Friday, March 13, 2009

What is wrong with this financial crisis thingamajig?

I've had friends and family come up to me during the last few months, looking to me for guidance about this whole thing kicked off. They know I have some sort of handle on this whole thing, and it's a very complex and tricky issue with no one person to blame. Heck, itwould be good if we could blame this whole thing on Bernie Madoff, but a number of events and lending practices has lead to the meltdown of the current capitalistic system.

First of all, we had the sub-prime mortgage crisis. Now, this basically stemmed from really bad home loans being given out. You see, at the height of the property boom in the US, there was a lot of money floating around the system, so lenders were able to package loans that they wouldn't have in normal times.

Like, the pay nothing for two years and then pay a fuckload of interest later on. These loans were offered to those who couldn't pay the interest straight up, and usually that's a sign that they're not ready for the financial strains of a home loan, but heck, there was money to be made so agents just gave the okay and collected the comission on the sale.

Now, the banks started to realise they had a lot of dodgy loans on their hands. So, they decided to package them up as securities and offload them onto Wall Street in order to safeguard their money. These securities took the form of bonds which the investor would hold, and eventually they'd get the full amounts of the loans and the interest.

Now, to help sell these securities, they were all put into a giant pool.The securirties were given AAA, BBB, and CCC security ratings by insurance companies. This means that the AAA were likely to be paid back, but with less interest and the CCC securities were less likely to be paid back, but the interest rate was higher.

Now, the people in charge of the securities thought by putting them in a giant pool wouldallow them to colate all the money in the one place, so the AAA security holders could be paid back first, the BBB second and so on. That's not it though, to help sell the securities they added on what's known as a Credit Default Swap onto the security.

This is basically insurance for the security, which means if you pay more you can basically guarantee a return on your investment. Here's the kicker though, these things could be traded as well. That's right, you could hold the insurance on another person's mortgage security.

So, you could basically bet on the mortgage not being paid back. Now, the market has gone nuts with these things, to the tune of an estimated 42 Trillion dollars.

Back to the Wall Street people who packaged up these securities. They thought at the worst, they could sell the houses if people didn't pay the money back and give it to investors. Here's the thing though, the availability of these cheap loans led to a heck of a lot more houses being built. Now kiddies, what happens when there's an oversupply in the market? The value goes down.

So of course there wasn't the money there to pay back investors and holders of CDS contracts and a lot of people lost money. Now the investors weren't just mum and dad investors, multi-billion dollar companies also got onto these securities and they weren't being paid back.

Now, there were a heck of a lot of companies not getting money back for their investment, and coupled with the market's penchant for CDS contracts which weren't subject to normal security scrutiny they found themselves in a highly leveraged position.

That means they were getting loans from a lot of other companies, and they didn't have the wherewithal to pay them back. So they had to sell assets, file chapter 11 (bankruptcy) and eventually the debt position of companies were exposed and the whole thing collapsed like a jenga pile.

Whew, I hope that helps explain the whole thing rather than fuzzy the picture for you, and crystallises why you should stock up on food sraps to throw at Wall Street gurus.

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