federal Reserve have to stop such panics?

The Federal Reserve has several powers that they can use to prevent such panics from ever happening again.

First, they control the money supply. If a bank is about to run out of money because the customers are demanding all of their money, the Federal Reserve can print more money (they can print less money, too). This has a bad effect over the long run (I’ll talk about that later), but over the short run, it can keep a bank afloat and maintains the trust that people have in putting their money into banks.

Second, they control the federal funds rate. The federal funds rate is the interest rate that private banks can charge other banks on short term loans, usually overnight loans. Although the actual process is somewhat more complicated, it essentially works like this: Bank A and Bank B are both operating in the same town. Bank B has several customers wanting to make withdrawals today and they don’t have enough cash just sitting there to cover all the withdrawals. So Bank B asks Bank A for a quick overnight loan so that the withdrawals can be covered. The interest rate on that loan is (more or less) determined by the Federal Reserve and is known as the federal funds rate.

More or less? The actual truth is that the Federal Reserve itself lends out money at a slightly higher rate, called the discount rate. Any bank can borrow from the Federal Reserve at the discount rate, which means that it’s the default rate that banks can get for those quick overnight loans. Other banks will compete with that rate on the open market by offering a lower rate if they think it’s worthwhile, and the Federal Reserve uses a big bag of tricks to encourage banks to lend among themselves at a rate very close to the lower federal funds rate.

The Federal Reserve has a lot of other powers, too, but those are among the biggest.

3. Why does it matter when the federal funds rate goes up or down?

As a general rule of thumb, a lower federal funds rate means that it’s much easier for banks to carry on their normal business. They can lend with more confidence, knowing that if the depositors come around wanting withdrawals, they can borrow the money back pretty cheap. A higher rate means that banks are more cautious about lending money.

As a result, the Federal Reserve usually cuts their rates when the economy is starting to look weak (encouraging more loans) and usually raises the rates when the economy is starting to look strong (encouraging more conservative loans).

4. Why would the Fed ever want to raise rates if it makes the economy worse?

Think about your own life – one year, you might buy a car and a new living room set, but then you won’t buy anything over the next few years. This is probably affected by a lot of things – your feelings about how secure you are in your job, how the economy is doing in general, and so on. If you lose your job, for instance, you’re not going to be buying a new car.

The reverse of this is true, too. When people are buying, companies are doing well – they’re hiring more people and posting great earnings reports. However, when people stop buying, companies usually have to tighten their belts.

This creates a cycle, something that happens in any economy. It goes up, it goes down.

If the Federal Reserve just dropped rates to the floor, the economy would take off like a rocket and we’d have several years of a booming economy. After that, though, we’d be in a 1929 position all over again – many years of exuberance would leave a lot of consumers content with their big purchases and a lot of companies with overvalued stock prices as a result of that exuberance. In other words, a crash.

In order to prevent such a crash, the Federal Reserve moves to slow things down when they start really rolling along. They do that by raising the interest rates, so that companies can’t borrow money quite so easily and thus can’t quite run as efficiently as they might otherwise run. It protects us (theoretically) from another Great Depression.

5. What is a subprime mortgage?

First of all, let’s look at what a “prime” mortgage is. A “prime” mortgage is one that a bank is willing to offer to someone that they view as being trustworthy and highly likely to repay the mortgage without difficulty – someone with a steady, high income and a good credit rating. The term “prime” actually refers to the prime lending rate, which is an interest rate that most banks agree upon to use (yes, another different interest rate). The prime lending rate is usually close to 3% higher than the federal funds rate – right now, the federal funds rate is 2.25% and, thus, the prime rate is 5.25%. If you’re a trustworthy borrower, that 5.25% rate is approximately (not exactly in any way, shape, or form, but a guideline) what you should get on a mortgage right now.

Subprime mortgages are those offered to people who are deemed not as trustworthy, usually people with a less reliable income or a lower credit rating. These are people who are pretty likely to repay, but it’s not quite as clear cut. In order to help make up for that increased risk, many banks offered all sorts of special loans to these borrowers, usually at higher interest rates. ARMs were one particular option – they would have a great interest rate at first, but would adjust to a very high interest rate over time.

In order to sell more mortgages, many companies started offering these “subprime” loans quite easily, often loaning higher amounts to people at low income levels. For example, I was able to get a prime mortgage for a little less than double my family’s annual income, but I could have received a subprime loan for about four and a half times my family’s annual income.

6. How is that a bad thing?

The emergence of subprime mortgages had several effects. First of all, it increased the number of people who could buy homes very quickly, and it also increased the amount of money that people could get to buy homes. That meant there were a flood of potential home buyers in the late 1990s to mid 2000s. This caused the prices on the homes to rise – if there’s an increase in demand, the supply’s going to change to match that. (I’m simplifying a bit here, I know.)

Eventually, though, tons of new homes were being built, which increased the supply. Also, people were now sitting in subprime mortgages that were adjusting to rates that they couldn’t afford, so they were either not able to keep their house or they were walking away from them.

So, now you have two problems: the housing market is in bad shape because supply is higher and demand is lower, and there are people out there holding onto mortgages that are now very difficult for them to pay.

7. How does this affect big banks?

At this point, a lot of people are simply walking away from their subprime mortgages – they’re not paying the bills and letting the bank take their house. They have monthly payments that are too high for them to cover and thus they’re simply being foreclosed on for failure to pay their mortgage. Other owners are realizing that their houses are now worth less than they paid for them and, in some cases, the house is worth less than what they still owe on their mortgage, so some of these people are simply walking away, too, and letting the bank foreclose on their houses.

A big bank would much rather have a mortgage with a nice fat interest rate on it than a house with a low value on it. Every time a person walks away from a mortgage, the bank is force into trading that mortgage for that lower-value house. When you hear about subprime lending losses, this is where the losses start at.

The big problem is that these losses multiply. Whenever a person walks away from a mortgage, that loss doesn’t just affect whatever company actually holds the mortgage. It also affects everyone who is invested in that mortgage holder, and that’s a lot of people. That’s because home mortgages were previously seen as a rock-solid investment for investors, and thus a lot of different investment firms would invest their money in home mortgages, seeing it as being a very stable place for their money. Suddenly, that most stable of places is looking pretty risky and coughing up losses.

That’s how Bear Stearns got into trouble. They had a lot of their money invested in supposedly stable mortgages, but when people started walking away from those mortgages, suddenly Bear’s most stable investments were losing money pretty quickly. If that’s coupled with an investment in the stock market – a risky investment that’s also down right now – all of a bank’s investments could be losing money rapidly.

This creates a domino effect. Suddenly, banks stop trusting each other. If all of the other banks are losing money like gangbusters, why would you want to give that bank an overnight loan? It’s not really very safe to do so, so many banks become very hesitant to loan out a dime to each other. That’s very bad. It’s those overnight loans that make it possible for banks to conduct business – to lend money to entrepreneurs and companies and individuals who need the cash to keep their businesses and lives going. This is the so-called “credit crunch” that you keep hearing about on the news.

This, coupled with a long series of foreign policy initiatives not liked by most of the rest of the world, is also why the dollar is losing value against the rest of the currencies in the world. Think about it – from the eyes of someone outside of America, would you rather own a Euro – backed by nations that aren’t in a foreign policy fiasco and aren’t dealing with this subprime mess (at least not directly) – or a dollar, which comes from a nation with these problems? I know which one I would probably view as being more stable, and I’m an American.

8. What’s next?

In response to all of this, the Federal Reserve has been cutting the federal funds rate like crazy to encourage banks to lend money to each other. They’ve also made it much easier for banks to borrow money from the Federal Reserve at that discount rate mentioned above – they’re letting banks borrow the money for up to ninety days and have made more money available in this fashion than ever before. In other words, the Federal Reserve is trying to stabilize this mess.

What does it mean for you? It means that most investments are pretty awful at the moment – over the long haul, they’ll probably rebound as this crisis works itself out. Inflation is going up because the Federal Reserve is pumping money into the economy right now (those “discount rate” loans) – that’s why you’re paying higher prices at the grocery store, because with more dollars out there, an individual dollar is worth less than it used to be. Housing prices will certainly drop in the near future as all of this flushes out – that’s why it’s probably a good time to buy a house over the next few years.

Thankfully, banks are learning from this. It’s not a path they want to go down again, because this has been very dangerous for their business. It’s almost hard to get a prime mortgage now, and actual subprime mortgages are very hard to find.

My suggestion is be patient. If you’re investing for the long haul, now is as good a time as any to buy most investments, but if you’re looking at the short term, it’ll be pretty bumpy. If you’re looking to buy a house and have good credit, now’s a great time to start looking. Otherwise, now’s a great time to build up an emergency fund and

use other tactics that are appropriate for any downturn in the economy.