Financial crisis

On the bus to New York City I researched into the fundamentals behind the financial crisis. The synopsis of the disaster came from homeowners representing mortgages through their houses and investors representing money through large institutions such as pension funds, insurance companies, sovereign funds and mutual funds. Wall Street and Main Street bring homeowners and investors together through financial system.

            Investors look for good investments such as the US Federal Reserve through treasury bills. During the .com bust and September 11st the Federal Chairman, Alan Greenspan decided to lower interest rates to 1% In order to keep the economy strong. Investor didn’t not want a 1% return from treasury bill so instead the US banks borrowed money for 1%, leading to an abundance of cheap credit and surpluses from china, japan, and mid east making borrowing money easy. The banks when crazy with leverage borrowing in order to amplify the value of a deal. By using leveraging they could use $10,000 to borrow $990,000 making $1 million. They were able to sell them for $1100,000, pay back the $900,000 and use the $10,000 investment to make $90,000 profit. These enabled banks to make large quantities of money. Wall Street continued to take out lots credit growing their risk and still is able to pay back the loans. Families across American wanted a home; they only had enough for a down payment so they went to a mortgage broker who dealt with a mortgage lender. An investment banker wants to buy mortgages, so they would be sold to them in the masses and collected in a box of mortgages. This gave the investor all the monthly payments, he then would cut the boxes in three categories: Safe, Okay, Risky, this is called Collateralized Debt Obligation (COB). The mortgage repayments come in order from the safest mortgages. The bottom risky tray may not get filled so to compensates the safe tray gets lower interest rate while the riskier ones gets higher making the rate of return overall safer. Bankers will insure the safe tray, which is called credit default swaps; Banks will give these an AAA rating (very safe). Investment banker can sell safe ones to investors, okay ones to other bankers and risky ones to hedge funds. An investment banker can then make millions enabling them to pay of the loans and the other investors get more than the 1% treasury bills making them want more of the COD.

            However, everyone already has a mortgage that qualifies so the investment banker calls a lender who contacts the broker but he or she can’t find anyone. If a homeowner defaults the lender gets to keep the house with the idea that it will increase in value. The lenders add riskier new mortgages by not making the homeowners have a down payment or proof of income. The first time mortgages are called prime mortgages this new types are sub-prime mortgages.

            Everyone was becoming richer so no one worried, but when the homeowner begun to default on their monthly payments the investors turned these mortgages into houses as the back up security. This increase produced a greater supply than demand in the houses market so house prices fell. When homeowners realize they were paying back a $300,000 mortgage on a $90,000 worth property they decided not to continue to pay of the mortgage and walk away from the house. The investor then tried to sell CDO to another investor but they refuse so most became bankrupt and the homeowner’s then had a worthless investment.