I'll now explain to you why,
from 2000 to 2005, we had very low defaults on mortgages. Let's say that I buy a
house for $1 million. I buy a $1 million house. So let's say the bank
gives me $1 million. And then I'm willing to pay
a percentage on it. So this is from the bank. This is me. And I use that to buy a house. I don't know if these
diagrams help you. But you get the general idea. And the bank does that. And let's say, I don't know,
a year later I lose my job. I just can't pay this
mortgage anymore. So I have a couple of options. I can either sell the house
and pay off the debt, or I guess I could just tell the
bank, well I can't do anything, and I'm going
to foreclose. And that would ruin my credit. It would hurt my credit. And I would lose all
my down payment. So what are the circumstances
that I can sell the house? Well, if I borrowed $1 million,
as long as-- and let's say I didn't put any
money down, just for simplicity. If I can sell the house for
$1.1 million, well I would do it, right? Let me sell for $1.1 million. If I sell for $1.1 million,
I pay the bank-- let me switch colors. I pay the bank $1 million,
and I net $100,000. And everyone's happy. The bank got their money back,
so they didn't lose any money on the transaction. I made $100,000. And so the whole reason why this
worked out, even though maybe I was a credit risk,
is because the housing prices went up. So when you have rising housing
prices, the banks will not lose money lending you. Because if you can't pay, you
just give back the house, the bank can sell it. Or, you won't even give
back the house. You'll sell the house and you'll
pay it off, even though you can't pay the mortgage
anymore. The only situation where I
would foreclose is if the market price of the house
goes less than my loan. And that's actually
the situation that we're facing now. So if, let's say that
I can only sell this house for $900,000. Well, then I'm just
going to give the keys back to the bank. That's actually called jingle
mail, because you just mail the keys back. And then the bank sells the
house for $900,000. And then they would
take a loss. So when housing prices go
down, that's the only situation where really you
should have foreclosure. When housing prices soon. go up,
the person who borrowed it is just going to sell the house
and pay off the loan. And they are actually probably
going to make some money. So there was every incentive
to buy a house. So let's think about this whole
dynamic over the last several videos that we've
been building. So we said, from 2000 to 2004
housing prices went up. Let me do it like this. Let me change it a little bit. We can even say, from
2000 to 2006. So we know that housing
prices went up. And why did why did housing
prices go up? Well, we saw the data. It wasn't because people
were earning more. It wasn't because the
unemployment rate went down. It wasn't because the population
increased. It wasn't because the supply
of houses were limited. We disproved all that. We realize it was just because
financing got easier. The standards for getting a
loan went lower and lower. Financing got easier
and easier. And because housing prices went
up, what did that cause? We just said when housing
prices go up, default rates go down. You could give a
loan to someone who's a complete deadbeat. But as long as housing prices go
up, if they lose their job, they can still sell that house
and pay you back the loan. So housing prices going up
makes sure there's no foreclosure, so defaults
go down. So then the perceived risk
goes down, of lending. Perceived lending
risk goes down. So that makes more people
willing to lend. And the corollary of more people
willing to lend, is you that the actual standards
go down. That's financing easier. We could actually write that. Standards go down. So you had this whole-- I guess
you could argue whether this is a negative or
a positive cycle. But you had this whole cycle
occurring from the late '90s, but especially, it really got
a lot of momentum at around 2001, 2002, 2003. That financing got easier,
despite the fact that people were earning less, population
wasn't increasing that fast, that there were all of
these new houses. And that caused housing
prices to go up. Housing prices went up, then
we had a lot fewer people defaulting on their loans. No one would default on their
loans if they could sell it for more than the loan. Then a lot more people said,
well these are super safe. And so the ratings agencies,
Standard and Poor's and Moody's, were willing to give
AAA ratings to more and more, what I would argue,
are risky loans. So the perceived lending
risk went down. Then more and more people
liked this asset class. They said, wow, this is great. I can get a better return than
I can get in a bank, or in Treasuries, or in a whole set
of securities, even though these are very low-risk
or perceived low-risk. So I want to funnel more
and more money in here. And so the mortgage brokers and
the investment banks said great, the only way we can get
more volume to satisfy all these people who want to lend
money-- the only way we can find more people to lend
money to, is by lowering the standards. And this cycle went round
and round and round. And it really started because
this whole process of being able to take a bunch of people's
mortgages together, package them up, and then turn
them into securities and then sell them to a bunch of
investors-- this was a quote-unquote innovation in the
mid-'90s, or early '90s. I forgot exactly when. And it really started to take
steam in the early part of this decade. So that's essentially why
housing prices went up. And why kind of all of this
silliness happened. And in the next video, I'll talk
a little bit more about maybe who some of these
investors were. And I'll tell you what a common
hedge fund technique. And I think it's very important
not to group all hedge funds together. There are some good ones. But what a common hedge fund
technique was, to take advantage of this virtual cycle,
to make the hedge fund founders very wealthy. I'll see