The 2008 Crash for Dummies

Recently, I saw The Big Short, a movie about the 2008 financial crisis. It was infuriating to see how Wall Street ruined the lives of ordinary Americans. If you haven’t seen this film, I urge you to view it. You can see this on Netflix, or U-Tube.

After the film, I spent a lot of time trying to understand how the crash came about and how all the pieces including the technical terminology fit together. After viewing the film a second time I realized that I could break this fiscal fiasco down into five easily understood stages. It won’t be necessary to understand the terms used by Wall Street. You don’t have to know what credit default swaps or derivatives are. But you should know that the reality is more complicated than these five stages.

Stage 1: before the early 2000’s, before the Bush election, most banks had been granting mortgages to top credit-worthy customers who showed a strong ability to repay their mortgage. They would bundle these mortgages into bond funds and buy and sell them to each other and to mortgage holding companies. This was a steady and honest practice at that time. These bond funds were rated AAA or AA as most contained quality mortgages. Banks made millions using this business practice.

Stage 2: after a few years into the Bush administration, two things happened; the first had actually been going on for several years since Reagan’s election in the 80s. Corporations had been shipping their jobs overseas and closing their home offices and in some cases even relocating overseas. Many jobs and businesses began to close. Of course this meant that these unemployed workers could no longer afford their mortgages. Slowly at first, then more quickly people began defaulting on their mortgages.

The second thing that happened was that with more and more mortgages going into default, banks were hard pressed to fill up their mortgage baskets. Now, these bond funds or buckets of mortgages were filled with hundreds of late or defaulted mortgages. Former AAA mortgages rated at the AAA level soon achieved the value of a BB or B level.

No bank is going to be able to sell B rated bond (read junk) funds. The banks had to do something fast. They were stuck with all these under-performing mortgages.

Stage 3: the banks did two things to cover themselves. First, they refused to change their bond fund ratings. They “persuaded, coerced, threatened”—you name it—their auditors to keep their AAA ratings. After all the auditors were told, “If you don’t go along with us, we will go to someone who will.” If that weren’t bad enough, the Bush Administration and its government regulators in the name of deregulation turned a blind eye to these unsavory practices.

The banks continued to sell these falsely-rated bond funds to retirement funds, seniors, unions, colleges, and other investors who believed they were buying quality funds. All the big banks did it: Lehman Brothers, Morgan Stanley, Goldman, and Merrill Lynch, they all did it and the party kept going on.

The second thing the banks did since they were running out of mortgages to fill their bond baskets with was to offer individual homes purchasers things like no-income verification, easy credit, no down payment, and a variety of other things to poor people who clearly couldn’t afford these homes. Especially toxic was the use of adjustable rate mortgages. In some cases they offered mortgages to immigrants who couldn’t even read. They didn’t care since they were going to sell these funds to other banks. It would not be their problem. They continued rating these junk bonds funds as AAA.

Stage 4: a few sharp hedge-fund guys and investment banks saw what was going on. They got the bright idea that if they shorted these junk bonds, they could make a fortune.

To “short” a bond or a stock is to borrow someone else’s stocks or bonds that are selling at a high price. They would sell that stock and when that stock or bond drops in value—these bond funds have to drop in price because they are filled with junk—buy back and replace the borrowed stocks or bonds. Their profit is the difference between the low replacement price and the high selling price they received.

For example, if XYZ mortgage fund is selling at $10.00 per share, the hedge-fund guy gets $10.00 for each share of stock he sells (someone else’s stock who probably doesn’t known that his stock has been sold) and he buys it back at $2.00 per share, he has made $8.00 per share profit (minus fees, etc.) The downside of shorting a stock or bonds is that if the price of that stock or bond rises, the hedge-fund guy loses money.

The hedge fund guys sat back and waited for the price of the junk bonds to drop. Unfortunately, they had a long wait. The auditors refused to devalue their ratings. Government regulators under the Bush Administration didn’t intervene. The banks kept selling these “high-valued bonds” to naïve investors. The hedge fund-guys began losing money.

So how did the party end?

Stage 5: the banks kept selling their AAA rated junk bond funds to pensioners, institutional funds, seniors, etc. Eventually, houses and mortgages came underwater. Mortgage holders couldn’t sell their homes; renters got kick out of rented homes. Millions lost everything; hundreds of thousands of homes were underwater. People lost even more jobs, as well as their savings and their retirement money.

Did anyone come out on top? Yes. The banks did. The taxpayers bailed out the banks, not one banker went to prison. The banks used their bailout money to award themselves bonuses. They then blamed poor people and immigrants for the crisis.

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