It’s a worldwide financial fiasco involving terms like:
- Sub-prime mortgages
- Collateralized debt obligation
- Frozen credit markets
- Credit default swaps
Who is affected? EVERYONE
How it has been happen?
The credit crisis brings two groups of people together => Homeowners and Investors
Homeowners represent their mortgages and Investorsrepresent their money.
These mortgages represent houses and the money represents large Institutions such Pension Funds, Sovereign Funds, Insurance companies, etc.
Theses groups are joined together to the financial system composed of banks and brokers communally called “Wall Street”.
These banks of Wall Street are closely connected to these houses.
Years ago, the investors were sittingon their empire 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 believe to be the safest investment.
But, after the 11 of September 2001, the Federal Reserve lowered its interest rates to only 1% to keep the economy strong. 1% is a very low return of investment, so the investors said “no thanks”. Onanother side, this means that Banks of Wall Street can borrow from the FED for only 1%. Ad to that, general borrows from Japan, China and the Middle East and there is an abundance of cheap credit! This makes borrowing money easy for Banks. Banks to go crazy with leverage:
Leverage is borrowing money to amplify the outcome of a deal.
How it works?
In a normal deal, someone with 10.000 $ buys abox for 10.000$. And then sells the box to someone else for 11.000$, for 1.000$ profit = a good deal.
But using leverage, someone with 10.000$ would go borrow 990.000 more $, giving him 1.000.000$ in hand. Then he goes and buys 100 boxes with his 1.000.000$. And sells it to someone else for 1.100.000$. Then he pays back his 990.000$, plus 10.000$ in interests = after his initial 10.000$, he earns90.000$ profits!
Leverage turns good deal into great deals!
This is the major way how Banks make their money.
So Wall Street takes tonne of credits, makes great deals into grows extremely rich. And then pays its back.
The investors saw this and want to be a piece of the action. This gives Wall Street an idea:
They can connect investors to the homeowners through mortgages.
How it’s work?
Afamily wants a house so they save for that payment and contact a mortgage broker. The mortgage broker connects the family to a lender who gives them their mortgage. Our broker takes a nice commission. The family buys a house and becomes homeowners. This is great for them because house price is rising practically forever. Everything works nicely.
One day, the lender takes a call from an investmentbanker who wants to buy the mortgage. The lender sells it to him for a very nice fee. The investment bankers then borrow millions of dollars, and buy thousands more mortgages and put them in a nice little box. This means that every month, he gets the payment from the homeowners above their mortgages in the box.
These boxes are cutting in three slices:
Then hepacks these into a box called Collateralized Debt Obligation (CDO). A CDO works like three cascading trays. As money comes, the top tray fills first and then spills over into the middle and whatever is left into the bottom.
The money comes from homeowners who pay their mortgages. If some owners don’t pay and default on their mortgage, less money comes in and the bottom tray has some problem toget 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 and the top receives the lower but still nice return. To make the top even safer, Banks would assure it with a small fee called Credit Default Swap.
The Banks do all of these works so the credit rating agency was stamped the top slice as a...