In determining the cause of a fire, forensic experts dig through the rubble and ashes of buildings looking for clues as to what started the fire. In the same way, I’m interested in understanding the recent economic meltdown that we are in the midst of. What started the whole thing to begin with? The most typical answer that I hear is the “financial markets” and more specifically that our circumstances are a result of the collapse of the sub-prime lending market and all of the defaulted loans that were generated from that market.

There is no doubt that the sub-prime lending practices were certainly a major factor in the catastrophic economic disintegration that has been taking place, but that in itself is not what started the meltdown, no more than a burning house is caused by dry rotting timbers or piles of oily rags. Sure they don’t help the situation and they certainly act as an accelerant, but they are not the cause of the fire in the first place. We therefore have to look closer and comb through the mess to see what really started the whole thing. We also need to look further back than just the last few months or even the last year to find the spark that was smoldering and waiting to be fanned into the inferno that has engulfed our economy.

In continuing with my fire analogy and forensic efforts to locate the start, let’s narrow it down to the location of where the calamity started. We know it had its origins within the sub-prime lending market. Sub-prime lending was created as a means of providing loans to individuals and groups that would not qualify for traditional loans, i.e. prospective homebuyers that didn’t have the cash or credit ratings to make them eligible for conventional loans. What that means is that typically individuals or families that were young first time homebuyers or individuals with lower incomes, bad credit ratings and other factors that put them at the lower end of the economic spectrum, were taking advantage of the sub-prime model to acquire homes and the ensuing mortgages. Most of this started after the loosening of the mortgage regulation by Fannie Mae and Freddie Mac under direction from Congress in 1999 and 2000.

Naturally the nature of these high-risk loans made them a more than likely area to see loan defaults, but if people were working and earning money as they had been when they first qualified for these loans couldn’t they make the payments and keep from defaulting? Yes absolutely, but something caused them not to be able to make their payments, and most of that started in 2005 and continued to increase through 2008. But wasn’t the economy still humming along okay in 2005, 2006 and 2007? We didn’t really see layoffs or increased unemployment during that period, inflation was low, interest rates were low, and most every other economic indicator was fairly positive throughout 2004 to 2007. So what caused individuals to be unable to make their payments?

One thing that has been identified as a factor is the fact that these were ARM’s (Adjustable Rate Mortgages) that increased the interest rates and payments after one to three years. These no doubt were a contributing factor, but the number of defaulted ARM loans were only a small percentage of the total loans that were defaulted on and also the interest rates continued to stay low, therefore the ARM’s did not increase defaults by a large amount. ARM’s were just another oily rag on the pile. No the spark that caused the fire and continued to fuel the problem was literally “fuel”, in other words Gasoline. Gasoline prices started to significantly rise at the beginning of 2004 and go up until they peaked at over $4 a gallon in the summer of 2008. There was certainly a lot of noise made in 2008 about oil prices and naturally gas prices, but the real problems had already started back in 2005.

To understand what effect the rise in gas prices had on the population most likely to have sub-prime mortgages, let’s take a closer look at the numbers and compare and contrast salary levels:

If you’re earning $100,000 a year and you fill up your car’s tank once a week and then gas prices jump by 50 cents or even a dollar, it’s an irritant and a nuisance, but certainly not unbearable. If In 2000 when gas prices were averaging around $1.50 per gallon and you filled a 20 gallon vehicle once a week you spent about $1500 annually which utilized about .5% of your $100,000 yearly salary on gas. In early 2005 when gas jumped to a little over $2 per gallon, your yearly cost jumped to about $2100, but that still only utilized about 1% of your $100K salary annually. Then when gasoline jumped to over $2.50 per gallon in 2006, you spent about $2600 annually and utilized about 1.5% of your $100k salary. Now let’s suppose you were earning a $40,000 annual salary (U.S. salary average for 2002 was $36,764), and you still needed to fill up a 20 gallon vehicle once a week. In 2000 with gas prices averaging $1.50 per gallon you utilized about 1.10% of your salary annually to pay for gas. In early 2005 when gas went to over $2 per gallon you were now using 2.65% of your annual salary, and then in 2006 when it went over $2.50 per gallon you were now utilizing about 4% of your salary on gas. Then of course by 2008 with gas averaging over $3.50 per gallon, a person with a $40,000 annual salary was using over 6% of their gross salary for gasoline. Remember this is Gross income not Net or take home. We are also assuming only one vehicle per family in this example; you might be doubling these numbers or even more if married and had other household members driving.

This example also only identifies the use of gasoline for driving a car, but the reality is that a large number of the families and individuals utilizing sub-prime home mortgages were also self-employed or working for small firms in a variety of professions such as, construction, truck-drivers, courier services, landscaping, and many more. These are typically professions that require the use of gasoline as a significant commodity in the running of the business. This huge jump in price for a commodity that was necessary for the daily use and work of individuals put a financial burden that crippled their efforts to make payments on home mortgages and other loans. So it seems to me that the real spark or flame that started the economic and financial meltdown was the rise in gasoline prices, which by the way, could have been prevented, but that’s another posting.

What has continued to be distressing is the slow rise of gasoline prices over the last month. Prices dropped dramatically at the end of 2008, after the collapse of so much of the economy, but gasoline prices have since then begun to rise again, and not because of the rise in oil prices. Oil prices have continued to fall and stay low. There are various reasons that are being reported for the rise in gasoline prices such as the cutbacks in production at the refineries and so on, but this will continue to hamper our economy from getting back on track.

Small businesses comprise the largest market of employment for individuals in the United States and is the true economic engine running this country. Small businesses are where new ideas and innovation is generally first created and implemented. If we truly want to stimulate our economy, then it’s the small businesses and self-employed people that we are wanting to focus on stimulating, and to do that, we better figure a way to keep gasoline prices as low as possible.