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Finance and capital markets
Course: Finance and capital markets > Unit 10
Lesson 2: Housing price conundrumHousing price conundrum (part 3)
Why did lending standards become more and more lax from 2000 to 2006? Created by Sal Khan.
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- One basic definition of fraud is an expert knowingly giving false information to others out of personal interest. For example, a surgeon telling a patient that they need surgery without disclosing that there is chance that the patient won't live. If these banks were certified financial experts and giving loans to people who couldn't afford them so they could bundle the sub-prime investments with more enticing ones and expecting a certain level of profit, how is this not clear-cut fraud?(8 votes)
- We don't have any real regulation on the shadow market or Derivatives. The Ratings agencies (moodys and the like) were the ones who were supposed to be telling the banks what was good or subprime, but were rating subprime as AAA.
It's true that we need to enforce our current regulations more, but we also need tighter more complex regulation on the shadow market and derivitives (which the republicans made sure to sideline in Dodd-Frank and in the watering down of the Volker rule).(5 votes)
- So, I get why the mortgage broker gets a cut, but why does the investment banker take a cut as well? Why don't the investors buy straight from the mortgage brokers and cut out the middle man? Are there any videos on this website that explain the investment broker's role in all of this?(5 votes)
- From what I understand, the mortgages were bundled with other stronger loans by Bear Sterns and the like in order to minimize the loss of sub-prime borrowers. The banks themselves probably didn't have the volume of loans at the local to accomplish an enticing bundle, so they all funneled through the investment banker(4 votes)
- Who is Franny Mae or Freddie Mac?(4 votes)
- Fannie Mae is the nickname for the Federal National Mortgage Association (FNMA -> "Fannie Mae"). Freddie Mac is a nickname for a similar company, Federal Home Loan Mortgage Corp. These companies were sponsored by the government in order to make home ownership more affordable. Fannie and Freddie would purchase qualifying mortgages from banks so that the banks could make new loans rather than hold the ones they already had.(4 votes)
- What does it mean when Sal says more people BID on homes?0:30(2 votes)
- Multiple people may want to buy a property, and the person who offers more money gets the property. Making such a kind of offer is called bidding.(2 votes)
- Hi,
Thanks for the class. One thing was not clear to me: it is easy to understand an investor would like to invest on something which generates a 7% interest rate, but mortgages take decades to be fully paid. In comparison, if they had this money on the bank, they would have a much smaller interest rate but they could take the whole sum back whenever they wanted, with mortgages they only get their full ammount on 30 years or so. How can this be considered good investment?
Thanks(2 votes)- All of investing is about tradeoffs between risk and return. For people who want to earn a higher return and can commit their money for a longer period of time, a mortgage could be a good choice for an investment. In practice, very few individuals provide mortgages to other people. Banks do that, and the reason we need the banks to do it is partly for the reason that you stated. By creating a bank, we can take the money that a lot of people have, use it to make loans, and still be able to return money to people when they want it.(2 votes)
- Why did the idea of mortgage backed securities ever catch on? Isn't it inefficient for all parties involved to move a loan through that many channels? Wouldn't it have just been more profitable for Countrywide to just hold onto them if they were so profitable?(2 votes)
- The reason why Countrywide and other banks like it sold the loans on was to reduce risk and to free up their balance sheet. If you had millions of loans sitting on your balance sheet that means more risk depending on the rating for the loans. (Keep in mind that a loan rated AAA typically has a lower yield than a more risky loan.) What the banks did was really smart if you think about it. They sold the loans on and in the process eliminated the risk and made a profit. Whenever the bank sold the loans it was able to issue more and the cycle was continuous.(2 votes)
- Did something like this ever happen before? Will it ever happen again, or will people learn from their mistakes and be less trusting and more vigilant?(1 vote)
- With the increasing power of banks and some very wealthy individuals when combined with the Citizens United Supreme Court case and the total unwillingness of the Congressional republicans to sponsor both legislation and oversight, the likelihood of market manipulation increases every year. The stop gap measures which had any chance to protect the consumer are being increasingly undermined by special interests, especially in the financial community, including major banks. These are the folks which use their power to funnel money to candidates and legislatures to protect their interests at the expense of consumer interests. The progressive and moderate republicans who created the social safety nets are all but gone. In their place, as better stated by others, are vulture capitalists. This is the present and this is the future.
These corporations and individuals create tax loopholes for themselves and hold the consumers hostage. They seek the benefits of our society, but use various schemes to avoid sharing in its responsibilities. As evidenced since 2008, earnings and wealth ascended to a few while the rest struggle. The middle class since Ronald Reagan, followed by Clinton's NAFTA has deteriorated. Work place protections have been evaporated. The frontal and indirect attack on unions has been successful. Republicans have tried every trick to make it harder for the average citizen to vote.
Given these factors and others, even if there is no blatant market crash, the quiet impact on the average consumer grows. Their capacity to participate is eroding. And as far as I can see into the future, the pattern will continue unabated. Home ownership will recede while rentals will increase. The wealth will buy the homes and rent them to the rest of us.(2 votes)
- Who are investors
????? What gives the money to all there banks like IB?(2 votes)- Investors are normal people. They give money to banks and get more money in return. That's how savings accounts grow :D(1 vote)
- Ask a question... Was it illegal for banks and financial institutions to package those types of securities? Did the federal government change the laws for securitization to take place?(2 votes)
- It was not illegal, although it could be argued that it´s on shaky moral ground.(1 vote)
- What are investment banks ? Do investment banks only deal in Mortgage backed Securities ?(1 vote)
- Investment banks are institutions that assist corporations, governments and individuals in transactions. These transactions can involve raising capital (such as underwriting stocks, bonds and mortgage backed securities) as well as purchasing other companies (mergers and acquisitions) and providing market research.
The main difference between investment banks and retail banks is that investment banks don't take in deposits from customers. But, the line between investment banks and retail banks has become increasingly blurry over the last few years as many investment banks have started to increase their retail banking segments.(2 votes)
Video transcript
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.