lets smiplify it
sub prime
Imagine I want to buy a home which is worth 30 lakhs, but I don’t have any kind of income to buy it. Other way is that I take a loan on the promise of paying back the loan at(for eg:) 3 lakhs/ yr for 10 yrs. Now common sense will tell us the lender has to wait 10 yrs to get his money back. So obviously lender will be very particular that I have enough financial back up to pay him back. So he will ask for some assurances (any other property I have, or other assets like gold). End result I wont get the loan and can’t have the house because I am subprime (meaning no chance of paying loan back).
Now let’s see what happened in US. The financial whiz kids in investment banks (like Lehman brothers, Meryl lynch, Goldman sacks) see that the value of property is always going to rise. So they calculate that if I can’t pay back the money after say 2 yrs they can sell the property which will be now worth 35 lakhs. So if I default the gain is 5 lakhs at 2 yrs! (so the more chances that I am going to default , better their prospects. ) a win- win situation. If I pay back well and fine, if I don’t then more than fine! So the investment banks start buying the mortgages from lenders. Meaning if ur a lender u can happily lend 30 lakhs to “sub-prime “me and then sell that mortgage to Lehman brothers for 30+. Even I win cuz I can use a posh house for 2 yrs then if I default again apply for another loan in spite of being “sub-prime” …wow!
securitization
Now the bankers get greedier. They see these mortgages which they have bought as permanently increasing pool of money (real estate prices will always rise!). So they repackage all these together in a fancy name “collateralized debt obligation” (CDO) and sell them back to investors. There are rating agencies (Moody’s, Stanford &Pooch’s) which rate these funds so as to guide common investor about where to put his funds. Hand in glove with bankers, they will give these CDO based funds highest possible rating (AAA). The investor will see this as a mutual fund like scenario where u put ur money and see it grow. Now the same penny less me will put my whatever lil savings into this fund seeing that its being growing regularly for last 3 yrs or so (this was true of lots of pension funds and provisional funds in US as such funds can only be put in AAA rated schemes!).
Seeing all these, insurance agencies (like AIG) also jumped into the orgy. They started issuing insurances against CDO based funds to investors. They called it credit default swaps (CDS). You have to pay a quarterly premium to AIG and if the fund fails AIG will pay u back! They went even one step further by issuing speculative insurances , meaning u can take an insurance against a fund that somebody else owns (almost like betting!). Meaning for a single fund there were multiple insurers! Again win- win!
the boom
Now the real fun started. Stock market indexes went through the roof, house prices became three times, investment bank & insurance company CEOs were taking home close to 400 million pounds a year , rating agencies issued AAA ratings without much care , lending agencies became very liberal to lend loans and yes the subprime guy in road can buy any house and use it for an year or two then move on to next house.
the fall
Story changed once the subprime lending became massive and completely senseless. People who couldn’t pay even a single premium started defaulting in huge amounts. Number of defaulted houses increased with few takers for them due to defaulting. House prices started to go down. Suddenly the cash drain started to dry off. Once the cash drain started to tickle off, the CDO based funds started to have less buyers and more sellers. Now the investment banks were full of toxic assets. Imagine my 30 lakh loan which Lehman brothers have brought from my lender. Now as the CDO market has few takers Lehman brothers are stuck with that 30 lakhs loan. If they sell the house they will get only 25 lakhs now. So it has become a toxic asset. AIG on other hand had investors asking for insurance money against failed CDO based funds. Now the house of cards started to come down
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