Let’s say a family wanted a home and they save for a down payment.They will contact a mortage broker which will connect them to a mortgage lender who gives them a mortgage.
Investor bankers started buying those mortgages from the lenders for a nice fee.
Investor bankers started bundling thousands of these home loans together in a box called collateralized debt obligations ( CDO). The bankers started slicing the CDO into three slices like a cascading tray. The top part was considered safe, the middle one considered okay and the bottom part considered risky. These were given ratings by rating agencies such as Moody’s.
The top part was rated AAA, the middle part BBB and the bottom part were unrated.
The AAA were the highest safest investment that existed.The BBB were still safe somehow.
When the homeowners defaulted on their mortgages , the bottom part didn’t get paid. The top part got paid as usual. To compensate for the risks the bottom part got a higher rate of return let’s say 10%, the middle part got 7% and the top part got 4%. To make the top part even safer they insured it by a credit default swap (CDS) for a 1% rate of return.
They sold slices of those CDO’s to investors. Pension funds bought only the AAA slices as they can’t aford to lose money. The bottom part were sold to hedge funds and those who could afford more risks.
The investors were making big money from all the mortgages inside the CDO. So they started to get greedy and pushed the mortgage lenders to get more mortgages. But lenders have already given morgages to borrowers with good credit called prime mortgages. When homeowners defaulted on their mortgages, the lenders gets the house. This was not a problem since the price of houses have always been increasing in value. So they go bottom feeding and lower their criteria. Before you needed a credit score of 620 and a down payment of 20%. Now they will settle for 500 and no down payment and no proof of income called sub-prime mortgages. That was the turning point. The banks CDO’s were based on very bad mortgages and were risky.
So they control their downside by buying a credit default swap. If the borrowers defaults on their mortgages the insurance company will pay a default swap . The banks ensure their potential losses and move the risk off their books so they can invest more and make more money. Well a lot of companies insured this stuff . One of them took on an almost unbelievable amount of risk (AIG) by insuring most of them.
AIG figured the housing market would just keep going up but then the unexpected happens.Home owner’s who bought their dream houses with a teaser rate on his mortgage. As soon as the teaser rate runs out thus his monthly payments go up , he defaults. Due to the large amount of defaults , there were more houses on sales. There were more supplies than demand. Housing prices stopped rising and eventually go down.
Aig has to pay off the swaps..all of them., all over the world and at the same time. Aig can’t pay and it goes under. Every bank they insured books massive losses on the same day an then they all go under.
The whole financial system crashed down.