1929 great depression is the worst recession we have faced so far.
Next worst recession is 2008 global financial crisis.
This is also called as great recession.
All of us know that this happened because the housing price went down.
But not many of us know how it actually happened.
This episode will cover that topic. It is bit complicated.
There will be lot of structured finance terms. But if you watch patiently without skipping, you should be able to follow easily.
Even then if you were not able to follow, just blame it on me.
Hi. My name is Vijay Mohan. You are watching - Investment Insights.
To understand how the financial crisis actually happened, we should know how our home loans work.
What do we do when we are ready to buy a home? We go to a local bank to get a home loan.
These local banks, they do not actually end up owning these loans.
They actually sell all their home loans to a bigger bank or to an investment bank.
Even though they sell all their loans, they play servicer role servicing all those loans.
That means, they play the role of collecting the mortgage payments from us and passing it on to the actual owners of the loans.
So what does the investment banks do with these loans from local banks?
They package them as bonds and issue them to public.
Let's say that a local bank is selling loans worth of $100 million to an investment bank.
Investment banks would have bought loans like these from many local banks.
Let's say that they have a total loans of worth $1 billion. How would they issue that as a bond?
They could break that 1 billion into 1 million units of bonds that are worth $1000 each.
These bonds are called RMBS - Residential Mortgage Backed Securities.
Because these securities are backed by residential mortgage.
Similarly, if commercial building loans are bundled and issued as bonds, they are called as CMBS - Commercial Mortgage Backed Securities.
Can an investment bank issue these RMBS bonds immediately? No, they cannot.
Before that, they should get the bond ratings from a credit rating agency.
There are 3 major credit rating agencies in US. Moodys, S&P and Fitch Ratings.
They should get ratings from at least two of these rating agencies.
These credit rating agencies will issue ratings based on the quality of the loans in that package.
Loans of people with high credit score are high quality.
So a bond created with these high quality loans would get a top rating like AAA.
As the quality of the loans go down, the rating would go down as well like AA, A, BBB, BB etc.
Depending on the credit rating of the bond, the coupon rate (interest rate) of the bond varies.
A high quality bond will have low risk. That means, its interest will be low as well.
Interest rate will be higher for a low quality bond.
Anyone can buy these RMBS bonds.
All major financial institutions like investment banks, insurance companies, pension funds will have exposure to these types of bonds.
In fact, all major financial institutions across globe like in China, Japan, Singapore etc. have exposure to these RMBS bonds.
If there is an opportunity to get exposure to American Real Estate, anyone would jump on it. So there is no surprise there.
"All that is OK. But how did the financial crisis happen?"
Till 2000, the housing market was very normal.
We were pushed into a recession in 2001 from dot com crash.
What does federal reserve do when there is a recession? To stir up the economic activity, they would reduce the fed funds rate rate.
Fed funds rate was reduced to 1%. What happens if the fed funds rate goes down?
That will bring down the mortgage interest rate as well.
When the mortgage interest went down, more people started buying home thinking that we will not get a better opportunity for a cheaper loan.
Housing price started to go up more than usual.
In addition to this, foreign investors started pouring their money into mortgage backed securities like RMBS and CMBS.
Their belief was that these are American mortgage bonds. It is impossible for these bonds to go default.
"We all know that housing price can only go up. Why would it go down?" - their blind belief.
Realizing the high demand for these mortgage backed securities, investment banks like Lehman Brothers, Bear Sterns started focusing on this sector.
They started making huge profits from these securities.
Greediness started taking over them. They pushed mortgage lenders to issue more home loans.
"All folks with good credit score already own home. How can we possibly issue more loans?" - they asked.
"Don't worry about that. Just issue the loans even if their credit score is bad. Even if they do not pay the loans, we will still end up with home" - investment banks pressured the mortgage lenders.
So the mortgage lenders started giving loans to every tom, dick and harry.
When the financial institutions behaved irresponsibly like this, public behaved even worse.
Though they know that their income is not going to support home buying, they still bought the home beyond their means.
They had the same blind belief as well. "Housing price is not going to go down. We can safely buy a home for any price."
These low quality loans - loans issued to people with poor credit score are called as subprime loans.
Usually it will be at 8%. But during this time, it went up to 20%.
What kind of credit rating would a bond with these low quality loans could get?
Of course it is going to be a bad credit rating.
Even though these bonds give high interest rate, insurance companies and pension funds were not ready to buy them.
Because they have minimum credit rating criteria for buying a bond.
So how can they convinced to buy these low quality loans?
Investment banks had a solution for that as well.
They are not working day and night making boat loads of money for nothing right?
Their business depends on inventing new investment vehicles like these.
What they did was - let's say that there is a low quality bond that has a 50% probability of going default.
What happens when we combine two similar bonds like that?
If they are combined, the default risk goes down to 25%.
Just combining 2 bonds is bringing down the risk from 50% to 25%. What if we combine 5 bonds?
How about 10 bonds? The default risk will go down significantly.
Thus a CDO - Collateralized Debt Obligations was created by combining many of these bonds.
Now all the credit rating agencies were convinced that the old wine is in new bottle and issued top ratings.
Again, there was a big rush to invest in these as well.
Addition to all these, there are real estate investors as well.
"Housing price is keep rising every month. Loans are cheap as well. It is not a bad idea to buy 2 or 3 homes, paying just the loan interest..."
and so they bought multiple homes hoping that they would be able to flip it and sell it for high profits in the future.
Usually these kind of loans will be at 20%.
But during these times, it shot up to 35%.
All these lead to big rise in house prices.
All investment banks were drowning with huge profits.
Their Christmas parties were so lavish during those periods.
But all great parties come to an end at some point. Right?
How did that happen? That will be in next episode. Stay tuned. Thank You!