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The Credit Crisis Visualized

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The Crisis Of Credit - Visualized What is the credit crisis? It's a worldwide financial fiasco envolving terms you probably heard like: Sub-Prime Mortgages; Collaterized Debt Obligations; Frozen Credit Markets; and Credit Default Swaps. Who's affected? Everyone! How then does 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... These groups are brought together thru the financial system. A bunch of banks and brokers communly known as Wall Street. It may not seem like it but these banks on Wall St. are closely connected... to these houses on Main St. To understand how, let's start from the beginning. Years ago, the investors were 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 Treasure Bills. Believed to be the safest investment. But, in the wake of the dot com bust - in September 7- Federal Reserve chairman Alan Greenspan, lowered the 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 St. can borrow from the Fed. for only 1%. Added to that general surpluses from Japan, China and the Middle East. 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 that wokrs: 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 $1,000 profit... A good deal! But using leverage: Someone with $10,000 would go borrow $990,000. Giving him $1.000,000 in hand. Then he goes and buys 1.000,000 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. ... his initial $10.000, he's left with $90.000 profit vs the other guy's $1.000. Leverage turns good deals into great deals. This a major way banks make their money. So Wall St. takes out a tunnel of credit. Makes great deals and grows tremendously rich. And then pays it back. The investor see this and want a piece of the action. And this gives Wall St. an idea. They can connect the investors to home owners thru mortgages. Here's how that 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 commision. 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 in 3 slices. Safe, okay and risk. They pack the slices backup 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 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 the 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 1% treasure bills. They were so pleased they want more CDO's 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 had a nice idea: When home owners default on their mortgage the lender gets the house. And houses are always increasing in value. Since they are 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 is exactly what they did. So instead of lending to responsible home owners called prime mortgages... They started to get some 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 commision. The family buys a big house. The lender sells the mortgage to the investment banker. Who turns it into a CDO. And sells slices to the investors and others. This actually works out nicelly for everyone and makes them all rich! None is worried because as soon as they sold the mortgage to the next guy... it was his problem. If the home owners were to default they don't care. They were selling off their risk to the next guy and making millions. Like playing hot potatoe with a time bomb. Not surprisingly the home owners default on their mortgage. Which at this moment is own by the banker. This means he foreclosures and one of his monthly payments turns into a house. No big deal. He puts it off 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 suply than there's demand. And housing prices are not rising anymore. In fact they plump. This creates an interesting problem for home owners still paying their mortgages. As all the houses in their neighbourhood go up for sale the value of their house... goes down. And they start to wonder why they are 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 the house. Default rates swip the country and prices has plumped. 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 isnt't stupid... and says: No, thanks. He knows that the stream of money isn't even a triple anymore. The banker tries to sell to everyone but nobody wants to buy his bomb. He is 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 xxx. But he is not the only one. The investors had 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 is not all. The investor calls up the home owner... Ans tells him that his investments are worthless. Ans you can begin to see how the crisis flows in a cicle. Welcome to the Crisis of Credit.

Video Details

Duration: 11 minutes and 10 seconds
Country: Brazil
Language: English
Views: 199
Posted by: renan.ferreira on Jul 18, 2013

The Short and Simple Story of the Credit Crisis 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.

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