In the world of finance, we are often quick to forget the tragedies of the past. Yet valuable lessons are to be had by exploring their causes and effects after all in the world of ever-changing rules products and services history is the one constant that can guide us through the ambiguity.
It’s the early 2000s and investors are looking for new safe sources of return, stocks and bonds are still pretty popular but the tech bubble at the turn of the century showed them that getting your money back from bankrupt firms can be a bit difficult. What about mortgages? That’s right mortgages, are the loan you take out when you want to buy a home. After all, for mortgage lenders, these loans are a lot like bonds with bonuses. You receive regular interest payments and if the borrower defaults you get the position of their house. This is a handy fallback because with real estate prices on the rise, recovering your losses is no problem.
Investors don’t want to buy the individual mortgages from people down the road, no my friend that’s where investment banks come in. These institutions with their large capital and industry expertise decide to buy up mountains of mortgages from lenders pull them together and then sell shares of the pool to investors as mortgage-backed securities mean the homebuyers now pay investors their mortgage payments, ain’t that nifty? Investors sure think so and soon enough people are flocking to investment banks to buy up their securities and it’s not just banks doing this, the government in an attempt to boost mortgage lending is using the Fannie Mae and Freddie Mac two sponsored corporations to do the same thing.
Soon enough lenders are facing a seemingly endless demand for the mortgages which they’re more than happy to part with because every time they sell the rights to their interest payments they get their money back which they can loan out again. Mortgage lending and home buying are kick into hyperdrive and investors are getting pretty rich in the process but other companies see the gravy train running full speed in the investment space are feeling left out and insurers wanting to cash in to begin to sell credit default swaps derivatives that payout if a mortgage borrow were default. It looks like a foolproof way of making money in fact why stop at just one policy per property when there are speculators interested in buying them – sure selling 10 policies on the same mortgage may seem excessive and dangerous but so long as we don’t experience a collapse in the real estate market it’s free money.
Soon enough the amount of credit insured jumps from 900 billion to over 62 trillion dollars and we probably don’t have enough money to cover that, so long as things keep trucking along insurers are making Bank and all is right in the world with rising housing supporting this great supply team that we’ve created or at least that’s what’s supposed to be happening but something’s changing because lenders are selling their loans, they’ve lost all incentive to avoid risk and with such a high demand for their mortgages they’re starting to give loans to borrowers with bad credit scores and low income and hold on a sec some of those subprimes are predatory. That may look like a low-interest mortgage but it’s chock full of terrible conditions but the subprime borrowers don’t seem to notice the fine print.
Now everyone is buying a home despite some having no possible way of paying off their mortgage. Investment banks are still gobbling up whatever the lenders are throwing at them. Meaning that these taking time bombs are making their way into the MBSs owned by investors but that’s not all investment banks are selling collateralized debt obligations similar to the MBS but riskier and claiming that they’re virtually risk-free even as they fill up with these toxic assets (Subprime Mortgages) but that’s not all again this way they’re only being so many mortgages to invest in people are using complex derivative investments like synthetic CDOs to get even more on where people will make the mortgage payments which in case you haven’t noticed is becoming less likely.
Now surely the rating agencies will notice the heightened default risk and let investors know “Hey, by the way, your holdings are full of crap”. Wait, are you kidding? Do they put an AAA safety rating on it? Well, everyone we’ve done it, we have a system where lenders don’t care about whether mortgage payments are made, investment bankers don’t care about risk, and the rating agencies designed for the people but paid by the banks don’t care about investors and for a while this web of liability and risk holds firm but it’s only a matter of time before the subprime borrowers start to default.
By October 2007, 3% of all US home loans are in the foreclosure process with another 7% one month past due mortgage. Investments are starting to turn into real estate and investment banks are flooding the market with foreclosed homes. Soon enough supply was greater than demand and in 2008 housing prices do something that nobody prepared for, they start to freak off and so begins the domino effect that was a 2008 financial crisis. Finance companies involved in the real estate game take a hit and despite 75% of CDOs receiving the highest safety rating 70% of them default. The investment banks seen the carnage they’ve caused, stop buying mortgages from lenders. The insurers find themselves facing impossible payouts. Banks, lenders, and matures start to shut down and despite the government trying to save the largest players from the brink of destruction.
On September 15th we see the largest bankruptcy in US history as Lehman Brothers an investment bank with 600 billion dollars in assets goes under. At this point anyone with – bear pulls it out of the markets and places it into Treasury bonds which leads the Dow Jones to lose its value and companies relying on loans to operate suddenly lose access to vital financing. Countries with ties to the U.S. are caught up in the disaster – by 2009 the global economic engine stalls. 2 million American jobs would be lost in the last four months of 2008 alone and while the recession would technically end in June 2009 the impact of the crisis would be felt for long afterward. In the kicker to at all despite financial institutions causing the whole disaster they received the most money from the government’s rescue attempts while the Dodd-Frank Act would be introduced in 2010 to crack down on the lending practices of financial institutions, one would hope that we never again need regulation to remind us that greed should never trump common sense and decency.