The GFC is a massive topic (which is why we’ve decided to spread this article over numerous parts). Now, you might be asking yourself – why so long? Well readers, there’s a lot more to the GFC that meets the eye. So, we’re going to give you the GFC in a nutshell then break it down further. Once upon a time the world experienced a real estate bubble (some people might know this as “the housing bubble”), and it was just a matter of time before this bubble would burst. Imagine chewing bubblegum and you blow a bubble… it eventually bursts and makes a mess; a mess just like the GFC. Houses in the USA were bought left, right and centre, and sub-prime mortgages were becoming even more popular. For those not in the know, a sub-prime mortgage is leant to someone who may not necessarily have the financial means to repay the loan – risky business. Just think, would you be willing to loan money to someone you don’t really know without knowing you’ll get it back? You may remember this being briefly being touched on in our Part Three of our Behavioural Finance Mini Series.
Anyway, these sub-prime mortgages were bundled all nicely together into a financial product called a Mortgage-Backed Security (MBS) or Collateralized Debt Obligations (CDO’s) and then sold off to investors willing to buy. They sound pretty fancy and not too shabby, but once you get down to the mechanics of them eyebrows should raise, especially if leant to uncreditworthy individuals.
Alright, so far we’ve got:
MBS: An asset backed security that is secured by a mortgage or a bundle of mortgages.
CDO: This is a type of asset-backed security (in the GFC’s case, an MBS). It basically pools together your cash-flow-generating assets and then repackages this into tranches that are then sold to investors.
What is a tranche you ask? Given there are different types of mortgages and hence different levels of risk, a tranche has the goal of dividing up the different mortgage profiles into pieces so that when an investor is interested, they can then choose the MBS which possesses desired level of risk.
So, unfortunately for the whole world, these financial products were being bought and sold, and bought and sold with no one ever questioning their origin. When people started to default on their mortgages, these financial products were soon worth nothing… and so our story begins here.
Everyone wanted to live the great American dream! You know, the home in the suburbs with a nice white picket fence, wrap around porch… Banks began to advertise mortgage loans and emphasized how piss easy it would be to get one even if you couldn’t make consistent repayments… sounds similar to the Australian market at times, so these actions should definitely raise eyebrows. Anyone could qualify for home loan! Hopefully you’re thinking to yourself right now how wrong that is, how could the bank possibly loan Joe Shmoe money when he hasn’t had an income stream in X amount of years. I bet you now begin to see an issue… yes, this is a freaking huge issue. For these lucky star individuals the banks issued sub-prime loans (see above). This was the age of easy lending in the US housing market with low-interest rates and reduced bank regulation. But, these mortgages were complex and banks often bumped up the repayments after only a few months (sneaky bastards, remember we touched on financial greed? Point proven). But, mortgage lenders didn’t want these ‘toxic products’ on their books and therefore, they were sold off to Wall Street who had a field day! There was pretty much zero regulation on these transactions, and yes you guessed it, banks made a fortune in fees from buying and selling! These financial products were selling like hot cakes, yet no one claimed responsibility for them. Everything smelled of greed… everyone pointing the finger the other direction when in reality it should have been pointed back at themselves. Seeking out massive mortgages for homes otherwise too expensive just because the banks would, and the banks turning a blind eye to the lack of creditworthiness and forgetting about checks and balances… then Wall Street just making squillions off of horrible judgment.
Outside of the US, one of the first places to feel the wrath of greed was London. Now, before the destruction, London was at its peak, they were in the Golden Age of finance. Why was there little regulation on these products? Well, New York and London were competing for top spot for the most powerful financial centre in the world. The analysts who were selling these products, they didn’t care about who they were selling to, they were there to earn money and make bonuses, even if that meant they had to lie, steal and cheat – GREED. How did they do it without people questioning them? Well, if you present something in a way where you seem to really believe in it, people trust you, and they trust what you’re selling… that’s how, someone who has had massive manipulative sales tactics. This idiocracy soon spread and started to infect other parts of the world and there’s one country in particular that was also at the backbone of the GFC… can you guess which country? You’ll have to wait until next week to find out in Part 2 of our GFC coverage…