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Everyone should watch this eye-opening documentary to refresh their memory as to how the 2008 financial meltdown occurred. Unfortunately, and as pointed out by Inside Job, little was done to address the underlining issues that triggered the collapse, and in fact things are arguably even worse today. I am posting this review on top of all the others to assert one thing; this stuff is easy to understand. It is not beyond the layperson to grasp what went wrong with the US economy, in spite of all the fancy terms like CDO and CDS. It is all truly quite easy to understand.
The only thing is, there are quite a number of moving parts, and it takes a few passes to soak it all in. For my own edification I penned the 5 steps involved in the 2008 financial crisis. When my memory gets hazy I refer back the notes I made. I am publishing them here, in case a written explanation may help augment this excellent documentary...
FIVE STEPS TO UNDERSTANDING THE 2008 FINANCIAL CRISIS
1) The Home Mortgage
It all starts with the venerable home mortgage. This is the most important piece of the puzzle. Think about how the traditional home loan works. You go to buy a house. You apply for a home loan at the local bank. The bank checks your credit. If you seem credit worthy the bank lends you the bulk of the money to buy the house. However, to insure that the bank doesn't risk suffering a loss it does three things: 1) it asks for a down payment. 2) It requires you to insure the house (fire insurance and what not). 3) the bank places a lien on the property, thus making the property act as collateral for the loan.
The down payment insures that there is equity in the home. Equity simply means the house is worth more than the amount owed. This is critical. The bank always needs to be in a position where the property is worth more than what it can be sold for. Ideally, a down payment needs to be sized such that there is sufficient equity to withstand minor fluctuations in the housing market. Positive equity, combined with homeowners insurance has for decades insured that the bank won't suffer a loss on money that is being lent.
2) Securitization
A properly structured home mortgage is a very safe investment, and thus a popular one for banks. The popularity, and sheer number, of mortgages made them attractive to a financial process referred to as "securitization". With securitization, large quantities of mortgages are purchased from the local banks by a financial services company. The loans are grouped together and then re-packaged into a variety of securities (investments) that are then resold to willing buyers. Think of securitization as you would processed foods. An organic vegetable garden in your backyard is analogous to the previously described traditional home loan. A garden produces pure and simple food. A home mortgage from the local bank is pure and simple. But if instead of consuming those vegetables, what if they were instead sold to a food conglomerate, which extracts a portion of the crop, adds some preservatives and cans the vegetables in various configurations and sizes (corn, peas, mixed vegetables, etc.)? That's equivalent to financial securitization. Home loans are processed into a variety of investment vehicles and made available to wide range of consumers.
By the way, although the umbrella term "securitization" is used to describe the aforementioned process, the term "derivative" is often used with regards to activities such as repackaging mortgages. The resulting security (investment) is *derived* from the original home loans in this case (there are many types of derivatives employed in the finance and investment world).
3) Deregulation
Securitization, in and of itself is not a bad thing. Fresh vegetables can potentially be processed in a manner that retains much of their flavor and nutritional value. For example, organic barley is grown in Oxnard, California and processed into a product called 'Barley Green'. This brings one of the best concentrated super-green foods to consumers who otherwise would not have access to such nutrition. Likewise, mortgages can be repackaged into safe investment vehicles available to those who otherwise could not participate in the mortgage market. But keeping securitized investments safe requires rules (regulations). There are two specific kind of rules (lack of rules, actually) that directly relate to the financial crisis in 2008.
First, in 1999 a very important law controlling the behavior of the financial services sector was repealed. It was the Banking Act of 1933, colloquially known as "Glass-Steagall", named after the two senators who proposed the law. Glass-Steagall was a very simple, 37 page law designed to help prevent another depression. It basically said: The bank cannot make risky investments with depositor's money.
[Some people will recall that in the 1980s the Savings and Loan industry was deregulated in a similar manner. In short order this led to the failure of hundreds of S&Ls.]
The second rule that was repealed was in fact never engaged. Congress tried to regulate the completely unregulated derivatives market. Recall that derivatives are tradable securities derived from real things (home mortgages, other types of secured loans, crops, etc.). In 2000 a movement was underway to regulate the trading of derivatives. Some law makers and people in key government positions fought against such regulation (probably the same people behind the repeal of Glass-Steagall), and Congress failed to pass any legislation on the matter.
So, going into the 2000s, banks now had the right to use customer deposits to engage in most any type of investment they wished, and this included derivatives. In the next section we will see how derivatives went wild, and how the whole securitization of home mortgages went very wrong.
4) Tail wags dog
So far we are talking about [safe] home loans being purchased en mass and repackaged for sale as collateralized (safe) investment vehicles. We also know that the derivatives being created in this process are unregulated, and we know that banks can use customer deposits to purchase these derivatives and resell them to their customers, but we don't yet know what deregulation shenanigans are about to occur.
The specific name given to securitized home loan derivatives is "collateralized debt obligation" or CDO. Don't get intimidated here. A collateralized debt obligation is simply a collection of mortgages! A mortgage is an *obligation* to pay a *debt*, with the *collateral* for the debt being the house and the property it is built on. Collateralized... Debt... Obligation. When you buy a CDO you are buying a portion of one or more home owner's mortgage.
CDOs became EXTREMELY POPULAR! Why? Because they were considered safe investments that produced a reasonable rate of return. CDOs came in many sizes to fit an array of portfolios, and, they were plentiful.
When a derivate of the nature of a CDO is offered for sale to certain market segments, such as retirement funds, the security must be rated by a third party as to its relative safety. Enter the Big Three rating agencies. Just as there are the Big Three credit reporting agencies, there are the Big Three companies that independently evaluate and rate securitized investments (Inside Job tells us the names). These agencies put their reputation on the line every time they rate a security. Many mortgage based CDOs received a rating of AAA, the highest possible investment grade rating. The venerable AAA rating is equivalent to a US Government Treasury Bill, which is considered the safest place in the world to put your money (the Federal government has never directly defaulted on a T-Bill).
As the popularity of the CDO industry grew, income of the ratings agencies skyrocketed because the agencies charge a fee to rate each CDO (nice work if you can get it). The CDO was a windfall for the Big Three credit rating agencies. Thanks to the CDO, mortgage backed securities were suddenly available to a wide array of investors. Institutional investors snapped them up. Demand became so high that there weren't enough home loans to produce the CDOs investors so coveted.
And this is where the trouble begins. Demand exceeded supply. This is where greed raises its ugly head and the slippery slope toward financial meltdown really began. This is where the tail started wagging the dog because loan demand began getting generated on the back end (the financial sector), not on the front end (a family seeking to buy a house). The quickest solution to create more CDOs was two-fold; a) make more home loans, and b) include other types of loans in the securitization process. Oh my. Yes, this is where the sub-prime loan comes in. Lowering lending standards was the quickest way to grow the number of mortgages that could then be re-processed into CDOs. It was easy for the loan originators (the banks that granted the loans) to grant sub-prime loans because they were selling the loans to the financial services industry for a fee, thus taking themselves out of the risk loop.
But that was not enough. The investment banks that created CDOs went a step further and started to include other types of loans in the CDOs; car loans, school loans, commercial loans, etc.
Oh my. So the logical question is: What happened to the ratings on these Frankenstein-esk CDOs? Sub-prime loans, by their very nature, are not the highest quality loans and thus do not deserve the highest quality ratings. The answer is the ratings agencies continued to issue AAA ratings for these CDOs. This is corruption, plain and simple. The ratings agencies were making money hand over fist rating these securities. They knew that if they kept issuing AAA ratings the investment banks would keep submitting freshly minted CDOs for rating. It's plain old greed and corruption folks, nothing complicated here. Inside Job shows clips of the heads of the companies testifying before Congress. It's laughable.
5) What's worse than a Frankenstein CDO? Leverage and Credit Default Swaps
At this point in time a lie is in effect. Institutional investors such as state pension funds, county retirement plans, and thousands of other entities seeking a safe place to grow their money are buying AAA derivatives that are in fact far riskier than they appear. The cancer of greed begins to spread further however. Large lending institutions that started to crowd out the proverbial local bank appeared on the scene. The biggest was Countrywide, issuing (as reported in Inside Job) a reported 97 billion dollars in home loans. This new breed of lenders invented additional ways to grow its profits. It lowered lending standards even further. It waved the down payment, relaxed income requirements, and failed to verify the income entered on loan applications... thus creating the liar loan. To add insult to injury the lenders also increased their profits by placing well qualified buyers into sub-prime loans, even if the buyer qualified for a lower interest loan. Sub-prime loans have a higher rate of interest and thus the lender's profits were higher. Is this not essentially stealing?
Bear in mind that the only thing that kept this scheme going was ever rising home prices. As long as the economy maintained enough jobs, as long as interest rates stayed low, this process continued. One side effect of the boom in easy home loans was a boom in demand for those loans, which produced the greatest ramp up in real estate prices in memory. Thus we have the "housing bubble".
But wait. The slippery slope of greed did not stop there. The engine that supplies mortgages to feed the CDO process was fueled further when the lenders and the investment banks started to BORROW MONEY to in-turn lend it out for more home mortgages. And where did a portion of those borrowed funds come from? From depositors accounts. Made possible by the repeal of a law that had kept the financial markets intact for decades since the Great Depression. Borrowing money to fund the granting of additional mortgages was a highly significant event for another reason as well. When you borrow money to make an investment (in this case to lend money to home buyers) you add "leverage".
Leverage was the straw that broke the back of the financial system in 2008, so it's helpful to understand how it works. Financial leverage works like any other form of leverage. A physical lever that you press down, say, one inch, might lift an object on the other end by 1 foot. Conversely, if you let up on that lever by, say, 1/2" the object lowers 6". Leverage works going up as well as coming down. The effect is multiplied in either direction.
In finance, if you have one million dollars to finance mortgages, and then borrow an additional million, you double your income. That's 2:1 leverage. All you have to do is pay a small loan payment once a month to service the loan on that second million dollars. If the income from securitizing the extra million dollars is greater than the interest rate on the loan, you're ahead. Inside Job asserts that investment banks leveraged as high as 33:1. This meant MASSIVE profits in the billions of dollars, but it also meant that the real estate market -which provided the collateral for these loans, had to keep rising, or at least tread water. If property values were to drop, the equity of the loan could become less than the amount owed. This is bad. It could in turn generate a margin call from the entity that lent you the million dollars, requiring you to come up with additional funds to make up for the loss. Also, if for some reason home owners started defaulting on their mortgages -say because they lost their jobs, or because the interest rate on their adjustable loan rose to fast- then you might not be able to even make the minimum payment on the money you borrowed, let alone pay back the principal. You would end up defaulting. It's like dominoes.
Now be sure to multiply all that by 33. With such extreme leverage, even if the homeowners kept up their payments, if the value of the home decreased by say, 25% in a caving real estate market you would still be on the hook for the full amount borrowed, and the losses could add up to more then the entire net worth of your bank. Whoops.
We know of course that the real estate market did indeed contract. But believe it or not, there is one more piece to this puzzle to cover first. And believe it or not, it is arguably the most insidious component of what lead to the collapse. Just to recap, we have safe AAA rated CDOs that have been Frankensteinized by folding in sub-prime and other lower rated loans. Borrowed money, including consumer bank deposits, has been used to make more CDOs. Now enters the "credit default swap", or CDS. This is another easy to explain term. A CDS is essentially an insurance policy on the default of a CDO. Recall that private investors and institutions were buying CDOs - which are just mortgage backed securities- for safety and income. The CDOs paid periodic dividends, and the capitol was returned to the investor when the CDO expired. The investment banks started to get worried about all those CDOs! They were so levered up that the slightest drop in real estate prices, or a rise in interest rates, or a contraction of the economy leading to increased unemployment... would lead to defaults on home mortgages, which in turn would lead to the failure of the CDO they were backing. So the banks took out insurance against this eventuality from yet another institution. They bought credit default swaps from insurance provider AIG (American International Group). With a CDS, the holder of the CDO paid a recurring fee to AIG. AIG in turn promised to make good on the CDO if goes bad (they swapped the risk to another party). What's not to love?
CDS insurance doesn't seem like too bad an idea until you start to see (as explained in Inside Job) that the investment banks were recommending supposedly safe CDOs to their clients while at the same time the banks were effectively betting the CDOs would fail by taking out credit default swaps with AIG. It should be underscored here that a CDS paid out to the INVESTMENT BANK in the event of a default... NOT to the customers buying the CDOs, not to the owners of the deposit accounts, and certainly NOT to the homeowners. Moreover, you didn't even have to own a CDO to buy a CDS for it! Meaning, anyone at all could take out an insurance policy against a CDO. Or multiple CDOs. There was no limit because THERE WAS NO REGULATION. AIG issued multitudes of CDSs. When the real estate market collapsed, AIG was on the hook for the full value of every single CDS taken out on each CDO! Huge-o leverage. This is where the government stepped in to bail out AIG and other institutions on the verge of bankruptcy.
Epilog
So add it up. Lack of regulation gives the nod to the financial services community to behave as they wish. Demand for safe mortgage backed securities in investment portfolios gives rise to relaxed lending standards (spawning the sub-prime loan, the no down payment loan, and the liar loan). The temptation to create more CDOs prompts the inclusion of non-AAA rated loans to the security and bribing the Big Three ratings agencies to rate all CDOs as AAA. The use of leverage multiplies the losses if the economy stumbles or interest rates rise. And finally the creation of a vehicles to insure against the failure of CDOs transfers so much risk to a single entity that it can not possibly pay out when the claims start rolling in. Most troubling is that politicians and holder of Federal Cabinet positions fought hard to make the system so vulnerable. And many of those people are still in office today.
Now you know why these instruments are termed `financial weapons of mass destruction'. Inside Job goes on to explain how very little has been done to address the underlying problem...
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Comment: After watching this documentary you realize how the word "deregulation" has become synonamas with the word "greed". You are left with a feeling of helplessness... especially when you realize the same people are in place to allow this madness to reoccur all over again. The only thing that has really changed is "new" institutions that weren't affected the first time around. So... are we ready to repeat what has happened in the past, (2008) with new (meat) institutions, and the same people at the helm from 2008... only time will tell. I for one are not.
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