Global Financial Crisis Explained
Crisis: it’s a worldwide financial Fiasco involving terms you probably heard like subprime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps. Who’S affected everyone. How did it happen? Here’S how the credit crisis brings two groups of people together: homeowners and investors. Homeowners represent their mortgages and investors represent their money. These mortgages represent houses, and this money represents large institutions like pension funds, insurance companies, sovereign funds, mutual funds, etc. These groups are brought together through the financial system, a bunch of banks and brokers commonly known as Wall Street, while it may not seem like it. These banks on Wall Street are closely connected to these houses on Main Street will understand how, let’s start at the beginning years ago, the investors are sitting on their pile of money, looking for a good investment to turn into more money. Traditionally they go to the US Federal Reserve where they buy Treasury bills believed to be the safest investment, but in the wake of the dot-com 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 investment, so the investors say no thanks. On the flip side, this means banks on Wall Street can borrow from the Fed for only 1 %. Add to that general surpluses from Japan, China and the Middle East and there’s an abundance of cheap credit. This makes borrowing money easy for banks and causes them to go crazy with leverage leverage is borrowing money to amplify the outcome of a deal. Here’S how it works and a normal deal, someone with $ 10,000 buys a box for $ 10,000. He then sells it to someone else for $ 11,000 for a $ 1,000 profit a good deal, but using leverage. Someone with $ 10,000 would go borrow 990 thousand more dollars, giving him 1 million dollars in hand. Then he goes and buys 100 boxes with his 1 million dollars and sells them to someone else for 1 million $ 100,000. Then he pays back his 990 thousand plus 10 thousand and interest, and after his initial 10,000 he’s left with a 90 thousand dollar profit versus the other guy’s 1,000 leverage turns good deals into great deals. This is a major way banks make their money, so Wall Street takes out its ton of credit, makes great deals and grows tremendously rich and then pays it back. The investors see this and want a piece of the action, and this gives Wall Street an idea. They can connect the investors to the homeowners through mortgages. Here’S how it works. A family wants a house, so they save for a down payment and contact a mortgage broker. The mortgage brokers connects the family to a lender who gives them a mortgage. The broker makes a nice commission, the family buys a house and becomes homeowners. This is great for them, because housing prices have been rising practically forever. Everything works out nicely one day. The lender gets a call from an investment banker who wants to buy the mortgage. The lender sells it to him for a very nice fee. The investment banker then borrows millions of dollars and buys thousands more mortgages and puts them into a nice little box. This means that every month he gets the payments from the homeowners of all the mortgage in the box, then he six his banker Wizards on it to work their financial magic, which is basically cutting it into three slices, safe, okay and risky. They pack the slices back up in the box and call it a collateralized debt obligation or CDL. A CDO works like three cascading trays. As money comes in the top tray fills first, then spills over into the middle and whatever is left into the bottom. The money comes from homeowners, paying off their mortgages. If some owners don’t pay and default on their mortgage, less money comes in and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer to compensate for the higher risk. The bottom tray receives a higher rate of return, while the top receives a lower, but still nice return to make the top even safer banks will insure it for a small fee called a credit default, swap the banks do all of this work so that credit rating Agencies will snap the top slice as a safe triple-a, rated investment, the highest safest rating. There is the okay slice, is triple B, still pretty good and they don’t bother to rate the risky slice because of the Triple A rating. The investment banker can sell the safe slice to the investors, who only want safe investments. He sells the okay slice to other bankers and the risky slices to hedge funds and other risk takers. The investment banker makes millions he then repays his lungs. Finally, the investors have found a good investment for their money, much better than the 1 % Treasury bills they’re so pleased they want more CDO slices. So the investment banker calls up the lender wanting more mortgages. The lender calls up the broker for more homeowners, but the broker can’t find anyone. Everyone that qualifies for a mortgage already has one, but they have an idea when homeowners default on their mortgage, the lender gets the house and houses are always increasing in value since they’re covered. If the homeowners default lenders can start adding risk to new mortgages, not requiring down payments, no proof of income, no documents at all and that’s exactly what they did. So, instead of lending to responsible homeowners called prime mortgages, they started to get some that were well less responsible. These are subprime mortgages. This is the turning point. So, just like always, the mortgage broker connects the family with a lender and a mortgage making his commission the family buys a big house. The lender sells the mortgage to the investment banker, who turns it into a CDO and sells slices to the investors and others. This actually works out nicely for everyone that makes them all rich. No one was worried because, as soon as they sold the mortgage to the next guy, it was his problem. If the homeowners were to default, they didn’t care, they were selling off their risk to the next guy and making millions like playing hot potato with a timebomb, not surprisingly the homeowners default on their mortgage, which at this moment is owned by the banker. This means he forecloses and one of his monthly payments turns into a house no big deal. He puts it up for sale, but more and more of his monthly payments turn into houses. Now there are so many houses for sale on the market, creating more supply than there is demand and housing prices aren’t rising anymore. In fact they plummet. This creates an interesting problem for homeowners still paying their mortgages as all the houses in their neighborhood go up for sale. The value of their house goes down and they start to wonder why they’re paying back their $ 300,000 mortgage. When the house is now worth only $ 90,000, they decide that it doesn’t make sense to continue paying, even though they can afford to and they walk away from their house default rates, sweep the country and prices plummet. Now the investment banker is basically holding a box. Full of worthless houses. He calls up his buddy the investor to sell his CDO, but the investor isn’t stupid and says no thanks. He knows that the stream of money isn’t even a dribble anymore. The banker tries to sell to everyone, but nobody wants to buy his bomb he’s freaking out because he borrowed millions, sometimes billions of dollars to buy this bomb and he can’t pay it back whatever he tries, he can’t get rid of it, but he’s not the only One, the investors have already bought thousands of these bombs. The lender calls up trying to sell his mortgage, but the banker won’t buy it and the broker is out of work. The whole financial system is frozen and things get dark. Everybody starts going bankrupt, but that’s not all the investor calls up the home owner and tells him that his investments are worthless and you can begin to see how the crisis flows in a cycle. Welcome to the crisis of credit, you
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