 Oh, and welcome to the session. This is Professor Farhad in which we would look at the financial crisis of 2008. This topic is typically covered in essentials of investments or in essentials of finance course. You cannot learn finance without learning about the financial crisis of 2008. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have over 1,700 plus accounting, auditing, finance, tax, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlist. If they benefit you, they might benefit other people, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources if you're trying to supplement your accounting education and or study for your CPA or CFA exam. So it's very important to look from a historical point of view, how does the housing market work in the US? So back in the old days of the US of A, if you wanted to buy a house, you would go to your neighborhood bank or credit union and you would lend money and the home will be used as a collateral. Simply put, your local bank will hold your home as a long-term asset against that loan. So they'll have a portfolio of homes and they will give you the money and they will hold the loan for 30 years. So basically the concept was the originate, you originate and you hold. It was really a boring business with limited capacity. What do I mean by limited capacity? Well, the bank, let's assume the bank will have a collateral of five million. They can only lend you money of five million. That's all what they have. So at some point the bank might run out of capacity because that's all what they have. And the other idea was it's your local bank, whoever lend the new money or whoever you're borrowing from, you're gonna see them, they're part of your community. That's important. They're gonna look you in the eye and you're gonna see why this concept is important when we talk about the new system. So back then in some states, for example, they had rules where the bank can only lend around 50 miles. They can only lend people in their 50 mile radius because they want to know their community and their community wanted to know them. Now in the 70s, what happened is we started to introduce a new concept. Two new companies entered this industry, Fannie Mae, which is the Federal National Mortgage Association and Freddie Mac, the Federal Home Loan Mortgage Corporation. What did they started to do? They started to buy large quantity of mortgage loan from originators and bundling them into pools that could be traded like any other financial asset. So rather than the bank originate and hold the loan, here comes these two corporations, they will take the loan off your hand and they will give you money where you can go back and lend that money again to more homeowners. So that's the idea. So these pools were essentially claims on the underlying mortgage. And what happened is what they do, they will take those home loans and they will sell them to investors in form of mortgage-backed securities. And I'm gonna explain this in a moment in the next slide in a form of a picture. And the process is called securitization. So what they did, they took your loan and they securitized it and they sold it to an investor. Don't worry, I'm gonna explain this in the next moment. Those loans were low risk mortgages. So the bank did a good job reviewing your loan, making sure you qualify for the loan. And the max loan to value was 100,000. So if your home was worth 100,000, the max they would give you is 80,000. Why? Because they want to have a buffer zone of 20,000 in case something happened to your value. And seldom people qualify for the 80%, that's the maximum. So if you don't have really good credit and good income, they may only give you 75 or 70% of your home value. But simply put, they will not exceed 80% and you have to have a good credit. You have to have, they only give it to people who would income, that for example, you've been working for two years, you have a stable job, so on and so forth. So that's a good idea. If you really think about it, what they did is they increased the capacity to the bank. So the bank can land more because what they did, they took the loan off your hand. And this is what it looks like. So let's take a look at it from a picture perspective. This is the old system. The old system is kind of boring. What happened is this, you go to the bank, you'll get your money, the bank will give you the money and basically you sign a loan. And this is the old system. That's it. That's what happened. And the bank would hold the mortgage for 30 years and you make payment to the bank. Now let's assume the bank just for the sake of illustration, they make loans, different loans worth of $10 million. So they issued loans, they funded loans worth of $10 million. Now remember, the bank will have to get their money from depositors because the bank don't have unlimited amount of money. They have to get the money from depositors. That's for, that's their limit. Let's assume that's the case. Here comes this new concept. Well, what the bank can do with this loan rather than holding this 10 million worth of loans, the bank can sell the loan. Hold on a second. Who's gonna buy the loan from you? Remember, Freddie Mac or Fannie Mae or some other third party. So a third party will buy those loans from you. Why would they buy the loans from you? We're gonna see why in a moment. So they will buy the loans from you and how are they gonna buy the loans? Where are they gonna get the money from? They're gonna take these loans and package them into mortgage-backed securities. Basically, they're gonna package them into bonds, mortgage-backed securities or mortgage-backed bonds. And what they do is they will sell those bonds. And who's gonna buy those bonds? Guess what? Someone will buy those bonds, investors. So notice, you got your money from the bank. The bank sold your loan to a third party and that third party packaged your loan in a mortgage-backed security. And guess what? Now, when you pay, and let's assume the average interest rate on these loans, the average interest rate is, let's assume 10%, 10%. So guess what? Now, when you make your payment to the bank, you're not really making your payment to the bank, you're making your payment to this investor who you don't know who they are. Basically, all what those investors did, somehow they have a piece of paper saying they have a claim on your home, although you don't know who they are. They could be in Germany, they could be in France and a lot of investors were actually Deutsche Bank, which is a German bank, but a lot of our mortgage-backed crap securities. But the point is, you're not dealing with your original originator. So what happened is, the risk is simply transferred from the bank to some investor, to some investor who bought the bond. Now, since investors, they're not all have the same risk. So you have different type of investors. For example, you might have safe investors, like senior citizens. Senior citizen, they wanna really invest and save investments, or pension funds. Let's talk about pension funds. Pension funds, they're very careful. Pension funds, they can only, they can only invest in certain securities. For example, they have to have AAA securities. What does it mean, AAA? Each bond, the bond are rated. So when you buy a bond, when you invest in a bond, they have AAA, AA, AAA, BB, so on and so forth. For example, the pension fund can, for example, they could have a rules, they can only buy AAA or AA bond. For example, other, for example, hedge funds, or some other trading, trading, trading parties, they don't care, they can take more risk, okay? So some people, they, they're willing to, you know, they're willing to buy AAAB bond. Remember, AAAB bond might pay you, you know, 10% and AAA bond would only pay you 6%, okay? So what happened is this, the average interest rate on these, on these bonds is 10%. So what they did is, to make this, this is more interesting, those third parties, the financial intermediaries, they took those bonds and they broke them down into tranches called collateralize that obligation. So what they did, remember, this is a pool of loan. This is not one loan for 10 million. Some of the loans were at 12%, some of the loans were at 8% of different risks, so on and so forth. So what they did, the financial industry is very creative. They took those loan and they broke them down into several tranches. To make it simple, we're gonna break them down into two tranches, senior 70%, junior 30%. So what they did, they took the loans and they say, well, if you are risky, why don't you buy the first tranche? So nothing will happen to your bond unless the 30%, the junior bond default. And for the risky investors said, why don't you buy the 30% part of the bond? Why? Because you were willing to take more risk, they'll pay you 10%. So the pension fund will be happy getting 6%, paying 6%, receiving 6%, and the risky bond, the people with the risky, with the junior tranche, they will get the 10% or whatever rate it is. So somehow they make it more interesting. And by doing so, and guess what they did? By doing so, they kind of, in quote, not in quote, they fooled the credit rating agencies. How? They told the credit rating agencies or the credit rating agencies started to kind of theorize. It's like, what are the chances of 30% of the bond of these loans go default? Well, there's really a small chance. Therefore, guess what? The CDO must be a AAA. And investors rely on the rating agencies. Once the rating agency says, this is a AAA bond, that's the job of the rating agencies. That's why we have rating agencies because you don't have the time to go into these banks and examine the loan yourself. You rely on someone else. So what they did, they packaged them. They packaged them as they are AAA. Why? Because really, if you are a senior, kind of if I curve the grade in the class, the grade looks good, but underneath the grade, the students did not do well, but I curve the grade. So in a sense, they curve the rating in that sense. So what happened is this. So looking at this picture overall, what happened is once the securitization model took hold, so once this model basically, you buy from third, you buy the loans and you packaged it. Okay, now you have a new opportunity for new firms to do what? To take subprime loans, loans that are not credit worthy. So they are not good loans and they securitize them. Those are high default risk loans. In other words, the people who took those loans out, there's a good chance they made the fault. But as long as you can fool the credit agency into packaging those loans and making them look good, some investor will buy them, okay? So the difference between the original idea in the 1970s where you can package those loans and sell them as bonds, it was a good idea. It was a noble idea. Why? Because you create more capacity for the bank. You free up the fund for the bank. So one important difference between the government agency path through and those so-called private label path through was that the investor and the private label would bear the risk that the homeowner might default on their loan. Why? Because they're not backed by the government, okay? Therefore the originating mortgage broker had little incentive to perform due diligence. So what happened is this, if you are the originator, if you are a bank or a shadow bank, you did not really care who did you give your money to? Why? Because you can take those loans and sell them to someone else. So the investor eventually will ultimately bear the risk. The person, remember I told you that this person right here really bearing the risk. So at this point you remove the, you remove any incentive from bankers to make sure they're giving loan to people who qualify for the loan. Because when the bank gives a loan, they make money on a origination fee. They make money on appraising your home. There's a lot of fees that they charge you. All what the bank want is to qualify for the loan, charge you the fees, give you the money, turn around and sell that loan. They don't care. They make your profit already. Then take that money and lend it again to another person who doesn't matter whether they qualify for the loan or not. So these investors had no direct contact with the borrowers. Think about Deutsche Bank and could not perform detailed underwriting concerning the loan quality. And that's not what you do. When you buy a bond, you rely on the rating agency. So that's what happened. So instead they rely on the boarders credit score who steadily came to replace the conventional underwriting. So let me tell you my story about this. I graduated in 1999 from college and I had a finance degree. So listen to my story and I'll tell you what happened. My first job after college was a loan officer with a company called City Financial. This is a secret, don't tell anyone because I'm not proud of it. I'm not proud of working with City Financial. But the point is part of my job, I was a loan officer. My title was management trainee, but my real title was a loan officer. So we used to give two type of loan, personal loan and home loans, basically mortgages. Either you want to get a car or you wanna get some loan or you want to buy a home or refinance your home. So here what happened, who goes to City Financial? People that goes to City Financial, they cannot get a loan at the bank. Basically, if you cannot get a loan at the bank, you'll come to City Financial. Back then, if you are looking to get a first mortgage, I still remember this. If you wanna get a first mortgage, you have an excellent credit. You have an excellent credit. You have a good job, okay? And we're talking about the first mortgage. We used to charge you, I still remember the sheet. 12.99% on a first mortgage. So why 12.99? Because the federal rate was around 6%. So the interest rate was high, but our rate was even higher. So this is if you have a perfect score. Nowadays, you can get a loan for nothing, for 4, 5, 6% max. And that first mortgage could go up to 18% on your home. So that's not the whole thing. And we're supposed to be a discount broker. Therefore, it will take us time to process your loan. It used to take a month. So if you wanted to get a mortgage, if you wanted to get a mortgage or get a second mortgage on your home, basically a second loan on your home, it would have taken you one month worth of time. We would have asked for your W-2, your paycheck, your tax return, if you are self-employed, we wanted your Schedule C, if you are a partner in a partnership, we wanted your K-1. So it would have took a month, literally a month to tell you, okay, get us the paperwork. We're gonna review all this paperwork and we'll let you know in a month, whether you qualify or not. And we were a discount broker, so we're supposed to move fast and it used to take us a month to do this process. Okay? So fast forward, 2005. 2005. In 2005, I decided to get married. I left this job and I decided to get married. I was planning to get married sometime in December by the end of the year. So here's what I did. I had a home. I wanted to take some money out of my home. So I wanted to borrow some money from my home to fix my home, because I'm getting married. So what I did, I said, okay, like mid-September or late September, I still remember, so we're talking September. So I said, you know what? Since it's gonna take a month or so to get money from my house, let me go in now and just in case I had some paperwork and start the process in September. So I'm thinking by the end of November, I will have the money. I will have a month to fix the home upgrade. I remember I wanted to upgrade the windows, do some major changes. By the time I'm married, the home is fixed. So I still remember sometime in September. I don't remember the date. I walked into Wells Fargo. The bank is Wells Fargo, it's a traditional bank. This is what I bank with. So I went in, I remember I went in because I was coming from work. I almost made it, it was around five o'clock. So I catch the person that still there said, would you mind helping me? I remember the lady said, okay, what do you need? I said, I'm looking to get money out of my house. I have some equity in my house. And I remember, I give you the value, it doesn't matter. I was looking to get around $20,000 from my house. I had an equity worth of 20,000. So she said, okay, so I gave her my license. She had my account information. And she's like, okay, she asked me how much? I said, well, around 20,000. I was not hoping to get 20,000. I said, if I get 20,000, I'm gonna ask for 20,000. And I told her, all I'm asking today is what type of paperwork do you need so we can start the process? She said, okay, no problem. So she just, I remember she just took two minutes. She typed something on the computer. She went inside another room and I heard a printer. And I know that that printer is, it's printing a check. Why? Because I used to be in this industry, we used to print the check at my work, like, you know, when I used to be at city financial. So like two minutes later, the lady came out with a check, with an actual check of $20,000. And she handed to me, she's like, that's your check. I was like, hold on a second. You didn't even ask for my W2. You didn't ask for my tax return. And I didn't tell her that I was like, is this a real check? Or is that kind of like, you know, those like ad checks where, you know, come back later and, you know, we say, no, that's your actual check. If you want to deposit this check today, you will have an additional 20,000 in your bank account. So the point is by 2005, it started around 2002, 2003. Now, no one knows everybody, the Republican playing the Democrat and the Democrat blame the Republican, that they ask the banks to lower the standard for borrowing, okay? In other words, make it easy for people to get a loan. And this is why I get a second mortgage in like literally in like five minutes. I walked out of the bank with 20,000. I thought that's gonna take me a month and ever. And I asked her, is like, could you tell me how did you came to the conclusion that I had, how did you trust like I had 20,000 in my equity? She said, oh, I went online and I saw, when we just did what's called a comp appraisal, comparison appraisal. And we find out that the homes that were sold next to your home were at the same value and we based it on that. So it was really easy. Back then, when I was at work, you had to have an appraisal. We had to have someone scheduled someone. It will take 10 days to schedule someone to go to look at your house. So the point is in 2001, 2002, all those strict standard, they were going down. And as a result, we had more, what's called subprime loans. It's not only subprime loans. We had all sorts of crazy loan, loans that are called low documentation where you did not need any documentation for the loan, no documentation or low documentation. So they did not have to verify anything. For example, I believe I was credit worthy because I have a good credit. They had high loan to value. They started to give you 100% of your home value. So if your home is worth 100,000, they would give you up to 100,000. So they'll give you up to 100% of your home. And for example, city financial, what I used to work, they would give one, they used to give, when I was working there, they used to give 110%. So they would give you more money for your value, but you'll have to pay high interest rate. And there's the Ninja loan. Ninja, no income, no job application would give you a loan. Either you have no income or no job. Then they'd have what's called adjustable rate mortgage. And those adjustable rate mortgage, they were known by ARM, ARM loan. ARM loan, basically what they do is, they would, you would start at 2%, then your interest rate will go up to, it would reset in three years at 8% plus the treasury bill rate. So it would be around 10%. So you'll start at 2%, but you're in your payment because it's 2%, your payment is low. Then suddenly in two years, your payment will be, will get higher. And this is really what really collapsed everything, those adjustable rate mortgage. And what happened is this? So they used to call them teaser rates. So they will offer you a low interest rate early on, then eventually they will, then you'll have a payment. You will start with a payment of $400 and suddenly your payment becomes like 1200. So this is what happened. So they will have the treasury bill rate plus 3% or some sort of a formula. What happened is this? When these adjustable mortgage started in 2001, 2002, again, we're not gonna get into politics, no one when that started, people did not care. Why? Not people did not care. What they told people is look, you're gonna buy your home for 100,000 today and your payment is around $500 based on the current low mortgage, low interest rate. Guess what? Come back a year from now, come back a year from now, your home value will be around 140,000 and home values were going up in those years. And what we do is we refinance. Refinance means what? It means we're gonna take your old loan, scratch your old loan out, give you a new loan with a new teaser rate and move that payment two years down the road. Let's assume you took a loan in 2002 and 2003, you would refinance it. Then in 2004, you would say, hold on a second and everybody was qualifying for a home, so home prices were going up. Then in 2004, you will go back and you would refinance your loan because you needed to lower your payment and push that large payment down the road. You will do the same thing for 2005. And people were borrowing around their homes. So the home values were going up, but the loan against those home values were going up as well. So that kept happening. And by 2004, the ability to refinance to save a loan began to diminish. Why? Because what happened is, more and more people were refinancing and if you could not refinance, if you don't qualify for refinance, what you do is you will try to sell your home. So by 2004, 2005, people started to feel that things are slowing down. By 2006, the majority of subprime borrowers purchased homes borrowed entirely by the purchase price. At this point in 2006, if you have a subprime mortgage, if your home is worth 300,000, your loans were worth 300,000 as well. So basically you had no equity because homes can go up forever. Now you can no longer go back to the bank and extend the loan because you already used up all your equity. So although your value went up, also your loan went up. At this point, you ran out. Okay, refinancing was not possible. So what do you do when refinancing is not possible? And at this point, what happened is oil prices went up. In 2006, 2007, the barrel of oil reached over $100. And guess what? When oil goes up, people's expenses go up. Your mortgage is going up. Your mortgage payment is going up. You can no longer afford to pay. What do you do first when you cannot pay for your home? You all try to sell it. And guess what happened when everyone in the country tried to put their home on sale? The prices immediately drop. The prices of the homes immediately drop. So the prices of your home immediately drop. So if you had a loan of 300,000, now your home, your loan is 300,000. Now your home is worth 210,000 or even less or even 180. Why? Because everybody else is trying to sell their home because your home went up because everybody else was buying. Now your home went down and you were borrowing against that value. Everybody else is selling and your home value went down. So when home prices began falling, these highly leveraged loan were quickly under water. Under water means you have more loan than value. So what do you have? When you have more loan than value and you cannot pay, you cannot pay, you simply walk out. People literally walk out of their homes and they left the abandoned their home. So home prices peaked in 2006. Homeowner could not refinance because they used up all the equity that they could have. And mortgage rate began to surge. Mortgage rate default. So basically people started to default, started to fall behind on their bills. Let's go back to this picture. So here's what happened. When these investors, these investors, they were buying bonds from 2002, 2003, 2004 booms. When 2005, 2006, the homeowners, they could not pay the bank or they could not pay them specifically because the payment was going to them because the bank transferred the bond to a third party. So these people started to lose money and they started to lose billions of dollars. So these people are losing money. Home value is going down. The economy starting to slow down. So this is what actually happened. This is what actually happened. And as a result, a lot of third-party intermediaries, what they did is they had those mortgage-backed securities. They were not, really, it's like they drank their own poison. So if you created those mortgage-backed securities and you cannot sell them, it's a toxic asset. They become toxic asset on their books. So it's not like they were trying to fool people. They believe the system is working because investors were eating those bonds up. Somebody was buying them. But when nobody was buying them, then you have those investments on your books and they're shitty investment because you thought the homeowners are going to pay to make the payment, but the homeowners are no longer making the payment. So part of the problem is, because the question is, why were people buying those risky subprime mortgage? The reason is because they relied on Fitch, S&P, and Moody's. Those are the credit rating agencies. So, securitization, the way they restructured those loans, the way they made them look good, people were buying them, okay? So what they did, they have a new risk-shifting tools enable investment banks to carve out triple-A rated securities from original junk loans. Remember those branches that they did? They make it look good. They make it look relatively good, relatively safe, and they stamped on it triple-A. Now we're going to see, there's another reason why they did it, but we're going to talk about this. So CDOs were among the most important in eventually damaging of this innovation. So when they did those CDOs with the trenches, they make it look good. They make the bond look good. So CDO were designed to concentrate the credit risk of a bundled loan on one class of investors. So what they did is, although you had crappy loans within the package, they only looked at the good loans, okay? So leaving other investors in the pool not protected from that risk, okay? So the idea was to prioritize the claim, repayment by dividing the pool into senior versus junior slices called trenches. As I showed you, so the senior trenches had first claim on the repayments. So if you're a senior trench, you got your money first. If you're a junior trench, you can have your secondary, but you earn higher interest rate. But overall the bond is AAA because we had some AAA loans in there. Also, so why would the credit agencies dramatically underestimate the credit risk? So did they do it on purpose? Did they do it because they did not understand the risk? One reason is default probabilities had been estimated using historical data from under-representative period characterized by housing boom and uncommonly prosperous economy. So they were comparing the 90s default rate to the 2000 and the two were not comparable. And we're gonna see this. So the rating agencies extrapolated historical default experience to a new sort of borrower pool, one without down payment. And they were comparing the old loan underwriting where you had to have a down payment of 20%. And that's the other thing. The new loans, you did not have a down payment. Usually the loan, you have to have a put a down payment down. The new loans, those fancy loan, you did not even have to put down payment. So you'll walk in, you'll buy your home without no down payment, low interest rate, no income, no job verification, nothing. So we're comparing those loans to people that put down payment, they had documents, they had income, compelling apples to oranges. So they came up with that conclusion by comparing traditional underwriting to the new underwriting rules. And past the fault experience was largely irrelevant given these profound changes in the market. So they did not take into account the new underwriting rules. Also, there was excessive optimism about the power of cross-regional diversification to minimize risk. So what they did is, and that's another thing that the third parties did, to fold the credit agencies what they did, they bundled loans from different geographical area. For example, they took five homes from New York, five homes from California, five homes from Chicago. And they told the credit agencies, look, those homes are in different geographical area. Therefore, we are diversifying the bond. Therefore, it should be AAA bond or AA bond. And the credit agencies went for it. Why? Because they wanted the fees. The credit agencies, some people think they did it for the fees. So that's another reason why they did it. And that's why it's a bit and ethical to say the least. Also, what came into the picture later on in this tobacco is something called the credit default swaps or CDC. What is the CDC? It's in essence an insurance contract against the fault of one or more borrowers. So what happened is, to make this looks more interesting, they said, okay, you buy this bond, we can sell you what's called credit default swaps. In case something happened to that bond, you collect your money. So it's like an insurance. The purchaser of the swap pays an annual premium like an insurance premium for the protection from the credit risk. So this is, if you have the bond and you wanna protect yourself, you can do it. But I'm gonna tell you what's gonna, what happened with this credit default swaps. So the credit default swaps became an alternative method of credit enhancement. So to make the bond looks good, you said, well, I don't have to worry about the second even buy insurance against it. So it allow investors to buy subprime loans and ensure their investments if they want to. But this is not what really happened. This is not what really happened. So some swap insurers ramp up their exposure to credit risk to unsupportable level without sufficient capital to back those obligations. The first thing that happened is some companies went crazy of selling insurance. And what happened when you sell? When you sell insurance, when you sell insurance, you are responsible for making the payment on these insurance. So that's an issue. That's a problem, why? Because if things go bad, you have to make payment. Let's assume you insure 2,000 cars. Well, that's good. They're gonna pay you premium because you insured 2,000 cars or you insured 5,000 cars. But if 500 of these cars went into accident all at once, you're gonna be in trouble. Okay, that's not what you do. You insured 2,000 cars, you think maybe 20 cars will get into an accident. But if 500 go into an accident, then it's become a big trouble. And what happened with those credit default swaps, and this is very, very interesting and this is where this movie or the big short comes into place, few individuals, and I suggest you watch the movie. What they did is they purchased those credit default swaps. So these people did not own the bond. So what they did is they told bankers, they did told people like AIG, large insurance company like AIG sold more than 400 billion of CDC contract on subprime mortgages. So what they did is they sold the insurance and these guys purchased the insurance without having the bond. So all what they said is, it's like buying an insurance on your neighbor's homes. On your neighbor's homes. If your neighbor's home go on fire, you collect. So these guys, they said, you know what? This subprime, it's gonna collapse. Let's benefit from this and let's buy those CDC. That's what they did. They bought the CDCs and when the whole system collapsed, these guys collected a lot of money. I strongly suggest either watch the big short or you read the book. I read the book and I watched it. I read the book several times. I watched the movie four or five times already, if not 10 times. Okay, so that's what I suggest you do. So if you're interested, start with the big short. So also by 2007, the financial system as a whole, the banking system were starting to show several troubling features. Many large banks and quasi banks and financial institution, they called them shadow banking. They were apparently, what they were doing is financing their short-term borrowing, financing with short-term borrowing, their long-term illiquid assets. Simply put, when you borrow money, if you borrow money for short-term versus long-term, when you borrow money for short-term, your interest rate is lower. When you borrow money for long-term, your interest rate is higher because whoever is lending you the money, they have to wait longer. Longer means more risk. The compensate the risk, they have to charge you higher interest rate. So banks were relying on short-term borrowings. So what does that mean? If you're relying on short-term borrowing, you have to constantly refinance. So you have to go back and turn over your loan because it's short-term and you have to get a new loan. So what happened if interest rate goes up? Well, you're in trouble because you have to refinance at this higher rate. Or else you have to sell your assets, whatever assets you have. And maybe your assets went down in value. Now you have to sell them in a financial stress situation which their prices will go down. So these institutions also were highly leveraged. So the banking system at that time, highly leveraged means they were relying on that with a little buffer. They had a little bit reserved for losses because they did not think they're gonna suffer those large losses that came up. So even small portfolio losses will drive their net worth negative. So they were not highly capitalized. And this is what the DAB Frank we're gonna see in a moment try to do is to increase the capital reserve for banks on case of losses, they could still withstand. For example, a company like Lehman Brothers were leveraged $30 to $1 at some point. That means for every dollar in equity, they had $30 in debt. So the company was negative net worth. They were relying on debt constantly. Merrill Lynch, 27 to one or 26.9 to one. So all these institution, if anything happens, they were highly leveraged. They were not ready to absorb the losses. And the shoe started to drop. By the fall of 2007, housing prices were declining. Remember, all these people when the market was going up when they were easy, easy, peasy market for home buying, there's a lot of demand on homes. Remember, we talked about the teaser interest rate when those teasers started to reset and the payment went up and the payment went up. All these people then they could not refinance what they did is the exact opposite of what they did when they were buying, they were selling. And what happened when you're selling, you have a lot of supply of homes on the market. And I remember, I still remember really, this is a true story, on my block in my town, I used to live in Eastern Pennsylvania. I still remember and that's why I sold my house. I'm not exaggerating on every block, on every block in the city. There was like four to five homes on sale. I mean, I wish my wife can testify to this. I remember telling my wife, we get to sell out and move out. And this was happening in 2006. And this is exactly when I sold my house. I sold my house fall of 2006. This is when I sold my house. So when all those homes went on the market, houses prices started to decline. So you could not refinance because to refinance you have to have a higher, higher, higher value. And the default rate, the delinquency rate increase and people are not paying their bills anymore. They're not making their payment. As a result, the stock market foresees this ahead of time and started to drop, which would make it worse for people because if oil prices went ups, everything went up in price. If you have any money in the stock market, you feel poorer because the stock market went down. Your mortgage payment went up. It was a perfect store. So many investment banks with large investments in mortgage started to have some serious issues. And really the crisis speak in September, 2008, I still remember that time because I was working as an auditor. I was still working in a CPA firm. I remember September 7th. I still remember that day specifically. The giant, Fannie Mae and Freddie Mac, which they had a large position in those subprime mortgage securities were put into conservatory ship, which is it means the government took them over. And as a result, confidence went down in the housing market. If these two companies, these two large corporations, they need government help. That means we have a real problem. By the second week of September, it was clear that both Lehman and Merrill Lynch were on the verge of bankruptcy. And I still remember, I mean, I don't wanna, you know, the reason I remember this because I lived through this. And at the office, you know, the partner says no more talking about the housing crisis. Actually what the partners did for two weeks, they shut down the internet for us. You only could have internet during lunchtime. And back then you did not have the smart, you know, people did not have those smartphones. Not everybody had a smartphone. So you just, you know, at work you would check the financial news because everybody was consumed with it. And I still remember on my lunchtime, on my lunchtime, I would walk to the Bethlehem Public Library in Bethlehem, Pennsylvania to check to see what's going on, to read the news. So I still remember that those days, and especially that I was working, I work at some point with Merrill Lynch. So I was like, kind of, I was like, what's going on to this company? And by the way, I also bought 200 shares of Lehman right before they went bankrupt. I was taken aback and I lost that back. So on September 14th, Merrill Lynch was sold to Bank of America. So what happened? The government arranged Merrill Lynch to be sold by Bank of America. Now Merrill Lynch is part of Bank of America. The next day Lehman, which is few days earlier, I bought Lehman, I bought 200 shares. Lehman was denied equivalent treatment. They did not, the government decided not to help Lehman, but kind of punish people to say, look, you will pay a price for taking risk because Lehman was taking a lot of risk. Remember, they were highly leveraged. So that's what happened. Two days later, the government, they gave 85 billion to AIG. And I was debating, should I buy AIG or should I buy Lehman? I decided to buy Lehman and I lost, which is not much, like 200 years was like a little bit over a dollar a share. They gave the money to AIG and they didn't really want to, but they had AIG because if AIG went out of business, AIG is an insurance company. Then all these people that are insured, now they are at a risk. So it was too big to fail. That term became very common. Too big to fail, that means if they fail, everybody else will be affected, okay? The next day, the treasury revealed, unveiled its proposal to spend 700 billion to purchase toxic mortgage-backed securities. So to solve the problem, the government said, look, we're gonna start to buy those toxic asset. Any toxic asset companies have, banks have, will buy them, will give you cash for them. You have the cash to keep the economy running. Cause what happened is when Lehman went down, and by the way, since that time, with that 700 billion purchase and toxic asset, the government has been dumping money into the economy, especially now with the coronavirus. Now the government almost dumped in six trillion, including help and buying all sorts of bonds. Right now that's what the government is doing. If you're living today, June 11th, 2020, that's what the government is doing, buying bonds right and left. Any type of bonds this way to keep the economy running to give the company's money so they can survive. And this is when it all started before that was unheard of where the Treasury or the Federal Bank, or the Federal Bank does this. So why Lehman was important? Why Lehman, why the fall of Lehman affected the market substantially? Well, because the Lehman, they used to rely on money market. What is money market on the money market, on the money market? What's a money market that's short-term lending? So they used to borrow money on short-term basis using what's called commercial paper. Now to borrow money, you have to borrow money from someone. It's a mutual fund that they have this money market. So what happened when Lehman went bankrupt and everybody knew Lehman was borrowing that money, borrowing commercial papers. Now everybody was careful because they didn't want to give any money to those mutual funds because they did not know which mutual fund gave money to Lehman. So if he gave money to Lehman, you lost your money. And if he gave money to Lehman, I'm not gonna put my money with you because you lost a lot of money. You're gonna lose my money. Therefore what happened, that short-term lending froze because now everybody doesn't trust everybody. That's why the government intervened. I will, don't worry, lend each other and I will guarantee the loans. So this is what happened. But back then, when that happened, it froze the market. When Lehman felt her fear spread that these funds were exposed to losses on their large investments. And the money market fund customer across the country rushed to withdraw their funds. So if he had money in the money market, you went and he told your mutual fund, I want my money back because I don't know what your exposure to Lehman. I don't know what's your exposure to someone other than Lehman for that matter. Therefore I want my money back. Therefore when people take out their money, there's no liquidity in the market. And they started to put their money with the government. That's what happened. And when there's a crisis, you buy treasury bill. So this way, your money is safe with Uncle Sam. Supposedly, let's always hope that that's gonna be always the case. So as a result, the short-term financing market shut down and corporations rely on the short-term borrowing. Large corporations, they use commercial paper on a regular basis to finance their operation. So if that operation is done, then they can get money, they cannot finance themselves. Also the banks, okay, when the commercial market freezes, that also affected Wall Street, that also affected Main Street because large bank also rely on commercial paper to raise short-term funds. When the bank needs money overnight or for a week or for 10 days, they go to the commercial paper market to raise this money. And that commercial paper market shut down. There's no activities because no one is trusting anyone, especially banks. So the banks find it difficult to raise money and this is a real problem. Now, if banks find it difficult, bank will stop giving car dealership, construction companies, retailers, they will start to, they will stop lending them money. And when they stop lending money to these people, when they shut down your line of credit and you rely on your line of credit to pay your employees, you have no money. So what do you do? You start to lay off your employees. What happened when you start to lay off your employees? The unemployment goes up. You have less people, less people working. It means it's getting worse and worse for everyone. So capital staff companies were forced to scale back under operation, laying off people, unemployment throws, and the economy went into a recession. Okay, obviously it didn't take us much. We kept printing money until we got out of that recession. But bear in mind, this was not limited to the US. The, this financial crisis affected the whole world and especially government in Europe, like the German, the Italian, the French, everybody was exposed. But the people who are exposed, the most people that already had that, like somebody like Greece, they had what's called sovereign debt crisis because they were already in debt. And now they are affected, they were affected more because the European Union economy contracted and they rely on tourism. So a country like Greece, they were hit the hardest. So the government that, it's government debt was about 460 billion. And that's what happened when you have that. When you have that, you always expose yourself to risk. Why? Because if you expose yourself to risk and a financial crisis indeed happened, you cannot survive that risk. So that's why you want to have at least that as possible because financial crisis happen on a regular basis. It's a fact of life. It's going to happen. It's, there is no way around it, okay? In 2011, it was the first kind of country to the default. They could not pay 130 billion of their debt despite a series of rescue package from the EU, from the European Central Bank and the IMF, they are still in trouble up to this point, which is we are in 2020. In the US as a result of this financial crisis, we had the DOP-Frank Reform Act. And the reason for this is to mitigate systematic risk specifically in the banking system by imposing stricter rules for bank capital. It means now you have to keep a larger reserve at your bank in case something happened. You have to have more liquidity, more cash, and you have to manage your risk, especially as banks became larger and their potential failure would more threaten other institution because the way the banking system work, all the banks are interconnected. So if one bank fails, you'll have a domino effect because banks borrow from each other overnight. So if I lend you money, okay, and tomorrow, and tomorrow you failed, I can't get my money back. Then I also borrowed money from someone else. I cannot give them back the money. So there's always a domino effect. So that's why they wanna make sure it's to reduce containment. So they want to make sure banks have plenty of capital and they can withstand any stressful situation. In addition, when banks has more capital, they have less intensive to ramp up risk. So if you have capital, then what happens is you take less risk because even if you take the risk, you are going to absorb the risk. You are going to absorb the losses because you have the capital. So you have to be very careful. Then you are not incentivized to take risk because the FDIC will not help you. You have to pay for your own risk. So basically the attempt to limit the risk activities in which banks do engage. And specifically, they have this new rule called the Volcker rule, named after the former chairman of the Federal Reserve, Paul Volcker, limits the bank ability to trade for its own account and to own or invest in hedge funds or private equity fund, which is riskier investment. So this is the DAB Frank. Also the DAB Frank looked at the credit rating agencies. They remember the credit rating agencies stamping everyone with triple A bond. So the bonds would sell. They created an office to oversees this. Office of the credit rating agencies. So the incentive of the bond rating were also a sore point. A lot of people were complaining that part of the problem is the credit rating agencies. It wasn't only the credit rating agencies was banks, originator, credit rating agencies, accountant, we were responsible. Auditors were responsible. Consultant, everyone was complicit in this because nobody raised a red flag. Nobody said anything because everybody was benefiting. Especially the rating agencies that were selling, literally investigation shows, investigation showed later that they were technically in quotes selling those triple A. So if you don't give me triple A, if Fitch doesn't give you triple A, you go to SMP. If SMP doesn't give it to you, you go to Moody's. And they know, those are the three main ones, they know if I don't give them triple A, they're gonna go somewhere else. So that's why that put an incentive pressure on them. Few are happy with the system that the rating agencies paid by the firm that they rate. That's still a problem because what's the alternative? The alternative is every time you need to buy an investment, you have to find your own rating. Those agencies, they rate everything for you, but they are paid by the companies that rates them. So there's a conflict of interest, but we have to live with that. The act create an office of credit rating within the Securities and Exchange Commission to oversees this credit rating agencies. And if you are still listening, we'll go toward the end. This is my house. This is the house that I sold right before the financial crisis happened. And guess what? All the profit that I took out of this house, I put it in the stock market and the stock market tank. So although I made money, I used to live in this apartment, I used to rent this place. So this was one unit, this is unit one, this is unit two, I used to rent this unit and I lived in this one and it paid for itself. I got out of it. I took the profit, put it in the stock market, didn't do very well because the stock market tanked. Anyhow, as always, I would like to remind you to like this recording, share it, put it in playlist. If you are an accounting or finance students, please check out my website for additional resources. If we are still living through this coronavirus, make sure to stay safe, good luck, study hard, whether you're studying for your CPA or CF.