How Did The GFC Happen?
With all the recent talk about Joe Hockey raising the ‘Debt Ceiling’ and the phrases ‘Another Global Financial Crisis’ being thrown around, people are getting worried, and quite confused. Relax. Nothing is on the radar yet. But it has made us think… Remember the actual Global Financial Crisis? The original, The Best. Did you ever really understand what went wrong? Well it all started off with our pals from the U.S. of A.
If you finally want to know what happened, and what caused it, then get comfortable, sit back, and get ready to read, and be amazed. There’s about 2000 words ahead of you, but trust us, it’s worth the read.
To start off, we have to explain a few basic things. But bear with us. It’ll all make sense in the end.
What exactly does the bank do to help people purchase homes?
To begin this explanation lets go through an example, we start off with a man who has money, and he wants to save it. This man has several options, firstly he could hide the money under his bed... but there is a problem with this, inflation. As time goes on, inflation starts to rise and with it go prices of food and items. This makes his money not seem like as much as it wouldn’t be able to buy him as many things as it did when he first put the money under his bed. The cash isn’t rising in value at the same rate as the prices of everyday items.
His second option is to go to a bank and deposit the money into a savings account, unlike under his bed, the money won't just sit there, what actually happens is the bank is borrowing this money off the man, so that they can finance their other projects. In return for borrowing this money they pay the man interest. To understand where this money comes form, we must look at the other side of the bank's process.
Now we use the example of a typical family, they want to buy a house. The problem is, the house costs $250,000, and of course hardly anyone can afford to pay $250,000 upfront. This is where the bank comes in, the bank has access to all these savings accounts previously mentioned. It will pool a few together to get enough to give the family a loan. The bank then becomes the middleman. The bank pays for the house, and in return gives the family a mortgage. Under this mortgage, the family agrees to pay the bank back in small monthly payments. Because these payments are so small, it will take the family a long time to pay off this amount.
The typical mortgage is 30 years. Why does it take so long to pay back? This is because mortgages are so expensive! When the family pays back the bank, their monthly repayments are divided into two parts, principal which is the original amount of the loan you used to purchase the house, in this case $250,000. The second part of the payment is the interest, that's the fee you have to pay the bank for borrowing their money in the first place. What most people don't realise is how large this total interest payment actually is! For example if this family had an interest rate of 6% and their mortgage took them 30 years to pay off, the total cost of the mortgage is $539,539. That’s more than double the value of what the price was listed for.
So how is the man who decided to put his money in the bank instead of under his bed and this family buying their house connected? Well the bank pools all the money that they get from people like that man, uses it to give money to the family to buy the house and charges them 6% interest to borrow that money. The bank says thanks to the original man by paying him an interest rate of 3%, the bank then pockets the other 3% difference, and this is how they make money.
How did this process contribute the Global Financial Crisis?
Well this all started with investors. A group of investors have a large pool of money, they want to invest in low-risk but high-return investments. in 2001, the market didn't have very many options, the governments treasury bill returns were only 1%, and there had just been the dot com bust. So the investment banks could only see one area that was stable and had a good return, this was the housing market. The average return on investing in property was around 6%, so a lot of investors looked at this market as a great way to make their money work best. They started looking at mortgages as great investment products. But how do you turn a mortgage into an investment product?
The larger question becomes how are these two connected? How does a large group of investors who have billions of dollars make money off a tiny house mortgage? Well the link between the two is a bank, or rather many commercial banks. On one side you had the home owners with mortgages who would eventually be paying them back to the commercial banks, on the other side you had investment banks receiving money from investors that the investment banks needed to spend on something. The commercial banks needed more and more money, due to this booming housing market and the banks having more and more people wanting home loans. The investment banks with lots of money and nothing to do with it, decided that this was a good time to link up with the commercial banks. The giant pool of money from investors was given to investment banks, the investment banks gave this money to commercial banks, the commercial banks then gave this money to families who wanted a home loan.
But who makes money here?
Well the commercial bank took all the mortgage agreements they had with the families paying off their homes, packaged them up in a big nice bundle, gave them over to the investment banks and charged them a fee. Investment banks take this package of mortgages and turn them into an investment product known as a 'Mortgage Backed Security'.
The investors buy the rights to these mortgages with their giant pool of money, and when it comes time for the families to make their mortgage payments, their monthly payments no longer go to commercial banks, they instead flow through this big process to investment banks, then to subsidiaries of the investment banks known as 'Special Purpose Vehicles' which distribute this money to the investors.
So what went wrong with this mortgage market?
Well, when applying for a mortgage a person had to have a good credit score, the person had to document their income and assets, his debt to income ratio had to be less than 35%, he had to have 2 months worth of income payments handy, and he had to have a 20% deposit. If he had all these requirements he would qualify as a A paper mortgager, the safest of all mortgagers. There were then people who fell into the Alt A mortgage category, these mortgages were not as safe as A paper, and were between A-paper and Subprime categories of mortgagers. Alt A mortgagers didn’t have the best documentation, they were perceived to be riskier and were thus charged a higher interest rate by the banks. Then you have the next category down, the Subprime (a word which you probably have heard a lot). These types of mortgages were the lowest quality mortgages you could have. In extreme cases mortgagees didn't even have the income or assets that were required to buy a house at all.
So lets say a family wants to buy a house, they can go to a bank or a mortgage broker. A mortgage broker goes between a bank and a family, they do not lend their own money, instead they find 'the best' mortgage for the families and try their hardest to get the family a mortgage. It is important to note that these mortgage brokers received a fee from the bank every time they put a mortgage through.
Now remember how investors were keen to get in on the mortgage market? Well word spread about how safe and profitable these investments were and soon more and more investors wanted to do the same, but there weren’t enough mortgages to go around. In order to fill the demand, mortgages were given out to riskier people.
Why were mortgages allowed to be given out to risky people?
Well before this mortgage investment market opened up, the traditional way for a family to get a loan was to apply directly to a commercial bank. Since the commercial bank was taking on the responsibility of the loan and assuming the debt, they would put the families through rigorous checks to make sure they would actually pay back the loan. Then along came 'Mortgage Banks'. These businesses were different to traditional banks, they only gave out mortgages and would not take deposits or savings form customers. Instead they would give out a mortgage to a family then sell the rights to this mortgage straight onto the investors who wanted them. This was called the 'Secondary Mortgage Market’. This was ideal for banks, as instead of waiting for years to get their money back, taking small amounts at a time, they could sell the rights to the mortgage straight away to investment companies, and get money straight away. Some of the big buyers of these mortgages on the secondary mortgage market were the now infamous, 'Freddie Mac' and 'Fannie Mae' corporations. The mortgage banks would then use the money to give out more mortgages! Traditional commercial banks saw how good this type of business was and started to do the same as the mortgage banks. And because the commercial banks were only charging a fee to the investment banks and didn't have to worry about the repayments or any of that messy stuff, they were less concerned with the quality of applicants, and were more willing to give out risky mortgages.
I think you can see where this is heading...
Remember how there was heaps of demand coming from investors, wanting more and more mortgages? Well there were only a certain amount of low risk, A paper mortgages available so banks had to start giving lower on the scale, higher risk mortgages. And these people who would only qualify for subprime mortgages couldn't always afford a traditional mortgages, so banks came up with 'creative' products for these people so they could afford to get a mortgage.
Interest only mortgages was one major product that was taken up by these people, these mortgages are cheaper to pay off in the first few years, up to maybe ten years, as you are only paying off the interest amount, and not the principal amount. Eventually this type of mortgage will revert back to a traditional mortgage though, and this would mean higher repayments would be needed. There were other types of products offered as well such as balloon payment mortgages and negative amortization mortgages, but they are all pretty much along the lines of: lower payments in the first few years, but higher payments later on.
But why would a family want to take out these mortgages knowing that there would be higher repayments in the future? well this is because housing prices were rising, and people thought that the rising value in their house prices would offset the higher cost of their loan. The prices were rising due to the whole process that you have just been reading about. The market was now open to all these people who would not have usually been able to borrow money to buy a house, so there was a lot more demand for housing, causing housing prices to rise!
Then came an interest rate rise...
For all the people that were barely able to afford the home loan in the first place, the subprime mortgage holders, this extra rise in their monthly repayments forced them to default on their loan. They had to give the houses back to the banks. The banks did not expect such a large number of people to do this. The result was that there were now a large number of houses on the market and no buyers. This caused housing prices to fall. This meant that the investment banks were no longer receiving the payments every month from borrowers, and were thus stuck with houses that were worth less than what the investment bank paid for them. These investment banks were then left with billions of dollars of losses and that is the way the cookie crumbled...
Phew, that was a long read. Hopefully now you will understand a little more about the GFC when it is brought up at work or discussed on TV.
Did this help you understand? Or are you still confused? Leave us a comment to let us know!