In layman’s terms, what caused the 2008 financial crisis?

Before we begin our story, let us define the characters of our story along with one key feature and function that defines our characters throughout the story.

Common People: They deposit money in banks. They buy houses by taking loans from the banks. They are innocent.

Banks : They provide loans to people and charge interest. They are greedy

Rich investors (Money Market): They have lot of money and always look for opportunities to invest money to earn big profits. They are profit seeking.

Credit rating agencies: They basically give ratings, just as our film censor boards, to investment products. They are competitive and greedy. for ultra simplification:

5 star rating→ best investment. Low risk

1 star rating→ worst investment. Big risk

Federal reserve: It is basically to regulate the financial system ensuring the preservation of interest of the common people who have deposited the money in banks and invested in other securities (like shares).

Smart guys: They understand the fundamentals of economics and are very observant. They are greedy too.

Now. Let us understand how the economy works domestically and how it is interconnected with the globe , step by step.

A person want to buy a house for $100.

He seeks loan from a bank. The bank gives him $100 on some interest rate, let’s say 5%. in return the person signs a piece of paper and gives it to the bank. Let us call this paper as a mortgage paper.

What is a mortgage paper?

A mortgage paper is basically a guarantee by the common man that hey will pay his loan + interest. If the person fails to pay his debts, the bank can confiscate his house , sell it and recover the outstanding amount.

Let us see inside the Bank now. The bank has given loans to many common people. It has many mortgage paper with it. The bank now bundles all the mortgage papers depending on the quality of loans.

What is a quality of loan?

Highest quality bundle → people with good paying capacity. LOW chance of people not paying the debt (Low Defaulting)

lowest quality bundle → People with poor paying capacity. HIGH chance of people NOT paying the debt.( High Defaulting)

Who decides the quality of loans?

For this we have our 3rd character, the Credit rating agencies.

What does the credit rating agency do?

It bundles the loan together as per their quality and gives them ratings. 5 star for highest quality loan. 1 star for lowest quality loan.

The bundle after the rating is now called a “CDO”. leave the nomenclature, it is not important here.

Why does the bank bundles the mortgage together?

To sell it to rich investors.

Why does the bank sell the bundles to rich investors?

Let’s say the bank has 10 mortgage paper with $100 loans on each and 5% interest rate. consider the loan paying deadline to be one year. so the bank will have to wait for 1 year to get an amount of $100 X 10 + $5 X 10 = $1050.

So, the bank bundles the mortgage and sends it to the credit rating agency. The ratings agency rates the loans as High quality and Low quality.

The banks now, sells the bundle to the investor for a price. the price they charge is (loan amount+ a commission let say 2%). So the bank has gained $100 X 10+20=$1020 all at once, without waiting for a year, and thus saving a huge amount of time and resources.

Why do the rich investor buy the bundle (CDO) ?

Because the investors gets higher returns on their investments.

He buys one bundle for 1020. with a guaranteed recovery of 1050. So he buys many such bundles, as he is rich and has a lot of money. The more bundles he buys, the more his profit.

They buy these bundles from different banks and thus increasing their return on investment.

How do they Buy the bundles (CDO)?

They look for the star rating. they prefer buying 5 star rated bundles. ( Technically, the ratings are AAA for the best)

So, now where did the problem begin? Hope you remember the characteristics and function of our characters.

Greedy Bank: Since they were making upfront profits by selling the bundles (CDOs) to rich investors, they liked this idea. They started collecting more and more mortgage papers. All that the bankers cared was lending out as much loans as possible and disposing them off to rich investors and making quick profits.

How do they collect more and more mortgage papers?

By easing out their loan processes. verification of the people’s credit history, salary etc were all less of a priority now. Get as many people as possible to receive the loans.

Schemes like NINJA loans (No Income No Job) hit the market.

loans were given to migrants, people with low paying capacity etc which essentially increased the risk defaulting.

So, now our banks have a lot of mortgage papers with itself to bundle together.

Competitive and greedy rating agencies: Let say there are two famous and credible ratings agency in the market. M and S. the agencies charge a fee for examining the mortgage and providing it a rating. Now, as “M” see a lot of these bundles coming to it, and bank wanting best ratings possibles, the rating agency “M” didn’t want to loose such an opportunity to make huge profits to its competitor “S” . So it started giving the banks what they wanted. So, the bank wants high ratings on the bundle, Here it is. Thus, what was essentially happening:

Low quality bundle were given 5 star rating : Let us call these low quality bundles as ‘Sub-prime mortgages’ . But, as i said, nomenclature not important here.

Rich Investors: Since, all the bundles are now highly rated with low risk, the demand for such bundles increased.

Now, let us understand the basic demand-supply economics at play here:

Highly rated bundle → High demand by rich investor → higher value for such bundles→ more incentive for the banks to create more of such bundles → for more such bundles, the bank’s sough borrowers for housing loans→ more people can now buy homes→ greater demand for houses created→ homes are in limited supply→ the prices of houses go up→ house becomes a source of good investment as people can now buy houses via loans and sell them at higher prices due to its increasing prices→ buying of house becomes easy due to easy availability of loans→ Higher the prices of homes , more the value of loans→ more value of loans means more the value of the bundles → more lucrative the bundles become for our rich investors→ more the demand for such bundles.

This sets the vicious economic cycle of Boom, marked by high growth and high inflation. The only problem is that this type of growth is not sustainable. Hence, it is also called a bubble. Here, the housing bubble.

What is a bubble?

A bubble is exactly what is sounds. something that is made of thin layer with nothing concrete to support its increasing shape for a long duration, except Air, and which thus it can pop any time.

So, In economics, a bubble is when the prices of certain commodity rises based on speculation. people buy a certain product in the hope that the prices will increase in future and they can sell them at higher price any day. A wide number of people believe this, and start buying the product. this creates a great demand in the market for the product, this sentiment runs all across the market and more and more people want to buy this product.

When and How does a Bubble pop?

Now, when some people realize that the product they are buying is actually not worthy of the current value attached to it. The current value is quite higher than the true value. we call it “over-valued”, the investor start selling the product in large quantity to make profit before anyone else realizes this. Now, when there is a huge supply of the product in the market, its value decreases. as people see the price decreasing, majority panic and start panic selling the product. more supply in the market, lower the value of the product and this sets the vicious cycle for a bubble burst or an economic crash.

How did the housing bubble Pop?

Now, remember that many of the bundles were loaded with mortgages with high risk of defaulting by the borrowers. So, now came the time. The prices of house were sky rocketing. It eventually became impossible for borrowers to pay back the loans. Here two things happened.

Borrowers started defaulting: So, the risky bundle rated “5 star” now started loosing its value as there were not much recovery.

People started selling their house: now, again, with large number of people selling their house, the supply of houses increases and thus the value started decreasing. As the value of houses started to decrease, so did the value of the bundle. (since the bundle is nothing but a collection of mortgage on these houses)

So you see, the prices of houses started to fall drastically due to panic selling, as is the case with any bubble.

What about the smart guy character in our story?

Now, a few people actually went through the highly rated bundle one by one and checked whether the loans were actually low risk as stated by the ratings agency. they did the background checks on the borrowers. they sensed the reality behind such huge increase in prices and took advantage of the situation.

Smart guys started betting against the bundles. What does this mean?

So, the bundle that our banks and investors hold, i want to buy an insurance against these bundles. So, in event when these loose their value, the banks will have to pay me the insured amount. Until then, i pay the monthly/yearly premium on the insurance to the bank. This is just like any other insurance product. The only difference was, the smart guys knew for sure that these bundles are going to fail and the banks will have to pay them the insured amount. Let us call this insurance product as a “credit default swap”. But, as i said Nomenclature doesn’t matter.

So, what happened when the bubble burst?

Rich investors: They were loosing a huge sum of money on their investment as the bundles they held were of no value and no returns. A few investors were on the verge of bankruptcy.

The banks : They were under huge payment obligation for the insured bundles which were failing drastically. The payment obligation were so high that they many were on the verge of bankruptcy.

What happens when banks and investors are on the verge of bankruptcy?

Since, the banks and investors are listed on stock market, the news of bankruptcy causes their reputation and thus their stock to fall drastically, creating another blow to them.

Bank’s bankruptcy essentially means it has failed. Now, since the bank is made of the money from the people in terms of deposits, it means huge loss to the people.

How does this affect the common people?

The entire financial world, including banks, investors etc are made up of money from the people all over the world. So, these financial institutions failing implies the common people loose their money, their insurances, Investments, social security and ultimately their job. This creates huge unemployment.

The entire business world runs majorly on private investment. So the failing of financial firms (rich investors and banks) affects other core businesses due to loss of investment.This means loss of jobs in all other inter-linked sectors of the economic supply chain.

So, the economic cycle of bust sets in. This is called a recession.

Now, comes the federal reserve:

Fed says: The financial firms cannot fail for a long period of time. So, how do they recover? they need money. From where does this money come from? Let the people of the world, pool in and give the required amount to make these firms stand again. Or instead, there is already a pool of people’s money in the form of Tax collection by the US govt, let’s use this money. Let us Bail-Out these banks and investors. They are too-Big to fail.

Who is the ultimate looser:

The Banks?

NO, They are bailed out. No criminal or financial fraud proceedings against them. They conduct the business as usual.

The Rich investors?

NO, They are bailed out too.

The Smart guys?

NO, They made huge profit on the insurance claims for the failed bundles. They are praised for the “prediction” of the crisis.

The Credit ratings agency?

NO, Let’s just tighten the norms so that they don’t do this next time. But, who knows?

The people?

YES, the immigrants, the working class, the middle class.

Q.1) How did the smart guys buy an insurance over the product they don’t own?

Ans: Consider this, I own a car. I have the insurance on car and in case the car gets damaged, the insurance company will pay me. This is our simple world. Now, let’s take this car into the world of capital market (Where these Bonds, mortgages are traded). Here, I have full faith on my driving skills. You some how come to know that the right wheel of my car is going to burst after a few weeks and you want to capitalize on this. You come to me and say that you want to buy an insurance against my car. I wonder over the proposal. I am sure that i can never get my car into an accident. So i think you are a fool, digging your own grave, so i want to capitalize on this too. Hence i introduce a special paper which i will call “CAR ACCIDENT SWAP”. In case the car gets into accident, I will pay you. So, it is a kind of reverse insurance. Here, the owner of the asset is confident enough and based on this confident, he sells insurance , and not buy insurance. Hope this makes it clear now.