8/15/10

Credit Crisis Visualized a summary


One of the most common questions I get asked by friends and family is why and how the current recession came to be.  Most of it is due to the credit crisis, which thankfully has been more or less figured out by economists (not solved, but understood).  The following clip from U-tube does a great job of describing the credit crisis in easy to understand terms, and I agree with their analysis

Below the video is a short summary explaining what went on (with information from the video).











The global financial credit crisis had effects that were felt worldwide. The crisis was caused by subprime loans, collateralized debt obligations, frozen credit markets and credit default swaps. The problem began with homeowners and investors. The homeowners represented mortgages and the investors represented money. The money came from places like pension funds and insurance companies. These two groups were brought together by the financial system which consisted of large banks and brokers, and is commonly referred to as Wall Street. 

Investors were buying T-bills from the Federal Reserve, but in the wake of the dotcom bust and 9/11, Federal Reserve chairman Allen Greenspan changed the money supply to lower the interest rate to 1%.  Investors wanted a larger return than 1% on their investment and looked for better opportunities. At the same time the 1% interest rate allowed banks to borrow money at 1%, and public and private surpluses from Japan, China and the Middle East lead to an abundance of cheap credit. Banks then decided to acquire this cheap credit and make money with it using leverage. Investors saw the huge returns the bank’s were making and wanted similar returns. Wall St. then connected the investors with homeowners through mortgages. 

When a family wanted to buy a house they saved up for a down payment and used a broker which connected the family with a lender, who gave them a mortgage. Everyone in this cycle makes money, including the homeowners because of the increase in home equity. This is when an investment banker could step in to buy the mortgages from the lender to profit off of the mortgage payments. The investment banker could borrow millions to buy the mortgages which are then transformed into a collateralized debt obligation (a security).  At this point they are split into 3 categories which are; Safe (AAA), OK (BBB), and Risky (not rated). Each portion is then sold according to rating.  The AAA rated securities can be insured for a small fee called credit default swap and sold to investors that want a safe investment.  The other BBB rated securities can be sold to other bankers, and the Risky securities could be sold to hedge funds.

This worked for awhile, until all of the qualified potential homeowners already had mortgages.  Investment bankers then return to the lender to buy more mortgages but no qualified people looking for mortgages can be found. Lenders then came up with a new idea. Because home prices have historically always increased in value, it would not matter if a home owner defaulted because they could still make money off of the sale of the home.  This means that lenders can add risk to new mortgages, such as not requiring a down payment, proof of income or any documentation. This led to sub-prime mortgages. No one in this business cycle cared about the risk because it was passed on to the next person. If a home owner defaulted on his payment the investment banker got a home which was always increasing in value.  But over time more mortgage payments turned into homes which increased the supply of homes and prices began to fall instead of rise. Existing home owners saw the value of neighboring homes drop and would decide to default on their mortgages.  

This would leave the banker with worthless homes and no investors to buy them. At this point investors already have a lot of these devalued homes on their hands, and the lenders cannot sell any new mortgages. The lenders, bankers, investors and home owners’ investments all go bankrupt.

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