2008

On the financial crisis

For those of you who haven't seen 'The Big Short' – you know… that movie with Steve Carell and Christian Bale about the slaughter of the global economy – firstly, you're crazy, and lastly, you're welcome. 

The movie captures the 2008 financial crisis using an array of unhinged protagonists spewing what were perhaps the most convoluted terms I heard as a 12-year-old. Let me tell you now, though, they seriously love overcomplicating shit. 

Let's get started, shall we?

The foundation of the crisis resided in America's housing market, specifically the creation and use of mortgage-backed securities. A MBS is a bundle of different mortgages (home loans) and other real estate debt that investors can purchase shares of to receive periodic payments. They're very similar to bonds and coupon payments; only the money comes from people's mortgage payments rather than a more direct debt to a bondholder. 

The investor who buys a MBS is technically lending money to the homeowner and acting as the bank providing the mortgage. 'Traditional' banks delivering these mortgages would sell them at a discount to investment banks to be compiled into a MBS with the incentive that these banks get equity in the MBS after its creation. 

1. The bank provides the mortgage to a potential homeowner

2. The bank sells the mortgage contract to an investment bank

3. The investment bank compiles hundreds or thousands of other mortgages into a MBS

4. The MBS is divided into shares and sold to investors

   1. Standard practice dictated that banks would automatically receive equity in the MBS 

5. Every month, the investment bank collates every homeowner's mortgage payment and pays investors according to the equity they have in the MBS 

Banks could record a sale on their balance sheet without risking a homeowner defaulting on payments, all while earning interest. 

Eventually, collateralised debt obligations (CDOs) became a popular conduit for investing in MBSs. This is fundamentally the same thing as a MBS but slightly more nuanced. The critical difference is that CDOs incorporate tranches, the final investment product that investors buy. These tranches offer distinct risk levels by categorising the bonds according to higher and lower credit ratings (safety levels) with correspondingly higher or lower yields. 

Banks offered investors three different tranches:

• Senior

  • A high credit rating but a lower yield

• Junior

  • A lower credit rating but a higher yield

• Mezzanine 

  • Somewhere in between the other two

Should defaults occur, senior tranche investors receive payments first, and junior tranche investors receive them last. 

Indeed, that was a safe idea, right? Who doesn't pay back their mortgage? By 1999, EVERYONE wanted a piece of the pie, and people got greedy. Banks started deregulating their vetting process and issued infinitely more mortgages. Who wouldn't? So, the creation and popularisation of subprime mortgages began. 

Banks would effectively hand out adjustable-rate mortgages (ARMs) – home loans with variable interest rates – to people who didn't need to provide any proof of income! What's worse is that banks bundled these mortgages with safer, more stable ones to disguise the underlying danger while credit rating agencies would stamp them with a AAA rating (the safest of them all) and send them off for investors to play with. 

One by one, people began defaulting on their mortgage payments. Houses went on the market, but nobody could buy them anymore. Supply was up, demand was down, and home prices started collapsing. As time passed, mortgage holders found that they were making payments for houses that were now way overvalued, so they stopped paying money, too! As this happened, investment banks stopped buying subprime mortgages, and banks were getting stuck with faulty loans. It all came crashing down. 

Funnily enough, investment banks exacerbated the damage the crash caused without knowing it. They were so confident about the strength of MBSs, CDOs, and the housing market that they started offering credit default swaps (CDSs). 

CDSs are insurance on MBSs and CDOs available to anyone, even if you don't own any securities. A buyer of a CDS would often pay an ongoing premium similar to periodic payments on an insurance policy in exchange for the guarantee that the seller agrees to pay the security's value and interest payments if the underlying equity defaults. So, if the MBS or CDO failed, investment banks would need to pay the owner of the CDS. In a 2000s context, you'd be betting against the American economy. So banks would sell them, concluding they would never have to pay anything in return.

Of course, when everything crashed, investment banks owed far more money than they had. Twenty-five banks went under in 2008. 

This is, of course, an oversimplified explanation of the crisis. Regardless, this story is more than just information. Most banks stayed rich; one guy went to jail when hundreds should have, and all for what? Some money? People lost their homes, jobs, incomes, families, and lives. 

It's easy for me to talk about the crisis like a series of facts because I was three and oblivious. But there are hundreds of stories on the internet about people's experiences suffering post-collapse. Take some time now to read up on how it disrupted people's lives, and maybe we'll all learn a thing or two about the consequences of immense greed. 

It was more than just a financial crisis. It was armageddon. 

READ OVER! Here’s some things to keep your mind running.

• More than two weeks after House conservatives ousted Kevin McCarthy from the speaker's chair, the party is still looking for a replacement. The whole thing is in shambles.

• I found a new jazz song y'all might like: Blue Mood by Piero Piccioni. He captures sentiments of melancholy and longing in a serene blend of a piano melody and scarce accompaniment. It’s a great listen if you wanna ruminate and get all deep or just study.

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