I never had any education in finance or economy, but in the following decade I did some reading and I tried to come to an understanding of at least the big picture. I read about bad incentives, subprime mortgages, bubbles, inadequate regulations, and even some quasi-mathematical explanations of how the securitization of mortgages led to obfuscating financial risks instead of diluting them. But I never felt confident that I could explain the Great Recession well if I had to. In short, I lacked a coherent narrative.
This is the reason why I was so happy to put my hands on Firefighting: The Financial Crisis and Its Lessons, a book by Ben Bernanke, Timothy Geithner, and Henry Paulson, among whom the first held the office of the chairman of the FED, and the other two were the consecutive United States Secretaries of the Treasury at the time of the events. They were actually in charge of the US response to the crisis - within the limits of their offices, at least. If there was anyone who could explain what happened, I thought, these guys are the ones! Another big plus is that the book was published in 2019, more than a decade after the crisis. The future consequences of many of their actions were unknown then, but they have had the time to run their course by now.
The benefit of hindsight is a double-edged sword, of course, as the authors, who had, and at least with respect to their reputation, still have skin in the game, can present the events in lights more favorable to them. I don't have enough knowledge of the history of the Great Recession to judge that, and as a financial illiterate at worst and a curious but lazy layman at best, I really can't evaluate their decisions. In short, I just take their word for everything in the book.
And in the following, I try to summarize what I learned from a 160-pages long summary of a very tumultuous and controversial event, in chronological order. In the first part, we will look at ...
....how it all began
Crises naturally don't happen in a healthy economy, although their inevitability is only seen in hindsight. According to the current wisdom, what led to the crisis were the following: global savings glut, the common practice of overleveraged investments, a patchy system of regulations, bad incentives, rampant securitization, and a subsequent panic that turned a normal recession into the Great One.
Low interest rates and overleveraged investments
What experts called the global savings glut was the phenomenon that in the early 2000s foreign investment poured like rain into America (mostly from China), as local investors sought higher yields and better investment opportunities than they could find at home. This caused a huge build-up of debt (both by private households and banks) but plenty of cash.
The sentiment of never-ending good times and low interest rates incentivized financial institutions to overleverage, that is, they financed their investments largely by borrowing. Let's enlighten the concept of leverage with an example. In this, our private citizen Optimistic Oscar decides to buy a house for investment purposes. The house costs $1 million, Oscar spends $100,000 from his own money, and takes a loan for the rest - that loan is his leverage. He duly manages to sell it a year later for $1,200,000 (a 20% extra). He pays back the $900,000 loan to the back with let's say 5% interest, which amounts to $945,000. The rest, $255,000 remains in his pocket. He turned $100,000 to $255,000 in a year, earning a spectacular 155% profit!
Had he paid half of the original price himself ($500,000), then he would have to pay back $500,000 * 1.05 = $525,000 to the bank which leaves him with $1,200,000 - $525,000 = $675,000. His profit would be $175,000 on the $500,000 investment, that is, 35%. Not bad, but far from 155%.
How would the math look like in the first case if the price of his house had dropped 20%? He would sell it for $800,000, pay the bank its $945,000, which would leave him in $145,000 debt! He started with $100,000, ended up with -$145,000, that's a loss of $245,000. -145% loss!
What if he had paid half of it himself? Then after paying back $525,000 he would end up with $275,000. He lost $225,000 of his original $500,000. -45% interest. Bad, but at least not -145%!
This whole thing is very much like what banks have been doing since the Medicis. They have realized that not all their clients will come to take out their deposits at the same time. It's enough to keep a fraction of their assets at home, the rest they can invest, and earn profit.
In short, leverage is an essential tool in finance. It multiples wins and losses equally. The markets were superbly optimistic in the early 2000s and took gambles that rewarded them immensely. When the times turned bad, it wiped them out.
Patchy regulations and the shadow banking system
Shouldn't regulations have demanded more prudence? Don't banks have capital requirements stopping them from being overleveraged? Well, there were regulations, and banks had standards. But both were inadequate.
The hodge-podge regulation framework didn't make it easy to see what's happening in the economy. There was no single regulator that could assess the big picture, and the strong anti-regulatory lobby ensured there won't be either.
The regulation net didn't even cover the whole financial infrastructure. Many financial entities - part of the so-called shadow banking system - didn't have to abide even by the low standards imposed on banks. Moreover, government institutes, like the FED or the Treasury, didn't have the authority to help them in trouble, either.
Securitization
And then there was the magic of financial engineering, especially the technique known as securitization. Let's explain that briefly and inaccurately. When Joe Average takes a loan from the bank to buy his house, the bank gives him let's say 1 million dollars on the condition that in 20 years he has to repay $2 million (the numbers are completely ad-hoc). This mortgage is an asset of the bank. Now the bank might find itself in trouble one day and in need of quick money. It can decide to sell Joe's mortgage to another bank (or any financial entity) for, let's say 1.2 million. It forgoes the stream of revenue in the next 20 years in exchange for having the cash now (not completely unlike what Joe did in the first place). So Joe's mortgage is actually a product that can be sold and bought, like a second-hand car.
A mortgage is, of course, not a riskless product (another common trait with second-hand cars...). Joe can default on it, which is a loss for the bank on him (in case the value of his home doesn't cover the mortgage). However, smart statisticians have figured out that even though Joe Average has a 1% chance to default on his debt, one thousand Joe Averages' mortgages bundled together is a very safe investment, because according to the expectations only 10 of them will default. That's the reason banks bundle products together in big numbers, so the future aggregated loss on them is both low and foreseeable.
Of course, the mortgage is just one example of financial products that generate steady streams of revenue for some limited time. Jane's student loan is another example. Joe's mortgage can be bundled with Jane's debt and a hundred similar products and then sold and resold, and split into smaller products and merged into other bundles made of products originated from other banks. Products can be sliced even "horizontally". To explain it with an example, let's assume a bank has a package of 1000 debts, which it splits into 3 tiers or "tranches", each of which generates the same revenue to its holder. It sells the lowest, Tier 1, for 10 million dollars. When some of the 1000 debtors start to default, this will be the tier whose revenues will be affected by those losses. Tier 2 is sold for a bit more, 12 million dollars. The holder of that will be affected only in the unlikely event of more than 10 debtors defaulting. Tier 3 is the priciest, it's sold for 14 million dollars because its revenue is guaranteed. The owner of this has bought peace of mind for the extra 2 million bucks. The numbers might be unrealistic here, but the concept holds.
So at the end of the day, a Norwegian city council can invest into a product to enjoy a steady stream of revenue for the next 20 years that consists of a fraction of Joe's mortgage monthly payment from Texas, a fraction of Jane's payment on her student loan in California, and bits and pieces from a thousand different origins. Of course, by the time the first cent reaches Norway, these products went through so many hands and slicing and dicing that no one can trace them in either direction anymore.
The core idea behind this whole complicated business is to reduce risk. The products are made of diverse and often geographically distributed components. Some of them will default, but the overwhelming majority won't because they are independent. They need different reasons to fail (Joe's financial situation in Texas correlates very little with Jane's in California), and the failure of one product doesn't affect the other. With the vertical splitting, even the probabilities can be controlled, so risky products will be bought by those who can bear the risk.
At least, such was the consensus before 2008. What happened?
A housing bubble happened...
... that exposed the flaws in the theory brutally. From the early 2000s, the American government actively promoted house ownership. With the help of government subsidies (tax breaks and such) and the historically low interest rates, a huge number of people could afford (and were actively encouraged) to buy their own houses. They did it mostly by taking loans, sometimes with no capital at all (see overleveraged). House prices shot up all across America. This didn't stop the buyers, because the rise seemed to be inexorable. Joe thought that he could buy his house on a loan only. The interest rates were low (at least in the first couple of years, in the "teasing period") and he figured that the price of his home will continue to rise. Even if he ends up being unable to pay the monthly installments, he can sell the house for more than he bought it for, thus even earning some money on the whole thing.
Bad incentives
The buyers weren't alone to blame. Banks and brokers gave loans to people about whom a basic background check would have revealed that they will never be able to repay their mortgages (these were the so-called NINJA loans - for borrowers with No Income, No Job or Assets). Why? Because they had no incentives to do so, just the opposite. The practice of securitization made them indifferent to whether the buyers will be able to meet their obligations or not. The originators of the loans immediately repackaged and sold them, and thus they no longer bore the risk. Brokers even received hefty commissions after each mortgage they negotiated, making them financially interested in not making those background checks.
What about the financial entities who bought the securities? Shouldn't they have demanded more checks? They actually did, that is what credit rating agencies, like Moody's and Standard & Poor's, are for. However, these agencies were funded by fees paid by issuers or sellers of securities. This is called a conflict of interest. It's like you were paid by Adam Sandler to write a review of one of his movies.
And the panic
Eventually, more and more homeowners defaulted on their mortgages. They put the houses on the market which started to push the prices down. Once the trend turned, there was no stop to it.
The bubble burst and so did the theory of risk-defeating securities. House prices started to fall everywhere, which eliminated the supposed safety of the geographic diversity of the securities. Banks and other financial institutions that stored their wealth in mortgage-based securities saw them evaporate. The byproduct of the financial engineering of spreading out and diluting the risk was obfuscation. No one knew exactly which financial products were affected. So instead of cauterizing the rotten part of the system - and rid it of the bad actors and practices with some collateral damage -, the fire spread. The market players started to distrust those who dealt with any kind of securities. Then those who made business with them. And then those who had links to those. And so on. Everyone was reluctant to lend to anyone else, and the system started to come to a grinding halt.
In the second part, I will sum up how the events unfolded in the following 2-3 years, and what role the FED and the Treasury played in the story.
