ECON 101: Credit Crunch for Dummies

Starting in September 2007, the Federal Reserve has tried to make it more affordable for individuals, banks and companies to borrow by lowering interest rates, which also makes it easier for banks themselves to borrow money directly from the Fed.

But there have been many bumps along the way.

Just last week, investors started to question the health of Wall Street brokerage firm Bear Stearns and pulled their money out of investments there. As everybody pulled their money out at the same time, the investment bank collapsed.

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Home Prices

While all of this has been occurring on Wall Street, home prices across the country have been falling.

It started with the rise in foreclosures, which created a surplus of homes on the market.

Further compounding the situation, lenders have now tightened the standards of who can borrow money to buy a home. So there are more homes now available for purchase and fewer people who can buy them. That causes prices to fall.

Real estate agents suffered. So did mortgage lenders, real estate appraisers and everybody else involved with the sale of a house.

Developers stopped building new homes because the demand was no longer there and they couldn't get the same price for their products.

But it didn't end there. The home improvement industry also suffered. With homes worth less, homeowners no longer have as large home equity lines and can't afford to put in that new deck or buy that new refrigerator.

Additionally, since fewer people were buying homes, there was less renovating. So that meant decreased sales of paint, new sofas or whatever else people typically buy when moving into a new house.

Recession Watch

So that's the housing market and the world of Wall Street. But why are we now talking about a full-scale recession hitting all parts of the economy?

It all comes down to consumer confidence.

Americans have much of their savings and their sense of wealth tied up in their homes.

When home prices start to fall, that feeling of wealth disappears. Whether they are really worse off today than than they were a month ago doesn't matter. What matters is that they feel poorer, which in turn leads them to spend less.