The 2008 global financial crisis explained in simple terms.

Greed is good, right?

Well, not really. The consequences of that greed are still present nowadays. But what was the cause of the global financial crisis in layman’s terms?

It all started in AIG, the American International Group. As flows started to pour into the US in the early 1990’s, domestic banks had a lot of cash that wasn’t really moving so, they have decided to start lending this money at looser rates. Most people could get home loans that were previously unattainable.

The banks simply took the properties (houses) as collateral which is the normal thing to do. The bottom line is that Americans could buy homes even if they couldn’t afford to. How was the “couldn’t afford to” state evaluated? Simply, by individual credit scores, which tell you how likely the applicant will pay back the loan. However, too much money lying inside the banks meant that they could take the added risk and this prompted the creation of subprime mortgages. Knowing that these loans were carrying too much risk, banks started packaging them up into more exotic products called CDOs — Collateralized Debt Obligation. They would then sell these products as diversified (remember they did contain bad loans but they were different bad loans). Buyers went wild for these financial instruments; little did they know how toxic they were.

By selling these products, banks got back their money much quicker than if they have waited for the loan to be completely repaid (if ever). The problem did not stop there, buyers were not that stupid and demanded some form of guarantee, so, banks ensured payment through insurance companies. Now, naturally, since these products were risky, buyers bought them at a discount and knowing that they are insured, they have looked for even more risk so as to maximize their returns.

Let’s review what we have so far. The banks have provided an opportunity for lower-income people to buy homes through subprime mortgages, packaged these mortgages in diversified products and sold them to buyers at a discount all while insuring them with insurance companies. But, why would insurance companies accept this? Well, they had a nice vision but rather an incomplete one. What would you say will happen if people kept buying houses due to the fact that banks gave them this golden opportunity? Housing prices would go up, right? This is the main reason. People started to flip houses rather than occupy them.

Even if someone could not repay their house now, they can just wait for a couple of years and actually sell it at a hefty profit. People who could not afford houses were not only buying them but actuall yselling them at a profit. This caused the prices to skyrocket. Insurance companies saw this as an opportunity to charge greater premiums and were actually making lots of money alongside the banks, so the music was still playing.

AIG is the largest insurance company in America that has roots all over the world. They had the biggest exposure to CDOs underwriting and buyers of CDOs were sure that AIG would pay them back in case the products default. AIG was swapping the bad ratings of the CDOs through its reputable rating by underwriting them and this is known as a CDS (Credit Default Swap). These products were in high demand and made lots of money to AIG. But the insurance conglomerate did not have reserves equivalent to the possible payouts in case of default, they have relied on some shady probabilistic measures which is a fancy way to say, that won’t happen to us.

They have also used some accounting manipulations to hide this. By 2007, the bubble finally burst and borrowers defaulted because they could not sell their houses at a profit anymore and had no actual income to repay their mortgages back. This chain reaction led to the mass default of the different CDOs. The final result? AIG defaulting on its insurance, and thus, many banks relying on AIG for providing the insurance went bankrupt. Lehman is the most famous example of this. In the aftermath, AIG was bailed out by the US government because letting it fail was simply going to be too catastrophic, it however, turned its back on Lehman brothers.

Still, the result of all of this fancy talk is that millions lost their jobs and homes. Hopefully, this type of greed will be controlled in the future but as history tells us, we will always be creative in finding new mistakes.

Written by

Institutional FOREX Strategist | Trader | Data Science Enthusiast. Author of the Book of Back-tests:

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