I'd like to double check if I understand the cause of the financial crisis in 2008. Correct me where I'm wrong please.

So when people buy a house they can take a mortgage. This is basically a loan with your house as collateral in cause you won't be able to pay your loan back in the future.

To get those mortgages people go to a bank, these banks make money out of it by asking interest on your loan. It was also possible for people to invest in mortgages. When you invest in a mortgage the bank shares a part of the profit gained by the interest with you.

Then in 1970 a man called Lewin Ranieri had the idea to take those individual bonds, and bind them together. He is also called the father of mortgage-backed securities. Which are mortgages with an asset as collateral (what I don't understand, because each mortgage has a collateral?).

Anyway, because now different mortgages are bound together investors could buy a lot more mortgages than ever before. The banks were making big money out of this. But because you have a limited amount of houses in America, and thus a limited amount of mortgages, the banks were running out of mortgages to sell.

To 'solve' this issue, they started selling sub-prime rated mortgages. What are sub-prime rated mortgages? Well, not everyone can just get a mortgage. People who don't have jobs/have a bad payment-reputation/... get a low rating. This means they shouldn't be able to get a huge mortgage, because as bank you can't be sure they'll be able to pay. People who on the other hand have a high change of paying their mortgage get a high rating, AAA. But now the banks just gave everyone a mortgage now matter the chance of them paying back, and the banks also sold those bad mortgages.

So by not only including high-rated mortgages in their collection to sell, but also low-rated mortgages they again have tons and tons of mortgages to sell. Such a collection of mortgages is called a CDO by the way. (right?)

But because no sane investor is going to buy a CDO (collection of mortgages) with a low average rating of BBB, the banks had to find a solution to get a higher rating. They achieved this by simple asking the credit rating agencies to rate their mortgages AAA and pay them good money if they did. If those credit rating agencies refused to follow along in this fraud, the bank would just go to a competitor of the rating agency.

And because everyone could just get a mortgage now with a good rating, they started buying houses, stuff, and loans they actually could not afford.

So the banks were able to sell a collection of shitty mortgages who were labeled AAA. This wen't good for a while, however, because it are actually sub-prime mortgages you can expect that those people won't be paying their mortgage.

And that's what happened. A lot of people didn't pay their mortgage, resulting in the banks (who owned those mortgages and CDO's) not getting any profit of it. In fact, the banks lost so much money that a lot of investors dumped their stocks they had by that bank, resulting in the banks crashing.

Normally the banks were insured against failing mortgages, but all insurance company went bankrupt as well because they could not pay back banks their huge losses of money.

I find it pretty weird that a bank can get bankrupt so quickly by one failing financial product. Don't they have other assets/investings/... than CDO's/mortgages?

Anyway, a lot of people lost their jobs and houses because of this. And the government bailed out the big banks using tax payers' money.

Thanks for baring with me through this long text, however, is what I have written correct? Have I missed something? And a few questions: I still find the concept of CDO's vague, could someone explain that more? And if banks go bankrupt, why do people lose their jobs? How can for example a small independent baker by affected by a big bank going bankrupt? How can a bank go bankrupt so fast by just one failing kind of investment? What exactly is the difference between a normal mortgage and the mortgage-backed securities of Lewis Ranirie.



1 Answer 1


Fantastic questions! I might only take 1-2 of them on, though. Paraphrased below.

1. How could a bank fail from just one bad product (MBS), shouldn't they be more diversified?

So: substantively, one way this could happens is if you don't have a lot of equity in your business. I.e. you've financed a lot of your business with debt. At the end of 2007, Lehman Brothers had $691b in assets, and only $22.5b in equity. This means they had $691b - $22.5b => $668.5 in debt. Which is a 30:1 Leverage Ratio. Thus, if only a small percentage (1/30th) of their assets go bad -- they're literally insolvent. When you drive with a knife next to your neck, you only need to hit a small speed bump to get killed.

2. "What is a CDO?"

Watch this video from Investopedia. A CDO is just a collection of Asset Backed Securities (ABS). A mortgage-backed security is a TYPE of ABS. CDO is just a general name. A group of MBS would technically be considered a type of CDO. Also a group of car loans would be considered as a CDO. Because there is a physical asset/collateral underneath it (a house, a car) - that is the 'C' in CDO ... C = Collateralized. A Khan Academy video here.


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