0:00:01.681,0:00:05.545 The Crisis of Credit, Visualized. 0:00:08.535,0:00:10.705 What is the credit crisis? 0:00:10.705,0:00:12.920 It's a worldwide financial fiasco 0:00:12.920,0:00:15.873 involving terms you've probably heard,[br]like 0:00:15.873,0:00:20.157 sub-prime mortgages, collateralized debt[br]obligations, frozen 0:00:20.157,0:00:23.510 credit markets, and credit default swaps. 0:00:23.510,0:00:24.740 Who's affected? 0:00:25.560,0:00:26.400 Everyone. 0:00:26.400,0:00:27.930 How did it happen? 0:00:27.930,0:00:28.930 Here's how. 0:00:28.930,0:00:34.052 The credit crisis brings two groups of[br]people together, homeowners and investors. 0:00:34.052,0:00:39.680 Homeowners represent their mortgages and[br]investors represent their money. 0:00:39.680,0:00:44.870 These mortgages represent houses, and this[br]money represents large institutions 0:00:44.870,0:00:50.590 like pension funds, insurance companies,[br]sovereign funds, mutual funds, etc. 0:00:50.590,0:00:53.630 These groups are brought together through[br]the financial system, a 0:00:53.630,0:00:57.670 bunch of banks and brokers commonly known[br]as Wall Street. 0:00:57.670,0:01:00.200 While it may not seem like it, these banks[br]on 0:01:00.200,0:01:04.629 Wall Street are closely connected to these[br]houses on Main Street. 0:01:04.629,0:01:07.470 To understand how, let's start at the[br]beginning. 0:01:07.470,0:01:11.150 Years ago, the investors are sitting on[br]their pile of 0:01:11.150,0:01:15.620 money looking for a good investment to[br]turn into more money. 0:01:15.620,0:01:18.540 Traditionally, they go to the US Federal[br]Reserve, where 0:01:18.540,0:01:22.620 they buy treasury bills believed to be the[br]safest investment. 0:01:22.620,0:01:28.330 But in the wake of the dot-com bust and[br]September 11, Federal Reserve Chairman, 0:01:28.330,0:01:33.640 Alan Greenspan, lowers interest rates to[br]only 1% to keep the economy strong. 0:01:33.640,0:01:39.990 1% is a very low return on investments, so[br]the investors say, no thanks. 0:01:40.700,0:01:43.110 On the flip side, this means banks on Wall 0:01:43.110,0:01:46.340 Street can borrow from the Fed for only[br]1%. 0:01:46.340,0:01:50.590 Add to that, general surpluses from Japan,[br]China, and 0:01:50.590,0:01:54.370 the Middle East, and there's an abundance[br]of cheap credit. 0:01:54.370,0:02:00.825 This makes borrowing money easy for banks[br]and causes them to go crazy with leverage. 0:02:03.025,0:02:06.870 Leverage is borrowing money to amplify the[br]outcome of a deal. 0:02:07.990,0:02:09.085 Here's how it works. 0:02:09.085,0:02:16.212 In a normal deal, someone with[br]$10,000 buys a box for $10,000. 0:02:16.212,0:02:25.538 He then sells it to someone else for[br]$11,000, for a $1,000 profit, a good deal. 0:02:25.538,0:02:29.504 But using leverage, someone with $10,000 0:02:29.504,0:02:34.118 would go borrow 990,000 more dollars, 0:02:37.468,0:02:40.674 giving him $1 million in hand. 0:02:40.674,0:02:46.269 Then he goes and buys 100 boxes with his[br]$1 million 0:02:47.939,0:02:53.990 and sells them to someone else for[br]$1.1 million. 0:02:56.030,0:03:00.887 Then he pays back his 990,000 plus[br]10,000 in 0:03:00.887,0:03:05.105 interest, and after his initial 10,000,[br]he's left with 0:03:05.105,0:03:09.542 a $90,000 profit versus the other guy's[br]1,000. 0:03:09.542,0:03:13.120 Leverage turns good deals into great[br]deals. 0:03:13.120,0:03:15.770 This is a major ways banks make their[br]money. 0:03:16.890,0:03:19.000 So, Wall Street takes out a ton of 0:03:19.000,0:03:24.270 credit, makes great deals, and grows[br]tremendously rich. 0:03:25.460,0:03:27.029 And then pays it back. 0:03:28.770,0:03:30.890 The investors see this and want a piece of 0:03:30.890,0:03:34.120 the action, and this gives Wall Street an[br]idea. 0:03:34.120,0:03:40.785 They can connect the investors to the[br]homeowners through mortgages. 0:03:43.648,0:03:45.400 Here's how it works. 0:03:45.400,0:03:48.030 A family wants a house, so they save 0:03:48.030,0:03:51.800 for a down payment and contact a mortgage[br]broker. 0:03:51.800,0:03:57.640 The mortgage broker connects the family to[br]a lender, who gives them a mortgage. 0:03:57.640,0:03:59.734 The broker makes a nice commission. 0:04:00.320,0:04:04.030 The family buys a house and becomes[br]homeowners. 0:04:04.030,0:04:05.800 This is great for them because 0:04:05.800,0:04:09.500 housing prices have been rising[br]practically forever. 0:04:09.500,0:04:11.790 Everything works out nicely. 0:04:11.790,0:04:13.820 One day, the lender gets a call from 0:04:13.820,0:04:16.640 an investment banker who wants to buy the[br]mortgage. 0:04:16.640,0:04:19.986 The lender sells it to him for a very nice[br]fee. 0:04:19.986,0:04:25.290 The investment banker then borrows[br]millions of dollars and buys 0:04:25.290,0:04:30.180 thousands more mortgages and puts them[br]into a nice little box. 0:04:30.180,0:04:32.742 This means that every month, he gets the[br]payments 0:04:32.742,0:04:36.283 from the homeowners of all the mortgages[br]in the box. 0:04:37.147,0:04:42.445 Then he sics his banker wizards on it to[br]work their financial magic, which 0:04:42.445,0:04:49.480 is basically cutting it into three slices,[br]safe, okay, and risky. 0:04:49.480,0:04:51.850 They pack the slices back up in the box 0:04:51.850,0:04:57.020 and call it a collateralized debt[br]obligation, or CDO. 0:04:57.020,0:05:00.260 A CDO works like three cascading trays. 0:05:01.000,0:05:04.770 As money comes in, the top tray fills[br]first, then spills 0:05:04.770,0:05:08.550 over into the middle, and whatever is left[br]into the bottom. 0:05:08.550,0:05:12.310 The money comes from homeowners paying off[br]their mortgages. 0:05:12.310,0:05:16.200 If some owners don't pay and default on[br]their mortgage, less 0:05:16.200,0:05:19.640 money comes in and the bottom tray may not[br]get filled. 0:05:19.640,0:05:24.051 This makes the bottom tray riskier and the[br]top tray safer. 0:05:24.051,0:05:28.638 To compensate for the higher risk, the[br]bottom tray receives a higher 0:05:28.638,0:05:33.473 rate of return, while the top receives a[br]lower, but still nice return. 0:05:33.473,0:05:36.810 To make the top even safer, banks will[br]insure 0:05:36.810,0:05:41.137 it for a small fee, called a credit[br]default swap. 0:05:41.137,0:05:46.414 The banks do all of this work so that[br]credit rating agencies will stamp the top 0:05:46.414,0:05:52.113 slice as a safe, AAA-rated investment, the[br]highest, safest rating there is. 0:05:52.113,0:05:55.127 The okay slice is BBB, still pretty good, 0:05:55.127,0:05:58.489 and they don't bother to rate the risky[br]slice. 0:05:58.489,0:06:02.015 Because of the AAA rating, the investment[br]banker can sell 0:06:02.015,0:06:07.030 the safe slice to the investors who only[br]want safe investments. 0:06:07.030,0:06:10.310 He sells the okay slice to other bankers,[br]and 0:06:10.310,0:06:14.290 the risky slices to hedge funds and other[br]risk takers. 0:06:14.290,0:06:17.750 The investment banker makes millions. 0:06:18.460,0:06:20.480 He then repays his loans. 0:06:21.590,0:06:24.760 Finally, the investors have found a good[br]investment for their money. 0:06:24.760,0:06:27.560 Much better than the 1% treasury bills. 0:06:27.560,0:06:31.050 They're so pleased, they want more CDO[br]slices. 0:06:31.050,0:06:35.470 So, the investment banker calls up the[br]lender, wanting more mortgages. 0:06:35.470,0:06:37.350 The lender calls up the broker for 0:06:37.350,0:06:41.810 more homeowners, but the broker can't find[br]anyone. 0:06:41.810,0:06:45.990 Everyone that qualifies for a mortgage[br]already has one. 0:06:45.990,0:06:47.510 But they have an idea. 0:06:51.840,0:06:55.349 When homeowners default on their mortgage,[br]the lender gets 0:06:55.349,0:06:59.480 the house, and houses are always[br]increasing in value. 0:06:59.480,0:07:04.190 Since they're covered if the homeowners[br]default, lenders can start adding risk to 0:07:04.190,0:07:08.130 new mortgages, not requiring down[br]payments, no 0:07:08.130,0:07:11.250 proof of income, no documents at all. 0:07:11.250,0:07:13.620 And that's exactly what they did. 0:07:13.620,0:07:19.020 So, instead of lending to responsible[br]homeowners, called prime mortgages, 0:07:19.020,0:07:23.310 they started to get some that were, well,[br]less responsible. 0:07:23.310,0:07:26.280 These are sub-prime mortgages. 0:07:26.750,0:07:29.044 This is the turning point. 0:07:31.953,0:07:35.231 So, just like always, the mortgage broker[br]connects the 0:07:35.231,0:07:39.400 family with the lender and a mortgage,[br]making his commission. 0:07:39.400,0:07:42.142 The family buys a big house. 0:07:42.142,0:07:45.221 The lender sells the mortgage to the[br]investment banker, 0:07:47.221,0:07:53.831 who turns it into a CDO and sell[br]slices to the investors and others. 0:07:54.481,0:07:59.342 This actually works out nicely for[br]everyone and makes them all rich. 0:07:59.342,0:08:01.738 No one was worried because as soon as they[br]sold 0:08:01.738,0:08:04.424 the mortgage to the next guy, it was his[br]problem. 0:08:04.424,0:08:07.288 If the homeowners where to[br]default, 0:08:07.288,0:08:09.439 they didn't care, they were selling off[br]their 0:08:09.439,0:08:16.053 risk to the next guy and making millions,[br]like playing hot potato with a time bomb. 0:08:16.053,0:08:19.600 Not surprisingly, the homeowners default[br]on their mortgage, 0:08:19.600,0:08:22.650 which at this moment, is owned by the[br]banker. 0:08:22.650,0:08:28.600 This means, he forecloses, and one of his[br]monthly payments turns into a house. 0:08:28.600,0:08:29.740 No big deal. 0:08:29.740,0:08:31.220 He puts it up for sale. 0:08:33.539,0:08:37.130 But more and more of his monthly payments[br]turn into houses. 0:08:40.690,0:08:44.159 Now, there are so many houses for sale on[br]the market, creating 0:08:44.159,0:08:49.110 more supply than there is demand, and[br]housing prices aren't rising anymore. 0:08:49.110,0:08:51.350 In fact, they plummet. 0:08:52.720,0:08:57.830 This creates an interesting problem for[br]homeowners still paying their mortgages. 0:08:57.830,0:09:00.140 As all the houses in their neighborhood go[br]up 0:09:00.140,0:09:03.610 for sale, the value of their house goes[br]down, and 0:09:03.610,0:09:06.386 they start to wonder why they're paying[br]back their 0:09:06.386,0:09:12.770 $300,000 mortgage when the house is now[br]worth only $90,000. 0:09:12.770,0:09:16.240 They decide that it doesn't make sense to[br]continue paying, even 0:09:16.240,0:09:19.590 though they can afford to, and they walk[br]away from their house. 0:09:19.590,0:09:23.570 Default breaks sweep the country, and[br]prices plummet. 0:09:23.570,0:09:28.280 Now, the investment banker is basically[br]holding a box full of worthless houses. 0:09:28.280,0:09:30.940 He calls up his buddy, the investor, to[br]sell his 0:09:30.940,0:09:35.780 CDO, but the investor isn't stupid and[br]says, no thanks. 0:09:35.780,0:09:39.860 He knows that the stream of money isn't[br]even a dribble anymore. 0:09:39.860,0:09:44.530 The banker tries to sell to everyone, but[br]nobody wants to buy his bomb. 0:09:44.530,0:09:48.140 He's freaking out because he borrowed[br]millions, sometimes billions of 0:09:48.140,0:09:51.599 dollars to buy this bomb, and he can't pay[br]it back. 0:09:51.599,0:09:54.799 Whatever he tries, he can't get rid of it. 0:09:56.949,0:09:59.818 But he's not the only one. 0:09:59.818,0:10:04.390 The investors have already bought[br]thousands of these bombs. 0:10:04.390,0:10:09.810 The lender calls up trying to sell his[br]mortgage, but the banker won't buy it. 0:10:09.810,0:10:12.000 And the broker is out of work. 0:10:12.000,0:10:17.675 The whole financial system is frozen and[br]things get dark. 0:10:22.388,0:10:24.942 Everybody starts going bankrupt. 0:10:27.492,0:10:29.140 But that's not all. 0:10:29.140,0:10:31.410 The investor calls up the homeowner and 0:10:31.410,0:10:35.300 tells him that his investments are[br]worthless. 0:10:35.300,0:10:40.270 And you can begin to see how the crisis[br]flows in a cycle. 0:10:41.120,0:10:44.474 Welcome to the Crisis of Credit.