What Happened in Collapse of 2008-2009 ?
The Housing Bubble Bursts – U.S. Bank like Countrywide and Washington Mutual continue to give housing loan to low-income household (sub-prime family) from 2000 – 2007 because housing market boom. Housing values fall as supply overwhelms demand. Many sub-prime borrowers find their house worth less than their mortgages, and they can’t afford to pay monthly payment as its interest adjustable. Defaults rate rise because borrowers don’t pay and foreclosure come in, which sends housing prices lower. The downward spiral begins.
CDOs Festival – Investors particularly foreign investors seeking higher yields (return on investment), then the new innovation kicked in. Government backed-up private organizations like Freddie Mac and Fannie May buys mortgages on the secondary market, combined them, and sells them as mortgage-backed securities to Investment Bank; then Investment Bank sell to investors on the stock market. Banks and investors all over the world bought these CDOs because it’s rated AAA so they assumed it must be safe.
Leverage Loves Greed Company – Investment Bank or Financial firms like Lehman Brothers, Merrill Lynch and Bear Stearns leverage their money 30 times to load up on CDOs as much as they could to sell to investors so they can make a gigantic profit out of nothing. This mean they bought $300 billion CDOs by using ONLY $10 billion money.
AIG vs. CDS – How come insurance company involve in this turmoil? Answer is Credit-Default Swap (CDS). Yes!! AIG sells Credit-Default Swap for those CDOs to the most of Banks and financial firms in order to insure their money in case of CDOs default.
The Mortgage Collapse – Borrowers whose is low-income family begin to late on payment, and then default on loans rise to maximum 9% this year. Lender like Countrywide and Washington Mutual take a hit first and finally collapse.
Finance institutions is Next Victim – Rising delinquencies in home loan mean that CDOs lose value. Nobody wants to buy CDOs anymore and everyone wants to liquidate it. The investment banks must take write-downs (bad debt on balance sheet). To compensate, they must raise new capital (money), probably by selling their bond or accepting external fund, to maintain balance ratio between their asset and capital. However, they have no way out to raise enough capital because they already leverage too much.
CDS Ripple Hit AIG – Many CDS were sold as insurance to cover those exotic financial instruments (CDO) that created and spread the subprime housing crisis, details of which are covered here:
As those mortgage-backed securities and collateralized debt obligations became nearly worthless, suddenly that default was happening daily. The banks and hedge funds selling CDSs were no longer taking in free cash; they had to pay out insured money. However, most banks were not all that bad off, because they were simultaneously on both sides of the CDS trade. Most banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection to someone else at the same time. When a bond default; the banks might have to pay some money out but they'd also be getting money back in. Everyone, except for AIG do that.
AIG was on one side of these trades only. They sold CDS. They never bought. Once CDO bonds started defaulting, they had to pay out and nobody was paying them. AIG seems to have thought CDS were just an extension of the insurance business. But they're not. When you insure homes or cars or lives, you can expect steady, actuarially predictable trends. If you sell enough and price things right, you know that you'll always have more premiums coming in than payments going out. That's because there is low correlation between insurance trigger events. My death doesn't, generally, hasten your death. My house burning down doesn't increase the likelihood of your house burning down.
Not with CDO. Once some CDO bonds start defaulting, other bonds are more likely to default. The risk increases exponentially. Credit default swaps written by AIG cover more than $440 billion in CDO bonds. AIG has nowhere near enough money to cover all of those. Their customers-those banks and hedge funds buying CDSs – started getting nervous. So did government regulators. They started to wonder if AIG has enough money to pay out all the CDS claims it will likely owe. Just when AIG is in trouble for being on the hook for all those CDS debts, along comes this credit-rating problem that will force it to pay even more money. AIG didn't have more money. The company started selling things it owned-like its aircraft-leasing division.
All of this has pushed AIG's stock price down dramatically. That makes it even harder for AIG to convince companies to give it money to pitch in. So, it's asking the government to help out because the global economy could, possibly, come to a halt. Banks all over the world bought CDS protection from AIG. If AIG is not able to make good on that promise of payment, then every one of those banks has lost that protection. Overnight, the banks have to buy replacement coverage at much higher rates, because the risks now are much worse than they were when AIG sold most of these CDS contracts. In short, banks all over the world are instantly worth less money. The numbers seem to be quite huge-possibly in the hundreds of billions. To cover that instantaneous loss, banks will lend out less money. That means other banks can't borrow to pay this new cost, and weaker banks might not have enough; they'll collapse. That will further shrink the global pool of money.
