See: Subprime.
It was the worst of times; it was the worst of times. Yes, hit that weird movie DISSOLVE button and step into the Wayback Machine with us. It's mid-2007. Banks are desperate to show growth to shareholders. Lending laws are liberal; banks are allowed to lend many multiples of the equity they have on hand, so if anything should go awry, they will suffer greatly. It's as if you, an individual, make $100,000 a year and you have a million dollars worth of loans out there at 5% interest. You can juuuuuust make the payments, but after you do, there's not much left over for luxuries. Like, um...food.
So the banks loaned money to a lot of people who couldn't afford them. A janitor married to a substitute school teacher who together made $88,000, would get a loan for $800,000 to buy their dream home. And as they moved in (with a bad moon a-risin' in September of 2007), all seemed good and fine and just..and they hearted The American Dream.
Then the economy softened. People got fired. Jobs went away. And as one homeowner defaulted, which led to another defaulting, there was a chill in the air. The 10,983 buyers all scrambling to buy homes suddenly just...went away. And the supply of homes for sale on the market, relative to buyers, mushroomed in all kinds of psychedellic colored ways. So that $900,000 home with the $800,000 loan? Yeah, its actual market-clearing price went down, a year or so later, to be more like $576,000. And the $900,000 that the bank loaned $800,000 on lost a fortune selling it. After closing and realtor and lawyer costs, the bank kept $500,000, having to write down hundreds of thousands in losses. Now multiply this event by thousands.
But wait...it gets worse.
Subprime mortgage packages are bought and sold just like any other bundles. Drug dealer cars are bought and sold by the dozen at auctions. All kinds of trade happens in life insurance products and other financial stuff. Subprime mortgages are bought and sold the same way. They exist as a kind of unified, single financial product which trades in "packages" about the same way an ETF trades.
And stocks and ETFs can be bought with leverage, i.e. an investor can take out debt to buy an ETF, believing it will go up. It's a margin purchase of an equity, more or less. So now you have a mortgage which is, by definition, a leveraged instrument...being bought with leverage. And wow, that's a ton of gasoline on the pile of dry timber. Should anyone be smoking around here, really bad things can (and did) happen.
The explosion when housing prices went down and homeowners just gave back the front door keys to the bank, walking away from homes which the banks couldn't sell...almost bankrupted the country. Historic. We're still feeling the effects. Shakespeare's thing about being neither a borrower or lender kinda plays along in the background in the hallowed halls of banks, for better or worse.
Related or Semi-related Video
Finance: What is Collateralized Mortgage...65 Views
Finance a la shmoop what is a collateralized mortgage obligation or
CMO all right people well this is a GMO and this is a CMO yeah it's a bunch of
mortgages in one investment vehicle pot like mortgage Stone Soup not nearly as [Mortgage stones in a bowl of soup]
exciting is that that man-eating plant over there
so yeah just a bunch of mortgages that are packaged together when banks and
investors package mortgages together well they can treat them like they're a
big fat indexed bond fund because these groups of mortgages while they pay
interest ie the interest comes from the people who are actually paying off their
mortgages so why would you collateralize a mortgage obligation anyway answer risk
by packaging lots and lots of mortgages together the theory was that well as a [CMO boxes on a conveyor belt]
whole they would create a much less volatile environment than the former
alternative of having tens of thousands of individual mortgages many of which at
any given time were you know in do rest as people were dead beating and not [Man playing video games]
paying what they promised to pay back right well collateralizing this group
meant simply placing all of them into one investment vehicle that could be
bought and sold as if it were in ETF or individual closed end fund but Wall
Street being Wall Street where greed is good until it's not abused the notion of [Boxing gloves punch collateralized]
collateralized mortgages and actually applied the notion of collateral against
them pledging as collateral the equity in these mortgages or packages of
mortgages and then borrowing against them so it's like leverage on leverage,
highly volatile and this is sort of like the brilliant idea of the fraternity [Man walking along]
social chairman sending the pledges to get graham crackers marshmallows and
chocolate when he sees his you know couch is on fire yeah like why wouldn't [People carrying snacks and a couch on fire appears]
he just put it out like what was he imbibing there all right well in fact
this is more or less what happened in the mortgage meltdown of 2008 and 9 and
it was helium inside of the couch that exploded in the form of many of these [Helium explodes on a couch]
mortgages becoming insolvent and as one mortgage went bad
well it caused a chain reaction of panic up and down the economic food chain
which resulted in the near bankruptcy of the United States financial system
basically the people who pulled together these CMOS forgot what the O stands for [Man walking along the street and plant eats him]
oh dear, oh my
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