Welcome to my series of articles on Finance and Economy. I don’t know how i got my interest in Economics suddenly, but it gives a turing feel when you see something coming from a mile away.
The Sub-prime mortgage crisis and the Lehman Brothers Collapse:
The story beings with the low interest rate set by Federal Reserve of the USA. Due to the low interest rate (1%), investors who were buying treasure bonds were not making sizable profits and they have to think of alternative investment plans. On the other hand, low interest rates means, banks can get more credit from the Federal Reserve with a 1% interest, which is a super deal for them.
The usual way:
Families who want to buy a house contacts a mortgage broker, who in turn sets them up with a mortgage lender (usually a bank which got credit at 1% interest from the federal reserve). The family agrees for a down payment and the mortgage lender issues them a mortgage monthly. In case the family failed to pay their mortgage, the bank can claim the house and sell it for a higher price, since the housing prices were rising.
Investment banks saw this as a good place to invest their investors money, and they thought it was risk free as housing prices were sky rocketing. So, Investment banks like Lehman brothers and Goldman Sachs, contacts the Mortgage lender to buy mortgage contracts which the lender has issued. The investment bank buys a bunch of such mortgage contracts from many mortgage lenders. They pile up all the obtained mortgage contracts and classify them into three (Safe, low and risk). The classified mortgage contracts are called as CDO (Credit Default Object). They sell this CD’s to their investors. So every one in the system were making good money and in case a CDO failed (if some one didn’t pay their mortgage), the investor can claim their house, sell it and still make profit.
The investors were very happy with their investment on CDOs, so now they want more such investments. But, how come?. All the people who could afford a house, already have a house. So, to have profits, the mortgage lenders started offering mortgage for people who weren’t qualified, for people who didn’t had any proper job and lesser financial stability. This kind of mortgages are called as sub prime mortgages. Again the cycle continued, the Investment banks payed large cash to rating agencies to rate these risky subprime mortgage as AAA and BBB, so that they are can be sold easily. Every ones life was normal till the bubble burst. Many subprime mortgages started to fail. Investors, claimed the houses and decided to sell them. This resulted in lots of houses in the market against the demand, which pushed the housing price down. Since now housing prices were falling down, people who were paying mortgages properly started to move out, because they are paying for a $300,000 house which now costs just $100,000.
Investors soon realized that CDOs are not safe option now, and they started saying no thanks for CDOs offered by investment banks. But the investment bank is already sitting on a stock file of horse shit CDOs and no one wants to buy it. With almost no money to repay the credit they obtained from the federal reserve they started filing bankruptcy.