How to financially fuck up 8 million people for profits.
How Mortgage Backed Securities(MBS) and CDO's used irresponsibly caused whole markets to collapse.
Okay, so there’s some context that is required for the folks not coming from a financial background. plus some history.
Early Banking
Banking in the early 70’s and 80’s used to be pretty boring, all dependent on deposits that banks were provided by the general public. All the loans given out, were based out on investments with the bank. Money has always been simple, though it was straight up monotonous back then.
Someone BORROWS money, Someone LENDS.
That all was swirled up when in 80’s Lewis S. Ranieri got up with the concept of Mortgage Backed Securities(MBS).
but what tf is security/securitization of an Asset?
Security is nothing but anything which holds some financial value and is tradable. Securitization is basically taking illiquid assets(an asset class which can’t be readily available to cash out, they’ll eventually pay out, just not now) and creating securities.
Okay so imagine loans, you are a regular joe, wanna buy a home? prolly won’t have 100k$ lying around, Would you?
You’ll go to a bank, now that banks who’re working purely on deposits, gives you up a 100k loan for a 5% interest for 30 years, now you’re indebted to the bank. The bank however could just sit on that 100k loan for 30 years, earning a cool lil interest of 5%.
OR
it could bundle up such loans, securitize them and sell them up to some investment bank as MBS(Mortgage Backed Securities). Why though? so they can get off debt of their balance sheets and have the money quick.
REMEMBER, banks only used to work with people’s deposits, now they could give out loans, then securitize bundles of those said loans and sell them to investment banks.
debt is off thier book, they would still earn a cute lil interest(less ofcourse) but most importantly they can do it all again, since they have the money back(investment banks purchasing MBS from banks, so they have liquidity again).
well then why Investment bank would want such Debts?
now these MBS/ABS can be converted to bonds, which can be sold to the general public, this keeps debt off, makes the investor money, the investment firm, banks.
bcos, WHO TF DOSEN’T PAY THEIR MORTGAGE? yeah this didn’t age well.
Credit Debt Obligation (CDO)
these investment banks made bonds out of MBS, got them rated by the rating agencies. there were three levels of CDOs (basically a categorisation of MBS based on risk levels)
EQUITY: High Risk, High Return
MEZZANINE: Medium Risk, Medium Return
SENIOR: Low Risk, Low Return.
Credit Default Swaps (CDS)
It’s like insurance on such MBS based Bonds, if the underlying asset would fail, having swaps could reduce the damage financially.
So like it’s betting against a particular asset, shorting it.
Why Credit Default? bcos the only chances of MBS backed securities failing is if more than half of the general public fails to comply by their mortgage contract and defaults on their loans.
WTH actually happened.
you need to understand one last thing, before getting into the ordeal.
Subpar Loans: usually when you’re out their asking for a home loan, there are checks in place, your financial background, credit scores, spending backgrounds etc.
But banks, who were turning up quite a profit, realised quick, that there money making machine, would stop if there aren’t enough loans to give.
So they started giving subpar loans, loans with a higher interest rate in exchange for relaxation in financial checks, they thought or at least declared publicly, that these “risky investments” when bundled together become less risky and not a bad investment after all, and note: these banks were getting higher profits with them.
Though these subpar loans had a higher probability of defaulting, still with the profits, banks felt it safe enough to play the gamble.
p.s those rating agencies, yea they were on payrolls, by the same fucking bank whose bonds they rated.
on a fine morning in 2008 it all came crashing down.
more than 80% of those loans defaulted, people lost homes, pension funds, investments, jobs. leaving 8 mill people homeless, millions without any job or savings.
quant finance at it’s worst, costs lives. a lot of them.
Nightmare.