It has been 3 years since the 2008 Financial earthquake hit us and recovery still seems to be a long winding road ahead. We have seen a lot of European economies go bust. The American economy has been limping along, unemployment still hurts and houses are available in the flea market. So I decided to understand this better. And luckily I ran into Professor Eisenkleiftovich, the genius, who agreed to give me interesting insights to help me decode this monster.
Me: Professor, I have heard a lot about this Credit Crisis and the devastation it caused around the world. But I never completely understood it. Could you shed some light?
Prof: Sure, my boy. It is going to be a long night. Where do you want to start? By the way, did you know that holiday homes in
Europe are currently selling for as
low as $200K. Guess you should get one of those!
Me: Well, I am just $190K short. Prof, let us come to the topic at hand. As far as I know, the economy was fairly stable after the Great Depression in 1930s for a long time. But then over the last 2 decades, we have seen a lot of crises from which we haven’t recovered yet! Why is that?
Prof: Hmm..True. These crises were all caused by an out of control industry which was allowed to become a monster starting from the 1980s!
Me: I don’t get that. So what happened in the 1980s?
Prof: De-Regulation! Let me start simple here. There are 2 types of banks: 1) Savings & Loan Banks which lend you money in return for promises (that you make your loan payments) 2) Investment banks that give you promises (of higher returns) in return for money. Now for a long time, regulation managed to keep these 2 entities separate. Investment banks were private and the owners put in a lot of their own money as part of the investments and monitored the returns very closely. But it all changed too soon.
Me: Ohh.. So what did de-regulation do?
Prof: Well, first things first, investment banks went public and started investing with stock holder money. Savings and loan banks were also deregulated and they made riskier investments with depositor money.
Me: Sounds like recipe for trouble!
Prof: No, not yet. We are just getting warmed up. This was the period which saw the rise of one of the most influential groups in American politics: financial lobbyists. In a span of 30 years, Wall Street has taken over
and the de-regulation they pioneered is feeding on our economy. Here is a fun
fact: In 1972, Morgan Stanley had 110 employees, 1 office and $12M in capital.
Today, it has over 50,000 employees, offices around the world and several
Billion dollars in capital. Washington
Me: So Professor, why didn’t anyone oppose this de-regulation?
Prof: Oh, yes. Lots of people did. But the lobbyists were so powerful that any attempt at regulation was promptly suppressed. The
economy and political system was dominated by 5 Investment banks (Goldman
Sachs, Morgan Stanley, Lehman Brothers, Merill Lynch, Bear Stearns) and 2
Financial Conglomerates (Citi and JP Morgan) who were all powerful and ushered
in the era of de-regulation. US
Me: Okay, got that. So what do you think led to the Credit Crisis of 2008? Wasn’t it called the Sub Prime Mortgage meltdown?
Prof: Aha… now we are getting into a very important discussion. Are you ready to hear about the true “Weapons of Mass Destruction”?
Me: Of course. I am all ears. What are they?
Prof: Derivatives, of course. They are such fancy toys to play with. But for you to understand the crisis completely, I need to tell you about mortgage loans, CDOs and CDSs which combined to create what I call: “The ticking time-bomb”.
Prof: Ha Ha! Let me start with the “Securitization food chain”. It is a nexus of Home buyers, Money Lenders, Investment banks and poor unassuming investors. Owning a house has long been the “American” dream and the use of tricky lending programs to lend money to people with “weak” or limited credit history started the sub-prime mortgage crisis. This first started a housing boom wherein even people who could have qualified for a traditional loan fell to the aggressive mortgage sharks who promised simple loans at supposedly rock bottom rates without explaining the stricter repayment terms and higher interest rates towards the latter half.
Me: Okay, hang on. If you lend money to people with poor credit, the risk of repayment is so obvious. Why would they do that?
Prof: That is where CDOs (Collateralized Debt Obligations) rein their ugly head in. These lenders would have been worried about the borrower’s credit status if they were to collect the money from them. But they instead sold those loans to investment banks which created a complex creature called CDO. Basically they combined different types of loans like student loans, credit card loans and mortgages and packaged them into a CDO. These banks then sold these CDOs to investors who had no clue what they were getting into. Oh, by the way, these banks paid Rating Agencies to evaluate these CDOs and these agencies were happy to provide them with excellent ratings.
Me: Oh.. that is a vicious circle. And I can see it continued to fuel the housing boom for a while before the free fall.
Prof: Yes. The investment banks went crazy and borrowed heavily to buy more loans and created more CDOs. And to further entice investors, AIG came with another genius: CDSs (Credit Default Swaps). Now in plain English, this is insurance for the investors against CDOs if they went bad.
Me: Well, that seems like it solves part of the problem, isn’t it?
Prof: No, it was exactly the other way around. This increased trouble exponentially. Now there were 2 kinds of people who bought these swaps. One: the regular investor who had the CDO. Two: The speculator who bought these swaps to bet against the CDO which he didn’t own.
Me: Okay. But I still don’t see how it multiplies the problem!
Prof: Well, first of all you are allowing someone to buy insurance for something they don’t own. Now imagine how many insurances it could create for 1 single home. And take a moment to think about the chaos that could ensue if that house burns down.
Me: Hmmm… I see what you are saying. In this case, people weren’t able to repay the loan; the CDO failed resulting in a cascade of losses.
Prof: You seem to be getting into your element here. Further more, these swaps were unregulated too and no money was put down to cover the losses. Instead huge bonuses were paid out in AIG. Eventually the bubble exploded, triggered a chain reaction and things went into a downward spiral. The whole system started falling like a pack of cards. And the rest is history. But what pains me is that still no strict regulation has been enforced.
still functions as a Wall Street Government. The lobbyist nexus still runs very
deep with economists and even some reputed scholars supporting these financial
instruments through their academic and literary works. On the other hand, if
you see, at least Washington Europe did take a lot of
measures to tighten the screws on their financial system. Wish we can take a
leaf out of their book. Let us hope for the best. Before I go, let me leave you
with a parting thought! And I am going to be philosophical about it.
Real Engineers build bridges.
Financial Engineers build dreams.
When dreams turned out to be nightmares, other people paid for it!