The Crisis of Credit Visualized - HD

The Short and Simple Story of the Credit Crisis -- The Full Version

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.

This is the original, full version.

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’s 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 on the wake of the dot.com bust and September 11th,

Federal Reserve Chairman Allen 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%.

Add to that general surpluses 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 $1,000 profit, a good deal.

But using leverage, someone with $10,000
would go borrow 990,000 more dollars

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 guy’s $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,
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 fixes 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 insure it for a small fee called the 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 this loans.

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

much better than
the 1% Treasury Bills.

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
in 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.

So, just like always, the mortgage broker connects
the family with the lender and the mortgage

Making his commission.

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 nicely for everyone
and makes them all rich.

No one was 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 didn’t care

They were selling off their risk
to the next guy and making millions

Like playing hot potato
with a time bomb.

Not surprisingly, the home owners default on
their mortgage, which at this moment is owned by the banker.

This means, he forecloses and one of his monthly
payments turns into a house.

No big deal, he puts it up 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 supply than there is demand

And housing prices aren’t rising anymore. In fact, they plummet.

This creates an interesting problem for home
owners still paying their mortgages

As all the houses in their neighborhood go up
for sale, the value of their house goes down

And they start to wonder why
they’re 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 their house.
Default rates sweep the country and prices plummet.

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 isn’t stupid and says “no, thanks”.

He knows that the stream of money
isn’t even a dripple anymore.

The banker tries to sell to everyone
but nobody wants to buy his bomb.

He’s 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 rid of it.

But he’s not the only one

The investors have 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’s not all

The investor calls up the home owner
and tells him that his investments are worthless.

And you can begin to see
how the crisis flows in a cycle.

Welcome to the crisis of credit.