Today, In this article, I'm gonna explain you everything you need to know 'bout the Great Recession!
So lets start the explanation....
So, it is the Year 2001.
& the Dot Com Bubble have bursted recently....
So no one was really willing to invest in Share Market during that time & neither were the investors willing to keep their money in the Banks; that was because the interest rates were too low, during that time.... to be exact the interest rates were around 1%, during that time.
So investors were in a search of a new profitable investment opportunity.
Banks were giving loans to people (home loans to he specific) & 'cuz the interest rates were low.... people were willing to take loans (as they had to pay low in interest).
Which means that there were mortgages, basically!
You know mortgages,
Its basically a document in which the borrower agrees to pay the money they've borrowed.... to the lender on time with interest. So its kind of free money for the lenders which they receive time to time!
Also, if the borrower defaults than the lender has the right to take over the particular thing the money was borrowed for.
So, hence it is a win-win situation for lenders, especially!
So, in our case the lenders are the Banks.... & the borrowers are we or I might say, general public who take Home Loans, or other sort of loans.
So investors really saw this as an opportunity.... 'cuz there were so many people who were taking Home Loans....
So all the investors wanted.... was basically the ownership of those mortagages & get paid over time as profit!
But the investors didn't wanted to go to individual people & lend them money!
No, my friend.... thats where Investment Banks came into the game.... to play a vital role....
Introduction To Investment Banks:
An Investment Bank is a Bank basically that works under/with Government.... it basically helps businesses to raise funds....
An Article.... Coming Soon On Investment Banks!
So Investment Banks knew 'bout the new hype among the Investors regarding Mortagages....
So they did one thing....
They bought many Mortages OR Loans from the Banks.... with the large capital they owned.... & collected the Mortagages at one place & created a bundle of those Mortgages....
& made a thing called CDO's (Collateral Debt Obligation).... a CDO is basically a complex derivative/financial/investment instrument.
& the Investment Banks got these CDO's rated by the Credit Rating Agencies.
The Credit Rating Agencies were such agencies that used to check the fundamentals of a financial instrument (in this case, CDO's) & rate them on the basis of how safe the investment actually is....
The highest rating was the "AAA Rating".... which means that the Mortgages that had this rating were super duper ultra Safe!
After getting the CDO's rated, the Investment Banks used to sell them to the Investors....
Now how are the CDO's profitable for the investors.... well, we'll talk 'bout this in depth on some other day.... so Stay Tuned to RSPH Blogs - Finances!
Now Investment Banks had sold all these CDO's to the investors.
& now the Investment Banks demanded Banks for more Mortgages/Loans to make more CDO's!
It was so because the demand of CDO's among the investors was still very high!
But the Banks had already given loans to people who can repay them!
Dont worry.... it'll make more sense in a moment, now!
Actually, generally when ever banks give loans to individuals.... they tend to check the individual's capability of repaying the loan.... this includes, checking whether if the individual have a job or any other income generating stream that'll help the individual pay off the loan....
But as I said.... The banks had already provided loans to such people who were capable of repaying them!
Now let's have a look at....
WHAT WAS THE MAIN CAUSE OF THE GREAT RECESSION?
So now banks did something which was the main cause of the 2008 Crisis/Recession!
Ok so.... 'cuz of the greediness to earn more commission from the Investment Banks. Banks started giving more loans to people; even to those who didn't even had a proper income source for loan repayment!
These sort of low quality loans are known as *sub prime loans*!
So now these mortgages/loans (subprime loans to be specific) were sold to Investment Banks & the Investment Banks got these too.... AAA Rated by the Credit Rating Agencies.
Around 70% of CDO's were AAA Rated.... by the Credit Rating Agencies!
During that time the Credit Rating Agencies also made a huge amount of money in commision from Investment Banks!
As we know that these sub prime loans were risky.... & carried the Risk with them!
So, this Risk was tranferred by the Banks to Investment Banks & than from Investment Banks to the Investors!
Now as all of this was going on.... the insurance Companies were sort of feeling left out.... so they too decided to join in....
They introduced 'CDS' / Credit Default Swaps.... & these were nothing but an Insurance for the CDO's.
Let us understand how it worked with the help of an example!
So as we know that a car insurance is an insurance for the car.... & we pay the Insurance Company over a fixed period of time.... & so if we have a Car Insurance & if the get car get into an accident or if there's any damage caused to the car.... than its the Company who has to look after the Car & pay the money required to fix the car.... which means that we don't have to spend money on the Car's repayment.
& this is kinda profitable!
But if the Car does not get any damage than the Insurance Money we pay.... may be our loss!
So, similarly CDS were an insurance for the CDO's.
Which means that if the CDO's failed than the Insurance Company will look after the lossses of the Investors!
One more thing about the CDS was that the people who didn't owned the CDO's can also buy CDS!
CDS OR THE CDO'S INSURANCE was to be paid quarterly.... that is every 3 months!
Some Investors didn't bothered buying the CDS 'cuz they thought that CDO's are AAA RatAA.... so there are very few chances of them failing!
The Insurance Company was pretty much making alot of profit 'cuz of people buying CDS to avoid losses & to cover up the risk!
The Insurance Companies gave their employees bonuses with the profit they werCompahey due to CDS!
The Insurance Company also legit thought that the CDO's won't really fail 'cuz they are AAA Rated!
*The things went like this for like upto 4 yeras!*
But after 3-5 years.... in the Year of 2007 to be exact.... we came to know 'bout 2 more mistakes the Banks had made while giving loans.... one of 'em was that the banks didn't informed plenty of borrowers 'bout the Adjustable Interest Rates.
The Adjustable Interest Rates were such Interest Rates which increase over time & basically are adjustable!
Do you remember I told y'all in the beginning that the Interest Rates were only 1% (in the year of 2001-2002).... well, in the Year of 2007 the Interest Rates were higher than they were earlier!
Many borrowers especially the ones that were the sub prime loan borrowers started defaulting....
[DEFAULTING DEFINITION!
When a borrower fails to do a loan repayment is known as Defaulting a Loan!]
So now the Banks had to recover the money.... so for that the Banks had no other choice but to put the houses up for sale.
ANOTHER MISTAKE.... ONE MORE MISTAKE.... that Banks made was that they had paid the entire amount of money by their own self....
Where as we know.... around 20% of amount of the property is to be paid by the Borrower itself & the rest can be borrowed/payed via loan!
& now as Banks are putting houses up for sale....they are unable to find any buyers.
& after some time there were way too many people Defaulting Loan Repayments.... which means, there are way too may houses on sale.... yet 0 to NO buyers!
So now the Demand was low & the Supply was high....so the housing prices decreased.... & BOOM.... the Housing Bubble Bursted!
& now this resulted in even more Defaulting of the loans 'cuz people's loans which were right now yet to pay WAS NOW MORE THAN THE HOUSE'S MARKET VALUE!
So it had a negative impact on people & now they just aren't willing to repay the loans at all!
The Insurance Companies on the other hand had to give Funds to the investors who had bought CDS.
& it was a huge loss for them repaying for the CDO's failure.
Like---- the Housing Market had crashed now!
Coming back to the Banks....
The Banks are short on money.... as people are not repaying the laons and neither is someone buying any houses!
Infact, the money the Banks had.... was being taken out by people.
The CDO's value had decreased to 0.... & the investor who invested in them had to face losses (if they didn't owned CDS!).
But the peopel who owned CDS managed to make some profit over all!
AIG which was one of the largest Insurance Companies in the US had to face a loss of around $99 Billion & it had to be rescued by the Government of US, itself.... by bailing it out after putting in $85 Billion.
Investors on the other hand stopped buying CDO's, now!
But the Investment Banks still had several CDO's left but as there was no buyer.... the losses of the CDO's were to be faced by the Investment Banks, itself!
Lehman Brothers had a lot of CDO's but as I said there were none buyers.... Lehman Brothers were the one's who had to bear the losses of around 450 Billion Dollars.... Lehman Brothers was one of the largest Investment Bank in the US.... BUT IT WENT BANKRUPT IN THIS FINANCIAL CRISIS!
Now due to so many Large Corporations, Agencies, etc., etc.; going Bankrupt.... the unemployemt was on a new level....!
& people were facing problems to get a loan.
Many new start ups shut down because of being unable to raise any funding....!
The US Economy's growth kind of freezed!
The unemplyment was high!
Banks were out of cash!
Many Large Companies went Bankrupt!
This Crisis/Recession was so deep that this had an impact on many other countries tooo.... Which means it had an impact globally!
This was the Greatest Recession & The Worst Financial Crisis of all time since the Great Depression!
~~---- Anyways, so this is how things basically went In The Great Recession &/OR The 2008 Financial Crisis!
Anyways, so that's all for today!
Thanks For Reading!
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