Do you feel like you really understand what happened back in 2008? If not, you should.
Have you ever been cruising down the street when suddenly you’re compelled, by either spirits or randomness, to stop and think, “Hold on a second… Besides giving me a .05% yield on my account balance, what does my bank actually do?”
Commercial banks are in the business of creating money and making loans.
“Oh, like the Federal Reserve?”
Not exactly. Commercial banks can’t create money out of thin air. However, by the power vested in them per the Federal Reserve Act of 1913, they can loan up to 10x the dollar amount that they have in deposits. This is called fractional reserve banking, and it has its pros (more credit in the system, which, when interest rates are low, can help spur economic growth) and cons (if everyone wants to pull out their deposits at once, the bank is screwed).
This isn’t the same as the paper money that is minted by the Treasury, it’s digital and actually much more common — physical cash now only makes up 3% of the money in circulation, compared to 97% of digital money that has been created by commercial banks.
That said, loans and money creation are just the products of a bank’s real job, which, like most players in the financial system, is risk management.
So let’s explore what happens when commercial banks and other financial players (insurance agencies, investment banks, credit agencies, etc.) completely abdicate their responsibilities as risk managers and let themselves be consumed by greed.
Conditions and Assumptions in the early 2000s
At the dawn of the 21st century, a few coincidental events took place (I’m not talking about the Mad Cow disease scare in Europe).
- Following the dot-com crash, investors were eager to find new places to grow their wealth.
- Mortgage lending requirements were loosened (“everyone in America should be able to buy a home!” … even people with less than stellar credit, also known as “subprime” credit).
- Alan Greenspan, then chairman of the Federal Reserve, reduced interest rates to 1% (i.e. credit was very cheap).
At the time, the dogma that no one seemed to be willing to shake, was that “housing only goes up.” So, an attractive investment was in mortgages — you know, the huge loans people take out to buy a house, and pay interest on for like, 30 years.
Quick sidebar: There’s a common myth worth dispelling here, and that is the idea that your house is an asset. If you buy a house outright with cash, yes, it’s an asset. But most people can’t do that. So remember this: a house is only an asset to the lender. If you default on your mortgage payment, it’s the lender that gets your house.
But how do investors get access to mortgages?
In 1981, the Federal National Mortgage Association (known colloquially as “Fannie Mae”) issued the first mortgage-backed security or MBS.
An MBS is basically a collection of thousands of mortgages, bundled into one big basket by the bank and sold to Fannie Mae, who then resells the asset on the bond market. Investors can buy these securities to get a monthly slice of the interest (and principal) payments. In the early 2000s, MBS’s started selling like hotcakes.
Lenders love selling these mortgage-backed securities because every time they sell them, they have more money to lend. It’s a great system when new housing is being built faster than you can blink (remember that 1% interest rate? That meant developers could get really cheap loans to build new homes) and new homebuyers — creditworthy or not — are lining up to take the first step in achieving the American Dream (homeownership).
This business was so profitable, that lenders were incentivized to attract even folks with terrible credit into the system using predatory offers (e.g. zero interest in the first year or two, then a massive, almost unfathomable hike). But hey, even if they defaulted on the payment… the lender owns the house and as we know, HOuSinG oNLy GoEs uP! So what did they really have to lose?
The Insurance world was watching this gravy train from the sidelines
And these companies were getting serious MBS envy. Not to miss out on this golden opportunity, insurance companies started selling these funny little things called Credit Default Swaps (CDS), which would pay out if someone defaulted on their mortgage. This gave investors the opportunity to hedge their mortgage-backed securities by buying CDSs. In other words, if the mortgage payments stopped coming in due to default, the CDS would payout. Smart! (Only one more new acronym today, I promise).
Not sure what the insurance companies were smoking at the time, but they were so convinced that this housing market was going nowhere but up, that they would regularly sell up to TEN of these CDSs against a single mortgage. The insurance companies were basically building a house of cards — they had created more policies than they could ever expect to service if the housing market ever saw a downturn and debtors started defaulting on their loans. As you can tell, things are starting to get frothy.
The Dangers of Miscalculating Risk
As lenders started taking on more default-prone debtors, adjustments to the traditional mortgage-backed security were in store. Instead of selling the whole thing as one asset, it became possible to slice and dice the mortgages into different “tranches”.
Think of an MBS like a parfait. You’ve got…
- the granola on top represents the mortgages at the lowest risk of default (those are the mortgages that have solid debtors — good credit, payment history, income, etc.)
- then the yogurt represents maybe slightly more risk, but still safe (these mortgages are with slightly less qualified borrowers, but not horrible)
- and last, the sugary fruit goop at the bottom is the high-risk stuff (serious risk of default — the borrowers are considered “subprime” and they were also likely the victims of predatory offers)
The respective categories earned the following ratings from the credit rating agencies: granola got AAA (basically the highest rating possible, yogurt got something between AA and BB, and sugary fruit goop got the “junk” rating. These junky tranches are called the “equity tranche”.
I think it’s important to call out how CRAZY this rating assessment is
The idea that a collection of mortgages could get a AAA rating (which is the same as the credit rating for the United States Government) is absurd. Ratings agencies exist to help investors understand risk. This was a massive failure on their part… it’s negligence, really.
The higher the rating, the lower the risk
This means that the AAA-rated tranche would pay out a lower interest rate. The tranches of these mortgage-backed securities, which were now being packaged up and sold, are called “collateralized debt obligations” or CDOs. Let’s pause for a quick acronym review:
Mortgage-Backed Security (MBS): is a bunch of mortgages bundled into a basket and sold as a security
Credit Default Swap (CDS): is a financial instrument created by insurance companies to let investors hedge the risk of default on the mortgages inside a mortgage-backed security
Collateralized Debt Obligation (CDO): is a tranche (slice) of mortgages within an MBS which, based on the composition of mortgages therein, could earn a credit rating corresponding to the “quality” of the borrowers who were paying off the mortgages.
Appetite for equity tranches isn’t super high
Which makes sense — sure the interest payouts would be astronomical to compensate for the risk, but lots of investors found that the risk maaaaaaybe wasn’t worth it. And good for them, because if debtors DO start defaulting, anyone holding the equity tranche is the last person to get paid out.
It begs the question: if people don’t want to buy the equity tranche, what happens to it?
Banks just keep them on their balance sheet. Said differently, it is the BANKS that are holding on to the crummiest, highest-risk slice of the MBS. And remember, MBS’s (and now CDOs) are flying off the shelves, and every time no one buys the equity tranche, it adds risk to the banks.
So, to recap…
We’ve got developers banging out new homes left and right on cheap credit, unqualified homebuyers snagging up predatory mortgages, banks packaging up mortgages and selling the “good” tranches to investors while leaving the garbage on their balance sheets, and insurance companies levering up policies that they’ll never be able to pay out if the housing market takes a turn. And that’s just on the institutional side of the house!
Individuals were also being incentivized to take on massive amounts of risk
My neighbor shared this little anecdote with me, he said, “It was absurd — in 2003 the downpayment on my house was $200. I was then able to borrow up to the total value of the house, which I did, and used that money to buy my first few rental properties. If I wanted more capital, I just needed to get the properties refinanced. That’s where an appraiser we called “Wild Bill” came in. He would just ask you how much you needed the house to be worth, do a casual drive-by, and poof, you’d have the documents you needed to get another loan from the bank. I probably refinanced 8 or 9 times.”
Friends, that’s what we call a ticking time bomb. In 2008, the timer dinged.
Borrowers, in over their heads, can’t make their payments
It was bound to happen sometime. And it sets off a chain reaction.
Since people can no longer make their payments, they default on the loans. Now, banks have a bunch of real estate on their hands. The effort to offload these foreclosed homes into a market without a ton of buyers triggers a decline in the housing market. It turns out, housing doesn’t always go up.
Investors stop buying mortgages from lenders and now insurance companies are on the hook for massive payments against their CDSs that they can’t make. Investors see the havoc unfolding, lose confidence, and pull money out of the stock and bond markets (seeking safe haven in US Treasury Bonds) triggering a massive crash.
Looking at their balance sheets, the banks start to panic
They have equity tranches that they thought were worth something (but may actually be worthless). If it turns out they are indeed worthless (which would be the case if people aren’t making mortgage payments… which IS the case) then the asset side of their balance sheet is tragically overstated.
If assets are overstated when liabilities (e.g. loans they’ve received from other banks) come due, it’s very likely that banks won’t be able to cover their payments, which would imply insolvency (in other words, they’d go bankrupt).
This wouldn’t be a huge issue if it was just one bank
But the entire system has gotten caught up in this game of risk — it is systemic. Tons of banks have CDOs on their balance sheet, every bank has loans to other banks, new money is NOT entering the system (i.e. insolvent banks can’t get equity infusions to cover their short-term obligations), and everyone wants to collect on their loans.
Banks, realizing that they may be in a major crunch for cash, stop loaning out money to businesses (you know, those things that create REAL value for our economy). The impact? Millions of jobs are lost practically overnight.
The Federal Reserve Steps comes to “save the economy”
There’s no doubt about it, the system needs liquidity. So how does the Fed proceed?
The Fed turns on the money printer
It creates money out of thin air, buys those horribleassets on the banks’ balance sheets, and signals to current and future participants in the financial system that greed beyond measure is rewarded, and major screw-ups will get bailed out. This is called moral hazard, and it’s a bad thing.
The money goes into the financial system, but it doesn’t come out into the real world (Side Note: money printing is inflationary when the money enters the real economy. In this case, it only entered the financial system).
The impact
The United States’ central bank bailed out the most irresponsible parties, printing a ton of money to do so, while the everyday person lost their job, their savings, and their retirement funds. These default-prone assets were taken off the banks’ balance sheets, replaced with cash, and transferred to the balance sheet of the United States government… which is the collective balance sheet of all American taxpayers.
The cherry on top of this whole thing? There are actually a few…
- No Wall Street exec would go to jail
- Bailed out banks would give their executives millions in bonuses
- The net worth of the richest 1% saw their wealth increase by 7.8% in the years following the crisis
Sometime in the 1930s, Henry Ford was paraphrased saying,
“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
I have a hard time disagreeing with that. What about you?
Oh, before I forget…
Another thing happened in 2008.
A person going by the pseudonym “Satoshi Nakamoto” published an 8-page white paper to a small email list of cryptography enthusiasts. In the paper, Satoshi outlined a technology called “blockchain” that would enable digital, decentralized, peer-to-peer cash…
What do you say, ready to learn a thing or two about Bitcoin?
Nothing in this essay is investment, legal, or tax advice. It’s a general discussion of concepts I find useful in my work and shouldn’t be relied on as a recommendation for your specific situation. Talk to a qualified advisor (ideally one who knows you) before acting on anything here.
