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2008 Financial Housing Collapse

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In 2007 to 2008, there was a financial collapse in the United States, which resulted in us homeowners losing accumulative $3.3 trillion in home equity, and the stock market losing around $6.9 trillion. And this is interesting because it was a result of some of the financial tools and instruments that were being used at the time, and to a certain extent, are still being used. Let's discuss how this financial collapse occurred. So the spark, of course, was the housing collapse. And this was caused by homeowners able to get mortgages that they weren't able to afford. They specifically weren't even able to afford the interest payments on the mortgage, but somehow the bank is still given them a massive multi million dollar mortgage to people who had a measly income.

Now why would this occur in the first place? banks are supposed to plan against this and only make mortgages to people who have afford them? Well, this is due to some of the financial instruments that were being used at the time. And what was occurring was that the bank that made the mortgage to the homeowner wasn't actually bearing the risk that the homeowner would default, they were able to give the risk to another party. So they would collect the funds, transfer the risk to someone else. And so they could just collect this commission without having to worry that the homeowner would default, the bank will engage in something called a credit derivative.

And this is where they have a credit protection buyer. Make a contract with a credit protection seller who provides protection against a specific credit loss. So what we're saying is that the bank will buy insurance against the situation where the homeowner defaults a credit default swap is where the credit default swap buyer makes payments to the seller. The seller doesn't make any payments until a credit event occurs such as a bankruptcy or failure to make a schedule payments. And they have the promise of compensation for credit losses from the defaults of a third party such as the homeowner. So a credit default swap is essentially insurance.

So we now have two different cash flows. We have money coming from the homeowner to the bank from the mortgage, and we now have money that the bank is giving to the credit default swap seller. The people that they are paying to ensure the mortgages now fewer the company that is insuring the mortgages. For many years this will seem like just easy free money because you're just receiving cash flow. And as long as the homeowners don't default on their property, You don't have to pay anything, you just collecting money. Whenever you have something that's essentially a series of cash flows, you can create a financial instrument out of this.

One of the things that the banks did is they transformed the payment streams using something called asset backed securities. This is where they divided the payments from the bank to the credit default swap cellar into slices called trenches. And the whole purpose behind these trenches is that you can now have different priorities of claims. Where if you, if you were just dealing with something like a bond mutual fund, all the investors have the same claim the same rate of return, but with an asset backed security. Some investors take priority over others over the returns. And they also have different levels of risk.

Whenever there's a cash flow that has consistent returns like this. It's enticing to investors to invest in this. And you can think of this essentially like a bond. They are collecting payments over time. And someday in the future, they're going to have to pay back his principal. But in the meantime, they're just collecting money.

So what's the benefit of having a collateralized mortgage obligation? The benefit is this, you can have different levels of return and different levels of risk preference for investors. realize that there is a cash flow stream going from the CMO to investors. And what they investors have done is they've purchased a specific trench in the CMO. They've said that I am going to either buy a train a train speed train, see if I buy tranche a, I am taking the safest investment, but I'm gonna get less return. If I purchase training.

See, in contrast, I will be subject to more risk, but I'll receive a higher return. What's causing this risk? Well, let's say we have the homeowner who either refinance to defaults. Now there's less money going into the CMO. So there's less money now for the CFO to give to the investors. How is this money divided up?

Well, everyone in tranches gets paid first. All the investors who purchase that get paid, then we go to tranche B, if there's any money left over, these people get paid a little bit more, because there's tranche B. If there's any money left after that, then we move to trans See, if there's no money left, then the people who purchased transfer didn't get paid at all. So this is the benefit of having these different trenches. You can invest and receive a return in proportion to how much risk you invest into. So you can see that a collateralized mortgage obligation is a really useful financial tool for the banks.

They're now able to collect money from the homeowners, the mortgage owners, they were able to collect that cash flow, they're now able to transfer the risk of these mortgages on to the investors. From the investors perspective, a CMO isn't necessarily a bad thing either. It's essentially just a form of a bond, were they able to collect a income stream over time. If they invest in a tranche a they're going to receive less return, but it's a little bit safer, they invest in a tramp see, they're going to receive a higher return. It's a little bit risky, though. It's the same thing as investing in a safer bond or a rescue bond, though, depending on how much risk preference you have depends on how much return you're going to receive.

So what occurred during the 2008 financial collapse was that the banks now had an incentive to create lots and lots of mortgages. Even if the homeowners couldn't afford them, because they were no longer bearing the brunt of the risk of default of the mortgage, they were able to transfer that risk on to the investors. There's supposed to be rating agencies, such as Moody's who will take a look at these asset backed securities and appropriately read them. But what they didn't do at the time was identify that these collateralized mortgage obligations had become a lot riskier. In years leading up to 2007 2008, a whole bunch of mortgages had been created with these variable interest rates, where the homeowner wouldn't have to pay very much interest for a few years, maybe zero percent even. And then in 2007 2008, they would suddenly have to pay something like 12% 20% interest.

And what happened is that of course, the homeowner would default. The bank themselves that made the mortgage they're not exposed. Remember, all of the exposure is in the collateralized mortgage obligation. So So who are the people who own these, all of the investors who've been collecting money for many years, such as the company, AIG, they own a whole bunch of these asset backed securities. And what they suddenly discover is that these are about to implode. These tranche C's of these collateralized mortgage obligations, are no longer going to be providing payments.

And this is why AIG suddenly lost billions and billions of dollars. They were expecting these asset backed securities not to collapse. And of course they did. And remember, at the end of the day, this is a credit default swap agreement, which means that when everything is good, the banks will be paying money to the credit default swap seller. But when the credit event occurs, like a more home mortgage default, then it's like an insurance policy and the bank now gets to make a claim and say, Hey, this event occurred. I want to get paid.

So the companies like AIG, who had been insuring who had been selling the credit default swap agreements, all this time they've been collecting money, they now have to pay the principal onto these agreements. So this is why AIG, Lehman Brothers, Merrill Lynch, and other banks lost all of these billions of dollars, because all of these claims suddenly came in on these credit default swaps. And that's why a whole bunch of these banks went bankrupt. It's like when you have insurance for a car, the insurance company just collects money, as long as you're not in an accident. But as soon as you're in an accident, you suddenly make a claim and the insurance company has to pay you. It's the same principle going on here with the credit default swap.

In the book, The Big shorts by Michael Lewis, also made into a big movie production. It discusses how several investors realized that these mortgages we're about to experience a major credit event and what they wanted to do was buy a bunch of credit default swaps against specific trenches in the CDO, see collateralized debt obligations. Essentially what they wanted to do with buy insurance against these asset backed securities, they wanted to say that if these things collapse, we want to get paid. And so they were searching for particular trashes in these collateralized mortgage obligations that contains toxic mortgages. They then bought a bunch of credit default swaps against those trenches. You can think of this as buying put options against them, or buying insurance against them.

And then when the housing collapse occurred, they got paid big time. And that's what the movie is about. It's about these investors who identified this financial collapse before it occurred and made money off of it. So this is essentially what happened in the 2007 to 2008 collapse. Is that the moment Just went bad. The banks the way they were using these financial instruments weren't exposed to the risk, and rather the bank, some of the investors which in this case of a bear stearns and Merrill Lynch, who works as well as AIG, they bore the brunt of all of these collateralized mortgage obligations, and this is what caused them to go bankrupt will go nearly bankrupt.

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