During the Promos when I was mugging, my thirst for some comparable form of break led me to follow a bit of the financial crisis, since not knowing what was showing on TV mobile was a bit of a challenge for my inquisitive self. Might not be very interesting to some though... I'll admit. It was a bit dry to me, too. Nonetheless, its effects seem to be far-reaching, so you might want to know.
This is a video on the financial crisis occuring now, summing it up in simpler terms (compared to what you might read in the newspapers)
In addition, there are some other facts missing in the video that can aid your understanding. Word of caution though, these answers are not 100% true, and are either my speculations, from what my parents told me, or a mix of both.
Why the mortgage payers couldn't pay the mortgage any longer:
The mortgages were at first with usual fair interest rates (by market standards) and adequate financial background checks to ensure that the homeowners could afford to pay back the loans. These were divided into smaller chunks and sold out to the CDOs mentioned in the presentation. This was done so that the CDO manager minimises his risk (of payments not being met) and quickly liquefies his assets. In essence, he transfers the risk to ther 'wine glasses'.
However, when the housing market bubbled, the CDOs found large sources of untapped revenue-in the poorer citizens who wanted to own homes, but could not afford the loans. They thus decided to lower the criteria and change the interest system (essentially sub-prime loans) to a sneakier one: low interest rates for the starting years, but one with which the interest rate soars quicky and unnoticably, such that there is virtually no way the homeowners can pay back the loan.
This is when the foreclosures start the cycle; since homeowners cannot pay back their loans, the CDOs managers seize the property, and the homeowners just walk away. It's apparently a credit quirk only seen in the US, according to my Economics teacher. All other nations require the homeowner to become bankrupt of incur some sort of financial debt, even after foreclosing. This is all fine, because the new property is repackaged and loaned out, and the unknowing poor mortgage payers will keep filling the coffers of the CDO.
What happened was the pop of the housing bubble, and the revenue stopped flowing; the houses couldn't sell any longer at the same value. The cycle was broken, and the assets that were meant to be assured to the secondary investors were not there at all. these assets had been assured a value by credit rating companies, but there is no point of the assets if there is no capital to back it up. Think of it as saying John owes you $1K, and you claim you have the $1K on hand, since, after all, he is going to pay you. What's worse, you use the 'funds' to buy other things, and hand the I.O.U. from John to the other party as payment. What if John always pays, but this time around, he can't?
The fact that these "I.O.U.s" were traded also accounts for the reason why the world is affected; the tentacles of the seemingly trustworthy assets were spread wide and far. The reason for their initial popularity: the tantilising high interest rates that followed in the years to come, extracted from the homeowners, was one that many found worth their risk.
Why were the assets given good ratings by credit rating firms? There are several reasons and speculations as to why this is so. Firstly, there is one where apparently firms made contracts that stipulated that so long as the rating firm does not give a good credit rating, there would not be any payment made. they managed to get away with this because a lot of institutions were doing the same thing, and it was either a take it or leave it deal.
Another speculation involves bribery and corruption, the age-old tradition of banks/institutions paying for good credit ratings.
One firm role is that initially, the rating firms were convinced that since the risky but high interest loans made up small amounts of packaged investment deals, the risk as a whole for the package was more or less low. Much of the package could consist of seemingly safe deals from trusted names, such as General Electric. Thus due to this 'overall low risk' of the packages being offered to the investors, they were certified AAA.
Is this it? What part does short selling play then? Short selling is the selling of assets without actually posessing the assets. this can be done through borrowed short selling (1) and naked short selling (2)
(1) This is where a person borrows assets from either a shareholder of the company or the company itself. The person is willing to lend the asset since he isn't doing anything with it at that moment, and earning a bit from the lending wouldn't hurt. So the borrower calls his broker and sells the borrowed stock, having to get it back (to return to the lender) in a stipulated deadline. It's up to him to make or lose money from trading the stock by the end of the deadline. This brings the simple concept of buy low, sell high into the picture.
(2) On the other hand, why deal with borrowing? Why not just claim you have the asset, so that the gains are more for keeps? Naked short selling is just this. Again, buy low and sell high, and at the end of the few days, when the stock exchange does (it will) find out you are doing naked short selling, it will buy back the asset at 2 bids higher, causing you to lose some gains, or just lose.
You may now ask, why then are they able to claim they have the funds, when they don't? Won't there be checks before the selling takes place? The answer is, more often than not, when done through a broker, the system works in trusting you have the asset. This is because many of the assets are pooled into a system, and it is very likely that some other financial guru has put his stocks into the same system, the very ones you claim to have. This is why the exchange has to buy back the assets from you, to return it to the system so that when the guru wants to move those assets around, he isn't inconvenienced.
So then, how are both short selling methods to blame for excacerbating the problem? Well, when the problem came when the short selling attacked the falling stocks from the bubble burst. The harassing of the market by small individuals who wanted to cash in on the rapidly falling situation happened to panick other investors more, since with the unrestrainted selling of the unowned shares. people thought the situation worse than they imagined. This is partly why governments have stepped in to heavily penalise short selling. In the past, when markets were stable, short selling was helpful in providing indicators to a certain firm's valuation by the individuals, and usually harmed the ecomony little, since the lower profits earned through said method was not enough of an incentive to attract wanton short selling.
posted by joseph at 2:43 PM