This will be the most interesting thing you will read today.
If you want buy a house, you will go a bank will ask for home loan so that you can pay mortgages and one day own that house. Home loans are disbursed on the basis of your credit ratings so basically there are two kinds of mortgages:
Traditional mortgages: It generally require a minimum down payment of anywhere from five percent to 20% and a credit score of more than 700.
Borrower has to pay a fixed interest rate of say 6% throughout the tenure.
Subprime mortgages: A subprime mortgage is a type of mortgage that is normally issued by a lending institution/banks to borrowers with low credit ratings below 700. As a result of the borrower's lower credit rating, a Traditional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Here interest rates are higher and variable(In ARMs). Say 5% for first 5 years and then 7% for next couple of years and then 10% and so on.
So, Bank charged 6% as interest in Traditional and more than 6% in Subprime.
now they got a brilliant idea. They offered big investment bankers like Morgan Stanley, Lehman brothers to buy those mortgages in the form of Mortgage Backed Securities(MBS) and in return banks demanded commission. It is is win-win deal for Banks and Investment bankers because Banks are transferring the risk and Investment bankers is going to receive high returns in those mortgages in the form of interest.
So basically banks were acting like a middleman and what borrowers paid as a mortgages they simple transferred to the investment bank’s investors pool of money.
That was indeed a perfect profitable scenario where everybody were making making.
Borrowers: Got the houses and paying the martgages.
Bankers: Selling the MBS to Investment Bankers and getting commissions.
Investment Bankers: Got the best and the continuous source of income for investors.
Now the actual game begins, ‘The Game of Greed’
When banks observed that they are getting less interest(%) in Traditional mortgages and getting more Interest(%) in Subprime then they started increasing the number of of dark shit in MBS, The Subprime(Risky Mortgages) than that of Traditional ones(Less Risky Mortgages).
Banks sold the Mortgage Backed Securities(MBS) in the form of CDOs.
A collateralized debt obligation (CDO) is a structured financial product that pools together cash flow-generating assets and repackages this asset pool that can be sold to investors. A collateralized debt obligation is named for the pooled assets — such as mortgages, bonds and loans — that are essentially debt obligations that serve as collateral for the CDO.
Big rating agencies also played the game and given AAA rating to all BBB Bonds which were actually Subprime(Too Risky).
Now here comes Michael J. Burry
He identified these data already knew that US housing market is going to collapse.
This time he has done something that nobody could have imagined, He Shorted (Betting against the market) the US housing market with his investor’s $1.3 billion wealth and placed a Moratorium (a legal authorization to debtors to postpone payment) on withdrawals.
His own investors thought he went out of his mind but he didn’t stop here. He went to big banks and Bought Credit Default Swaps which is kind of insurance of his investments. For Ex- If housing market collapsed then those big banks where he visited to buy those Swaps will pay him the insured amount to Bonds he shorted and instead of that banks demanded high yearly premiums.
A credit default swap or CDS is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. In a credit default swap, the buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract. In return, the seller agrees that, in the event that the debt issuer defaults or experiences another credit event, the seller will pay the buyer the security’s premium as well as all interest payments that would have been paid between that time and the security’s maturity date.
In 2003 and 2004, with the U.S. housing boom well under way, Lehman had acquired five mortgage lenders and made to borrowers without full documentation. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenues of $19.3 billion.
However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high.
On June 9, Lehman announced a second-quarter loss of $2.8 billion, its first loss since being spun off by American Express,
The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on Sept. 9, as the state-owned South Korean bank put talks on hold.
The news was a deathblow to Lehman, leading to a 45% plunge in the stock and a 66% spike in credit-default swaps on the company's debt. The company's hedge fund clients began pulling out, while its short-term creditors cut credit lines.
The firm reported a loss of $3.9 billion, including a write-down of $5.6 billion and the same day, Moody's Investor Service announced that it was reviewing Lehman's credit ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a ratings downgrade.
These developments led to a 42% plunge in the stock on Sept. 11.
With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Last-ditch efforts over the weekend of Sept. 13 between Lehman, Barclays PLC and Bank of America Corp. (BAC), aimed at facilitating a takeover of Lehman, were unsuccessful.
On Monday Sept. 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on Sept. 12.
With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman's demise also made it the largest victim of the U.S. subprime mortgage-induced financial crisis that swept through global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008 – the biggest monthly decline on record at the time.
As Berry bet against the market, he sold his SWAPS to another big players and demanded a five fold price as compared with its original SWAP value.
As a results Burry along with fellow investors like Jared Vennett got the high valued Cheque for Deutsche Bank.
Congratulations! You understood the 2008 World Economic Crisis in minutes.
(Author is SEBI Regd. Research Analyst).