The Crisis of Credit Visualized
What is the credit crisis?
It’s a worldwide financial fiasco involving terms you’ve probably heard, like sub-prime 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
Home owners and investors.
Home owners 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.
Although it may not seem like it, these banks on Wall Street are closely connected to these houses on Main Street.
To 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 on the wake of the dot.com bust and September 11th,
Federal Reserve Chairman Allen Greenspan lowers interest rates to only 1% to keep the economy strong.
1% is a very low return on investments so the investors say “no, thanks.”
On the flipside, 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: in 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 990,000 more dollars
Giving him $1,000,000 in hand.
Then he goes and buys 100 boxes with his $1,000,000
And sells them to someone else for $1,100,000.
Then he pays back his $990,000 plus $10,000 in interest
And after his initial $10,000, he’s left with a $90,000 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 a 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 home owners through mortgages.
Here’s how it works
A family wants a house so they save for a down payment and contact the mortgage broker.
The mortgage broker connects the family to a lender who gives them a mortgage.
The broker makes a nice commission.
The family buys a house, becomes home owners.
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 home owners of all the mortgages in the box.
Then he fixes 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 CDO.
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 home owners 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 the Credit Default Swap.
The banks do all of this work so the credit rating agencies will stamp 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 this loans.
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 home owners
But the broker can’t find anyone.
Everyone that qualifies for a mortgage already has one.
But they have an idea
When home owners default on their mortgage, the lender gets the house and houses are always increasing in value.
Since they’re covered in the home owners' 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 home owners, called prime mortgages
They started to get some that were, well, less responsible.
These are sub-prime mortgages.
This is the turning point.
So, just like always, the mortgage broker connects the family with the lender and the 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 and 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 home owners 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 time bomb.
Not surprisingly, the home owners 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 home owners 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 dripple 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.