Below the video is a short summary explaining what went on (with information from the video).
The global financial credit crisis had effects that
were felt worldwide. The crisis was caused by subprime loans, collateralized debt
obligations, frozen credit markets and credit default swaps. The problem began
with homeowners and investors. The homeowners represented mortgages and the
investors represented money. The money came from places like pension funds and
insurance companies. These two groups were brought together by the financial
system which consisted of large banks and brokers, and is commonly referred to
as Wall Street.
Investors were buying T-bills from the Federal
Reserve, but in the wake of the dotcom bust and 9/11, Federal Reserve chairman
Allen Greenspan changed the money supply to lower the interest rate to 1%. Investors wanted a larger return than 1% on
their investment and looked for better opportunities. At the same time the 1% interest
rate allowed banks to borrow money at 1%, and public and private surpluses from
Japan, China and the Middle East lead to an abundance of cheap credit. Banks
then decided to acquire this cheap credit and make money with it using leverage.
Investors saw the huge returns the bank’s were making and wanted similar
returns. Wall St. then connected the investors with homeowners through
mortgages.
When a family wanted to buy a house they saved up
for a down payment and used a broker which connected the family with a lender,
who gave them a mortgage. Everyone in this cycle makes money, including the
homeowners because of the increase in home equity. This is when an investment
banker could step in to buy the mortgages from the lender to profit off of the
mortgage payments. The investment banker could borrow millions to buy the
mortgages which are then transformed into a collateralized debt obligation (a
security). At this point they are split into
3 categories which are; Safe (AAA), OK (BBB), and Risky (not rated). Each
portion is then sold according to rating.
The AAA rated securities can be insured for a small fee called credit default
swap and sold to investors that want a safe investment. The other BBB rated securities can be sold to
other bankers, and the Risky securities could be sold to hedge funds.
This worked for awhile, until all of the qualified
potential homeowners already had mortgages.
Investment bankers then return to the lender to buy more mortgages but
no qualified people looking for mortgages can be found. Lenders then came up
with a new idea. Because home prices have historically always increased in
value, it would not matter if a home owner defaulted because they could still
make money off of the sale of the home.
This means that lenders can add risk to new mortgages, such as not
requiring a down payment, proof of income or any documentation. This led to
sub-prime mortgages. No one in this business cycle cared about the risk because
it was passed on to the next person. If a home owner defaulted on his payment
the investment banker got a home which was always increasing in value. But over time more mortgage payments turned
into homes which increased the supply of homes and prices began to fall instead
of rise. Existing home owners saw the value of neighboring homes drop and would
decide to default on their mortgages.
This would leave the banker with worthless homes and
no investors to buy them. At this point investors already have a lot of these
devalued homes on their hands, and the lenders cannot sell any new mortgages.
The lenders, bankers, investors and home owners’ investments all go bankrupt.
