If you have six people and only five potatoes, you make mashed potatoes. A mortgage backed security is similar, which makes this recipe of mashed potatoes magic because it grows, or it was supposed to grow, I mean that's what everybody thought. At least the gullible were lead to believe that everyone thought that.
Mortgage lenders treat mortgages like hot potatoes. Once they sell a borrower a loan, the lender turns around and sells the paper on the loan to an investment broker. The lender has made back his money already and doesn't need to wait for the loan to be paid off to make back the money he loaned plus the interest.
The investment broker buys loan papers from several different lenders. The investment broker wants to make a profit, and also doesn't want risk, so he mashes the loans together into a "derivative" we will call Magic Loan Mashed Potatoes. They are magic because if everything works out in the end, they will grow to at least twice their original size, hopefully more!
The investment broker can sell spoonfuls of magic loan mashed potatoes to investors at a profit. Thus, the investment broker has already made back his money that he spent on the loan papers, plus the price markup for a profit.
The investors have as many spoonfuls of mashed potatoes as they can afford. The investors must wait for all of the loans to be paid off before they can make their own profit, in 15 or 30 years.
Someone bought several spoonfuls of mashed potatoes and started waiting. He waited and waited. He didn't like how long it was going to take. He thought the risk was going to be bad, so he decided to create an insurance company specifically for the mashed potatoes. He made it a corporation so he could sell shares of stock in his insurance company. He based his assets on all the spoonfuls of mashed potatoes he had. Since it looked good at the time, he was able to sell shares of his insurance company, and make back the money he spent on the spoonfuls of mashed potatoes he originally bought. He made a huge profit too.
And in the fullness of time, all the loans were paid off, and everyone made a profit. They all retired happily ever after. This was the plan anyway, if you're an idiot.
Way back at the beginning of the chain, where the lenders were selling the original hot potatoes, the lenders were not selling enough hot potatoes. They were told that they would get large bonuses if they sold enough loans, but not many people were buying loans for homes.
Smart* people were saving up cash and paying for their homes straight-up, without paying any interest. Lenders couldn't lower interest rates enough to make smart people buy loans for homes. What could they do?
The lenders could hook poor, under-educated people by offering Adjustable-Rate-Loans that started out at only 2%, but increased to 7% after a couple of years. Another gimmick is the "interest-only" loans in which you pay only the interest, but only for a set period of time. You must eventually start paying off the principle, which will increase your payments.
Some lenders offered "zero percent financing" which means the payment is still higher because the amount of money that would normally be called "financing" is simply worked into the original price. Nothing is free.
Some lenders were letting borrowers lie about their income, but the bad loan papers somehow made it into the investment broker's magic mashed potato recipe. Some lenders knew that the borrowers could not afford the payments on an adjustable rate mortgage when the interest rate adjusted higher in a couple of years, but the lender also knew it would not be his problem or his bank's problem long before that happened, because the lender would pass along the hot potato to the investment broker.
Since not many smart people buy loans for homes or cars, the investor who created the insurance company was smart enough to know the high failure rate of fancy gimmicky loan types like the "Adjustible Rate Mortgage" and the "Interest Only" loan, and the loan for the car that's interest-free for 6 months or two years.
The investor who created the insurance company and sold shares of his company on the stock market, sold shares to other people who were not invested in the magic mashed potatoes, other people who did not know anything about the magic mashed potatoes.
When the investor who created the insurance company sold enough shares of his own company, he bought an insurance policy against his own magic mashed potatoes, because he knew better.
Gradually, thousands of Adjustable interest rate mortgages adjusted higher. Thousands of interest only loans finished the interest only payments and it became time to start paying the principle. People who were barely getting by because of low wages suddenly found themselves falling behind on their loan payments. On top of home loans, some people were making car payments too. Some people were already struggling with medical bills.
Gas prices went up. Food prices went up. People stopped spending their money and businesses were closing and laying off employees. The unemployment rate went up to ten percent. Lots of people forclosed on their homes and were evicted or walked away.
The investor who created the insurance company filed a claim against his magic mashed potatoes because the mashed potatoes went bad. He made a huge profit. Unfortunately, the price of his insurance company's shares plummeted because his insurance company assets were drained away due to the claims. He later went to the government and asked for a bailout with taxpayer money because his insurance company was "too big to fail."
*"Smart people don't borrow money, ever." -- Dave Ramsey
Mortgage lenders treat mortgages like hot potatoes. Once they sell a borrower a loan, the lender turns around and sells the paper on the loan to an investment broker. The lender has made back his money already and doesn't need to wait for the loan to be paid off to make back the money he loaned plus the interest.
The investment broker buys loan papers from several different lenders. The investment broker wants to make a profit, and also doesn't want risk, so he mashes the loans together into a "derivative" we will call Magic Loan Mashed Potatoes. They are magic because if everything works out in the end, they will grow to at least twice their original size, hopefully more!
The investment broker can sell spoonfuls of magic loan mashed potatoes to investors at a profit. Thus, the investment broker has already made back his money that he spent on the loan papers, plus the price markup for a profit.
The investors have as many spoonfuls of mashed potatoes as they can afford. The investors must wait for all of the loans to be paid off before they can make their own profit, in 15 or 30 years.
Someone bought several spoonfuls of mashed potatoes and started waiting. He waited and waited. He didn't like how long it was going to take. He thought the risk was going to be bad, so he decided to create an insurance company specifically for the mashed potatoes. He made it a corporation so he could sell shares of stock in his insurance company. He based his assets on all the spoonfuls of mashed potatoes he had. Since it looked good at the time, he was able to sell shares of his insurance company, and make back the money he spent on the spoonfuls of mashed potatoes he originally bought. He made a huge profit too.
And in the fullness of time, all the loans were paid off, and everyone made a profit. They all retired happily ever after. This was the plan anyway, if you're an idiot.
Way back at the beginning of the chain, where the lenders were selling the original hot potatoes, the lenders were not selling enough hot potatoes. They were told that they would get large bonuses if they sold enough loans, but not many people were buying loans for homes.
Smart* people were saving up cash and paying for their homes straight-up, without paying any interest. Lenders couldn't lower interest rates enough to make smart people buy loans for homes. What could they do?
The lenders could hook poor, under-educated people by offering Adjustable-Rate-Loans that started out at only 2%, but increased to 7% after a couple of years. Another gimmick is the "interest-only" loans in which you pay only the interest, but only for a set period of time. You must eventually start paying off the principle, which will increase your payments.
Some lenders offered "zero percent financing" which means the payment is still higher because the amount of money that would normally be called "financing" is simply worked into the original price. Nothing is free.
Some lenders were letting borrowers lie about their income, but the bad loan papers somehow made it into the investment broker's magic mashed potato recipe. Some lenders knew that the borrowers could not afford the payments on an adjustable rate mortgage when the interest rate adjusted higher in a couple of years, but the lender also knew it would not be his problem or his bank's problem long before that happened, because the lender would pass along the hot potato to the investment broker.
Since not many smart people buy loans for homes or cars, the investor who created the insurance company was smart enough to know the high failure rate of fancy gimmicky loan types like the "Adjustible Rate Mortgage" and the "Interest Only" loan, and the loan for the car that's interest-free for 6 months or two years.
The investor who created the insurance company and sold shares of his company on the stock market, sold shares to other people who were not invested in the magic mashed potatoes, other people who did not know anything about the magic mashed potatoes.
When the investor who created the insurance company sold enough shares of his own company, he bought an insurance policy against his own magic mashed potatoes, because he knew better.
Gradually, thousands of Adjustable interest rate mortgages adjusted higher. Thousands of interest only loans finished the interest only payments and it became time to start paying the principle. People who were barely getting by because of low wages suddenly found themselves falling behind on their loan payments. On top of home loans, some people were making car payments too. Some people were already struggling with medical bills.
Gas prices went up. Food prices went up. People stopped spending their money and businesses were closing and laying off employees. The unemployment rate went up to ten percent. Lots of people forclosed on their homes and were evicted or walked away.
The investor who created the insurance company filed a claim against his magic mashed potatoes because the mashed potatoes went bad. He made a huge profit. Unfortunately, the price of his insurance company's shares plummeted because his insurance company assets were drained away due to the claims. He later went to the government and asked for a bailout with taxpayer money because his insurance company was "too big to fail."
*"Smart people don't borrow money, ever." -- Dave Ramsey
