(Part2) The Housing Debacle of 2008

# You might want to go through part 1 before you read this one#

Before we start, let me quickly reiterate what we discussed in the last part. Our story started with banks lending riskier and riskier loans to less and less prudent people. Eventually, some smart bankers figured out that packaging these loans into boxes(housing bonds) and selling these to investors could generate much more profits. They became an instant hit so much so that the banks ran out of loans to put in them. This, in turn, made them give out more of subprime(risky) loans to keep the profit machinery churning. All this was going really well for the banks except the fact that some of these boxes were too bad to sell. Now banks obviously won’t just warehouse them, right? So they started packaging these bad unsold boxes (bonds) into a bigger box known as a CDO. Basically, bankers worked their magic and disguised it into something that appears lucrative and safe. Soon everyone wanted CDOs and nobody cared to actually look at what’s inside. Nobody cared to understand that they were being sold horse shit in a beautiful glittering gift box.

Now comes another inflection point in the market where a new ‘security’ arrives that is even crazier than the ones mentioned before. This goes by another obscure name of a CDS or a Credit Default Swap. A CDS is nothing but simple insurance on something. We all buy insurance so that we will be compensated if in case our car is crashed, right? A CDS is exactly this but instead of cars, we have our earlier boxes(bonds). The twist here is that you can not only buy insurance on your car but on my car as well. And by doing this, you can turn these insurances into a betting instrument. Confused? Don’t worry, just read along.

Say I have a big sea-facing house on marine drive worth about 10 crores. One gloomy day, the world wakes up to terrible news of a Tsunami heading towards Mumbai. This will destroy everything that’s there on the coast which sadly includes, my house. Now a guy comes to you and offers you insurance on my house. Given the circumstances, would you buy this insurance? Normally this doesn’t make sense because why on earth would you buy insurance on my house.  But remember, it is almost a certainty that my house will be destroyed by the tsunami and if someone happens to hold insurance on it, he is sure to be paid its worth. It's in your interest now to buy the insurance as you expect my place to be obliterated by the incoming catastrophe. Simply stated, CDS allows you to bet on the fact that my house gets destroyed.

The arrival of CDS allowed people to bet on our initial crappy housing loans. People stopped seeing these insurances as insurances and started seeing them as a way to place their bets in the markets. These CDOs and CDS were what turned a simple housing market crisis into a worldwide economic fiasco.

Let us quickly flashback to what has happened until now. Initially, there were simple house loans, the only problem being that they were given to people who were sure to default. Then there were these bonds that “was a box containing crappy house loans”. Then there was a CDO, which was a bigger box containing everything that didn’t sell, from actual loans to our original boxes or bonds. You could even put you unsold CDOs and make a CDO of a CDO. Then there was a CDS which was basically insurance on these CDO and Mortgage bonds. And as if it was already not complicated enough that they started selling a box containing all these CDS as well, a CDO of CDS. So in short, find anything that’s not selling, irrespective of whether its a loan, a bond or insurance, put it in a box, pay credit rating agencies to mark it safe and sell it to innocent investors. Although a little complicated, this infographic pretty much sums up everything.

I am not sure whether you have realized this or not but in a way, all of these bets were placed directly or indirectly on home loans. Irrespective of whether its a bond, a CDO or a CDS, it all relied on home loans in the end. Every last one of them tracing its roots to the same housing loans which were now part of god knows how many boxes. And these boxes were humongous, not even comparable to the size of actual loans. For instance, the volume of debts covered by CDS was more than $45 trillion dollars at the end of 2008. To put that number in perspective, that is about 15 times the entire GDP of our country!

Imagine an inverted pyramid with its base as these loans. And what would happen to this pyramid if the loans went bad? Nobody thought about this. All of this was based on a single assumption that since housing is always stable, it could never collapse.

April 2007, that’s when the economy got its first shock with New Century Financial, a sub-prime mortgage(worst loans) lending company filing for bankruptcy. That would mean that all the loans that New Century owned, on which there was an insanely big amount of money betting, were now worthless. And now that those loans have gone bust, the pyramid made of bonds, CDOs and CDSs should immediately collapse, right? Well, not in this reality. That would mean all the banks going bust and bankers would obviously won’t let it happen. So yeah, nothing actually changed apart from the fact that banks realized that they are screwed right now, selling all those CDO and CDS to people. At this point, the banks were holding a hell lot of these securities and suddenly they were worthless. So they continued as if nothing had happened and almost secretly started selling their positions before everyone else catches up.
In terms of our earlier example, banks sold a lot of insurance on sea-facing houses in the greed of collecting the premiums because well, they never thought that the tsunami would come. But they caught on to the inevitable Tsunami much before everyone else and sold their positions so that someone else and not they would have to pay that 10 crores to you (if you were smart enough to buy the insurance).

The level of crookedness in the markets was beyond fathomable at this point. Everything was behaving weirdly. Take the bonds or our original box for instance. The sub-prime loans were worthless now, but the bonds which were made of these subprime loans were more valuable. It’s like the sweets have gone bad, we can see it but the “assorted box”(part 1 reference) which is made of these sweets was suddenly more valuable. Or take CDS which were still being traded in the market in spite of the underlying loans being worthless now. How can the prices of these insurances not be affected by the demise of the very thing that it insures? It’s the same as, there are no more cars in the world, but car insurance is being traded amongst people. Isn’t it completely against what an “insurance” stands for?

But even these last desperate attempts to stay afloat were not enough and the ship had already started sinking. Meryl Lynch had already declared $55 billion in losses and was bought over by Bank of America, layman brothers had gone bankrupt overnight, Bear Sterns sold to JP Morgan for $10 dollar a share and Citigroup with its $60 billion debt, waiting for its uncertain future. On 15th September, when layman brothers filed for bankruptcy, it wiped away 25,000 jobs in an instant and set off a domino effect across global markets that led to the worst financial crisis since the Great Depression of 1929.

All of them would have definitely collapsed had not the US government intervened. Uncle Sam couldn’t allow all the banks to fail simultaneously because that would have implied the end of capitalism. These banks were simply “too big to fail”. So in a dramatic meeting on Sept 18th, 2008, Treasury Secretary Henry Paulson and Fed chairman Ben Bernanke proposed an emergency bailout to these banks. Bernanke reportedly told them, “if we don’t do this, we may not have an economy on Monday”.  So yeah, banks got greedy, took away people’s jobs, screwed economy completely and in the end, it was the US government and its taxpayers who had to bail them out.

I am sure you might have found these last 2 posts pretty involving and complicated but that’s all the more reason to understand this. I don’t think enough people know about these events which makes them even more obscure and disastrous. At times it gives us the impression that all of this is happening far far away from us, in some streets with obscure names like Wall Street or Dallal street and there’s no way it can impact us. But remember, normal housing loans were a root of these problems and the people who paid the price of losing their pension funds, retirement savings and mutual funds were just like us.  The sheer number of us is so huge than even very small and seemingly insignificant decisions taken by us create socio-economic forces that are well beyond the control of any human being. And with the current state of the economy, it becomes even more important to understand these things. You need to know things first in order to protect yourself from their ill effects.

Our Indian economy and the entire global economy has been in a state of slowdown for some time now. We have been receiving strong signals of an inbound recession for some time now (read about Bond Yield curve inversion if you are curious). And with the entire world in a state of lockdown following the coronavirus, the economy is bound to suffer even more. Stock markets around the world are tumbling and our own NIFTY with its 30% fall is not an exception. We definitely have some very difficult times ahead.  The best way forward would be to learn the skill to surf these ways seamlessly and it won’t hurt to learn a bit of finance. I will try to cover all the things that we might go through and how can we try to mitigate the effect in the upcoming post.

Until then, Take care and be safe

- Nikhil Mudholkar