2007 Financial Crisis Explained (Kind Of)

The tyranny of a prince in an oligarchy is not so dangerous to the public welfare as the apathy of a citizen in a democracy.                              

Charles de Montesquieu 

Nearly a decade on from the greatest economic collapse this world has seen since the Great Depression, everybody has their own unique spin on what happened. Ask them to explain it and you’ll probably get a soup of meaningless acronyms like “CDS” and “CDO” and some paroxysms of “moral hazard” and “taxpayer’s money”. Lewis’ The Big Short (film|book) does much to amend this by telling the story of how a few mavericks bet against the rest of the financial industry – essentially humanizing a story about numbers – and along the way explains exactly what happened.

(The Economist’s explanation does well to explain the mess, but below is my explanation-- it comes with stick-men diagrams)

Simply put, the first purely financially-engineered economic collapse was the outcome of collusion between mortgage lenders, investment banks, and rating agencies, who, driven by greed, and blind to the risk their bets entailed, sustained the greatest housing bubble the U.S.A. has ever seen and exposed the rest of the world to it.

The subprime (meaning offered to the least creditworthy) mortgage crisis had its roots unsurprisingly in subprime mortgages, which initially made a little sense: mass-marketing subprime mortgages drives down homeowner’s costs since higher interest rate credit card debt can be replaced with lower interest rate mortgage debt, then, borrowers' have less net debt and so are more likely to be able to pay off their mortgage. But it all got a little silly when mortgages were being offered to people who couldn’t even make the first payment on their house. YES THAT HAPPENED. And for a while, 2004-06, this wasn’t a problem because as long as house prices were rising, homeowners’ could refinance their mortgages, i.e. because they had more equity (house value) they could borrow more and pay off existing debt, rinse and repeat – to the delight of the lenders. THEN SUDDENLY HOUSE PRICES deaccelerated, they simply didn’t rise as fast as they used to. And s*** hit the fan. (i.e. people couldn't pay off their mortgages and suddenly lenders and bond holders are holding onto these foreclosed properties around the country which they can't liquidate, i.e. turn into cash)

Published on April 26, 2011 in Housing Price Index for the United States 2000-2010

OK a housing bubble popped. But why did Lehman Brothers, Wachovia, Bear Stearns, and AIG, all go bust? Well it’s because they all had housing-related investments on their books. Eh? Can’t be that serious… Well it can when you’re Lehman (which filed for Chapter 11 with assets worth $600b, biggest ever) and you’re leveraged 40:1 (meaning for every $1 in actual cash you have, you have $40 in housing-related investments that are suddenly now worth $0.00).

OK so how did an investment bank staffed by the elitist of the elites from Ivy Leagues, etc. make such a stupid decision? Well here’s where the acronyms and the rating agencies come in. Solomon Brothers in the 80s invented the mortgage backed security (MBS), which was a claim on the cash flow of thousands of individual home mortgages. They also soon engineered the collateralized debt obligation (CDO) which was essentially thousands of MBS’ packaged together. These were sliced into tranches assigned grades according to exposure to default.

OK bear with me, 2 more… credit default swaps or CDSs had previously existed for publicly traded companies and acted essentially as insurance: I pay Company Y 0.1% every year betting that Company X will default, which if they do requires Company Y to pay me 100%. Something like that anyway. But since CDSs can also be thought of as bonds: the premium you pay mimics the mortgage payments paid to the bond holder, and what the CDS seller (Company Y) stood to lose replicated the potential losses a bond owner stood to lose if the homeowners defaulted… you can repackage CDSs and get a synthetic CDO. TADAH. You completed the most challenging part, the rest is smooth sailing from here. (Also, low-grade CDOs could be sliced up into higher grade CDOs, it's all really cyclical and silly)

Cue the rating agencies. So three firms dominate this market: Moody’s, Standard and Poor, and Fitch, but the first two do like 80% of all ratings. Yup rating is their business. Using fancy mathematical modelling they calculate the probability of certain assets going bust, and accordingly assign risk ratings to them. AAA is super safe, and BBB is dangerous stuff.

The heart of the SPMC is right here. Basically BBB-ranked MBSs were pretty risky, and everyone knew that, but what people at Goldman managed to do was create CDOs out of BBB-ranked MBSs and get these new products rated as AAA. The reasoning was basically: “they can’t all fail at the same time”, which superficially makes sense because it is statistically unlikely (especially with a recent history of increasing house prices) for there to be THAT many defaults. But what the RATING AGENCIES failed to account for – this is essentially their fault since they’re doing the risk-assigning – is that the whole housing market was interconnected and vulnerable to systematic risk: if the market tanked, all the homeowners would default, and all the MBSs and the CDOs they comprised would be worthless. So seemingly-safe assets that "only in a doomsday scenario" would become worthless were being assigned AAA ratings and being sold all around the world. 

Then the financial contagion spread around the world. It turns out that a lot of retail banks and other important High Street financial institutions had bought CDSs or other related financial products and when these were soon worth little to nothing and customers started reading of the economic malaise in the news and wanted to withdraw their cash, banks had no cash to give. Anddddd then you have a  “run on the banks”, i.e. you go to the bank and they won’t give you your own money back. Washington Mutual, the largest savings and loan institution in the US at the time, went bust when $17b in deposits were withdrawn this way.

Q: OK so greed and stupidity caused a lot of normal people to lose money at the expense of the rich (taxpayer funded bailouts, i.e. Troubled Asset Relief Program (TARP), gave money to financial institutions who continued to pay employees and executives huge pay packages: AIG gave $200m MORE in 2009, the midst of the financial crisis) … can I have some good news?

              Not much sorry. The banks are back at it making a killing, and the general economy (in 2016) is due for at least a global market correction, if not recession, as Chinese growth slumps and deflation spreads around the world thanks to cheap oil (thanks OPEC, f*** you)… people are kind of tired of QE, so we can’t do much more of that; and emerging markets are going to fare even worse as (a) nobody (China/Brazil/Russia/etc.) buys their product, and (b) they suffer capital outflows thanks to upcoming rate rises. 

             Specifically regarding the US, there’s been some new legislation, namely the Frank-Dodd Wall St Reform Act which re-enacted the original provision of the Glass Steagall Act (1933) that banned proprietary trading (i.e. consumer banks using deposits to make leveraged risky bets), which Gramm-Leach-Bliley (1999) repealed.

                 Globally, the new Basil III accords (a financial regulatory framework) implemented in the aftermath of the crisis have increased banks' minimum capital requirements = more safe.

~~ Bonus ~~

Q: How did the rating agencies f**k up so badly?

              Well apparently the answer is half their model was screwed up: BBB-rated securities were rated thus if the probability of it defaulting was 1 in 500, yet BBB-rated MBSs only required 8% of underlying assets to suffer losses to tank for the whole bond to tank, and this was far more than a 1 in 500 likelihood in 2007… and half S&P were afraid to lose business to Moody’s who were afraid to lose business to S&P, so when Goldman came round asking them to rubber stamp CDOs A, B, and C, as AAA, they did that.

Q: Why did some banks make a killing while others were killed?

              Banks that made $, like Goldman and Deutsche, acted mainly as middlemen, packaging CDSs and MBSs into CDOs and selling these to clients with huge commission to boot… while others like Merrill Lynch lost a ton because they were holding onto the wrong side of the CDOs.

Q: How did nobody see the housing bubble coming?

              Well The Big Short is essentially a story about the people who did see it coming, and bet against it, i.e. shorted the market. Most notably John Paulson made $20b doing so. But in the context of 2007, nobody saw a housing market meltdown coming because trusted authorities like Ben Bernanke, chairman of the Fed at the time, were proclaiming that the housing market was stable and that there was no way Fannie Mae and Freddie Mac would go under.

Q: I’ve got my pitchfork, who do we lynch?

              Time’s list of 25 people right here, which interesting includes Wen Jiabao (for supplying the US with easy credit), and Bill Clinton and Alan Greenspan (for de-regulating, Gramm-Leach-Bliley Act, and keeping interest rates so low for so long – there’s an observable correlation between low interest rate environments and criminal financial activity)

Q: Deets on AIG and TARP

              So when people like John Paulson were shorting the market, who was buying up the other side of these AAA-rated CDSs? Initially it was AIG, who was only too happy be paid premiums to hold these “risk-less” (AAA is the same rating as a 10 year T-note) assets… they didn’t even have to be declared on their balance sheet!! They soon wizened up their act in 2007 when their risk management team realized what kind of s*** they were in. Too late though. Later TARP came to the rescue with $700b of taxpayer money to buy failed subprime mortgages, shoring up companies like AIG, which the government deemed too important to the American people. “Too big to fail” sound familiar? The fact that AIG was receiving taxpayer money and yet still giving huge pay packages kind of pissed people off. Luckily, however, TARP was reduced to $475b by Frank-Dodd and much of its investment into companies like AIG and GM have paid themselves off.

Q: Other consequences of SPMC?

              Bear Stearns and Lehman Brothers, two huge global investment banks that were too exposed to the wrong side of the CDSs went under. The Government encouraged JP Morgan to buy Bear (at a discount price) by guaranteeing its assets, and encouraged Citigroup to do the same for Wachovia, which was eventually bought by Wells Fargo.

Q: “Originate and sell”, what does that mean?

              So mortgage lenders played a role in this mess as they went round giving out mortgages like candy. To them it was seemingly risk-less money because they would originate these loans and sell them to investment banks who would package… you know the rest of the story. That’s where the phrase comes from. Funny story, however, originating these loans wasn’t risk-free because the originator held onto a portion of the mortgage. Thus when the market started crashing, lenders started suffering heavy losses, and when they went down… all the mortgages went down with them. The rest is history. 

here's a bear, cos that's my outlook on '16