Financial Crisis Handbook

Financial Crisis

A simplified guide to the causes of the 2008 global financial crisis.

Where Did It Go Wrong?

This book gives you an introduction to some of the main reasons of how the 2008 fianancial crisis came to be. This could be split into 5 sections:

Housing Bubble Leverage Irresponsible Regulators Subprime Mortgages Complexity of Financial System

Blame it on the Bubbles Here is a graph that shows the Case-Shiller Index, a measures of the REAL house prices—house prices deflated by the Consumer Price Index (CPI).

In plain English, what we see here is the history of house prices relative to the prices of other things that consumers buy.

1929–1941 The Great Depression 1890 The index is structured to start at 100.

The Case-Shiller index tells us how big the housing bubble is; it measures how much the housing prices have deviated from the average price in 1890.

2006 The house-pricing index peaked at 198.01, double the price of 1890. Prices came crashing down.

2012 Prices only stopped falling after 6 years.

1997 The real housing prices began to grow by almost 30% each year.

Even until today, the prices never really got back to the average levels in the early 1900s.

Debt, Debt, & More Debt National Debt $9.6 trillion

We need a financial system with much less leverage.

U.S. Deficit $357 billion

A budget deficit results when the federal governement spends more than it brings in during a given year.

By 2008, the U.S. deficit reached an estimate of $357 billion while the debt reached $ 9.6 trillion—this makes the deficit look like a minor problem.

However, the federal government does not follow the same accouting practices it requires corporations and state/local governments to follow. The national debt would be $ 59.1 trillion if it did.

There are also derivatives, which are designed in contracts and used to create synthetic leverage.

Leverage was everywhere. Indeed, often leverage was piled on top of leverage— as when companies with highly levered balance sheets bought derivatives with high synthetic elverage. The hint here for regulatory reform is too obvious to miss.

Debt as % of GDP

2008 Household debt rose from about 100% of GDP to about 140% in only 8 years.

Total Household Debt

Mortgage Debt

Personal Credit and Other Debt

100%

2000 Household debts begin to show significant increases.

50%

1992

1996

2000

2004

2008

Where Were the Regulators?

The rationale for financial regulation is often summarized as ensuring the safe and sound operation of banks and other financial institutions. Yet, regulatory failures were legion in the years leading up to the crisis.

These regulators serve many purposes but these are the main four:

Minimize costs to the taxpayer.

Prevent collapses such as the one we suffered through.

Ensure square dealing.

Limit contagion from one sick institution to another.

Where did the bank regulators go wrong?

One of the tragedies of the financial crisis is that bank regulators could have shut the door on the outrageous underwriting practices but didn’t.

Regulators received plenty of unsolicited warnings.

Their exceedingly permissive attitudes toward subprime lending.

OTS

Federal Reserve

Heavily influenced by political pressure.

FDIC

OCC

The Federal Reserve is not solely at fault for regulatory failures. In truth, while the Fed was the most prominent of the nation’s four bank regulators, it was not the biggest player. Most bankers dealt much more with regulatory personnel

None saw the complete picture for what it was.

from the Office of the Comptroller of the Currency (OCC), the now-abolished Office of Thrift Supervision (OTS), and the FDIC. And each was just as asleep at the wheel as the Fed.

Subprime Mortgages—CDO To explain how subprime mortgages have affected the economy, first I must explain what a CDO is and how it functions.

Mortgage

Mortgage

Mortgage

Mortgage

Mortgage Lender

The mortgage lender sells the mortgages to the investment banker; he no longer has risk and gets quick cash, why not?

The bankers then combine the mortgages into a CDO.

Investment Banker

A CDO stands for Collateralized Debt Obligation—which stands for a group of pooled assets that may include mortgages, bonds, and loans.

The banker would get monthly payments from every household who borrowed a mortgage.

To get as many mortgages approved by the credit rating agencies, investment bankers combine mortgages from the three different tranches. These CDOs then get overall average of AAA credit ratings because “the good loans balances out the bad loans�.

SAFE

CDO

OKAY RISKY

A A A Investors

Bankers

Hedge Funds

The top tranche is sold to investors as it fits their low-risk profiles, the middle tranche is sold to other banks, while the mortgages from the bottom tranche are sold to the risk-takers and speculators.

Subprime Mortgages—Loans Designed to Default The investors are so happy with their tranches that they ask the banker for more.

So the banker asks the lender for more mortgages.

The problem is that the lender cannot find any more people to buy his mortgage, yet everyone who qualifies for a mortgage already has one.

NO Down Payment

FREE MONEY!

NO Proof of Income

Everybody who were involved got rich! YAY!

Interest Payments only

Lenders start to write up riskier mortgages called subprime mortgages. These new mortgages became riskier and riskier, to the point where someone could get a mortgage without presenting any proof or document at all!

None of the rating agencies find this troubling at all, since the loans are all packaged up in CDOs, they are passed with, as always, AAA ratings.

But eventually the subprime mortgage borrowers have to begin repaying the principal on their loans, and their montly payments skyrocket.

The sub-prime mortgage borrowers begin to default.

Default

As more subprime mortgages default, more and more houses on the market become available, causing them to plummet in value.

The banker needs to sell the CDO to the investors to pay back all of the money he borrowed to buy it. But they do not want it, they already own thousands of CDOs that are plunging in value.

Everyone gets paranoid because no one knows who has CDOs or how many.

Banks and institutions stop buying or lending any thing, and star t running out of money...

Therefore, leading to the crashing of the economy.

It’s Too Complex!

Many mortgage-related assets were far more complex than suggested so far, and most of them are designed this way to confuse regulators and ordinary people who are not aware of being invovled. In fact, a lot of how the fianancial crisis came to be is not fully explained.

Credit default swaps ($62 trillion, notional value) (more than $2 trillion, replacement value)

Just to show you how complex the financial engineering is, here is a “simple” diagram of how modern finance works:

FHA/VA mortgages

DIVIDED INTO TRANCHES

Alt-A mortgages Residential mortgage-backed securities ($1.2 trillion in 2006)

ORIGINATOR

Asset-backed securities ($10.7 trillion in 2006)

Mezzanine Equity

Prime mortgages Student loans Subprime mortgages ($10 billion in 2001, $600 billion in 2006)

Senior

Credit cards

Auto loans

Commercial mortgagebacked securites

Simple enough?

CDO cubed

The recipe for how $ 500 billion in subprime mortgages can become a multitrillion-dollar mess. Take those mortgages securitized them. Mix and match them. Combine them with other securitized debt. Mix and match some more. Add debt at every step. A lot of leverage and a big mess.

CAN BE DIVIDED AND COMBINED

CDO squared

CAN BE DIVIDED AND COMBINED

Collaterlized debt obligations ($2 trillion in 2006)

CDO investors

Banks warehouse and reconstitute

CDO managere borrows money

Conduits SIVs

Funded by assetbacked commercial paper (ABCP)

BANKS PURCHASE

Sources Blinder, Alan S. After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. New York: Penguin, 2013. Print.

“Case-Shiller Home Price Indices.” Standard & Poor’s Dow Jones Indices. N.p., n.d. Web. 20 Oct. 2014. <http://us.spindices.com/indices/real-estate/sp-case-shiller-us-national-homeprice-index>.

“Federal Debt: Total Public Debt as Percent of Gross Domestic Product.” Federal Reserve Bank of St. Louis. N.p., n.d. Web. 20 Oct. 2014. <http://research.stlouisfed.org/fred2/series/GFDEGDQ188S>.

Holmes, Nigel. “GOOD Sheet - It’s the Economy, Stupid!” GOOD Magazine 2008: n. pag. GOOD. Web. 16 Oct. 2014. <http://awesome.good.is/goodsheet/goodsheet006economy.html>.

Rendgen, Sandra, Julius Wiedemann, Paolo Ciuccarelli, Richard Saul Wurman, Simon Rogers, and Nigel Holmes. Information Graphics. Köln: Taschen, 2012. Print.

The Crisis of Credit Visualized – HD. Dir. Jonathan Jarvis. Perf. John Levoff. The Crisis of Credit Visualized. Youtube, 22 Jan. 2011. Web. 17 Oct. 2014. <http://crisisofcredit.com/>.