Between 2008 and 2011 the debacle that took place in the American banking system cost Americans 8.5 million jobs and erased over $11 trillion of their net worth. Headlines both old and new have instilled fear and raised questions, and still do, over whether this "crisis" or that "crisis" will soon be the end of the world. As an investor, I wanted to understand whether I should care about any of this or if it was just useless drivel designed to improve the news agencies' ratings. While much of it is indeed (in my opinion) useless drivel, the underlying theory and the danger of a financial crisis is real, and as an investor, a home buyer, a saver, or even a spender, you should care because it can directly affect the amount of money you possess.
This is part one of a three-part series that will detail in easy-to-understand terms how the 2008 financial crisis started, how it affected the global economy, what could have been done to prevent it, and how it is or is not still affecting the world (and your wallet) today.
A Little Background:
The first thing to understand is how a bank works. When you put your money in a bank, the bank doesn't just keep it there. It loans it out to others. If you put your money into a savings account that earns interest, the bank loans that money out to others who want to buy homes and cars or start businesses. Banks charge interest on their loans, and logically, more than they pay on things like savings accounts, CDs, and other interest-bearing accounts. This is how banks make money. They "buy" money from people and pay in the form of interest rates, and "sell" it to others as loans which they charge higher interest rates on. Additionally banks charge fees for various things and make investments in stocks, bonds and other investment vehicles. These practices all exist so the bank can pay you a fair interest rate and still make money by loaning your money out to others.
Today, most banks in developed countries function under a system called fractional reserve banking which basically means that they can loan out a set percentage of the deposits they have on hand and the rest they have to keep available in cash in case the depositors (you and I) want their money. The amount they must keep on hand is known as the reserve requirement or reserve ratio, and in the United States it's set by the Federal Reserve (aka the Fed). If you clicked the link above, you'll see that if you deposit $100 into a bank, at a reserve rate of 10% it would keep $10 and loan out $90. The person who gets that loan will either buy something with it or put it into another bank. If they buy something, the seller will put that money in the bank. Ultimately it will just end up in another bank. The second bank then has $90 and they must keep 10% on hand, so they keep $9 and loan out $81. The money is spent again and the next bank loans out $72.90 and keeps $8.10 on hand. This continues until the supply of the original $100 is exhausted. Theoretically, this system will never break down as long as the people that the banks are loaning money to continue to make their payments. The problem is that the system is entirely built upon trust, and this is where a financial crisis begins.
The Setup:
As we noted above, when a bank loans out money it is required to keep a certain amount of cash on hand in case of a default on that loan, but banks don't want a lot of cash; They want to loan out money so they can charge interest on it and make money for themselves (like any other business). In the early 90's, a group of young JP Morgan bankers (mostly in their 20s) were tasked with finding a way to reduce the risks associated with loaning out money, since if the risk on the loan were lower the fed wouldn't require the bank to keep as much cash on hand and they would have more money to loan out and charge interest on. The idea that they came up with to reduce risk was called a credit default swap. It was sort of like an insurance policy protecting against the possibility of default on a loan. Basically, the bank would loan out money and then turn around and say to another bank "we want to make another loan, so if you guarantee us that you will pay us if the person defaults, we'll pay you a monthly payment for that protection." Of course other banks agreed to this because they were being compensated with money they could then loan out and charge interest on, making more for themselves.
The Growth of a New Kind of Banking:
At first, credit default swaps were only made on very secure loans (those that the bank made to companies that they trusted would pay back what they borrowed). The first major credit default swap involved JP Morgan, ExxonMobil and the European Bank for Reconstruction and Development (EBRD). After ExxonMobil spilled 11 million gallons of oil off the coast of Alaska in the Exxon-Valdez oil spill, they took out a multi-billion dollar loan from JP Morgan to handle lawsuits and reconstruction/fallout costs. JP Morgan knew this was risky but they trusted ExxonMobil so they agreed, loaned them the money and then turned around to EBRD and made a deal to pay them if they would agree to assume the multi-billion dollar liability if ExxonMobil couldn't pay it back. This type of credit default swap quickly spread as banks realized that they could make a lot more money by reducing their reserve requirements through using credit default swaps. It allowed them to loan out way more money than they could ever repay if there were a string of defaults on the loans or a run on the bank in which everyone wanted their money at once. Still, this practice was accepted and utilized for a long time, mainly with big, well-known companies that the banks trusted. Companies like Johnson and Johnson, Proctor & Gamble, Microsoft, Apple, and WalMart. But there was a problem with all of this.
Obviously,
for the banks who were obligated to pay another bank's loan back should the
borrower default, the credit default swaps were a form of risk. If
ExxonMobil defaulted on their loan, for example, JP Morgan would stop making payments
to EBRD and EBRD could potentially owe JP Morgan billions of dollars. Of course EBRD and JP Morgan would have agreed to terms they both thought were favorable in terms of risk to reward, but it was still risk for EBRD. JP Morgan realized that they could offset more of their loan risk if they pooled the loans together and split them into different risk levels. For example, there might be a pool of very low risk loans to companies like Microsoft, Apple and ExxonMobil, and a pool of loans with more risk (i.e. the borrower was more likely to not be able to pay it back) to smaller, unknown companies or businesses that had poor earnings or credit ratings. Likewise, it would theoretically be less risky for EBRD to agree to pay out on a collection of low risk loans than it would for them to agree to pay out on a collection of high risk loans. And so JP Morgan pooled their loans together into things called CDOs or Collateralized Debt Obligations and split them into different risk levels, then tried to make deals with other banks to offset the risks of the various CDOs. Other banks ate it up because it basically gave them the ability to say "If you want us to agree to pay you if these high-risk loans default, you'll have to pay us more each month." Cha-ching! More money.
This form of "risk reduction" spread like wildfire throughout the financial world. Banks everywhere were starting to become more and more willing to give credit to riskier and riskier borrowers, because they could slap high interest charges on the loans and make more money. The goal, obviously, was still to charge a high interest rate on the high-risk loans and pay other banks slightly lower monthly payments to assume the risk if the borrower defaulted. In this way, the banks giving out the loans could make a profit and have more money to loan out and continue the process. For them, the sky was the limit. In theory, there is absolutely no limit to the amount of money that can be made with this system.
Unless the borrowers start to miss their payments.
Warnings:
As this process began to spiral out of control, Washington started to get wind of it and a fierce battle ensued. The argument was over whether or not the trading of these financial instruments should be regulated (like the stock exchange is regulated by the SEC) or not. Up to this point, all of these transactions involving loans, credit default swaps and CDOs occurred in what is known as a dark market, or a market that is not regulated by any federal or international agency. In the dark market there were no reporting requirements. The banks weren't obligated to tell anyone, not the SEC, not the federal reserve, and certainly not the public how much risk they were taking on or how much money they were making on it. So congressional representatives (the smart ones, if there are any of those) lobbied for more regulation. Unfortunately for Washington, money is power, and the banks had no problem at all funding the campaigns of the political representatives who would side with them and vote for no regulation.
Ultimately, the banks would win because they had the money and the power. The chairman of the Federal Reserve at the time, Alan Greenspan, argued that regulation was not required because the transactions were being carried out by seasoned professionals who could manage their own risk and regulate themselves. To him establishment of a regulating agency for these types of markets would be a waste of taxpayer money. The lack of regulation continued, and banks soon learned that they could apply the same principles they had used on corporate loans to consumer loans. They began pooling together groups of mortgages and trading the CDOs amongst themselves.
A Looming Disaster:
As banks pooled more and more mortgages and corporate loans together, stranger and stranger derivatives of these securities began to appear. Consider the JP Morgan/EBRD/ExxonMobil example from above. EBRD could offset the risk of having to pay JP Morgan by paying Citigroup or another bank monthly premiums to assume the risk. In this way, if ExxonMobil defaulted on the loan, JP Morgan would activate its agreement with EBRD, and EBRD would activate its agreement with Citigroup. Citigroup would pay EBRD, who would then pay JP Morgan, and ExxonMobil would go bankrupt. Just like banks bundled groups of loans together, they learned that they could bundle groups of credit default swap agreements together and trade them as synthetic CDOs. The problem with all of this is that the risk of ExxonMobil defaulting (no matter how small it was) never actually went away. It was just passed from JP Morgan to EBRD and then to Citigroup. Because these markets were not regulated, banks could simply pass the risk along to anyone else who would agree to take it. And why wouldn't you agree to it if you could get paid for it and then just pass it off to someone else?
The system seemed to be working perfectly. Stocks were booming, the financial world was experiencing heavy growth, housing prices were rising, and all was well. As banks became more and more greedy though, they started to write mortgages to riskier and riskier borrowers. Some borrowers made very little monthly income, had low credit ratings, a history of not paying their bills, or simply couldn't afford what they wanted to buy based on their income. This didn't matter to the banks because the more money they could loan out the more money they could make by trading the derivatives of the loans such as credit default swaps, CDOs and synthetic CDOs. These mortgages that were given to people sometimes had extremely high interest rates or very long payback terms, some rates as high as 42% and terms longer than a person's lifespan. Many regulators and banking professionals now admit that there were a slew of mortgages handed out that they knew didn't make any financial sense. These mortgages were known as sub-prime mortgages and were the main ingredient in the "sub-prime mortgage crisis" we hear so much about.
The Inevitable Crash:
As time went on, some banks, particularly Goldman Sachs, began to realize that something wasn't right. Because they realized that a crash was coming, they decided to "prepare" by taking advantage of it. Goldman is now known to have pooled together collections of CDOs backed by sloppy sub-prime mortgages and sold them to their customers, then bet against their own customers by issuing credit default swaps against the CDOs! As Goldman knew that the mortgages would never last, they made agreements with other banks to pay them attractive fees in exchange for a payout if the borrowers defaulted. One of these banks was a German bank called IKB. They continued to assume Goldmans' "risk" (which was at this point almost a certainty) because they assumed it was unlikely that all the loans would default at once and Goldman was paying them attractive fees for the protection. Their assumptions were wrong. In 2007, IKB was the first bank to fail because it couldn't pay off its credit default swap obligations when the underlying mortgages and loans started to go bust.
As the news of the IKB crash spread, other banks quickly (and cleverly) began attempting to write off their risk to each other, but it was too late. Housing prices were plummeting and defaults were everywhere. Because of the string of defaults (which should be been forseeable since these borrowers were known to be high-risk!) a chain reaction of credit default swap payment requirements was initiated. Basically, everyone in the world owed everyone else in the world money. In 2008, AIG was on the hook for over $440 billion in credit default swap payments and there was no conceivable way they could pay it.
In Part II:
We'll talk about how the failure of IKB led to a loss of confidence in the global financial system and what happened to AIG with that $440 billion in debt. You'll also see how the crisis really became a crisis and how it affected average investors. Read on!
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