Hedo summed up the real estate aspect of the current financial crisis very well, but this is about a lot more than real estate. It’s about easy credit in general, which was being used for a lot of things besides real estate.
Sub-prime mortgages are certainly a PART of what is bringing some of these investment banks down, but they are by no means all of it.
Bear, Lehman and Merrill had LOTS of crazy debt instruments on their balances sheets which started defaulting and causing them to go tits-up, and much of that didn’t even have anything to do with consumer mortgages.
It became very popular over the last decade for banks and investment banks to structure all kinds of asset-backed securities and CDOs.
What are these? (CDO stands for collateralized debt obligation, by the way). Anytime a bank or lending institutions has lots of any type of receivable, meaning something on which they are owed money – like a mortgage they’ve given to a homeowner, a credit card they’ve given to a person, a student loan, commercial things like airplane leases, equipment leases, etc., etc. – that’s called a receivable.
It’s something in which the borrower owes that bank money, so the deal (the loan) is looked at by the bank as “almost” guaranteed money coming in at a set rate, but of course there’s always the risk that the lendee will default.
So it’s a deal where someone owes me (the lender) a certain amount of dollars and they’re going to pay me X dollars a months (part of the principal debt plus some interest) for the next 15 years (or whatever it is), as per our agreement.
But as far as the bank’s CREDIT QUALITY and balance sheet go – these things represent money that they don’t yet have back, and there is some risk that the lendees might default and never pay them back.
Now, why do the banks care what their balance sheet looks like? Because it affects the bank’s credit rating. Depending on the rating system you look at, the highest rating is AAA, then AA, then A, then BBB, and so on.
Every bank would like to be able to advertise “We’re AAA-rated, so do your banking with us. We’re very safe. We’ll NEVER go under!”
But if you have a lot of outstanding loans on your balance sheet that are owed to you, there’s a risk that the people who borrowed money from you might default on those loans, and if a LOT of those people default, then you (the bank) COULD go under.
So how do we (the bank) make it look like our balance sheet doesn’t have all that outstanding risk, even though it does, thus convincing the credit rating agencies to keep giving us a AAA or AA rating? We collaterilize it. We wrap it all up into big bundles and sell it off!
Say you’re a bank (or a mortgage broker or whatever – any kind of lending institution). You probably have thousands upon thousands of credit cards that you’ve given out to people. Those are all receivables.
You probably have thousands of mortgages you’ve given out to people. You probably have thousands of commercial leases, student loans, equipment leases, sometimes sports stadium leases, etc. that you’ve given out.
If you take ALL of your credit card receivables and bundle them up into one package, you can SELL that package to an investor (usually an investment bank, hedge fund or other institutional investor) for an agreed-upon price.
Why does the investor want to buy this bundle of receivables? Because it’s (semi-) guaranteed money coming in every month, every time those people make their monthly credit card payments or loan payments. Some of them will even be paying pretty high interest rates on that outstanding debt.
NOW, there is the risk that some of those underlying lendees will default, but you take that into account when you negotiate the price for this whole package that you’re buying. This is called an asset-backed security.
It’s been made into one big bundle, one product (a security) and it’s backed by these underlying assets (credit card receivables, or some kind of receivables) that will give you payment streams every month.
CDOs are a form of ABS (asset-backed security). I’ve listed some simple examples, but some of them got REALLY complex. Sometimes the underlying assets wouldn’t be just of one type (like credit card debt), but would be a big mixture of different types of debt underlying one CDO.
There were also CDOs of CDOs (no joke!), and the underlying debt instruments got to be zany, zany shit that you would never even imagine – really high-risk stuff at times. Movie rights receivables, record sales receivables (David Bowie famously did a CDO on one of his albums a few years ago) . . . crazy shit.
These ABS/CDO products became very very common, to the point where they were tradeable, and were very openly traded by investment banks and hedge funds. You buy one, after a while you either think the default risk is more than you want to deal with, OR you just think you can get a great price for it, so you sell it to someone else.
So GENERALLY, the way it would work was that the investment banks (Lehman, Bear Stearns, Merrill Lynch) would approach the lending institutions (commercial banks like Washington Mutual, North Fork, Comerica, your local bank, etc.) and say, "You guys have got all this ugly-looking shit on your balance sheet that’s negatively affecting your credit rating.
Let us structure a deal for you where you can wrap it up and sell it off. We (the investment bank) will take it off your hands. We’ll hold it ourselves for the time being, but will quickly be able to sell it because we’ve got institutional investor clients who will be happy to buy these kinds of CDOs/ABS."
So Lehman, for example, would take on all this risk by holding onto a bunch of these products. Many of them they would sell off to investors, but some of them they might just hold for themselves if they thought it was a good deal.
Also, though, the trading desks at these investment banks would buy and sell these things on a proprietary basis (meaning, just for the bank’s own sake), so if a trader at Lehman thought that a certain bunch of CDOs looked like a good investment, he’d buy them – and they would be held on LEHMAN’S balance sheet until he sold them.
So now LEHMAN, the investment bank (and investment banks have a much higher risk tolerance than commercial banks do) has a LOT of this shit on THEIR balance sheet.
Then the people who took out those loans and owed them money every month – whether they’re homeowners, credit card holders, big companies that borrowed money to buy expensive equipment, whoever – started to default.
(For a variety of reasons – the housing values plummeted so people decided to just walk away from their houses, the economy in general slowed for a variety of reasons so big companies are having losing quarters for the first time in history and can’t pay back their loans that they took out to buy new equipment, etc.).
Now Lehman has a bunch of this shit on their balance sheet that’s defaulting all at once – so now they’re going bankrupt.
That’s a very simplistic explanation for it, but it gives you the gist.