Let us think of the housing loans as cookies and the cookie salespeople as the banks.
In this virtual world of ours, for every box of cookies that the salesperson sells, the customer pays her a token, claiming that he will pay for the cookies in installments(of 10$ each) over the next year(=120$). Since she has to give the cookie company only 100$, this seems like a pretty good deal, so she sells the cookies.
Till this moment, the responsibility of choosing the “right customer” is on her, since if the customer refuses to pay(defaults), she loses the money she has paid to the cookie company and doesn’t make any profit.
Introduction to CDOs(Collateralized debt obligations)
The salesmen together sell 100 cookie boxes in our imaginary world.
Now, a smart guy from the locality enters and makes a deal with the sales people. Together they decide to sell these coupons that their customers give them, back to the public at 100$ with two offers to choose from
50 coupons(Group A )That will pay 9$ a month(108$) as and when the cookie customers pay back
50 coupons(Group B) That will pay 9.5$ a month(114$) as and when the customers pay back.
The catch is that the people who buy group A coupons get paid first, so for a given month, if 50 of the 100 customers don’t pay, the people from group B don’t get their money, but the ones from A do.
Think of it as a bucket with the installments from the customers as a water source.
Now a strange thing begins to happen. For ever cookie box that the salespeople sell, they get an assured 9$(on average), irrespective of whether the customer pays or not. This makes them sell cookies to people who are very unlikely to pay back! The demand for cookies begins to skyrocket as everyone begins to purchase more cookies. Everyone’s happy, but everything isn’t as rosy as it looks. It is the birth of a bubble
As the demand increases, so does the price of the cookies. The cookie company now sells the box for two times the price. However since people who aren’t capable of paying face no resistance from the sales force, the demand is unaffected.
The problem begins to surface when it is time to payback for the cookies. Since a lot of our cookie eaters didn’t have the money to pay for them, the funds begin to dry. The banks take back the cookies from the customers since they haven’t been able to pay.(assume that in our virtual world the people don’t eat cookies, just sniff them :P) This leads to a large supply of cookies in the market, and the prices drop. So the people who had bought the cookies at 240, will now get only 120 if they sell them in the open market. Knowing that paying installments worth 240 doesn’t make sense for a 120$ cookie box, they declare that they aren’t able to pay as well.
From there it is a downhill journey. People who had bought the cookies as well as the ones who had bought the coupons from the smart guy lose money, and the world faces one of the biggest recession in recent times.
Now if your 10 year old has lost faith in the world, show him this picture of a panda rolling downhill. Might just cheer him up!
From my Quora answer