Week 6: THE CREDIT/MORTGAGE CRISIS

What is the credit crisis?

The founding fathers of the US wanted to create a “flawless” financial system that would not allow private interests to impact on fiscal policy. Nowadays we can call it worldwide financial fiasco involving the best investment advisors in the world. What they created is so amazing, so smart, but also really difficult to comprehend.

Dictionary

Few explanations just to make things easy from here on out:

1)       Sub-prime mortgages – basically it means giving loans to people who might have difficulty maintaining the repayment plan. These loans have higher interest rates, poor quality collateral in order to compensate for higher credit risk.

2)       Collateralized debt obligations – or CDOs, are a structured financial product that gathers cash flow-generating assets and “repackages” these assets into product that can be sold further to investors.

3)       Frozen credit markets - A period of time when banks either do not have enough money to give loans to individuals or corporations or they implement strict rules and limitations regarding loan qualification.

4)       Credit defaults swaps – or CDS is a financial swap agreement. The seller of the CDS will compensate the buyer in the event of a loan default or other credit event (further crisis). It was invented by Blythe Masters from JP Morgan in 1994.

So who is affected by this scheme?

Well, simply everyone. The credit crisis in the early XXI brought two groups of people together: Home owners and Investors. For simplicity, home owners represent their mortgages (or loans tbh) while investors represent piles of $$ (pension funds, sovereign funds, insurance companies, mutual funds……..). Both of them wouldn’t meet in normal world, but hey we have bankers, brokers (the whole of Wall St.).

How did it start?

Years ago, the investors were literally stacking piles and piles of $$, looking for possibilities to make even more. Before, they would usually buy Treasure Bills with AAA rating (the safest investment there is). But things changed after dot.com bust (and in extent after 9/11) Federal Reserve chairman lowered the interest rates on these bills to mere 1% (it was to keep the economy strong). Investors started looking for other possibilities. On the other hand it meant that banks could borrow money from the F.R. with only 1% interest. Every single bank was interested in this. Hell, even offshore banks were interested! What did it do? It made easy for everyone to get credit with very good conditions. Banks were crazy about them. It allowed them to amplify their outcomes from international deals by hundreds. Let me explain…

How does the leverage work???

In a normal situation, with a 10zł in your pocket you could only buy 1 item for 10zł. But it is possible to sell this item to someone else for 11zł. Profit of 1zł. Simple and easy. Let’s go further. With that 10zł in your pocket, you go and borrow another 990zł (funny fact, it was possible to get credit like that before this crisis). So now with that you have 1000zł you go and buy 100 boxes and sell them to someone for 1100zł. So now, paying back your 990zł (with interest another 10zł) you made a profit of (100zł minus you initial 10zł) 90zł. Leverage turns good deals into better deals. This is one of the most common ways banks make their $$.

what now?

Wall St. takes all the money that it can from the banking system, and they make even more money with leverage. Paying back, leaves them with insane amount of profit. Investors (which I mentioned before) started to get involved in this. Now this is where the brilliance of Walls St. comes in. They figured out that they could connect investors with home owners by mortgages. But how?

Exactly, how?

Newlyweds want their first house! So they save some $$ for down payment (initial payment usually in cash as security) and contact their mortgage broker which then connects them to a lender. The broker (of course) makes some commission and the family buys a house. This is good (and sometimes the only way) because housing prices were going up constantly for years now. Now, the lender makes a deal with an investment banker who wants to buy the mortgage. The lender sells then the mortgage for a very nice fee. This procedure is multiplied by thousands as the investor borrowed a pile of money from banks (as explained somewhere higher). To imagine this, let’s say he puts every mortgage he has in one item (a box). Now every month he gets a nice payment from home/mortgage owners. Now, this box gets analyzed by the best bankers in the world and put in three groups:

-          Safe

-          OK

-          Risky

Anyways, they put everything in one product called CDO. Now, if some owners don’t pay their mortgage, or worse, default on their mortgage, less and less money is being put into CBOs. To compensate for higher risk, the “risky” group gets higher rate of return while “safe” receives lower rate (but just to make little more out of the “safe” group, be safest group can be insured for a small fee called CDS). Credit rating agencies will grade each of the group AAA for safe, BBB for ok and unrated for rest.

The AAA is then sold to other investors, safe and easy $$, the BBB are sold to other bankers while the worst and the most dangerous are resold to hedge funds (or other feeling little braver than usual) all while the initial banker get nice fees (usually more than 6 figures) for sales. He then repays loans and makes pure profit.

Where did it go wrong?

Investors wanting more. That was the root of the problem. Before this boom, there were not enough mortgages to supply a steady line of investments, so the mortgage brokers and bankers had to find other sources. They did have a solution. When a home owner defaults on his mortgage, a lender gets the house. And since (like mentioned before) houses constantly increase in value, and since they are covered if the home owner defaults, they still make their money and can even further extend their work areas. They began to add risk to mortgages, like no down payment, no proof of income or anything just to increase the number of mortgages being paid. Basically free money. Instead of stable and risk free mortgages (prime mortgage), they started borrowing to less responsible groups of people (sub-prime mortgage). The scheme of selling CDOs applies for both types of mortgages. Everyone is getting money, until…

Until what?

Until, groups of home owners (sub-prime mortgage CDOs) start to default on their mortgage. Bankers gets their house, but since this CDO had higher risk, more and more owners default. No more monthly payments from his investments, only houses. He can sell them at first, but soon there are so many houses for sales that they are creating more supply that there is demand. Now the house prices don’t increase anymore (when in fact they went down like crazy, 60% to 80% in 12 months).

Now the homeowners that are still paying their mortgage, their house doesn’t increase in value anymore. With other prices going down, their house is no different. Think about it for a second – home owner pays a mortgage for a house that he initially bought for 500.000zł when now its value is around 100.000zł. Since their mortgage was so open with no limitations, they just default on their mortgage. Simple as that.

Now, the investment banker has CDOs that are worthless. Since they are not the best CDOs anymore, the investor doesn’t want to buy them anymore. Banker is now in a big trouble. Why? He borrowed millions sometimes even billions of dollars for CDOs which he cannot sell to anyone.

What did happen next?

Investment banks couldn’t sell their CDOs, they cannot even get rid of them. They’re not the only one. Investors had previously bought thousands of such CDOs which they cannot turn into profits and cannot sell to anyone either. The lender is trying to sell his mortgage, but no investment banker will buy them anymore (mortgage brokers were fired by tens of thousands throughout the US). The whole financial system FROZE. The small ticking bombs were the nail in the coffin for most of the financial system nodes. They started going bankrupt. But even worse, the home owners had worthless mortgages that they were still paying off.

Question time!

1)       What happens next?

2)       How would you react as a home owner during the mortgage crisis?

3)       Naah it’s just these two, don’ worry.