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Econ Crisis 4 - Shadow Banks

4y ago


VOICE NARRATOR: Things are easier to understand when we connect it all in the same picture. These symbols can be used to cover many stories about wild nature and human societies. But for the economic crisis we only need some of them, if we expand these with a few shades and flags. So we are keeping some of the top colors, and adding variations. Here are the originals, and here is what we will use now. Don't bother memorizing. It will be flexible. For example, basic red is for all of finance too, and people for households. We saw before that mortgage loans pumped up the business cycle of the whole country. Red arrows are always for money. I also used a "group" pattern, to show the shadow banks and the housing market. There were two bubbles at the same time, one in house prices and one in derivatives values. The pinwheels spun from a mutual attraction of loans and debts. Let's start with two of the pin heads, you and me. You want to buy the property. So you will pay me money and you will receive the deed. First you have to get the money: you borrow the money from a mortgage company, called an "originator", and buy the property. Now I have the money and you need other income to pay the mortgage. You usually pay it to a service company. These companies are intermediaries, a part of the financial system. You exit the housing market. This stands for the millions of people who are in the process of buying and selling properties. There are lots of people getting in and getting out. So, the new owners start to pay mortgages. But a batch of mortgage agreements are sold, for what is really a big pile of money, to a shadow bank. So then, the payments go there. What are shadow banks? They are investment banks and funds, and they are not regulated like the deposit banks, whose rates are controlled by the central bank. We will look at these connections in another video. But deregulation blurs the boundary and extends the taxpayers' responsibility to bail-out the shadow banks. The big disaster will depend upon the next steps. The mortgages are put into an off-balance-sheet company with no reserve requirements, called a "special purpose entity", and they write purple paper called mortgage derivatives and sell them for good, red money. Then the mortgage payments are split to the owners of these new securities. A derivative can always be resold for money. It is what you call "negotiable". So then the mortgage payments go there. The original deal is that all the derivatives get paid. But if enough money doesn't come in, because some homeowners can't pay their mortgages, then the bottom tranche doesn't get any money. So the top tranche gets a AAA rating and it is worth more because it always gets the mortgage payments. The money from selling these derivatives goes into salaries and bonuses at the investment bank and the rest goes to buy more mortgages to make more derivatives and sell them for more profits, and so on. Well, all the triple-A derivatives are good as gold to everybody. They use them in other kinds of trades, as collateral for loans. We will return to this shortly. Each level has many kinds of transactions inside. It is all a part of finance. These are different views of the same thing. Next, our story will continue from the little pile of money that was lent to you, to buy a property. Then we will watch the housing market blow a bubble.