Making Sense of the Financial Mess

WHERE LENDE R 2004 MONEY Loan Agreement: MORTGAGE BACKED SECURITY A security composed of thousands of mortgages. MORTGAGES PRE PRIME - Meets all the requirements: credit score above 650, 20% down payment, steady income. COLLATERALIZED DEBT OBLIGATION (CDO) NOS MONE aPproved DOWNZ SUBPRIME - Doesn't DID ALL THE MONEY GO? meet one or more of the Thousands of different requirements - more risky. securities bundled together to into one huge container. WHY IS THIS sO GREAT? Securitization of Debt Easy Credit As long as the house prices don't fall, there ? is really no way to loose money. If the people No cash? No problem! As the global economy grew, the amount of money available for investment grew exponentially. Since a loan is a high yielding investment, there was a huge incentive to give out as Thousands of debts, such as mortgages, credit card debts or college loans, get packaged into a convenient storage unit called a security. Unlike individual loans, stop paying and default on their mortgage, you get their house which if the house prices keep going up, is probably worth more then the mortgage itself. And because the CDOS are so diversified and so large, the risk is spread out. these securities can be sold and traded on the stock many loans as possible, generating a society dependent on credit. Companies and individuals alike rely on credit to purchase even their most basic needs. Currently, US household debt adds up to market. eliminate the hassle of managing loans while still giving high profit returns. a 100% of our GDP. That means that private Americans alone hold AAA RATING as safe as the US Treasury as much debt as the entire country produces in a year. This has happened only once before in 1929. Debt Turns Toxic Stock When you take out a loan on a house, you are employing one of the FINANCIAL FIRM most basic tools of finance - leverage. You are taking on debt to supplement your savings (your equity) in order to buy an asset - the house. The higher the leverage (lower down payment), the riskier the investment. Watch what happens when the house prices fall. MARKET 20% DOWN (5:1 RATIO) down payment - equity 5% DROP ASSETS IN VALUE amount borrowed debt Easy Credit Global Economic Downturn LIABILITIES house = asset MONTHLY RETURN - 2004 As the debtors paid their monthly payments, the loan securities generated a return. Since there is always a small 2008 DEBT - $80,000 EQUITY = $20,00o $15,000 $100,000 $95,000 (fueled by growing foreign capital) SAFE SAFE Lack of credit caused a mad cycle of stock selloffs, bankruptcies, cutbacks, higher unemployment, lower spending & production. The global economy is shrinking. There is less money to go around. % of people who won't make their payments, the security is divided into different levels of risk. The safest investors get paid first and the riskiest last. In return, the riskiest $T00,000 $95,000 3% return 3% return Housing Boom 5% DOWN (20:1 RATIO) OK OK investments get a bigger share of the profit. When the 5% return 5% return Easy credit means more people can buy houses. The increased demand drives the house prices up. LIABILITIES housing market was booming, everyone got paid. As the ASSETS NO EQUITY 5% DROP IN VALUE house prices started falling, however, the securities stopped DEBT - $95,000 Credit Crisis RISKY RISKY giving returns. They became toxic. EQUITY-$5,000 7% return 7% return $T00,000 $95,000 $100,000 $95,000 Toxic assets, toxic companies and panic virtually stopped lending. Some investors/firms stopped lending because they were afraid that they would never get their money back, while others (such as major banks) simply could not afford to lend. They had lost so muc nothing to lend out. Mortgage Securitization Investors Demand Lowers Standards 5% DOWN (20:1 RATIO) Mortgage backed securities and CDO's are in high demand on the stock market. Virtually all the mortgages are securitized and traded. Banks are able to take their old loans off their balance sheets and aquire new ones (mak- ing money on the fees). ASSETS LIABILITIES NO EQUITY The global economy has been growing fast. It has been acquiring enormous amounts of capital. This money had to be invested somewhere. The CDOS were particularly TOXIC! 20% DROP IN VALUE As the demand for Mortgage Securities grew, the supply dryed up. Everyone who qualified for a loan and wanted one, already had one. In order to generate more loans to satisfy the growing demand for h capital that they had DEBT = $95,000 The is debt larger than the value of the assets. If you sell the house, will loose money. If you default on the house, you transfer the losses onto the investor. EQUITY-66,000 $00,000 $80.000 $100,00 $95,000 appealing because they were perceived as safe and they yielded a high interest rate at a time when the U.S. Bonds securities, the standards for getting a loan were lowered. Not only Subprime Crisis did this create "toxic" loans (packaged into toxic securities), but it were at a record low. also triggered the burst of the housing bubble. As the house prices Throughout the housing boom, the financial market has grown dependent on the idea that house prices wouldn't fall. Assets that were thought to be safe were only safe because they were backed by houses of increasing value. When the prices did fall, the entire system was turned on its head. peaked, the average income stayed flat. People couldn't afford to buy the overpriced houses. The housing market stopped, the prices fell & Market Saturation everyone found themselves owing a lot more then they owned. NO The easy credit allowed everyone who wanted a house to get one. The demand for CDO's still remained high. crap House Prices Fall LOANS! Crisis Spreads Lowered Loan Standards The unthinkable happens, house prices start falling drastically. There are a few reasons for this. The short term lending that most companies rely on for At the time when the house prices were consistently going up, the average household income stayed the same. Even with the easy loans, people simply couldn't afford the houses anymore. They stopped buying. This offset the natural supply/demand balance (as more houses were still being built) and the market had to correct itself. Credit Crisis Brokers needed to come up with ways to give out more loans, One obvious way was to lower the requirements for who could get. loan. Since they were selling the loan off, making money through a one time fee and bearing no risk if the loan defaults, it didn't matter if the loans would ever get paid back or not. day to day business practically stopped. This had enormous implications to the economy. It meant that most businesses coula were short on cash. The capital they usually borrow to pay for The toxic assets made their way through the financial system quickly. After several investment firms "broke the buck" - loosing the investors money, and several major companies nearly collapsed, full blown panic set in. No one knew who was going to go under next. Because the daily operations and payroll was simply not there. They had no choice but to cut costs. Jobs were cut, projects cancelled and FINANC company spending frozen. The lack of credit also uncovered deep financial problems that companies and individuals were able to hide by taking on more debt. Just like people borrowed assets they were holding were so complex, unregulated, more money in order to make their mortgage payments, and interconnected no one even knew to what extent companies borrowed to cover their losses. their own assets were exposed. Lending stopped. What is money? Money Supply Savings = $1 Debt = $1 Spending = $3 Total Economic Value (from the original dollar) = $5 Money can be anything. Rare & valuable resources have been used historically because they are easy to control, but anything that people collectively agree on can be used as money. There are four general functions money fulfills: medium of exchange, unit of account, store of value & standard of deferred payment. Money needs to have a perceived value. This is an overview of the different forms of money and The Money Supply is the amount of available BANK ONE DOLLAR CONE money in the economy. It fluctuates with the market. In times of economic growth, the money supply is high. In a recession, the money supply is low. Lending and spending are two major factors that influence the money supply. ONE DOLLAR ONE DOLLAR DOLLAR OOLLAR 1. You deposit $1 into your bank. It gets added to your balance. Barter Commodity Money Credit Money Fiat Money Representative Money 2. The bank lends your dolar to Tim 1. Tim buys a 1$ pack of gum from a local gas station. 2. The gas station owner takes the dollar and 3. The newspaper boy buys a 1$ lottery ticket. In a barter, no money is used. People trade goods or services directly. The value comes from the When you take out a loan, you agree to pay it back. In return the bank transfers money to your account. This money is not directly backed by a commodity. It is created when you take out the loan and is backed by your promise to pay it back. Money which is not backed by a commodity, but by a government law declaring it to be legal tender (currency that must be accepted as paymentl. It is usually printed by the country's national bank la private institution). buys a newspaper on the way home commodity it is made out of (gold, silver, bronze). In other words, a $1 coin made out of silver would have $1's worth of silver in it. Token money that stands in direct and fixed relation to Velocity of Money the commodity which backs it, while not itself made of it. leg. early paper money which originated as receipt for gold deposits). As a $1 bill circulates throughout the day, it multiplies its value in the economy. Every time it changes hands, it creates another $1 in economic activity. In a recession, when lending & spending is lower, there is actually less money in the economy. While no cash disappears, the velocity of the dollar goes down. where their value comes from. money = paper given value by law no money money = commodity money = promise to repay money = tokens backed by a commodity