After the dotcom crash in the 2000s, investors wanted to find a low-risk high return investment. Investors turned to the US housing market. Investors didn’t want to purchase your parent’s mortgages individually.
Instead, financial institutions bought Mortgage Backed Securities (MBS). A Mortgage Back Security is where a financial institution purchases thousands of mortgages, bundles them together and sells shares of the pool to investors.
Investors saw Mortgage Back Securities as a smart investment for two reasons:
- Rating agencies gave MBS AAA ratings = Making the impression of low risk as AAA means borrowers are unlikely to default on the mortgage
- Housing prices were increasing = If the borrower defaults the bank can just sell the property for a higher price
In turn, more and more investors wanted to purchase AAA Mortgage Backed Securities. However, the banks needed more mortgages to meet the demand.
The banks started making loans to people with poor credit and without verified income. We call this type of loan Subprime Mortgage Loan. While Subprime loans were risky the rating agencies still gave them AAA ratings. Why were they given AAA? Because the bank combined lots of BB’s, B’sand BBB’s making the loan “diversified”. The diversification created a false perception of low risk.
Resulting in investors continuing to pour money into Mortgage Backed Securities. Thus, the housing bubble formed.
Eventually, people couldn’t keep up with the ridiculous mortgage payments and defaulted. The bubble bursted.
This meant more houses were on the market (supply). However, no one was purchasing houses. Consequently, supply was up, demand was down, and housing prices started collapsing. The decline in housing prices resulted in big financial institutions not purchasing Subprime Mortgages anymore. Lenders (Banks) were now stuck with risky loans and overextended credit. Ultimately, resulting in some banks declaring bankruptcy.
Amidst the chaos, lenders sold a Credit Default Swap. A Credit Default Swap in the GFC was essentially a bet that millions of people were going to default on their mortgages. If the borrowers do not default the buyer was forced to pay monthly premiums. However, if mortgage borrowers’ default then the owner of a Credit Default Swap received a substantial payout.
Panic struck. The stock market crashed, and the US and world economy began to plummet.
That might have been a mouthful for some – If so the BIG SHORT explains the GFC in an entertaining way.
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The information above should not be taken as financial advice. Youth Investment Group has no liability for personal financial interests or investment decisions. You should make your own investment decisions based upon your own research and what you believe is best for you.
Written by Patrick McLoughlin, Associate of YIG.