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 is 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, in the wake of the dot-com bust in September 11th,
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 flipside, this means banks on Wall Street can borrow from the Fed for only 1%.
After that, general surplus is 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 $1000 profit: a good deal.
But, using leverage, someone with $10,000 would go borrow $990,000 more,
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's guy $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 and 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 seeks 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 ensure 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, "triple A" rated investment,
the highest, safest rate in the risk.
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 his loans.
Finally the investors have found a good investment for their money,
much better than the 1% treasury goals.
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, if 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.