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The 2008 Financial Crisis
How a bad loan became a safe bond
Eight steps, about twelve minutes, a question at each. You need no economics and no preparation, only a willingness to guess before you are told.
Step 1 of 8
American house prices had never fallen across the whole country until they did, and by 2006 much of the new lending was going to people who could not have borrowed a few years earlier.
The question
American mortgages were gathered into pools and each pool was sold on as a bond. The slices at the top of a pool were graded triple-A, the highest grade there is, and Moody's, one of the firms paid to grade them, put that grade to 30 mortgage-related securities every working day in 2006.
The losses that followed were counted in trillions of dollars, on four different measures at four different dates. The firms holding these securities had borrowed to buy them, and the two American bodies that measured how much they had borrowed do not agree with each other.
Eight steps take it in order: how a pool became a bond, how slicing it produced safe-looking securities, who graded it, what the losses came to, how the firms were funded, the leverage disagreement, the run on collateral, and where ordinary cash met it.
What this module covers
Written for every level. Tap any underlined word for what it means, and open the boxes below for the economics behind each decision. If you already know the theory, skip both and the history reads straight through.
A bank that lends someone the money for a house waits years to get it back. Selling the loan on meant it did not have to wait.
American mortgages were gathered into pools, and each pool was turned into a bond and sold to investors.
A bond is a promise to pay whoever holds it. Bonds built out of pools of mortgages are called mortgage securities, and whoever buys one is owed the payments the American households in that pool make.
The bank had its money back straight away once the loan was sold, and an American bank could lend it to somebody else.
Moody's, a , gave the top grade to nearly 45,000 of these mortgage securities between 2000 and 2007.
Take a guess. You are not expected to know the answers, and being wrong is what makes a number stick.
The pool has been turned into a bond and sold. Who now loses money if the mortgages in it stop being paid?
For scaleSix private-sector companies in the United States carried that same top grade in early 2010.
A pile of loans that people might never pay back is a hard thing to sell. Cutting the pile into ranked slices is how it was sold.
Each pool of mortgages was cut into ranked slices, and most of what came out of a pool of risky American mortgages was sold as low-risk securities.
Every payment the pool collects goes to the top slice first, and only what is left goes down the ranking. Losses run the other way, from the bottom upwards: the lowest slice is wiped out before the next one loses anything. An investor buys one slice and chooses which, taking a larger share of the payments in return for taking the first losses, or a smaller share in return for being paid first. The top slice is covered as long as enough of the households in the pool keep paying, which is why spreading the money across many loans was thought to make it safe.
Put it another way. Think of it like a queue at a payout window: the people at the front are paid out of whatever comes in, and only the people at the back go home with nothing when the money runs short.
The slices are s, ranked against each other. The top slice is paid first out of whatever the pool collects, and the bottom slice takes the first losses.
The top slice of a pool of risky mortgages was routinely given triple-A, the highest grade a bond can be given.
What made the top slice of a pool of risky mortgages count as low risk?
For scaleThe bottom slice of a pool had to be wiped out completely before the slice above it lost anything.
Moody's put its triple-A grade on mortgage securities every working day through 2006.
Moody's was paid for each grade by whoever was selling the security, and the grade was what an investor bought on.
In 2006 Moody's gave that grade to 30 mortgage-related securities on an average working day.
The grade did the work no buyer could do alone, which was to judge thousands of separate American mortgages. The firm that wanted the grade chose who would give it and paid for it.
Of the mortgage securities Moody's rated triple-A in 2006, how many out of every hundred later had that grade taken away?
For scaleTriple-A is the highest grade there is, and it is the grade Moody's was giving here.
Module 2 of 7 in The 2008 Financial Crisis
[1] The grades, and how little equity there was: Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, Official Government Edition, January 2011.
[2] The same firms, measured a second way: United States Government Accountability Office, GAO-09-739, Financial Markets Regulation, 22 July 2009.
[3] What the losses came to, and what lenders demanded: Bank of England, Financial Stability Report, Issue No. 24, October 2008.
[4] The write-downs still expected: International Monetary Fund, IMF Survey, Further Action Needed to Reinforce Signs of Market Recovery, 21 April 2009.
[5] Where ordinary cash met it: Bank for International Settlements, 79th Annual Report, chapter II, The global financial crisis, June 2009.
[6] What euro area banks absorbed: European Central Bank, Financial Stability Review, June 2009.
[7] Haircuts, surveyed independently: Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality, CGFS Papers No 36, Bank for International Settlements, March 2010.
[8] The part of the market that held: Adrian, Begalle, Copeland and Martin, Repo and Securities Lending, Federal Reserve Bank of New York Staff Report No. 529, December 2011, revised February 2013.
[9] Government bonds, and what did not change: Financial Stability Board, Securities Lending and Repos, Market Overview and Financial Stability Issues, 27 April 2012.
Country data from the World Bank (CC BY 4.0) and the UNDP Human Development Report (CC BY 3.0 IGO)
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