This is the third of four posts explaining how the economic crisis of 2008 came about. Make sure to read Part 1 on housing bubbles and Part 2 on financial derivatives and deregulation if you haven’t already done so.
A key problem in discussing financial issues is that too often the institutions and individuals are simply labelled ‘banks’ and ‘bankers’, which mixes up several very distinct groups. Here is a short list of a couple of the most important financial players, each with a simple definition of what they are. As usual, these definitions are for people not familiar with financial markets, and lack nuance, but allow for the broader picture to be understood.
Stock broker – This is somebody who buys and sells stocks and shares on the stock market. Shares are a portion of a publicly owned company, and may pay dividends and give voting rights, depending on the type.
Commodities trader – While seeming like a stock broker, a stock broker buys into companies, whereas a commodities trader buys raw materials themselves, looking for fluctuations in their prices to make returns on their money. They largely work around future derivatives. The four main commodity markets are agriculture, metals, meat and livestock, and energy.
Mortgage broker – A mortgage broker finds potential homebuyers and connects them to a mortgage lender and receives a commission.
Mortgage lender – a mortgage lender in a institution that lends money for people to buy real estate.
Investors – An investor is anybody putting up money with the hope of making a return on investment. A low risk investor might buy government bonds, which rarely fail, but have a low percentage return. An investor can be an individual or an organisation, including pension funds or even charities.
Ratings agency – The previous article described how tranches of a CDO might be labelled as safe or risky. However, all sorts of financial players may themselves be given a risk rating, even governments. The safest level given to anything is a AAA (said as ‘triple A’). The ratings agencies are the people who decide how risky a given investment might be. There are three main ratings agencies: Moody’s, Standard and Poor’s, and Fitch.
Insurers – An insurer is simply an organisation that provides insurance. The key role of the insurers in the 2008 crash was providing credit default swap insurances between banks. The main insurance giant in the crash was AIG.
In very broad strokes, a prime mortgage is a ‘good’ mortgage, and a subprime mortgage is a ‘bad’ one.
In the same way that a government bond gets a rating, individuals also get rated on Consumer Credit Ratings, but rather than given a letter code, they are rated on a score of 0-1000, depending on how good they have been at paying back debts etc.
When someone goes to take out a mortgage, there a few things that may factor into what conditions they get. If, for example, Amy goes to get a mortgage on her house and her credit score is 600 or more (i.e. she has been good at paying back loans on time in the past), then she is likely to be able to get a good mortgage with a low interest rate, and will be expected to also provide a downpayment, of say $20,000.
A key problem in the crash was that mortgage brokers approached people like Bob, who had a credit score of 450, and couldn’t afford the downpayment. Since his conditions made it more likely that he would fail to make his repayments, he will have a higher interest rate, say 6%. This is an example of a subprime mortgage.
One type of mortgage is an ARM – an adjustable rate mortgage – where the first few years are paid at one rate, then there is a reassessment and the rate changes, usually to a higher rate. If someone could pay the low rate, but not the higher one, they may default on their loan, and the mortgage dealer would take ownership of the property.
The final piece of the puzzle is leverage, which thankfully is easy to understand. Simply put, leverage is borrowing money to make more. For example, if a bank had £100, and could buy Christmas trees at £80, and sell at £120, rather than buying one at a time, and making £40 per Christmas tree season, it could borrow £900 to have £1000, buy 12 trees for £960 (with £40 left over) and sell them for £1,440, repay the £900 + £100 of interest, and have a total of £480 at the end of the day. If our bank started with £100 and borrowed £900, it would be said that it has a leverage ratio of 9:1. Provided the borrowing is followed by the selling, the leverage ratio doesn’t matter. However, if someone borrows money at a high ratio to buy something, then can’t sell it on, it becomes extremely problematic, as not only will it itself go bankrupt, but the lender could potentially lose extraordinary levels of money too.
In 2004 the Securities and Exchange Commission passed a change regarding leverage. This led to the average leverage ratio growing from 12:1 in 2004 to 33:1 just before the crash. The larger the ratio, the more of an effect that one bankruptcy has on other institutions.
At this point, you should now understand what a housing bubble is, what a financial derivative is, who the different financial players are, what leverage is, and what the subprime mortgage market is. Part 4 will explain how all these came together to cause the crash.