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The Subprime Mortgage Crisis

First, there are a ** few **  things you should know:


 * A very important fact;** not all banks are the same

("Commercial banks")
 * COMMERCIAL BANKS**: These are the banks that consumers usually transact with. The purpose of commercial banks is not to raise money but to lend money to customers and handle savings. Relevant examples are: Woori Bank (우리은행), Hana Bank (하나은행) etc.

Examples: Goldman Sachs, JP Morgan etc. ("What is investment banking?")
 * INVESTMENT BANKS**: These are the banks that interact with companies and which raise money by selling bonds and stocks or by investing themselves. The primary purpose of these banks is to raise financial profit, and they go on various ventures in order to do so.

Now...there was once a man called Bob, who had the dream of one day owning his own house.




 * Mortgages are loans taken out when you want to buy a house.**
 * So if Bob wanted to buy a 100,000 dollar house he would get a mortgage from a COMMERCIAL bank


 * There are three parts to the mortgage: the principal, the interest and the maturity. The principal is the amount you borrowed. The interest is the extra amount that you pay when paying back the money. The maturity is the length of the mortgage.**
 * So the principal of Bob's mortgage would be 100,000 dollars. The interest and maturity would change according to which bank Bob got his mortgage from - Bob has a lot of options here.


 * There are two types of mortgages: Fixed rate mortgages and adjustable rate mortgages. Fixed rate mortgages are mortgages in which the interest stays constant always, and in Adjustable rate mortgages the interest fluctuates during the time you are paying back the money.**


 * So Bob could go to Honest Commercial Bank Inc. which charges 20% interest per repayment each month for a maturity of 5 years (Fixed Rate Mortgage)
 * Math: This would mean around 2000 dollars per month.
 * Bob's reaction : Oh man... that's a lot of money that I've got to start paying... I don't know - what with my new job and everything.


 * Or Bob could go to Fraudsters Commercial Bank Co. which gives out Adjustable Rate Mortgages with a 10 year maturity. At the beginning of the 10 years there is 0.5 % interest. Bob is told that later on the interest will go up to around 800%.
 * Math: This would mean about 400 dollars a month at the beginning, and near the end... well who cares. Right?
 * Bob's reaction : THIS IS BRILLIANT! I can pay 800 dollars a month easily. Haha this is amazing. I just got my first pay cheque so with the left over money I'm going to go buy myself a T.V. for my house. I bet I'll work something out later.
 * Except... "later" Bob would be paying around 9000 dollars.


 * Stocks**: A share of a business which is bought by an individual, these stocks can go up and down in value based on the market and shareholders get money back depending on how well the company is doing (dividends)
 * Bonds**: Lending a business a certain amount of money with an agreement that you will get it back later with added interest
 * If an individual gets any of these two they will get something (a receipt, or paper document etc.) which represent a certain amount of financial value. These are called SECURITIES.**
 * Bob thinks Cola will do well so he buys 1 share of Cola for 100 dollars. He gets a piece of paper (a security) which says that he is entitled to dividends and can sell the stock as he pleases for his own profit, thus symbolizing money. Cola Inc. does better than anyone anticipated and the stock price goes up. Bob can now sell his stock for 150 dollars. He can take his 50 dollars and buy a bike.



Idealistic beginning:

America in the early 2000s had an extremely successful housing market.



Look at the red line on the chart - you can see that the housing market suddenly boomed. House prices were rising extremely fast, and people kept buying homes, and literally selling them after a week or a month - and a lot of money was made from this.

So now one day some smart guy had the smart idea that since house prices were so high, that people should be making money from this. He proposed **mortgage backed securities (MBSs)**

Securities can be thought of as pieces of paper that are bought, which entitle the recipient to a certain amount of money


 * The **INVESTMENT** banks and some other investment companies wanted to make money and a lot of money could be made from mortgage backed securities
 * What is a mortgage backed security?
 * When you pool many mortgages together and make them into a separate entity
 * Then these entities are made into securities
 * This means that people could invest in these mortgages by purchasing the mortgage backed securities, and the interest from the mortgages would go become their dividends
 * For more information go [|here] and watch the series of three videos that clearly explain MBSs
 * Thus the **INVESTMENT** banks and other investment companies bought the mortgages from the **COMMERCIAL** banks

But there were people who were willing to take on varying degrees of risk, so they instead began to create **collateralized debt obligations**

media type="youtube" key="XjoJ9UF2hqg" height="344" width="425"

//If you do not want to watch the whole thing, start watching from 3:10// The video explains that the CDOs were the same as mortgage backed securities, apart from there were different levels with varying amounts of risk. That way they can be suited to all types of people.

So this all sounds pretty good so far - everyone benefits: the banks get to make money by selling loans, the public can buy these securities and get profit, and the third parties that are buying these mortgages get profit because people are investing in them.


 * In principa**l: Yes, that was probably the idea behind these mortgage backed securities - so that everybody profits
 * In real life **: It wasn't that simple.

What happened:


 * Commercial banks were selling the mortgages to third parties.**

This seemingly innocent sentence has a lot of consequences. So think about it, since the commercial banks were selling the mortgages, the borrowers no longer paid back the money to the commercial banks, but to the third parties (including investment banks). Do the commercial banks really care whether these third parties get their money?


 * NO.**

Previously, commercial banks had only lent money to **prime** **borrowers** (borrowers that were likely to pay back the debt). But... now commercial banks began to lend money to **subprime** **borrowers** (borrowers that may not be able to pay back the loans)



This was because:
 * 1) The commercial banks no longer really cared whether the borrowers paid back or not
 * 2) There was a lot of demand and in order to meet the demand they needed to give out more mortgages
 * 3) They they thought the borrowers could probably pay it despite their credit record

Brief explanation:
 * 1) The commercial banks didn't care because the borrowers don't pay back the money to the commercial bank - they would pay back the mortgage to the third party that the commercial bank sold the mortgage to
 * 2) Because there was a limited number of prime borrowers, the banks could not lend exclusively to prime borrowers and meet the high demand for mortgages. This high demand was caused because mortgage backed securities were very popular and to make MBSs you need mortgages.
 * 3) The housing market was doing so well that they thought that even idiots could pay back the money. If you look at the graph then you can see how fast house prices were going up. So if someone took out a mortgage to buy a house, bought the house and sold it the next month they would still get enough money to pay back the mortgage.

But number 3 only applies if the people that buy the houses are doing it for profit. What about people like Bob, who want to buy the house and stay there, but can't afford to pay back the mortgage? (By the way, Bob is a subprime borrower)


 * Answer: ARMs (Adjustable Rate Mortgages)**



As this picture shows, in Adjustable Rate Mortgages the interest keeps changing - ultimately going up. However, because prices start very low, subprime borrowers are enticed into getting the loan.

Who is at fault here?
 * Subprime borrowers: they took out the loans despite the fact that they knew how much it would be going up
 * Banks: they issued the mortgages to subprime borrowers, and most of the time they tricked the subprime borrowers by using complicated jargon (because they needed to issue more mortgages) and made the borrowers think that eventually they would be able to pay back.
 * The banks engaged in [|predatory lending].

The Long Run:


 * Adjustable Rate Mortgages**. Scroll back up to the top and look at Bob's reaction and the math regarding adjustable rate mortgages.

Now what do you think will happen if this is multiplied amongst hundreds of thousands of people?

It's pretty easy to see that people would become unable to pay back their mortgages - Bob cannot pay 9000 dollars, even after 5 years. This was the case for most other subprime borrowers that took out adjustable rate mortgages. Even though they were able to pay back at the beginning, it was simply a matter of time before they began to default on their mortgages. (Default: Not pay back)



You can see in the above chart that the subprime borrowers default more than prime borrowers and that the subprime borrowers with an adjustable rate mortgage default far more than those with a fixed rate. Yet banks began to give out an extremely large amount of adjustable rate mortgages to subprime borrowers, a descision that would eventually backfire - it was only a matter of time.


 * What happens when they default?

At this moment the investment banks have bought most of the mortgages from the commercial banks, and so have the right to the house when then people default on their mortgages, so the bank takes the house if they cannot pay the mortgage. This is called a foreclosure.

**
 * media type="youtube" key="8TsO6wkdzhc" height="344" width="425" ||
 * Homeowners go to drastic measures to express rage at foreclosures ||


 * But investment banks don't want houses** - a bank is not a real estate agent - and thus they neither want to hold on to houses for profit, nor spend a lot of time trying to sell them for the best price. So, to get rid of the houses as fast as possible they sell them for extremely cheap prices. Foreclosed properties can be sold from as low as 30 per cent of the original asking price of the house.

To see how cheap foreclosed homes are for yourself go [|here].

As more defaults occurred these very cheap foreclosed homes began to appear more and more frequently on the market. Which would you prefer?
 * 1) A foreclosed home which is 70% cheaper
 * 2) A home sold by real estate agents which are much more expensive

So in order to compete with these foreclosed homes, the prices of new houses had to drop which drove down the price of housing.

WHAT?!


 * Housing prices had to drop.

Going back to the story of Bob:

Bob was shocked and appalled to learn that the house prices were dropping only 1 year after he had bought his home with the mortgage from Fraudster's Bank Inc. His mortgage payment was increasing more and more drastically as housing prices kept falling. Eventually price of the house that he himself earned fell below what he was paying back via mortgage repayments. If Bob were to put the house on the market it would be worth 60,000 dollars even though Bob paid 100,000 dollars for it.

"This is stupid." Said Bob to no one in particular. "I'm paying more for the house than it's even worth."

The next day Bob defaulted on his mortgage, and the day after that scary people arrived to take away his house. The house was taken by the bank and sold for 20,000 dollars. This contributed to the number of foreclosed homes and drove down housing prices even more.

And there were thousands of people just like Bob.

And there you have it: ** The SUBPRIME MORTGAGE CRISIS.

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