Continuation of: How The Great Recession started?
Financial Institutions, Insurance Companies, and Rating Agencies colluded to form a "Securitization Food Chain".
Traditional Housing Loan System:
Home Buyers <--> Lenders
Buyer will take years to repay the loan to lender.
Securitization Food Chain:
Buyer have to pay the loan to Investors
Home Buyers <--> Lenders <--> Investment Banks <--> Investors
Lenders sold the mortgages or the buyer's loan to Investment Banks.
Investment banks combine Thousands of loans including Home loan, Car loan, Student loan, etc. to create CDOs (Collateralized Debt Obligations) and sold them to investors.
Now Buyers' payments will go to to Investors all over the world.
The role of rating agency is to evaluate the CDOs.
Almost all the CDOs were rated Triple-A (AAA). AAA is the highest possible rating which means the the agency predicts that the buyer will repay the loan 100%. Investment banks paid the Rating Agencies to certify the CDO's as Triple-A.
- Lenders did not care anymore if a buyer could repay the loan, so they started approving riskier loans.
- Investment Banks did not care either. More CDOs sold, more profits made.
- Rating agencies didn't bother about the consequences of wrong ratings as they term their ratings as "Opinions".
- Nobody cared about the quality but aimed only at maximizing profits.
- Early 2000s saw a rise in riskier loans called subprime.
- A loan given to a risky borrower with high interest rate.
- They still received triple-A rating in CDOs. This led to predatory loans.
- The financial institutions offered incentives to mortgage brokers who brings more profit by deceiving and exploiting borrowers for a subprime loan. This is termed as predatory loans.
Buying a home is a lifetime dream for huge part of American population. This was well utilized by the investment banks and the subprime loan lending increased from $30 Billion a year to $600 Billion a year in 10 years span.
- Home Purchases and housing prices skyrocketed.
- Cash flow in Wall Street was enormous as bonuses and incentives.
Home loan is the problem at front end, on the back end there were other serious issues.
- Investment banks borrowed more money to buy more loans to create CDOs.
- The ratio between borrowed money and the bank's own money is called leverage.
- The more the banks borrowed, the higher the leverage. The leverage rate were frightening as it went almost 1:33 meaning banks borrowed 33 times more loan than their capacity.
Credit Default Swaps (CDS):
- CDS worked as an insurance policy.
- The investors who were holding the CDOs went to insurance companies like AIG to seek insurance for the CDOs.
- Investors paid the premium to AIG and if the CDO went bad, meaning, if the borrowers failed to payback the loan, AIG promised to pay for the losses.
- To make this even worse, there was betting where the speculators can make by paying insurance companies for the CDOs they did not own.
Investors --> AIG <-- Any number of speculators
- AIG's profits skyrocketed, but they did not care about the consequences when CDO's gone bad.
There was a possibility to regulate the "securitization food chain", but the powerful economic lobbyists in Government positions refused to do it.
Home buyers borrowed 99% of house price as loan. So if anything goes wrong, they could easily walk away.
There was a financial bubble which was about to explode at any time.
By late 2008, nearly 9 million home buyers started to vacate their properties as they were unable to pay the loan.
Investment Banks could not sell anymore CDO's as there were no buyers.
Securitization food chain began to collapse as the money flow started to decrease.
Many Banking giants like Lehman Brothers ran out of cash and declared bankruptcy.
The companies that depend on these giants also had to shut down.
AIG could not pay investors and speculators for loss of CDO's.
World's stock market crashed. Unemployment rate increased in U.S and Europe.
The recession started to spread globally as the economies of each Country is inter-linked.
10 Million Chinese workers lost their jobs as their products were no longer needed in U.S. due to decreased buying power.
Further Read: How the effects of The Great Recession were handled?