Credit Crisis
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The housing price conundrum
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Housing price conundrum (part 2)
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Housing Price Conundrum (part 3)
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Housing Conundrum (part 4)
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Mortgage-Backed Securities I
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Mortgage-backed securities II
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Mortgage-backed securities III
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Collateralized Debt Obligation (CDO)
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Credit Default Swaps
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Credit Default Swaps 2
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Wealth Destruction 1
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Wealth Destruction 2
Housing Price Conundrum (part 3) Why did lending standards become more and more lax from 2000 to 2006?
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- So just a bit of review.
- What happened from 2000 to 2004?
- Actually I should really say, from 2000 to 2006, because
- that really was when the housing bubble happened.
- Well financing got easier.
- Or essentially they lowered their standards.
- And it got progressively easier and easier and easier,
- every year we went.
- So then that allowed more people to bid on homes.
- So it increased the demand artificially in certain ways.
- Because we saw from that New York Times article that
- people's incomes weren't increasing, and the population
- wasn't increasing anywhere near as fast
- to soak up the supply.
- So all it did is allow people who were renting before, and
- who couldn't save the money for the down payment, now to
- participate.
- So now you had more people bidding for the same house, to
- bid up houses.
- But that led to the obvious question.
- Why did financing get easier and easier?
- So let's go back to the good old days, like the early '90s.
- Or actually, let's go even before that.
- Let's go to the classic, what happens to get a housing loan?
- Well traditionally, if I want to get a loan I
- would go to my bank.
- And that loan officer at the bank, he's going to be giving
- the bank's money for your house, right?
- He gives you money.
- And you're going to pay him interest. Right?
- This is me.
- And so that loan officer at the bank, he really cares that
- they're not going to lose money on the transaction.
- If he's going to give you $1 million, he wants to make sure
- that no matter what happens, if you lose your job, if you
- get arrested, if you skip town, that he's still going to
- be able to get his $1 million back.
- And if you go back to our equity and balance sheet
- presentations, that's why, back in the day, they made
- sure that you put 20%, 25% down payment on your house,
- that you had a good credit rating, that you had a good
- steady income.
- Because that banker, that loan officer, was
- going to be in trouble.
- And his bonus was based on how good the loans
- he gave held up.
- So that was the traditional model.
- What happened-- started to happen the mid-90s, especially
- in California, and then nationwide in about 2001,
- 2002-- is you had what we call a securitization of the
- mortgage market.
- And this, in all fairness, this actually happened a while
- before, with things like Fannie Mae and Freddie Mac.
- And I'll do a completely separate video on those.
- But Fannie Mae and Freddie Mac essentially
- had the same standards.
- They had the standards of, we call them, conforming loans.
- I think the numbers -- you have to have 20% down.
- You have to have a certain credit score,
- certain steady income.
- So Fannie Mae and Freddie Mac were these entities that might
- buy the loan from your local banker.
- But their standards were just as high as the local banker's.
- And they were based -- I think they were actually, they had
- oversight by Congress.
- So they weren't giving away loans for free.
- But I'll do a whole other presentation on Fannie Mae and
- Freddie Mac.
- What you had happen in the late '90s, and especially in
- the early part of this decade, is you had a whole industry
- outside of the government-sponsored entities.
- The government-sponsored entities are Fannie Mae and
- Freddie Mac.
- And this is essentially -- instead of you going to your
- local bank for a loan -- this is me again -- I would go to
- my local mortgage broker.
- Countrywide is the most famous of them.
- I think they're CFC.
- That's their stock ticker.
- They're not bankrupt yet.
- So I would go to Countrywide.
- And essentially I would get $1 million from
- them, a home loan.
- I would get $1 million from them.
- And I'd agree to pay interest to Countrywide.
- But then Countrywide would do this like, a million times.
- So times a million, right?
- They'll give home loans to a million people,
- put them all together.
- And then they'll sell the loans.
- They'll sell the loans to like, let's say, Bear Stearns.
- So that's an investment bank.
- Let's call it Bear Stearns.
- Hope none of these people sue me.
- I guess they have bigger troubles now, then wondering
- about my YouTube videos.
- They sell it to Bear Stearns.
- And then Bear Stearns will package a bunch of these
- mortgages together, essentially IOU's from people.
- And then they would sell those to investors.
- Right?
- So essentially, instead of Countrywide being responsible
- for my loan, my payments now go to these investors.
- And you could watch the-- that says investors.
- I know my penmanship is horrible.
- But you should watch the videos on mortgage-backed
- securities and collateralized debt obligations, if you want
- to get a better understanding of exactly how
- the money flows go.
- But the bottom line is, because of this process,
- what's happening?
- Countrywide is just being a transactional.
- They're just doing the paperwork for my loan.
- They're temporarily holding the loan.
- And they're doing a little bit of due diligence.
- And in return for that, that Countrywide mortgage broker
- will just get a fixed fee for doing that transaction.
- Maybe they'll get like $5,000 for just doing the paperwork
- for my mortgage.
- Right?
- And then Bear Stearns will package a bunch of these
- mortgages up-- and now it's going to be in the billions--
- and then repackage them and sell them to investors.
- In the process, Bear Stearns gets a cut.
- And Bear Stearns is doing this for millions of
- mortgages at a time.
- It's in the billions of dollars, and Bear
- Stearns gets a cut.
- So Bear Stearns essentially just gets a fee, like the
- mortgage broker.
- Of course it's a huge fee.
- And then the investors are going to
- get my interest payments.
- Right?
- And let's say if the interest rates, if I'm paying 7%, and
- the other million people are paying 7%, the investors are
- going to get 7% on their money.
- And that seems like a pretty reasonable proposition.
- And of course the investors would care that the money that
- they're essentially giving -- because they're giving money
- to the investment bankers who are giving money to
- Countrywide.
- And that's where my $1 million is essentially coming from.
- The only reason why the investors would give their
- money, is if they have a lot of confidence that these are
- really really good loans.
- Well the investors, they don't know who I am.
- They don't know what my job is, how likely I
- am to pay the loan.
- So the investors have to rely on someone to tell them that
- these are good loans.
- And that's where the rating agencies come in.
- And these are Standard & Poor's and Moody's.
- And they rate these assets, these mortgage-backed
- securities.
- And what they say is, well, they'll look at this big
- package of mortgages, these million mortgages that Bear
- Stearns has packaged together.
- And they'll look at the historical default rate.
- And they'll say, wow, these mortgages really haven't been
- defaulting.
- And you can think about why they haven't.
- Because housing prices been going up.
- So these mortgages really haven't been defaulting.
- There's a very high chance you're going to be able to get
- all your money back.
- So we're going to give these what they call, let's say they
- say AAA rating.
- So this investor, who knows, it could be the
- Central Bank of China.
- It could be a hedge fund.
- It could be a whole set of people.
- It might be the investment banks themselves.
- Sometimes they actually bought these just to
- make some extra money.
- These investors, they don't know who actually borrowed the
- money, or what kind of credit rating they had, or anything.
- But they just took a leap of faith.
- They said well, Standard & Poor's or
- Moody's did the work.
- They're telling me that this is AAA, which means the
- highest level of debt.
- Or you know, whatever they told them.
- Maybe it was A.
- I forget all the different qualities of debt.
- But they just took their word for it.
- And they got their 7% interest on their money-- whatever it
- was, 6% money.
- And that worked out pretty well.
- And so these guys, they liked the fact that they were
- getting the 7%.
- They said, this is a good asset class.
- So then they funneled even more money.
- So then there were even more investors that wanted do this.
- They're like, this is great, with very little risk I'm
- getting a pretty good return on my money.
- That's better than putting it in the bank.
- That's better than buying Treasury Bills, right?
- So then even more money flowed in.
- Well, more money wanted to invest in people's mortgages.
- But Countrywide would say, well, we're already giving
- mortgages to all the people who qualify.
- So in order to actually find more people who want mortgages
- from us, we'll just have to lower the
- standards a little bit.
- Right?
- And we can lower the standards, because we find
- even when we do lower the standards, no one's defaulting
- on their mortgages.
- And in the next video, I'll maybe give a little bit more
- [? color ?]
- why.
- So Countrywide will issue even more mortgages, and give them
- to these investors with even lower standards.
- Of course, the mortgage brokers at
- Countrywide, they love it.
- Because every time they do a transaction, they just get
- some money.
- And then they give the mortgage to the investment
- banker, which packages them up and then
- sells them to investors.
- So they get it off their hands.
- And they just got the fee.
- So they just collect the big cash.
- The investment banks love it, right?
- They just love doing the transactions, because they get
- more and more money every time they do the transactions.
- And for the moment, the investors seem pretty happy,
- because they keep giving money into this system, so to speak.
- Even though they might be reading the newspaper and
- seeing that the standards are going down.
- But they're consistently getting their return.
- And because the defaults were very low over this time period
- -- and I'll explain in the next video why the defaults
- were very low -- they felt that they were getting a good
- return, maybe 6% or 7%, on investments that had very,
- very low risk.
- So in the next video, I'll explain why the defaults were
- very low in that time period.
- See you soon.
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