Figure 1: Crisis Political Cartoon
The 2008 financial crisis was also one of the greatest investment opportunities of all time. The mortgage crisis was a gold mine for the people who saw it coming. This is one of my all-time favorite investment opportunities. Unfortunately, I was not old enough to invest and I was way to young to have seen the fall coming. However, many people do not know what truly happened.
Figure 2: Mortgage Backed Security Diagram
The major issue with the 2008 financial crisis was mortgage backed securities. Basically, when banks and institutions loan out mortgages, they create financial instruments called mortgage backed securities so that they can continue to loan out money. Thousands of these mortgages are packaged into bonds. The bonds can be purchased, and investor receive coupon payments based on the incurred interest.
As long as people pay their mortgages, the bonds will produce the payments and investors will make money. However, if people do not pay then the bond fails, and investors lose their money. The problem in 2008 was that the mortgages in these bonds were very risky.
Figure 3: Variable Rate Mortgage Diagram
If you were to look at the bond’s contents in 2008 you would see that many of the mortgages were variable rate mortgages. This means that the interest rates started out with a low rate called the teaser rate. The applicant could afford the low teaser rate, so they were approved for the loan. However, the rates could jump up 300% after a few years. Many applicants could not pay these high rates.
To make matters worse, the people who packaged the bonds artificially rated the bonds a high credit rating. This would falsely attract investors. Even though the bonds were filled with bad bonds, the credit rating would be in the A range which is a high rated investment.
In late 2007 many of the variable rate mortgages increased the 300%. Many home owners were unable to pay the interest on their loans. This led to millions of defaults, and hundreds of billions of dollars in lost investments. This destroyed the mortgage sector and the housing market all in a short span. This was enough to crash the entire market and force many top financial institutions into trouble.
Those that saw this crisis coming shorted or bet against the bonds. They placed insurance on the bond, so when the bond failed they were paid out in the full amount that the bond was insured for. Investors were able to make billions of dollars because the returns were up to twenty-five to one.
I fear that a similar situation may be coming. The banks were all bailed out and many of them lobbied congress to fight reform. Many laws did not change and not many people went to jail for these crimes. Only time will tell, but I am very scared.