The crisis of credit. Visualised.

What is the the credit crisis? It’s a worldwide financial fiasco involving the terms you’ve probably heard like sub-prime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps. Who’s affected? Everyone.

How did it happen? Here’s how. The credit crisis brings two groups of people together: home owners and investors. Home owners represent their mortgages and investors represent their money. These mortgages represent houses and this money represents large institutions like pension funds, insurance companies, sovereign funds, mutual funds, etc. These groups are brought together through the financial system, a bunch of banks and brokers commonly known as Wall Street. Although it may not seem like it, these banks on Wall Street are closely connected to these houses on Main Street. To understand how, let’s start at the beginning. Years ago, the investors are sitting on their pile of money looking for a good investment to turn into more money.

Traditionally, they go to the US Federal Reserve where they buy Treasury Bills, believed to be the safest investment but on the wake of the dot.com bust and September 11th, Federal Reserve Chairman Allen Greenspan lowers interest rate to only 1% to keep the economy strong. 1% is a very low return on investment so the investors say “no, thanks.”

On the flipside, this means banks on Wall Street can borrow from the Fed for only 1%. Add to that general surpluses from Japan, China and the Middle East and there’s an abundance of cheap credit. This makes borrowing money easy for banks and causes them to go crazy with…leverage.

Leverage is borrowing money to amplify the outcome of a deal. Here’s how it works: in a normal deal someone with $10,000 dollars buys a box for $10,000 dollars, even sells them to someone else for $11,000 dollars for a $1,000-dollar profit, a good deal. But using leverage, someone with $10,000 dollars would go borrow $990,000 more dollars, giving him $1,000,000 in hand. Then he goes and buys 100 boxes with his $1,000,000 dollars and sells them to someone else for $1,100,000 dollars. Then he pays back his $990,000 plus $10,000 in interest, and after his initial $10,000, he’s left with a $90,000-dollar profit versus the other guy’s $1,000. Leverage turns good deals into great deals. This is a major way banks make their money.

So Wall Street takes out a ton of credit, makes great deals and grows tremendously rich and then pays it back. The investors see this and want a piece of the action and this gives Wall Street an idea: They can connect the investors to the home owners through mortgages. Here’s how it works: a family wants a house so they save for a down payment and contact the mortgage broker. The mortgage broker connects the family to a lender who gives them a mortgage; the broker makes a nice commission. The family buys a house, becomes home owners. This is great for them because housing prices have been rising practically forever, everything works out nicely.

One day, the lender gets a call from an investment banker who wants to buy the mortgage; the lender sells it to him for a very nice fee, the investment banker then borrows millions of dollars and buys thousands more mortgages and puts them into a nice little box. This means that every month he gets the payment from the home owners of all the mortgages in the box, and then he fixes his banker wizards on it to work their financial magic which is basically cutting it into three slices: “Safe, Ok and Risky”.

They pack the slices back up in the box and call it the collateralized debt obligation or CDO. A CDO works like three cascading trays: as money comes in the top tray fills first then spills over into the middle and whatever is left into the bottom, the money comes from home owners paying off their mortgages. If some owners don’t pay and default on their mortgage, less money comes in and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer. To compensate for the higher risk, the bottom tray receives a higher rate of return while the top receives a lower but still nice return. To make the top even safer, banks will insure it for a small fee called the credit default swap. The banks do all this work so the credit rating agencies will stamp the top slice as a safe triple-A rated investment, the highest safest investment there is. The OK slice is triple B, still pretty good and they don’t bother to rate the riskiest slice. Because of the triple-A rating, the investment banker can sell the safe slice to the investors who only want safe investments; he sells the ok slice to other bankers and the risky slices to hedge funds or other risk takers. The investment banker makes millions, he then repays this loans. Finally the investors have found a good investment for their money, much better than the 1% Treasury Bills.

They’re so pleased that they want more CDO slices so the investment banker calls up the lender wanting more mortgages, the lender calls up the broker for more home owners but the broker can’t find anyone. Everyone that qualifies for a mortgage already has one. But they have an idea: when home owners default on their mortgage, the lender gets the house and houses are always increasing in value. Since they’re covered in the home owners default, lenders can start adding risk to new mortgages not requiring down payments, no proof of income, no documents at all and that’s exactly what they did. So instead of lending to responsible home owners called prime mortgages, they started to get, well, less responsible. These are sub-prime mortgages.

This is the turning point. So just like always, the mortgage broker connects the family with the lender and the mortgage, making his commission. The family buys a big house. The lender sells the mortgage to the investment banker who turns it into a CDO and sells slices to the investors and others. This actually works out nicely for everyone and makes them all rich. No one was worried because as soon as they sold the mortgage to the next guy, it was his problem. If the home owners went to default, they didn’t care; they were selling off their risk to the next guy and making millions, like playing hot potato with a time bomb. Not surprisingly, the home owners default on their mortgage which at this moment is owned by the banker. This means forecloses on one of his monthly payment turns into a house. No big deal, he puts it up for sale but more and more his monthly payments turn into houses. Now there are so many houses for sale in the market creating more supply than there is demand and housing prices aren’t rising anymore, in fact, they plummet.

This creates an interesting problem for home owners still paying their mortgages: as all the houses in their neighbourhood go up for sale, the value of their house goes down and they start to wonder why they’re paying back the $300,000-dollar mortgage when the house is now worth only $90,000 dollars. They decide that it doesn’t make sense to continue paying even though they can afford to, and they walk away from their house. Default rates sweep the country and prices plummet. Now the investment banker is basically holding a box full of worthless houses. He calls up his buddy the investor to sell his CDO but the investor isn’t stupid and says “no, thanks”. He knows that the stream of money isn’t even a dripper anymore. The banker tries to sell to everyone but nobody wants to buy his bomb. He’s freaking out because he borrowed millions, sometimes billions of dollars to buy this bomb and he can’t pay it back. Whatever he tries, he can’t get rid of it.

But he’s not the only one: the investors have already bought thousands of these bombs. The lender calls up trying to sell his mortgage but the banker won’t buy it and the broker is out of work. The whole financial system is frozen and things get dark…
Everybody starts going bankrupt. But that’s not all: the investor calls up the home owner and tells him that his investments are worthless. And you can begin to see how the crisis flows in a cycle. Welcome to the crisis of credit.