Credit Suisse Flashcards
What is a credit crisis?
It’s a worldwide financial fiasco involving terms like Subprime mortgages, Collateralized debt obligations,
Frozen Credit markets, Credit default swaps etc..
How does it happen?
Credit crisis brings two groups of people together. Homeowners and investors, homeowners represents mortgages, investors represent money, these mortgages represent houses, and money represents large institutions like pension funds, insurance, sovereign and mutual funds. They are brought together by a bunch of banks and brokers commonly known as Wall Street.
What happend and how it started?
Investors are sitting on their piles of money, looking for good investments to turn into more money. Usually, they buy treasury bonds, but Fed Chairman reduced the interest rate to 1%. very low ROI. But the flip side is the bank can borrow money for 1%. There is an abundance of money. This makes it crazy for them to go with Leverage.
What is leverage?
Leverage is borrowing money to amplify the outcome of a deal.
How did the credit crisis happen? Was it because of the leveraging of credit from FED?
Leveraging gives an idea to Wall Street. They can connect the investors to the homeowners through mortgages.
How did this happen?
The family wants a house and saves for a down payment, and calls a mortgage broker, he connects the family to a lender who gives them a mortgage. The broker makes a nice commission, and the family gets a house and becomes homeowners. One day, the lender gets a call from an investment banker who wants to buy the mortgage. The lender sells it for a nice fee. The investment banker then borrows millions of dollars and buys thousands more mortgages, and put them into a nice little box.
What does the investment banker do with his nice little box?
This means that every month, he gets the payment from homeowners of all the mortgages in the box. Then he sets his banker wizard on it to work their financial magic which is basically cutting it into 3 slices. SAFE, OK and RISKY. They pack the slices back up in the box as CDO. collateralized debt obligations. CDO
How does CDO works?
CDO works like three cascading trays. As money comes in first tray fills first, then spills over into the middle, and whatever is left into the bottom. Money comes from homeowners paying off their mortgages. If some owners don’t pay their mortgages and default on their mortgages, less money comes in, and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer. To compensate for the higher risk, the bottom tray receives a higher return while the top receives a lower but still good. To make the top tray even more secure, the bank will set up a small fee. CDS. This makes the top tray Tripe A and the next Triple B. Investment banks make millions and repays his loan.
How did the subprime loan started
The investment banker wants to make more money and calls the lender wanting more mortgages, the lender calls up the broker for more homeowners, but he cant find any. Everybody who qualifies for a mortgage already has one. but they have an idea; when homeowners default on their mortgages, the lender gets the house, and houses are always increasing in their value. Since their covered in case the homeowner defaults, the lenders start adding risks to new mortgages, not requiring a down payment, no proof of income, and no documents at all. So instead of lending to responsible owners called prime mortgages, they started to give loans to less responsible. These are subprime mortgages. This is the turning point.
After subprime loans effectuated what happen?
So just like always, the mortgage broker connects the family with a lender and a mortgage making his commission. The family buys a house, the lender sells the mortgage to the investment banker, he turns it into a CDO and sells slices to the investors. This is great and all rich. if the homeowners were to default, they were selling off their risk to the next guy. like playing hot potatoes with a time bomb.
What happens when subprime homeowners default on their mortgages?
When the homeowner default and the mortgage is owned by the banker, this means he foreclosures and one of his monthly payments turns into a house, no big deal, he puts it up for sale, but more and more of his monthly payments turn into houses, now there are so many houses to sale in the market creating more supply than demand the housing prices are not rising anymore, in fact, they plummet. This is a problem for homeowners paying their mortgages as all the houses in their neighborhood go up for sale, and the value of their home goes down. So they stop paying too. Now the investment banker is holding a box full of worthless houses, he calls up his buddy, the investor, to sell his CDOs, but he says no thanks. He knows the stream of money is not even a dribble anymore. The whole financial system is broken. Everybody is going bankrupt. Welcome to the cycle of credit.
What is a Credit default swaps?
A credit default swap is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting.
Collateralized Debt Obligation
A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets. These underlying assets serve as collateral if the loan goes into default. The tranches of CDOs indicate the level of risk in the underlying loans, with senior tranches having the lowest risk
What is an institutional investor?
Institutional investors are large entities such as pension funds, hedge funds, and insurance companies that hire finance and investment professionals to manage large sums of money on behalf of their clients or members.
He knows the stream of money is not even a dribble anymore.
This could be due to various reasons such as declining property values, lack of rental income, increased expenses, economic downturns, or other financial challenges affecting the property. The investment banker is facing a situation where the value of the houses he holds as assets has significantly decreased, leading to a scenario where the stream of money from these assets has dried up. This lack of income flow is likely due to homeowners defaulting on their mortgages, causing a ripple effect throughout the financial system. As a result, the banker is unable to sell these depreciating assets and is struggling to repay the borrowed funds used to acquire them. The investor’s refusal to purchase the CDs linked to these assets further exacerbates the banker’s financial distress. The overall financial system becomes paralyzed as more investors and lenders face similar challenges, leading to widespread bankruptcies and economic turmoil.
When someone mentions that “the stream of money is not even a dribble anymore” in the context of real estate, it suggests that the property is no longer generating the expected or desired level of income, making it less profitable or potentially causing financial difficulties for the owner.
