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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 involving terms [br]you’ve probably heard, like sub-prime mortgages

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Collateralized Debt Obligations, frozen[br]credit markets and Credit Default Swaps.

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Who’s affected? Everyone.

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How did it happen? Here’s how.

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The credit crisis brings [br]two groups of people together

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Home owners and investors.

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Home owners represent their mortgages, [br]and investors represent their money.

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These mortgages represent houses, and this [br]money represents large institutions

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Like pension funds, insurance companies, [br]sovereign funds, mutual funds, etc.

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These groups are brought together [br]through the financial system,

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a bunch of banks and brokers [br]commonly known as Wall Street.

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Although it may not seem like it, these banks on [br]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 money

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Looking for a good investment to turn into more money.

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Traditionally, they go to the US Federal Reserve where they buy Treasury Bills, believed to be the safest investment.

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But on the wake of the dot.com bust and September 11th,

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Federal Reserve Chairman Allen 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 flipside, this means banks on Wall Street can borrow from the Fed for only 1%.

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Add to that general surpluses from Japan, China and the Middle East

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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 [br]to amplify the outcome of a deal.

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Here’s how it works: in a normal deal someone [br]with $10,000 buys a box for $10,000

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He then sells it to someone else for $11,000

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For a $1,000 profit, a good deal.

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But using leverage, someone with $10,000 [br]would go borrow 990,000 more dollars

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Giving him $1,000,000 in hand.

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Then he goes and buys 100 boxes [br]with his $1,000,000

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And sells them to someone else [br]for $1,100,000.

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Then he pays back his $990,000 [br]plus $10,000 in interest

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And after his initial $10,000, he’s left with [br]a $90,000 profit versus the other guy’s $1,000.

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Leverage turns good deals into great deals. [br]This is a major way banks make their money.

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So Wall Street takes out a ton of credit, makes [br]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 the action, [br]and this gives Wall Street an idea

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They can connect the investors to [br]the home owners through mortgages.

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Here’s how it works

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A family wants a house so they save for a down [br]payment and contact the mortgage broker.

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The mortgage broker connects the family [br]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, [br]becomes home owners.

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This is great for them because housing prices [br]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 an investment[br]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 thousands more mortgages

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And puts them into a nice little box.

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This means that every month he gets the payments from the home owners of all the mortgages in the box.

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Then he fixes his banker wizards on it to work their financial magic

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Which is basically cutting it into three slices

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“Safe, Okay and Risky”.

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They pack the slices back up in the box 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 over into the middle, and whatever is left into the bottom.

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The money comes from home owners paying off their mortgages.

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If some owners don’t pay and default on their mortgage

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Less 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

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The bottom tray receives a higher 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 it for a small fee called the Credit Default Swap.

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The banks do all of this work so the credit rating agencies will stamp the top slice as a safe, triple-A rated investment

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The highest safest rating there is.

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The Okay slice is triple-B, still pretty good, and they don’t bother to rate the risky slice.

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Because of the triple-A rating, the investment banker can sell the safe slice to the investors who only want safe investments.

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He sells the "Okay" slice to other bankers, [br]and 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 this loans.

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Finally the investors have found a good [br]investment for their money,

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much better than [br]the 1% Treasury Bills.

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They’re so pleased [br]they want more CDO slices

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So the investment banker calls up [br]the lender wanting more mortgages

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The lender calls up the broker [br]for more home owners

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But the broker can’t find anyone.

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Everyone that qualifies for [br]a mortgage already has one.

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But they have an idea

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When home owners default on their mortgage, [br]the lender gets the house and houses are always increasing in value.

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Since they’re covered [br]in the home owners' default

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Lenders can start adding risk to new [br]mortgages, not requiring down payments

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No 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 [br]home owners, called prime mortgages

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They started to get some that were, [br]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 [br]the family with the lender and the mortgage

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Making his commission.

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The family buys a big house.

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The lender sells the mortgage [br]to the investment banker

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Who turns it into a CDO

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And sells slices to the investors and others.

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

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No one was worried because as soon as they [br]sold the mortgage to the next guy, it was his problem.

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If the home owners were to default, [br]they didn’t care

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They were selling off their risk [br]to the next guy and making millions

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Like playing hot potato [br]with a time bomb.

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Not surprisingly, the home owners default on [br]their mortgage, which at this moment is owned by the banker.

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

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No big deal, he puts it up for sale.

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But more and more of his monthly [br]payments turn into houses.

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Now there are so many houses for sale [br]on the market, creating more supply than there is demand

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And housing prices aren’t rising anymore. In fact, they plummet.

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This creates an interesting problem for home [br]owners still paying their mortgages

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As all the houses in their neighborhood go up [br]for sale, the value of their house goes down

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And they start to wonder why [br]they’re paying back their $300,000 mortgage

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When the house is now [br]worth only $90,000.

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They decide that it doesn’t make sense [br]to continue paying, even though they can afford to

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And they walk away from their house. [br]Default rates sweep the country and prices plummet.

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Now the investment banker is basically holding [br]a box full of worthless houses.

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He calls up his buddy the investor to sell his CDO, [br]but the investor isn’t stupid and says “no, thanks”.

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He knows that the stream of money [br]isn’t even a dripple anymore.

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The banker tries to sell to everyone [br]but nobody wants to buy his bomb.

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He’s freaking out because he borrowed millions, [br]sometimes billions, of dollars to buy this bomb

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And he can’t pay it back. [br]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 [br]thousands of these bombs.

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The lender calls up trying to sell his mortgage, [br]but the banker won’t buy it, and the broker is out of work.

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The whole financial system is frozen, [br]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 home owner [br]and tells him that his investments are worthless.

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

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Welcome to the crisis of credit.