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Understand the financial crises in simple language.

Q. Understand the U.S Credit Crises in Laymen Language?

A.  It’s a Worldwide financial fiasco involving terms you would have probably heard of like :-

·        Leverage

·        Prime Mortgages / Sub-Prime Mortgages

·         Collateralized Debt Obligation

·        Frozen Credit Markets

·         Credit Defaults Swaps

But don’t worry you don’t have to know financial language to understand this Crises, this is how you would be able to understand in Simple English Language because every one of us are affected and we don’t realize it.

            Here’s how, the credit crises brings 2 groups of people together home owners and Investors. Home owners represent their mortgages and Investors represent their money. These mortgages represent houses and this money represents large institutions like Pension funds, Mutual funds, Banks etc. These 2 groups are brought together through the financial system commonly known as the Wall Street.

            To Understand this let’s start from the beginning; years ago the investors were sitting on their pile of money looking for a good investment opportunity to increase their fortune. Traditionally, they went to the US Federal Reserve where they bought treasury Bills which were believed to be the safest investments (AAA ratings) But due to the dot com burst and September 11, 2001 the Federal Reserve lowered the interest rate to 1 % to keep the economy stable. 1% is a very low amount return on investment so the investors say NO THANKS. On the flipside, this meant that the Banks from Wall Street could borrow at just 1 %, adding to the general surplus from Japan, China and the Middle East. Thus abundance of CHEAP CREDIT was available making it easier for the banks to borrow and enjoy the crazy benefits of low leverage. Leverage is borrowing money to strengthen the outcome of a deal. Here’s how it works , in a normal deal  someone with 10000 $ will buy a box for 10000 $ and sell for 11000 $ making a profit of 900$(100 $ as interest to be given to the lender), what a good deal, but with this leverage someone with 10000 $ will go and borrow 9, 90,000 $(saying that he would pay you tomorrow).  Then sells it for 11, 00,000 making a profit 90,000 $. Leverage makes a good deal into a great deal and this is how major banks/institutions work.

            This gives investors a great idea to connect to the home owners through mortgages. A family wants a house so they save a down payment and contact the agent who connects them through the lender (Bank) who gives them a mortgage called as Prime Mortgages. In this, the agent gets a nice commission; the family gets the desired house(s) as the housing prices are soaring crazily and lenders gets a nice investment.  Now the lender gets a call from an investment banker and the lender sells these mortgages to the banker, for a very nice fee. Using the cheap credit the investment banker buys more and more such mortgages calling it Collateralized Debt Obligation (CDO) giving him monthly installments as a return to his investments. Then he divides these investments in three categories i.e.  Safe, Ok, and Risky with an increasing rate of return respectively. When the money comes from the home owners, the 1^st category safe is utilized then ok category and then risky category. The investor also secures the Safe category with the Help of a credit rating agency called Credit Default Swap so that they mark it as AAA (Safe as it can be), BBB and CCC (Risky) for 3 different categories. Because of the AAA rating the banker can sell to the investors who only want safe investments, BBB to the other bankers and CCC to the Hedge fund owners doing this the Investment bankers makes millions, then he repays his loans, all of them are happy as investors are happy as they get more then 1 %  and all. Thus they want more of CDO.

            Now the problem arises, as the investors wants more CDO, and investment bankers need more people for mortgages but they cannot find because everyone has one. So they come up with an idea as home owners default, they take the house and the value of the houses is always appreciating thus they give down payment to anyone without any security,  no proof of income, no documents at all(who are called irresponsible home owners) this is called Sub-Prime Mortgages

            This is the turning point so just like always the brokers connect the owners to the investment banker making his profit who then connects to the investors and hedge funds making profit making everyone rich because no one was bothered as soon as they sold the mortgage to the next buyer it was HIS PROBLEM because if the home owners were to default, they didn’t care as they were selling the risk to the next guy meanwhile making millions like a time bomb which would explode at any time and not surprisingly the home owners defaulted which at that moment was owned by the bankers this means his monthly installment turns into a house so he puts it up for sale but then more and more mortgages turn into houses and because of this there is more supply then demand. The houses start de-appreciating in value and plunge, thus the responsible owners think that why are they paying more in mortgages when the other houses are readily available for sale at 1/4^th its price thus they also start defaulting, this means that the investment banker has worthless houses in his COD so when he sells this to the investor they say no thanks and no one buys it. As the investment banker has borrowed million or even billions he cannot repay the loan so he cannot buy more and thus the whole financial system is frozen and everybody starts going bankrupt this is called as Frozen Credit Market. And this is how the whole crises flow in a cycle.