The Crisis of Credit Visualized - HD

The Short and Simple Story of the Credit Crisis -- The Full Version

By Jonathan Jarvis.

Crisisofcredit.com

The goal of giving form to a complex situation like the credit crisis is to quickly supply the essence of the situation to those unfamiliar and uninitiated.

This is the original, full version.

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, homeowners and investors.

Homeowners 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.

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

Alan 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 flip side, 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 million in hand.

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

and sells them to someone else for
$1.1 million.

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 ways 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
homeowners through mortgages.

Here's how it works.

A family wants a house, so they save

for a down payment and contact a 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 and becomes
homeowners.

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 homeowners of all the mortgages
in the box.

Then he sics 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 homeowners 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 a credit
default swap.

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

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

The okay slice is BBB, still pretty good,

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

Because of the AAA 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 his 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 homeowners, but the broker can't find
anyone.

Everyone that qualifies for a mortgage
already has one.

But they have an idea.

When homeowners default on their mortgage,
the lender gets

the house, and houses are always
increasing in value.

Since they're covered if the homeowners
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
homeowners, 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 a 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 sell
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 homeowners where 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 homeowners 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
homeowners 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 breaks 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 dribble 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 homeowner 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.