What is the Credit Crisis?

It is a worldwide financial fiasco involving terms you’ve probably never even heard.

• Sub-Prime Mortages
• Collateralized Debt Obligations
• Frozen Credit Markets
• Credit Default Swaps

Who is Affected By The Credit Crisis?

Everyone

How Did It Happen?

The credit crisis brings two groups of people together. Homeowners and investors. Homeownwers represent their mortgages and investors represent their money.

The mortgages represent houses, and the money represents large institutions like pension funds, sovereign funds, insurance companies, and mutual funds.

These groups are brought together through the financial system normally known as WALL ST.

How is Wall St. connected to Main St?

Years ago investors were sitting on piles of money looking for a good investment, to turn into MORE MONEY. Traditionally they would go to the Federal Reserve, where they would buy treasury bills. However, in the wake of the dot com bust and the attacks on 9/11 . Federal reserve chairman Alan Greenspan lowered the borrowing rate to only 1% to keep the economy strong.

1% is a very small return on investment so investors said “No thanks.” On the flip side this means banks can borrow from the bank for only 1%. Now add to that a large surplus of money from China, Japan, and Europe, and you have an overwhelming abundance of cheap CREDIT.

This makes borrowing money easy and causes them to go crazy with LEVERAGE.

“Leverage is borrowing money to amplify the outcome of a deal.”

How Does Leveraged Investing Work?

In a normal deal someone with 10,000 dollars buys a box for 10,000 dollars. He then sells that box to someone else for 11,000 dollars, making a $1,000 profit. Using leverage someone who has $10,000 will go and BORROW $990,000 instead. Using the original $10,000 as collateral.

He now has $1,000,000, and he can buy 100 boxes. He sells them to someone else for $1,100,000. Now he has to pay back his 990,000 plus 10,000 in INTEREST. After you subtract the initial $10,000 he is left with a $90,000 PROFIT

Leverage turns good deals into GREAT DEALS.

“This is how banks make their money”

Wall Street takes out lots of loans, makes great deals and gets really rich and then pays it back. Investors see this an want a piece of the action. This give Wall street an idea. They can connect their investors to homeowners with MORTGAGES.

Here’s how it works?

• A family wants a house, so they save for a down payment.
• They then contact a mortgage broker. The mortgage broker connects the family to a lender who gives them a loan.
• The broker makes a nice commission, the family buys a house, the banker makes some interest, and everyone is happy.
• One day the lender gets a call from and investment banker who wants to buy the mortgage, the lender sells it to him for a nice fee
• The investment banker then borrows billions of dollars and buys thousands of mortgages. He puts them into a nice box. Every month the investment banker sits back and collects the monthly payments from thousands of mortgages.

But the process doesn’t stop here.

What is a Collateralize debt obligation?

Each box of mortgages is cut into 3 separate smaller boxes named: Safe (AAA), Okay (BBB), and Risky (Unrated). They once again package these up and call it a COLLATERALIZED DEBT OBLIGATION (CDO)

As money comes in the top rated, safest investments are paid off first, then the okay loans are paid off, and whatever is left over goes into the risky loans.

If some homeowners don’t pay on the mortgages and go into default then less money is coming in and the risky box will not be filled with as much money. To compensate for the higher risk, the bottom risky tray pays out a higher interest rate, while the top safer investment receives a much lower rate.

To make the top tray even safer banks will sell insurance on it, called a CREDIT DEFAULT SWAP.

Now the investment banker can sell each piece of the pie to different investors who have different levels of risk and everyone is happy and making money.

The investment banker calls up the mortgage broker for more home loans, but everyone who is loan worthy already has a home.

Taking on more risk.

When a homeowner defaults on a loan, the investment banker is left with the home. Since homes are always increasing in value then banker is covered from any losses. Because of this he can start adding risk to his investments.

No down payment, no proof of income, FREE MONEY.

So instead of loaning to responsible homeowners called PRIME MORTGAGES.

they started to get people who were less responsible, these were SUBPRIME MORTGAGES.

TURNING POINT

Like usual the mortgage broker connects the family with a lender who writes the mortgage and the family buys a BIG HOUSE.

The lender sells the mortgage to an investment banker.

The investment banker turns it into a CDO and sells it in slices to the others

This works nicely for everyone, and everyone gets very very rich.

Except this time the model could not go on forever. Like playing a game of hot potato with ticking time bombs, each person has to pass on the risk to the next person.

As predicted the home owners defaulted.

Then the home is now owned by the banker who forecloses and one of his monthly payments turns into a house.

As more and more of his monthly payments turn into houses, the housing market gets saturated with too many houses for sale and houses start to drop in value.

As house prices plummet in value more and more families start to walk away from their mortgages once their home value are turned UPSIDE DOWN.

Now the investment banker is stuck with boxes of worthless houses.

The banker can no longer sell the CDO’s because everyone knows there is no money coming in anymore.

The investment bank goes into a downward spiral because the bank itself has borrowed Billions of dollars and sometimes TRILLIONS of dollars and he cant pay it back

The investment bank is not the only one in trouble because the investors have bought thousands of these junk bonds and the lender tries to sell mortgages but the banker has no more money to lend, the whole financial system is frozen and things get dark.

Everybody starts going bankrupt.

Welcome to the CRISIS OF CREDIT.