So basically the whole 2008 economic drama initially involved two groups: homeowners and investors.

Typically, investors invest in treasury bills to make money. The amount of money they make depends on the interest rate. So the higher the interest rate, the more money the investors will make. But in the years prior to 2008, events caused the interest rate to lower, to as low as 1%. This means the investors couldn’t make as much money as they could have if interest rates were higher.

But interest rates affect many more groups of people, not only investors. Economies such as the American economy function by borrowing money. Now banks cannot borrow money for free, they have to pay a fee. This fee or cost for borrowing money depends on the interest rate. The lower the interest rate, the cheaper it is to borrow money. So with this ultra-low interest rate, banks grab the opportunity and borrow loads of dough. Now how does this connect to the housing market?

Basically, if a family want to buy a house, they would need a mortgage. A mortgage is the loan someone takes to buy a house. Now these families need a little help to get the mortgage so they go to a broker. This broker helps the family get a mortgage from a lender and makes a commission on the deal. The family now has a house. But how does this connect to the investors?

So the investors buy the mortgage from the lender. Why? Because the investors will receive mortgage payments from the homeowners, making a profit. But the investors don’t buy just one or two mortgages. They buy hundreds.

Now the important thing to remember is that not all homeowners are the same. Some of them can pay off their mortgages more easily than others. This is because they have stable jobs, more savings, etc. So the investors need to know how “safe” the mortgages are. The credit rating agency rates how safe the mortgages are. A “AAA” (triple A) rating means that it is as safe as it can be. Like the safe mortgages, they are ok mortgages and risky ones. The investment banker can then sell these to whoever wants to buy them (other investors, bankers, hedge funds, etc) to make a laaaarge profit.

These people are much happier with this investment because their other option was the treasury bills (remember the super low 1% return?). So they earn a bunch of money but now want more mortgages so they can earn even more money. So the process begins again. Investor calls mortgage lender, mortgage lender calls broker, broker finds homeowners. Now this process can sustain itself for a while. But after some time, the number of homeowners run out.

But people are greedy. To sustain this process, they must find homeowners. So they settle for more risky homeowners. People who don’t have a stable income or who have no proof of income. So these risky people get a mortgage to buy a house. This is known as a sub prime mortgage (think high high risk!).

So now the process begins again. Broker, mortgage lender, investor. Now this can work for a while. But remember: the people buying the mortgage are RISKY! This process can only work if the money is flowing in from somewhere. But now these new homeowners cannot pay the mortgage and default. So the flow of money decreases and stops eventually. When the homeowners fails to pay the mortgage, the house goes to whoever bought the mortgage (like a banker). Now since the number of subprime mortgages is increasing, more and more homeowners fail to pay their mortgages. So the number of houses in the market keeps rising. That’s fine, right? No. There’s no one to buy these houses.

Now apply Econ 101. If the supply of these houses increases, but there is no increase in the demand, the price of these houses begin to fall. The banker needs to sell these houses because their value is dropping. But who wants to buy them? No one. Because everyone knows their value is going down. It’s important to remember that there isn’t only one investor with a bunch worthless houses, there are MANY. The whole process is beginning to fail. No one wants to buy mortgages anymore so the mortgage lender suffers. No one is buying houses so the broker is broke.

Remember how the economy works by borrowing money? Now that this process has failed, no one can pay back their loans. Slowly but surely everyone becomes bankrupt.

Movie Recommendation: The Big Short

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