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Celebrating the fifth anniversary of the financial crisis

by Eric Ferguson on September 18, 2013 · 38 comments

financial termsIt’s mid-September 2013, and we’re celebrating the financial crisis of September 2008 that nearly collapsed the whole economy. Maybe “celebrating” isn’t quite the right word. Maybe it’s the wrong word. Actually, it’s probably a grotesquely inappropriate word.

 

Anyway, it seems an appropriate time to re-post this diary I posted half a year after the financial collapse, in which I sought to dispel the notion that you, assuming you are not a financial professional, are perfectly capable of understanding the mysterious terminology and how these terms combined to create the crisis. You can’t understand the risks though, which I feel quite confident in saying because it turned out the supposed “masters of the universe” couldn’t understand the risks. They thought they did, and they were very, very wrong. Maybe they could have understood the risks, but you know, they were making gobs of money, so…

 

Since the following was first posted, there have been some changes. The banks are even bigger and their collapse would be even worse — yippee. Breaking up the “too big to fail” banks wasn’t taken seriously inside either Wall Street of the DC Beltway. It would be bigger than the typical FDIC breakup of a failing small or medium bank, but should hardly be impossible. The big banks grew significantly by mergers, so break them back into their businesses. Bank of America owns the commercial bank Bank of America and the investment bank Merrill Lynch, so make them two separate corporations again — risk reduced. No charge for the idea.

 

This diary was posted a year before Dodd-Frank passed, which addressed some of the problems. The big banks have bigger capital requirements (how much cash they have on hand, just in case they collapse again), and they’re supposed to have “living wills” to wind them down if they go under. The Volcker Rule, that banks can’t risk customers’ money in propriety trading, (trades made for the bank itself rather than on behalf of a customer), is now law. The Consumer Financial Protection Bureau (CFPB) is now fully up and running, and should prevent much of the predatory lending that helped cause the crisis. Republicans are mad as hell that the CFPB exists and that predatory lenders might be restrained from selling crud and lying to customers, so the CFPB must be a really good thing. Actually, that’s not a bad standard for the whole Dodd-Frank law: Wall Street is still hopping mad, screechingly outraged, so if you’re wondering if the law did any good — apparently.

 

On the other hand, the lobbyists have managed to game the rules-making process so most of the law isn’t in the form of regulations yet, including the Volcker Rule. Derivatives still are mostly unregulated. They’re what caused the crisis, so no need to frickin’ hurry.

 


OK, into the wayback machine.

 

The biggest lie of the collapse of the financial industry is we can’t understand it. It’s supposedly so complex, only the Wall Street high rollers can figure it out, and they can’t be bothered with the anger of the wee folk in the hinterlands, by which I mean those of us more than a couple blocks from Merrill Lynch HQ. Can we understand this stuff? Can I get a “Yes We Can!”, because we can understand this stuff. It’s not intuitive certainly, and a bit of homework is required, but please don’t think for a second you have to take some CNBC pundit’s word for anything.

 

So fellow wee folk, I hardly propose to explain everything about the banking crisis in a blog post, but I do propose to explain a couple terms you’ve have probably heard but not heard explained, just to prove that you can understand what’s going on.
A collateralized debt obligation (CDO) is basically of bunch of debts bundled together. Instead of buying one mortgage, paying off the lender in exchange for the right to collect the balance, some companies bought a bunch of mortgages, stuck them together, and sold them as a CDO. Supposedly this reduced risk because whereas buying one mortgage meant losing the whole investment if the borrower couldn’t pay and the house couldn’t be sold, buying a CDO meant losing only a little of the investment if one mortgage went bad. Buyers could even buy pieces of CDOs, so they owned a fraction of many different debts. Great idea, provided almost all those mortgages were low risk, which is what buyers of CDOs assumed. However, the demand for CDOs meant lenders lent to riskier and riskier borrowers in order to generate the mortgages they resold, so the CDOs were full of bad debts. [2013: we now know that some bundlers not only knew had bad the mortgages were, but shorted their own product after selling it. Ratings agencies knew their pay depended on giving AAA ratings to garbage, which Al Franken is trying to do something about.]

 

A credit default swap (CDS) is an insurance policy on a debt. Let’s say you grant a mortgage but you have doubts the borrower will pay it off, or you buy corporate bonds but you have doubts the corporation will pay them off. You buy a CDS, and pay the insurer a premium, which obligates the insurer to pay back the debt if the debtor defaults. So when the corporation goes into bankruptcy and doesn’t pay its bondholders, the bondholders go to the insurance company and ask for their money. This is great for the insurance company if almost all the debtors are good for it, and great for the CDS buyer if the debtor defaults. Of course, if lots of debtors default, as happened, and the insurer assumed it wouldn’t have to pay off on many policies and didn’t keep any cash on hand, as happened, there is a crisis.

 

One more concept if I may, but again you’ll see you can understand this. You may have heard the term “naked” like in “naked CDS”. It means basically making a bet without putting up any money. A naked CDS was purchased by someone who did not own that which they insured, so they would not lose their investment if a debt went bad, but they did hope to get paid off by the insurer. It would be as if we could buy fire insurance on someone else’s house, perhaps thinking it was a firetrap that was likely to burn, so if it burns we get paid the value of the house, but if it doesn’t, we lose our premiums. So we go to an insurance company to buy a policy on someone else’s house, and they think it won’t ever burn, and sell us the policy. Thinking this is easy money, they sell insurance on that house to ten people, even though, if it burns, they can pay off only one or two, which means they’re insolvent, and all their policy holders suddenly have no insurance on their houses. You can see why this shouldn’t be legal. It is legal with CDSs however.

 

So CDOs have gone bad in huge numbers, AIG can’t pay off more than a tiny fraction of the CDSs they sold on those CDOs, so CDS buyers can’t get paid when their CDOs go bad, so their risk is suddenly much higher, and the greater risk makes their CDOs worth much less. Those counting the former value of their CDOs among their assets find they may not have enough assets to stay in business.

 

And yes, there’s more to it than that. Much more; this was just the start. I never said it was easy, just comprehensible. So now comes the homework.

 

The best explanation of how the subprime mortgage market grew and blew up was broadcast on This American Life, The Giant Pool of Money. In fact, this American Life has been the single best source for understanding how the mortgage industry devolved into such a crisis. They followed that first program with Another Frightening Show About the Economy and Bad Bank. They have transcripts for those just not into audio, and MPR carries the program at 3 PM Saturday and 8 PM Sunday [Saturday's broadcast is now 1PM].

 

To understand just what AIG did to bring so much anger upon itself, read Matt Taibi’s article at Rolling Stone, The Big Takeover. You’ll get angry at what the people at the top of Wall Street were pulling and are pulling, but more important, you’ll understand it. Then reward yourself with a treat: you knew something was wrong about AIG exec Jake DeSantis complaining of his bad treatment over his bonus, but it was hard to put your finger on it. Taibbi put his whole fist on it.

 

Feel free to add more useful explanations for laymen in the comments.

 

give2attain September 18, 2013 at 5:13 pm

I assume from reading this that you think “they” own all the blame. And that you have assigned noneof the blame to us greedy little consumers.

You know the ones who took out 0% or negative equity loans, kept trading up houses assuming the double digit appreciation would last, took out home equity loans to consolidate our credit card debt, chose our house payment assuming “overtime pay” was permanent, did not hold cash for 6+ mths of unemployment, etc.

Remember the old saying… “You can’t cheat an honest man”

Dog Gone September 18, 2013 at 5:18 pm

Which would not happen without fraud on the part of the lenders and credit ratings organizations. Which would not happen with adequate regulation and policing.

People doing this were lied to about the ethical and legal practice. This was so minutely the fault of the consumers, who were harmed, in contrast to the entities that originated these practices and profited from them.

You have no valid basis to shift the blame here.

give2attain September 18, 2013 at 5:24 pm

“If it looks too good to be true, it probably is…”

However consumer / personal greed made the folks blind…

Eric Ferguson September 18, 2013 at 5:32 pm

What did consumers have to do with deregulating derivatives? Nothing. Everything you mention is puny in explaining the financial crisis.

Of course you can cheat an honest man. There are more sources of wisdom than the titles of W.C. Fields movies.

give2attain September 18, 2013 at 5:34 pm

I love this video.
http://www.crisisofcredit.com/

Dog Gone September 18, 2013 at 6:58 pm

You routinely believe in things that are factually inaccurate without bothering to check out your assumptions or if what you think is worth believing.

Therefore you usually appreciate stuff that is actually rubbish, and wrong, but which supports your crazy conservative notions. It’s a self-perpetuating fantasy.

give2attain September 18, 2013 at 8:36 pm

What in particular is wrong with the video. It seems pretty matter of fact to me.

Dog Gone September 19, 2013 at 3:18 pm

You ask what is wrong with it?
“The goal of giving form to a complex situation like the credit crisis is to quickly supply the essence of the situation to those unfamiliar and uninitiated. ”

The person who made the video is not an economist, has no apparent significant economic credentials to inform his understanding of the crisis, and most of all this is an oversimplified and inaccurate portrayal of the crisis.

It might look good to those who are economics ignorant, but anyone who fact checks, who knows the topic, wouldn’t give it credence.

Once again, you don’t know how to separate fact from fiction, or to fact check, and you don’t know how to recognize someone who knows what they are talking about from someone who is pretty much as ill-informed and ill-educated on a topic as you yourself are.

You believe things that are not true, because you want to believe things that are not true.

I am unwilling to believe things that are false or phony, or a scam; I LIKE fact checking, and I dislike being scammed. I’m not afraid of complexity, or the rigor of doing whatever research is necessary to actually learn a topic before forming an opinion.

give2attain September 19, 2013 at 4:47 pm

So you were smart enough to not end up “upside down” in a mortgage… Congratulations !!! Wish there were more of us…

give2attain September 18, 2013 at 5:37 pm

The video reminded me about another consumer ethics problem.

Those who ended up “upside down” in their mortgage and chose to walk away from the house instead of honoring their debt….

Dog Gone September 18, 2013 at 6:56 pm

Given they were tricked into it, I think those people made the only decision that was reasonable, in most cases.

give2attain September 18, 2013 at 8:35 pm

Must have been that mind control thing…

You need that huge house…. You deserve a 0% equity loan… Home price inflation will exceed the CPI forever… You will always get overtime pay, so you can afford the payment that is 30% of your gross income… No, you don’t need cash as your financial safety net… You deserve that nicer house… You got a spending problem and credit card debt, you should mortgage your house further.

You are right… They were very tricky…

Eric Ferguson September 18, 2013 at 7:54 pm

I’m guessing that when your car doesn’t start, you obsess over filling up the windshield washer.

give2attain September 18, 2013 at 8:29 pm

No. It is either a lack of fuel, air or an ignition source.

Remember my initial degrees were in Mechanical Engineering.

give2attain September 18, 2013 at 5:22 pm

Thoughts regarding THEY, the financial crisis and the silver lining of the recession.
http://give2attain.blogspot.com/2011/02/magic-of-they.html

give2attain September 18, 2013 at 7:50 pm

I forgot the other side of the equation. Us 401K, IRA , Pension, Personal, etc investors who demand higher than average returns investments… Otherwise we change banks, mutual funds, stocks, etc…

But I forgot… That villainous “THEY” made us upgrade houses, by a house, accept a payment we could not afford, demand high yields, etc, etc, etc… How exactly did “THEY” make us do it? Must have been form of mind control.

It sure is easy to blame “THEM” for the free will choices “WE” made…

Dog Gone September 19, 2013 at 9:41 am

It is easy to blame ‘them’, about whom I am very specific, when ‘they/them’ defraud people, lie, deceive, and are the ones who profited from doing so.

I’m still waiting for you, G2, to explain what a good reason is to let people starve, especially children and the elderly.
tick tock tick tock

Dog Gone September 19, 2013 at 9:48 am

Conservatives always like to blame the victims, be it massive financial fraud, or rape, or any crime.

I think it is because it gives them a false sense of security, that they are more in control of events affecting them than they really are.

They consistently excuse all manner of responsibility to the rich, and blame those who suffer, while doing nothing to either penalize the rich for crimes, and especially obstructing any efforts to prevent repeats of the abuse or crimes.

Such very funny, unjust, and usually very costly notions of law and order……

give2attain September 18, 2013 at 8:26 pm

By the way, remember that I am big believer in contributing factors.
http://give2attain.blogspot.com/2011/12/blame-vs-contributions.html

In this case, the problem occurred because a lot of different factors contributed to the meltdown. Now I will agree the banking folks own 50% of the contribution, that leaves investors, mortgagees, regulators, etc with the other half.

Sean September 19, 2013 at 8:59 am

No one forced the banks to offer people 0% equity loans that ate up 30% of their income. That’s an incredibly stupid use of the resource entrusted to them by depositors. Not to mention the financial chicanery detailed in the original post.

When Goldman Sachs is selling a security on one hand, and then betting against it on the other, that’s much more akin to fraud and a casino versus a market.

give2attain September 19, 2013 at 12:34 pm

I agree whole heartedly, the bank and investment firm management did make bad decisions and contribute to the problem. Just not 100% like these folks believe…

When I bought my first house the mortgage broker noted that I could qualify for a much larger mortgage. My wife and I were smart enough to look at personal budget and politely decline all that debt. It really wasn’t that hard, too bad many others didn’t do the same.

Dog Gone September 19, 2013 at 1:03 pm

Your mortgage broker didn’t engage in fraud or predatory lending, or just plain fake paperwork, or lie to people.

Here’s a clue; small, local banks and credit unions did not do so either.

We need to bring back Glass Steagall, and we need to be locking up big banksters who are criminals. NOT blaming people who lacked expertise in financial matters, who were lied to and defrauded by those who did have that expertise — and who profited by it.

Sean September 19, 2013 at 2:53 pm

What the bankers did is akin to going to the casino, placing your bets repeatedly on one number on the roulette wheel, and then blaming the casino when you lose all your money.

Did individuals do stupid things by taking on too much debt? Sure. But those individuals wouldn’t have been able to make those decisions and the net effect of those bad decision would not have risen to the economic-crashing level that it did without the incredible recklessness of the bankers.

give2attain September 19, 2013 at 5:01 pm

Correct, the banks leveraged their bets to make more profits. However if people hadn’t started defaulting there would not have been an issue.

Unfortunately too many people were carrying too much debt and too little cash. Therefore when the economy went South they started defaulting.

The mortgagees lacked the character and common sense to pay the debts that they signed up for of their own free will.

An acquaintance of mine got divorced after buying that big dream home. Then they were upside down in the house, so they made the choice to let it go back to the bank. What in the world happened to people feeling responsible for their personal debts and choices?

Oh I forgot it is easier to be the victim and blame “them”…

Sean September 20, 2013 at 8:40 am

Here’s the problem: the bankers were lending money to people who had no cushion. And they knew it. If you’re asking me who bears most of the blame: the very well-paid finance professionals or the working class families trying to scrap and find a way to get ahead, I’m going with the people who are paid millions to know better.

Sean September 20, 2013 at 8:49 am

Clearly it’s the character and common sense of the little people that are the problem here, not the character and common sense of the people who are paid literally millions of dollars per year to manage risks for multinational financial services companies.

Dog Gone September 19, 2013 at 9:37 am

They own a great deal more than 50%.

give2attain September 19, 2013 at 12:35 pm

Okay, maybe 60%…

Dog Gone September 19, 2013 at 1:01 pm

Ok, maybe 95%.

Eric Ferguson September 19, 2013 at 1:29 pm

Given that the financial system collapsed because derivatives drove everything that went wrong in the mortgage market, and got bigger than the whole global economy, and that it was all allowed by deregulation the financial industries lobbied for, I’m sticking to 100%. The idea the crisis was caused by some people buying more expensive houses than they could afford is just nuts.

give2attain September 19, 2013 at 5:07 pm

“financial system collapsed because derivatives drove everything that went wrong in the mortgage market”

It all triggered when people started to default… So technically the mortgagees were the root cause. Of course the banks probably shouldn’t have given these people loans in the first place. However the gov’t was also pushing banks to help the poor get into a home… And the gov’t was carrying the risk on these poor loans to help the needy own a home…

Seems like a lot of contributors…

Sean September 20, 2013 at 8:36 am

Can you give me an example of where the government forced a bank to issue a mortgage against its will?

give2attain September 20, 2013 at 6:03 pm

Now that question is below you. Please give me an example of when a banker “forced” a mortgagee to take out a loan against their will?

The reality is that the government encourages banks to give loans to high risk candidates through HUD, FHA, VA, etc. Just like it encourages people to build homes in areas that are prone to flooding. They offer insurance to reduce the risk to the bankers and place it on the tax payers. A very bad idea…

However some citizens seem to think it is important for poor / high risk folks to own homes, so we do it… I am assuming the 3 of you support the idea of HUD, FHA, VA, etc backed homes…

Dog Gone September 21, 2013 at 9:27 am

Wrong question. Show me where a banker made out like a bandit – or bankster – by doing something illegal, or unethical, and was stopped by the government regulation that was supposed to do that.

So long as there are no consequences, as we have here, greed will be the driving force.

The government didn’t force anyone to be bad, they just didn’t stop anyone, and created a playing field where it was greenlighted.

give2attain September 20, 2013 at 6:13 pm

I leave for China tomorrow, and will be in Chongqing Tuesday and Wednesday.(see video) It will be interesting to compare our cold capitalistic society against the more socialistic version I think you would favor.

http://www.youtube.com/watch?v=HMZEazYXXuY

Dog Gone September 19, 2013 at 3:01 pm

You are correct, Eric. There are supposed to be checks and balances that keep people safely in sound financial bounds, for their benefit, but also for the benefit of the lending institution. Local banks that do less selling off of these transactions were not involved in this crisis. Mega-banks and especially those where these dubious instruments were flogged that were investment banks, were the ones who circumvented the checks and balances – and who profited enormously more than any person borrowing against their home.

Both commercial banks and investment banks need to be separate, and MUCH more regulated. When you look to apply blame, look to who originated the scam, and who profited from it – and that is NOT the home owners.
http://www.reuters.com/article/2008/10/23/us-financial-greenspan-idUSTRE49M58W20081023

Despite concerns he had in 2005 that risks were being underestimated by investors, “this crisis, however, has turned out to be much broader than anything I could have imagined,” Greenspan said in remarks prepared for delivery to the House of Representatives Committee on Oversight and Government Reform.

“Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity — myself especially — are in a state of shocked disbelief,” said Greenspan, who stepped down from the Fed in 2006.

Greenspan was not ‘partially wrong’ he was completely wrong, and his shock is disingenuous, given it was a widely predicted result of the anti-regulatory position of the Bush administration and others, and that it was the predicted outcome of the repeal of Glass Steagall.

Liz Warren is right – we need Glass Steagall back, we need regulation of the dark markets, derivatives, and much more regulation of the financial industry generally. Or, as Franken correctly notes, the same thing WILL happen again. Conservatives are incredibly bad at anything relating to the economy.

Dog Gone September 20, 2013 at 10:11 am

Lovely snark sean; sarcasm well played.

Dog Gone September 20, 2013 at 10:12 am

Paid millions, misrepresented the safety and legality, lied and committed widespread fraud, and who circumvented every rule and regulation put in place to prevent them from doing this.

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