Well, we smoothly got to the last (or maybe the penultimate), the most famous crisis for us – the crisis of US mortgage bonds. As in many previous times, it all started with the United States, as it is the most developed and most liquid financial market in the world. By tradition, we’ll try to start looking at the situation from afar, and then gradually approach the crisis itself. Just note that in this article there will be several complex financial terms, but we will try to explain their meaning in simple words.
The crisis itself was based on a simple axiom – people always pay a mortgage. So it was for many decades, until a certain point. But more on that later.
Well, I think everyone knows what is a mortgage. This is a loan to buy real estate secured by this very real estate. You take money from a bank to buy a home and provide it with this housing. If you stop paying, the bank takes the property for yourself. Everything is simple.
We go further. The bank gave you money and received a stable cash flow in return. This cash flow is a burden for it. Why? Because it cannot further put this money into circulation. It finds a way to do this – it sells bonds secured by a mortgage agreement. Bonds are debt securities. Thus, the following construction appears: the bank sold a bond, in the security of which lies a loan agreement, in the security of which lies real estate. Everyone pays the mortgage, which means that there are practically no risks. But even if they don’t pay the mortgage, you can always sell the house and get your money back. But there is a problem – there is practically no profit. The rate on such bonds was small, not much higher than the yield on US bonds (risk-free securities).
That was until the early 1970s, when a character named Lewis S. Ranieri appeared in the financial world. He coined the term securitization, a form of raising finance by issuing securities backed by assets that generate stable cash flows. What did he suggest? It would seem a simple idea. He proposed combining thousands of mortgage contracts into one bond. The income of such a paper increases, but the risk doesn`t. This is AAA rated paper (the highest rating, this is bought by pension funds and other institutional investors). These securities are bought by those who cannot afford any risk, it is the financial system that holds them back. They hedge any risks by purchasing options and other derivatives.
This actually changed the entire banking sector of America for the next 30 years. Dozens of other securities started to come up, based on mortgages. They were all with a high yield and AAA rating, because everyone pays a mortgage, right? The real estate market is always growing. However, after 30 years, the collapse of the entire system, the mortgage bubble, which significantly pouted. This has hit all over the world, the crisis has affected China, Europe, Russia and other CIS countries. It is in second place on the scale of the tragedy after the Great Depression. No one of expert suspected that this could happen. Why did everything burst? Let’s get it right.
The beginning of the bubble inflating
Well, Lewis Ranieri came up with a way to make billions of dollars on simple things. Soon the mortgage agreement has ended, people who are steadily paying mortgage fees have ended. Rather, they are, but have already been used to create mortgage bonds.
But there were still a lot of houses. Then banks began to use subprime loans to secure bonds. What are subprime loans? These are loans that are issued to the borrower without checking income. In other words, anyone. Homeless, low-income, unemployed. Yes, anyone can give a subprime loan. They are issued on the security of real estate that is bought.
Once again. An unemployed person can buy a house for 500 thousand dollars on the security of this house. There are no risks for the bank, because in which case it will get a house and sell it. Banks received 2% of the transaction value after the sale of bonds secured by mortgages and subprime loans. Risks – 0. Income – huge. Why is income big? Because the rate on subprime loans is higher. It is understandable, the borrower is unreliable, and therefore must pay more. All this is based on a simple truth – the residential real estate market is stable and always growing.
Now add another one term – Collateralized debt obligations (CDO, Secured Debt Obligations). What is a CDO? Securities secured by debt obligations. Bur bonds are debt obligations.
Let’s see our pyramid again:
1. There is a house that is bought on credit.
2. This loan is placed as a security for bond.
3. The bond is placed in support of the CDO.
On the second and third items, banks try to diversify risks by diluting the instrument with agreements with different risks. For example, there are stable mortgage loans, and there are subprime loans. We take 50% of those and 50% of those. We get higher income, but the risk is the same. In fact, the risk is certainly higher, but then (before the mortgage crisis) they said that the risk is the same – AAA. After all, the instrument is diversified, and everyone pays on mortgages, remember? Such fraud was done in the process of turning secured bonds into CDOs. 93% of bonds were rated BBB or even lower, and the rest were highly rated. In other words, in providing CDOs, over 90% were subprime loans. However, the rating agencies assigned such securities an AAA rating, although it is obvious that they are very risky.
There is still a digression about the rating agencies. Why did they do this? The fact is that there is also competition. The bank turns to a rating agency and asks to evaluate the paper. If it is not given an AAA rating, bank will go to another rating agency and pay a commission there. In general, this is pure corruption, but a bit veiled.
So, it turned out that very risky papers had the highest rating. As we previously found out, this highest rating was bought by institutional investors, for whom the risk is unacceptable. Imagine a situation where half of the US pension funds went bankrupt. Half of the pensioners were left without pensions and actually cannot feed themselves. All because rating agencies were paid for a higher rating.
CDO – this is exactly the tool that turned the usual mortgage crisis into a global catastrophe. Let’s look at a small example to make it as clear as possible.
There is a bank. It has 3 million rubles. It approached 10 people for a mortgage. Each needs 200 thousand. The borrowers are reliable, there are incomes, everything is fine. Most likely, the money will be returned. You have issued 10 credits. Then they put these 10 mortgage agreements as collateral for the bond and sold it because you want to get the money as soon as possible and invest it somewhere else. The person who bought the bond actually bought a stable cash flow from 10 borrowers who took out a loan and bought a house for themselves. Everything is fine.
We go further. It was 3 million, and gave a loan 2. Million remained. The bank doesn`t want it to lie, and gives subprime loans. Loans that are unlikely to be repaid. Likewise, takes these loans and puts them in collateral for bonds. Such a bond has a low rating – BBB or even lower. Then the bank takes bonds with an AAA rating, bonds with a BBB rating and combines them into a CDO. But this CDO is already rated AAA. But we remember that in securing this AAA rated paper, subprime loans. We then know that, most likely, borrowers will not return the money.
We assume that, most likely, the CDO is waiting for default. But institutional investors don`t know this and buy these CDOs. They don`t understand what lies in the provision, they look at the rating. It should be understood that not only US pension funds buy securities. These tools are considered the safest and most profitable at the same time, which means that Europe is connecting, and China, and even Russia. The whole world buys American CDOs, suggesting that they are more profitable, but at the same time as reliable as American government bonds – actually risk-free securities.
Why did everything burst in the second quarter of 2007?
Here we add another interesting tool that allows banks to make good money and at the same time diversify risks – a floating interest rate. What it is? This is a rate that varies depending on market conditions. The price of real estate is stable – the rate is low. Volatility has begun – the rate is growing.
So, we briefly learned the ins and outs of this pyramid. Everything rested for 30 years on a simple truth – the real estate market is stable. If the borrower stops paying on the mortgage, the bank simply takes the property and sells it. Since banks are confident in selling real estate at any time at a good market price, respectively, subprime loans can be issued in any quantity to anyone. In any case, in 2-3 days this loan will be purchased by larger banks or institutional investors in the CDOs form.
The CDO contains over 90% of subprime loans. However, they have an AAA rating due to corrupt rating agencies. Subprime loans are loans that no one pays. Gradually, the bubble begins to inflate. A pile of mortgage debts that will not be paid. Why exactly 2007? Because in the second quarter of 2007, a floating rate begins to operate. Since no one pays loans, banks massively begin to increase interest rates. Borrowers cannot pay such high interest rates. They didn’t pay much before, but now banks are beginning to massively sell real estate for sale to cover the debts of borrowers. Here it is the most interesting. A large amount of real estate is being put up for sale, and, already obvious, the price is starting to fall.
What is it? The borrower took 500 thousand dollars and bought a house with this money. However, the bank cannot sell for 500 thousand. It sells at best for half the price and receives a net loss of 250 thousand. The chain begins to crumble. For bonds secured by subprime loans, they default. The CDOs backed by such bonds default. Institutional investors who have a huge number of «virtually risk-free» CDOs go bankrupt.
As always, the bankers are to blame for the bubble, and ordinary people suffer. An increase in unemployment of 1% is 40 thousand deaths. During the crisis, it grew from 4.5% to 10%. People lost their jobs, homes, savings, and pension savings. Americans lost 5 trillion dollars in savings and bonds, 8 million people lost their jobs, 6 million lost their homes. The entire American banking system was paralyzed. Lehman Brothers went bankrupt – a bank that has existed for 158 years and has survived more than one or two crises. It was the largest bank in America. They just invested too much in mortgage CDOs. Moreover, it is interesting that the Fed helped many banks and actually saved them from default, but not to the Lemons.
Moreover, when banks already understood the scale of the problem, they began to deal with fraud. They started selling their CDOs at a high price to gullible investors, and then buying swaps for the same CDOs. In other words, short them out as well. It is as if Sberbank sold you bonds that would default on tomorrow, but didn`t say that. Then it immediately opened a short on these bonds.
What do you think was in the following years? Hundreds of bankers and executives of rating agencies went to jail, the Federal Reserve was reformed, Congress broke up banks and started regulating the mortgage sector? No. Banks lobbied for Congress to abandon banking reform. They took the money of ordinary citizens and paid themselves giant bonuses. Then they blamed the emigrants and the poor, as well as the teachers. Only one banker got into the jail.
We tried to tell you the system from the inside in a simple way. There were also tools like synthetic CDOs – these are CDOs that consist of credit default swaps. Credit Default Swap (CDS) – derivative, according to which the buyer pays a premium to the seller for insuring third-party obligations. There were CDOs provided by other CDOs. All of this was insured, and then resold.
In fact, if a CDO or bonds secured by subprime loans was a match, then synthetic CDOs are actually an atomic bomb.
Yes, the system is complex and confusing, which is probably why no one understood the potential risks.
It is worth saying, that the whole pyramid described above was built not only because of greedy and stupid bankers or because of corrupt rating agencies. Regulators, authorities, government – they didn`t control bubble inflation. Pay attention to the current situation. What Trump interests? Market growth. It is important for him that the market grows before the 2020 elections, otherwise his re-election is unlikely.
Look, the market began to collapse and the Democrats’ chance of winning increased by 15%. Although before the collapse, everyone said that the winner of the election is Trump unconditionally. Americans live with financial markets. For them, the most important thing is growth of markets. It doesn’t matter due to what and why. Growth is important. The bigger, the better. No one goes into details and doesn`t look at the essence. It would seem, what does Trump have to do with the current collapse? The world economy and stock prices were knocked down by the coronavirus, but the fall affects Trump’s popularity… The market fell under his rule, so he is to blame, then another president is needed.
It was exactly the same in the mid-2000s. The bubble was growing, but who cares? It grows well and that’s ok, everyone is good. Until a certain point …
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