Subprime Meltdown

  

Categories: Banking, Credit

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.

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Finance: What was the Market Crash of 19...1 Views

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and finance Allah shmoop What was the market crash of

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1929 aren't people while there was cheap and easy credit

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and that's what the crash was really about Greed and

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a big bad bear market nobody could have imagined happening

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at the time right Nonprofessional retail investors were allowed to

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borrow some 90% of their investment portfolio to go buy

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new stocks beyond the stocks they already owned So quick

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Math If someone invested $1000 of their own hard earned

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savings and the stock tripled like it did in the

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mid twenties for a lot of easy money yeah well

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then that $1000 would have become $3000 in a very

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short period of time Great but in fact margin rules

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were almost non existent in era it was coming to

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allow investors to have 334 even five times they're invested

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equity as borrowed margin or set another way on an

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initial $1000 invested Many investors were stupidly allowed to buy

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$5000 worth of stocks So really volatile right If things

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go the wrong way it hurts But let's take a

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simpler approach If an investor had been allowed to margin

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there account up to 90% of its value like 50%

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is generally the maximum today that you could borrow Then

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that investor on $1000 of their own invested capital could

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have purchased $1900 worth of that stock that tripled So

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doing the math three times 1900 gets you What is

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that $5700 You pay back the $900 of margin that

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you borrowed against yourself and you'll have netted something like

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$4800 in profits albeit a little bit last because you'll

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have paid interest to the brokerage's that allowed you to

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borrow money in this manner That's a margin interests So

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in the margin case while the $1000 ofyour invested capital

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maybe 4.8 times your money rather of any paltry three

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times your money had you not been leveraged and that's

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way more dough to crow about right And in those

01:51

days well that extra $1800 would have bought you like

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a house So everything was great 90 50 1926 27

01:57

28 when the market mostly generally went up and provided

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easy money for the well heeled invest who could play

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the game and everyone was incentivized to keep the party

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rolling Yes that's a flapper girl Brokerages could charge fat

02:09

commissions on transactions and nobody complained Why Well because the

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markets rise more than eight for those commissions Brokerages could

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also charge big interest rates on borrowed margin because the

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markets rise Masked all those costs and everything ended up

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sweet and beautiful is the prince married the princess and

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they went off to their castle in the clouds Oh

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but wait Then reality struck One day a not so

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kindly old woman offered Snow White the apple she bit

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and the market went down down down Such that panic

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selling ensued and more or less Everyone who was on

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the hook to pay back borrowed money in the form

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of margin had their loans called immediately by the kindly

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smiling brokerages as they more or less lost while mohr

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than everything meaning that not only did the investors lose

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all of their investments but the brokerages who had underwritten

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those loans themselves went bankrupt because the stocks went down

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so far that even the margin limit covenants were violated

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That is on the stock purchased $4000 with the $900

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a margin That $1000 worth of stock ended up being

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worth well $500 or maybe a lot less so even

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if the brokerages sold every share of that original $1000

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investment now worth only $500 While the $500 in original

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value remaining didn't even come close to covering the $900

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in margin the brokerages clients took out in loans in

03:30

the first place So yeah it sounds like the crazy

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maddening crowds at work and the crowds back then were

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mad Everyone was buying on margin and if you weren't

03:39

well then sucker you were just yet another sucker hauling

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bricks or ice or railroad ties for a living Life

03:46

was way easier when you could just phone in a

03:48

stop order in you know play golf all day So

03:50

this was bad and 1/2 and it's part of the

03:53

process of investors panicking They lost trust in the financial

03:56

system of America Many investors then wanted to sleep on

04:00

a pile of their hard earned saved $20 bills so

04:03

they ran to the bank on Mass and asked for

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their money back They wanted to withdraw all their money

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from the banks And guess what The banks didn't have

04:11

the money sitting around because they loaned it out for

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mortgages and car loans and horse loans or over the

04:16

head back then So the frame then was a failed

04:19

stock market Lack of trust in the banking system in

04:21

America no credit then offered Teo Well pretty much anyone

04:25

You can imagine what America would be like if we

04:27

didn't have credit cards alive and well and no adult

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supervision to get this country out of the deep financial

04:32

hole that I dug well along came FDR With the

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New Deal he primed the pump and creating federal guarantees

04:39

for banking deposits upto a little certain amount like FBI

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see limits of 100 grand and change today He also

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enforced vastly stricter regulations on banks brokerages and pretty much

04:49

anything financial such that going forward this country ran a

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dramatically Mohr conservative balance sheets and investment people had to

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disclose well pretty much everything The result Well gradually greed

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came to overtake fear again and in mid thirties or

05:04

so the market slowly trundled northward again It's what I

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look like And then everything gave rise Teo Well this

05:10

really beautiful sight Welcome to America

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