WEBVTT 00:00:01.851 --> 00:00:05.658 The Crisis of Credit Visualized 00:00:09.027 --> 00:00:10.682 What is the credit crisis? 00:00:10.682 --> 00:00:17.001 It’s a worldwide financial fiasco involving terms you’ve probably heard, like sub-prime mortgages 00:00:17.013 --> 00:00:23.021 Collateralized Debt Obligations, frozen credit markets and Credit Default Swaps. 00:00:23.033 --> 00:00:26.019 Who’s affected? Everyone. 00:00:26.031 --> 00:00:28.080 How did it happen? Here’s how. 00:00:28.092 --> 00:00:31.083 The credit crisis brings two groups of people together 00:00:31.095 --> 00:00:33.096 Home owners and investors. 00:00:34.007 --> 00:00:39.027 Home owners represent their mortgages, and investors represent their money. 00:00:39.039 --> 00:00:44.068 These mortgages represent houses, and this money represents large institutions 00:00:44.080 --> 00:00:50.037 Like pension funds, insurance companies, sovereign funds, mutual funds, etc. 00:00:50.049 --> 00:00:54.031 These groups are brought together through the financial system, 00:00:54.031 --> 00:00:57.031 a bunch of banks and brokers commonly known as Wall Street. 00:00:57.031 --> 00:01:04.052 Although it may not seem like it, these banks on Wall Street are closely connected to these houses on Main Street. 00:01:04.064 --> 00:01:07.026 To understand how, let’s start at the beginning. 00:01:07.039 --> 00:01:11.069 Years ago, the investors are sitting on their pile of money 00:01:11.081 --> 00:01:15.025 Looking for a good investment to turn into more money. 00:01:15.037 --> 00:01:22.012 Traditionally, they go to the US Federal Reserve where they buy Treasury Bills, believed to be the safest investment. 00:01:22.024 --> 00:01:26.062 But on the wake of the dot.com bust and September 11th, 00:01:26.074 --> 00:01:33.082 Federal Reserve Chairman Allen Greenspan lowers interest rates to only 1% to keep the economy strong. 00:01:33.094 --> 00:01:39.069 1% is a very low return on investments so the investors say “no, thanks.” 00:01:39.081 --> 00:01:46.053 On the flipside, this means banks on Wall Street can borrow from the Fed for only 1%. 00:01:46.078 --> 00:01:51.058 Add to that general surpluses from Japan, China and the Middle East 00:01:51.070 --> 00:01:54.033 And there’s an abundance of cheap credit. 00:01:54.031 --> 00:02:00.063 This makes borrowing money easy for banks and causes them to go crazy with… leverage. 00:02:01.037 --> 00:02:07.004 Leverage is borrowing money to amplify the outcome of a deal. 00:02:07.060 --> 00:02:15.076 Here’s how it works: in a normal deal someone with $10,000 buys a box for $10,000 00:02:16.024 --> 00:02:20.002 He then sells it to someone else for $11,000 00:02:22.042 --> 00:02:25.052 For a $1,000 profit, a good deal. 00:02:25.064 --> 00:02:33.079 But using leverage, someone with $10,000 would go borrow 990,000 more dollars 00:02:37.028 --> 00:02:40.041 Giving him $1,000,000 in hand. 00:02:40.083 --> 00:02:47.004 Then he goes and buys 100 boxes with his $1,000,000 00:02:47.061 --> 00:02:53.019 And sells them to someone else for $1,100,000. 00:02:55.087 --> 00:03:01.083 Then he pays back his $990,000 plus $10,000 in interest 00:03:02.017 --> 00:03:09.059 And after his initial $10,000, he’s left with a $90,000 profit versus the other guy’s $1,000. 00:03:09.071 --> 00:03:16.002 Leverage turns good deals into great deals. This is a major way banks make their money. 00:03:16.054 --> 00:03:24.806 So Wall Street takes out a ton of credit, makes great deals and grows tremendously rich. 00:03:25.011 --> 00:03:27.228 And then pays it back. 00:03:28.068 --> 00:03:34.006 The investors see this and want a piece of the action, and this gives Wall Street an idea 00:03:34.043 --> 00:03:40.046 They can connect the investors to the home owners through mortgages. 00:03:43.051 --> 00:03:45.000 Here’s how it works 00:03:45.026 --> 00:03:51.052 A family wants a house so they save for a down payment and contact the mortgage broker. 00:03:51.064 --> 00:03:57.032 The mortgage broker connects the family to a lender who gives them a mortgage. 00:03:57.044 --> 00:03:59.071 The broker makes a nice commission. 00:04:00.033 --> 00:04:03.085 The family buys a house, becomes home owners. 00:04:03.097 --> 00:04:08.061 This is great for them because housing prices have been rising practically forever. 00:04:08.061 --> 00:04:11.061 Everything works out nicely. 00:04:11.061 --> 00:04:16.043 One day, the lender gets a call from an investment banker who wants to buy the mortgage. 00:04:16.055 --> 00:04:19.077 The lender sells it to him for a very nice fee. 00:04:20.078 --> 00:04:27.015 The investment banker then borrows millions of dollars and buys thousands more mortgages 00:04:27.027 --> 00:04:29.090 And puts them into a nice little box. 00:04:30.002 --> 00:04:35.074 This means that every month he gets the payments from the home owners of all the mortgages in the box. 00:04:37.023 --> 00:04:41.085 Then he fixes his banker wizards on it to work their financial magic 00:04:42.020 --> 00:04:45.042 Which is basically cutting it into three slices 00:04:45.082 --> 00:04:49.018 “Safe, Okay and Risky”. 00:04:49.031 --> 00:04:56.067 They pack the slices back up in the box and call it a Collateralized Debt Obligation, or CDO. 00:04:56.079 --> 00:05:00.024 A CDO works like three cascading trays 00:05:00.083 --> 00:05:08.023 As money comes in, the top tray fills first, then spills over into the middle, and whatever is left into the bottom. 00:05:08.047 --> 00:05:11.071 The money comes from home owners paying off their mortgages. 00:05:12.014 --> 00:05:15.065 If some owners don’t pay and default on their mortgage 00:05:15.077 --> 00:05:19.022 Less money comes in and the bottom tray may not get filled. 00:05:19.057 --> 00:05:23.099 This makes the bottom tray riskier and the top tray safer. 00:05:24.011 --> 00:05:26.048 To compensate for the higher risk 00:05:26.060 --> 00:05:33.048 The bottom tray receives a higher rate of return while the top receives a lower, but still nice, return. 00:05:33.060 --> 00:05:40.067 To make the top even safer, banks will insure it for a small fee called the Credit Default Swap. 00:05:41.012 --> 00:05:49.029 The banks do all of this work so the credit rating agencies will stamp the top slice as a safe, triple-A rated investment 00:05:49.041 --> 00:05:51.070 The highest safest rating there is. 00:05:52.019 --> 00:05:57.067 The Okay slice is triple-B, still pretty good, and they don’t bother to rate the risky slice. 00:05:58.024 --> 00:06:06.048 Because of the triple-A rating, the investment banker can sell the safe slice to the investors who only want safe investments. 00:06:07.001 --> 00:06:13.099 He sells the "Okay" slice to other bankers, and the risky slices to hedge funds and other risk takers. 00:06:14.011 --> 00:06:17.029 The investment banker makes millions. 00:06:18.018 --> 00:06:20.087 He then repays this loans. 00:06:21.033 --> 00:06:24.035 Finally the investors have found a good investment for their money, 00:06:24.035 --> 00:06:27.035 much better than the 1% Treasury Bills. 00:06:27.035 --> 00:06:30.074 They’re so pleased they want more CDO slices 00:06:30.099 --> 00:06:35.012 So the investment banker calls up the lender wanting more mortgages 00:06:35.024 --> 00:06:38.050 The lender calls up the broker for more home owners 00:06:39.003 --> 00:06:41.033 But the broker can’t find anyone. 00:06:41.058 --> 00:06:45.041 Everyone that qualifies for a mortgage already has one. 00:06:45.082 --> 00:06:47.033 But they have an idea 00:06:51.089 --> 00:06:58.093 When home owners default on their mortgage, the lender gets the house and houses are always increasing in value. 00:06:59.029 --> 00:07:01.088 Since they’re covered in the home owners' default 00:07:02.000 --> 00:07:07.064 Lenders can start adding risk to new mortgages, not requiring down payments 00:07:07.076 --> 00:07:10.065 No proof of income, no documents at all! 00:07:11.000 --> 00:07:13.002 And that’s exactly what they did. 00:07:13.038 --> 00:07:18.062 So instead of lending to responsible home owners, called prime mortgages 00:07:18.087 --> 00:07:23.004 They started to get some that were, well, less responsible. 00:07:23.016 --> 00:07:25.092 These are sub-prime mortgages. 00:07:26.055 --> 00:07:28.088 This is the turning point. 00:07:31.077 --> 00:07:37.084 So, just like always, the mortgage broker connects the family with the lender and the mortgage 00:07:37.096 --> 00:07:39.028 Making his commission. 00:07:39.040 --> 00:07:41.078 The family buys a big house. 00:07:42.014 --> 00:07:45.004 The lender sells the mortgage to the investment banker 00:07:47.016 --> 00:07:49.064 Who turns it into a CDO 00:07:50.061 --> 00:07:53.056 And sells slices to the investors and others. 00:07:53.068 --> 00:07:58.064 This actually works out nicely for everyone and makes them all rich. 00:07:59.049 --> 00:08:04.067 No one was worried because as soon as they sold the mortgage to the next guy, it was his problem. 00:08:05.018 --> 00:08:08.031 If the home owners were to default, they didn’t care 00:08:08.043 --> 00:08:12.004 They were selling off their risk to the next guy and making millions 00:08:12.029 --> 00:08:15.002 Like playing hot potato with a time bomb. 00:08:16.000 --> 00:08:22.042 Not surprisingly, the home owners default on their mortgage, which at this moment is owned by the banker. 00:08:22.054 --> 00:08:28.021 This means, he forecloses and one of his monthly payments turns into a house. 00:08:28.033 --> 00:08:31.021 No big deal, he puts it up for sale. 00:08:33.024 --> 00:08:37.028 But more and more of his monthly payments turn into houses. 00:08:39.095 --> 00:08:46.014 Now there are so many houses for sale on the market, creating more supply than there is demand 00:08:46.026 --> 00:08:50.089 And housing prices aren’t rising anymore. In fact, they plummet. 00:08:52.044 --> 00:08:57.034 This creates an interesting problem for home owners still paying their mortgages 00:08:57.059 --> 00:09:03.011 As all the houses in their neighborhood go up for sale, the value of their house goes down 00:09:03.023 --> 00:09:08.003 And they start to wonder why they’re paying back their $300,000 mortgage 00:09:08.015 --> 00:09:12.042 When the house is now worth only $90,000. 00:09:12.054 --> 00:09:17.043 They decide that it doesn’t make sense to continue paying, even though they can afford to 00:09:17.055 --> 00:09:22.080 And they walk away from their house. Default rates sweep the country and prices plummet. 00:09:23.038 --> 00:09:27.084 Now the investment banker is basically holding a box full of worthless houses. 00:09:27.096 --> 00:09:35.051 He calls up his buddy the investor to sell his CDO, but the investor isn’t stupid and says “no, thanks”. 00:09:35.063 --> 00:09:39.071 He knows that the stream of money isn’t even a dripple anymore. 00:09:39.083 --> 00:09:43.091 The banker tries to sell to everyone but nobody wants to buy his bomb. 00:09:44.027 --> 00:09:49.072 He’s freaking out because he borrowed millions, sometimes billions, of dollars to buy this bomb 00:09:49.084 --> 00:09:54.088 And he can’t pay it back. Whatever he tries, he can’t get rid of it. 00:09:57.017 --> 00:09:58.098 But he’s not the only one 00:09:59.089 --> 00:10:03.085 The investors have already bought thousands of these bombs. 00:10:04.070 --> 00:10:11.034 The lender calls up trying to sell his mortgage, but the banker won’t buy it, and the broker is out of work. 00:10:11.091 --> 00:10:16.099 The whole financial system is frozen, and things get dark… 00:10:22.010 --> 00:10:24.035 Everybody starts going bankrupt. 00:10:27.064 --> 00:10:28.091 But that’s not all 00:10:29.003 --> 00:10:35.044 The investor calls up the home owner and tells him that his investments are worthless. 00:10:35.071 --> 00:10:39.066 And you can begin to see how the crisis flows in a cycle. 00:10:40.090 --> 00:10:43.085 Welcome to the crisis of credit.