Transcript for The Crisis of Credit

the crisis of credit visualized

what is the credit crisis?

It is a worldwide financial fiasco

involvig terms you probably heard like

Sub-prime mortgages

collateralized debt obligations

frozen credit markets

and credit default swaps

Who is affected?

Everyone.

How then happen.

Here's How.

The crisis of credit brings two groups of people together

Home owners and investors

Home owners represent their mortages

and investors represent their money

These mortages represent houses

and these money represent large institutions

like pension funds, insurance companies

sovereign funds, mutual funds etc.

These groups are braught together to the financial system

a bunch of banks and brokers commonly known as

wall street

Although it might not seem like it

these banks at wall street are closely connected to these

houses at main street.

To understand how le't's start from the beginning

Years ago the inverstors were sitting on their pile of money

looking for a good investment to turn it 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 11 september

Federal reserve chairman Alan Greenspan

lowers interests rates to 1% to keep the economy strong

One percent is a very low return on investment, so the investors said

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 Middle East

and there is 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 is how it works:

Ina normal deal someone with 10 thousand dollars

buys a box for 10 000 dollars

he then sells it to someone else for 11 000 dollars

for a 1 000 dollars profit, a good deal

but using leverage, someone with 10 000 dollars

would go borrow 990 000 more dollars

getting him one million dollars in hand

then he goes and buys 100 boxes

with his one million dollars

and sells them to someone else for 1 100 000 dollars

then he pays back his 990 000 plus 10 000 in interest

and after his initial 10 000, he is left with 90 000 dollar profit

versus the other guys 1 000

levrage turns good deals into great deals

this is a major way banks make their money

so Wall st. takes out a ton of credit

makes grate 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 st. an idea

they can connect the investors to the home owners

through morgages

here is how it works

a family wants a house

so they save for a down payment

and contact a morgage broker

morgage broker connects the family to a lender

who gives them a morgage

the broker makes a nice comission

the family buys a house and becomes home owners

this is great for them because housing prices

have been rising practicaly forever

everything works out nicely

one day, the lender gets a call from an investment banker

who wants to buy the morgage

the lender sells it to him for a very nice fee

the investment banker then borrows millions of dollars

and buys thousands more morgages

and puts them into a nice little box

this means that every month

he gets the payments from the home owners of all the morgages in the box

then he (seeks?) his banker wizzards 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 laike three cascading trays

as money comes in, the top tray fills first

then spils over into the middle

and whatever is left into the bottom

the money comes from home owners paying off their morgages

if some owners don't pay and default on their morgage

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 recives a higher rate of return

while the top recives a lower but stil nice return

to make the top even safer the banks will ensure it

for a small fee called a 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 his loans

finaly, the investors have found a good investment for their money

much better than the 1% tresaury bills

they are so pleased, they want more CDO slices

so the investment banker calls up the lender

wanting more morgages

the lender calls up the broker for more home owners

but the broker can't find anyone

everyone that qualifies for a morgage already has one

but they have an idea

when home owners default on their morgage

the lender gets the house

and houses are allways increasing in value

since they're covered if the home owners default

lenders can start adding risk to new morgages

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 Morgages

they started to get some that were... well, less responsible

these are Sub-Prime Morgages

this is the turning point