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The Crisis of Credit, Visualized.

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What is the credit crisis?

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It's a worldwide financial fiasco

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involving terms you've probably heard,
like

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sub-prime mortgages, collateralized debt
obligations, frozen

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credit markets, and credit default swaps.

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Who's affected?

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Everyone.

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How did it happen?

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Here's how.

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The credit crisis brings two groups of
people together, homeowners and investors.

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Homeowners represent their mortgages and
investors represent their money.

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These mortgages represent houses, and this
money represents large institutions

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like pension funds, insurance companies,
sovereign funds, mutual funds, etc.

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These groups are brought together through
the financial system, a

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bunch of banks and brokers commonly known
as Wall Street.

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While it may not seem like it, these banks
on

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Wall Street are closely connected to these
houses on Main Street.

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To understand how, let's start at the
beginning.

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Years ago, the investors are sitting on
their pile of

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money looking for a good investment to
turn into more money.

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Traditionally, they go to the US Federal
Reserve, where

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they buy treasury bills believed to be the
safest investment.

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But in the wake of the dot-com bust and
September 11, Federal Reserve Chairman,

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Alan Greenspan, lowers interest rates to
only 1% to keep the economy strong.

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1% is a very low return on investments, so
the investors say, no thanks.

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On the flip side, this means banks on Wall

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Street can borrow from the Fed for only
1%.

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Add to that, general surpluses from Japan,
China, and

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the Middle East, and there's an abundance
of cheap credit.

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This makes borrowing money easy for banks
and causes them to go crazy with leverage.

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Leverage is borrowing money to amplify the
outcome of a deal.

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Here's how it works.

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In a normal deal, someone with
$10,000 buys a box for $10,000.

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He then sells it to someone else for
$11,000, for a $1,000 profit, a good deal.

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But using leverage, someone with $10,000

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would go borrow 990,000 more dollars,

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giving him $1 million in hand.

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Then he goes and buys 100 boxes with his
$1 million

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and sells them to someone else for
$1.1 million.

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Then he pays back his 990,000 plus
10,000 in

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interest, and after his initial 10,000,
he's left with

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a $90,000 profit versus the other guy's
1,000.

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Leverage turns good deals into great
deals.

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This is a major ways banks make their
money.

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So, Wall Street takes out a ton of

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credit, makes great deals, and grows
tremendously rich.

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And then pays it back.

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The investors see this and want a piece of

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the action, and this gives Wall Street an
idea.

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They can connect the investors to the
homeowners through mortgages.

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Here's how it works.

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A family wants a house, so they save

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for a down payment and contact a mortgage
broker.

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The mortgage broker connects the family to
a lender, who gives them a mortgage.

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The broker makes a nice commission.

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The family buys a house and becomes
homeowners.

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This is great for them because

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housing prices have been rising
practically forever.

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Everything works out nicely.

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One day, the lender gets a call from

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an investment banker who wants to buy the
mortgage.

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The lender sells it to him for a very nice
fee.

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The investment banker then borrows
millions of dollars and buys

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thousands more mortgages and puts them
into a nice little box.

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This means that every month, he gets the
payments

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from the homeowners of all the mortgages
in the box.

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Then he sics his banker wizards on it to
work their financial magic, which

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is basically cutting it into three slices,
safe, okay, and risky.

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They pack the slices back up in the box

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and call it a collateralized debt
obligation, or CDO.

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A CDO works like three cascading trays.

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As money comes in, the top tray fills
first, then spills

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over into the middle, and whatever is left
into the bottom.

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The money comes from homeowners paying off
their mortgages.

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If some owners don't pay and default on
their mortgage, less

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money comes in and the bottom tray may not
get filled.

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This makes the bottom tray riskier and the
top tray safer.

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To compensate for the higher risk, the
bottom tray receives a higher

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rate of return, while the top receives a
lower, but still nice return.

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To make the top even safer, banks will
insure

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it for a small fee, called a credit
default swap.

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The banks do all of this work so that
credit rating agencies will stamp the top

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slice as a safe, AAA-rated investment, the
highest, safest rating there is.

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The okay slice is BBB, still pretty good,

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and they don't bother to rate the risky
slice.

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Because of the AAA rating, the investment
banker can sell

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the safe slice to the investors who only
want safe investments.

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He sells the okay slice to other bankers,
and

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the risky slices to hedge funds and other
risk takers.

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The investment banker makes millions.

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He then repays his loans.

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Finally, the investors have found a good
investment for their money.

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Much better than the 1% treasury bills.

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They're so pleased, they want more CDO
slices.

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So, the investment banker calls up the
lender, wanting more mortgages.

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The lender calls up the broker for

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more homeowners, but the broker can't find
anyone.

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Everyone that qualifies for a mortgage
already has one.

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But they have an idea.

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When homeowners default on their mortgage,
the lender gets

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the house, and houses are always
increasing in value.

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Since they're covered if the homeowners
default, lenders can start adding risk to

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new mortgages, not requiring down
payments, no

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proof of income, no documents at all.

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And that's exactly what they did.

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So, instead of lending to responsible
homeowners, called prime mortgages,

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they started to get some that were, well,
less responsible.

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These are sub-prime mortgages.

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This is the turning point.

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So, just like always, the mortgage broker
connects the

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family with the lender and a mortgage,
making his commission.

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The family buys a big house.

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The lender sells the mortgage to the
investment banker,

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who turns it into a CDO and sell
slices to the investors and others.

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This actually works out nicely for
everyone and makes them all rich.

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No one was worried because as soon as they
sold

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the mortgage to the next guy, it was his
problem.

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If the homeowners where to
default,

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they didn't care, they were selling off
their

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risk to the next guy and making millions,
like playing hot potato with a time bomb.

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Not surprisingly, the homeowners default
on their mortgage,

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which at this moment, is owned by the
banker.

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This means, he forecloses, and one of his
monthly payments turns into a house.

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No big deal.

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He puts it up for sale.

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But more and more of his monthly payments
turn into houses.

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Now, there are so many houses for sale on
the market, creating

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more supply than there is demand, and
housing prices aren't rising anymore.

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In fact, they plummet.

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This creates an interesting problem for
homeowners still paying their mortgages.

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As all the houses in their neighborhood go
up

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for sale, the value of their house goes
down, and

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they start to wonder why they're paying
back their

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$300,000 mortgage when the house is now
worth only $90,000.

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They decide that it doesn't make sense to
continue paying, even

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though they can afford to, and they walk
away from their house.

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Default breaks sweep the country, and
prices plummet.

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Now, the investment banker is basically
holding a box full of worthless houses.

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He calls up his buddy, the investor, to
sell his

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CDO, but the investor isn't stupid and
says, no thanks.

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He knows that the stream of money isn't
even a dribble anymore.

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The banker tries to sell to everyone, but
nobody wants to buy his bomb.

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He's freaking out because he borrowed
millions, sometimes billions of

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dollars to buy this bomb, and he can't pay
it back.

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Whatever he tries, he can't get rid of it.

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But he's not the only one.

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The investors have already bought
thousands of these bombs.

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The lender calls up trying to sell his
mortgage, but the banker won't buy it.

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And the broker is out of work.

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The whole financial system is frozen and
things get dark.

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Everybody starts going bankrupt.

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But that's not all.

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The investor calls up the homeowner and

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tells him that his investments are
worthless.

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And you can begin to see how the crisis
flows in a cycle.

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Welcome to the Crisis of Credit.