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Studying for a test? Prepare with these 5 lessons on Current economics.
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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