Financial Education

The 2008 Financial Scam

October 27, 2020

“It was a scam”

- Matt Taibbi

In 2008, the worst financial crisis since The Great Depression set in and wrecked the American economy.  The effects of this rippled through the whole world and caused a recession for numerous countries across the globe.  Though national struggles have many obvious negative effects, there can be a nugget of good that emerges.  In this case, Bitcoin, and eventually, DeFi (and Digifox), was this nugget.  However, the circumstances leading up to The Great Recession could have been avoided with more responsible behavior on all sides.  

The Premise

When banks approve mortgages, there are certain precautions in place to minimize risk.  This process includes many parties and a system of what is supposed to be checks-and-balances.

In order to get a mortgage, a potential home-owner will go to the bank to get a loan to buy a house.  In order to get approved for this mortgage, they have to provide some kind of reassurance that they would actually pay back the loan.  This often means tax returns, pay stubs, credit card history, and renting history.  Banks should not want to give loans to those who are more likely to default (or miss a payment) on their mortgage.  It’s just bad business.

However, banks are also not super interested in taking on the risks of mortgages, no matter how financially secure the loanee may seem.  Instead, what they do is bundle these mortgages and sell them as mortgage-backed bonds.  Credit rating agencies will take these bonds and rate them based on how secure they are, or how likely they are to be paid back.  

AAA - The best rating there can be.  Practically guaranteed to be paid back, but since it’s less risky, there’s a lower rate of profit to be made.  

BBB - Still pretty good, but not as safe as AAA, so it has a slightly higher yield.  

Anything with fewer than three ‘B’s and getting into ‘C’ territory is considered risky.  Sometimes these risky bonds are simply left unrated.  But with higher risk comes greater reward, and these bonds have the highest potential yield.  

These ratings allow the banks to sell these bonds to investors who are willing to accept the amount of risk involved with each.  Investors who only want the safest investment will buy the AAA rated bonds, other banks might buy the BBB bonds, and risk-takers like hedge funds might buy the lower-rated ones.  

The Great Money-Making Idea

Everything started out great.  The economy was thriving, real estate was booming, there was money to be made.  

Usually, investors might put their money into government-backed treasury bills from the federal reserve, which were considered the safest investment.  However, interest rates on these treasury bills dropped to 1-2%.  This was down from the 6% interest that could be earned the previous year, in 2000.  

Because of this drastic change, there was more money to be made in the housing market, as real estate was steadily climbing and had been for some time.  With the low return on investment for treasury bills, this meant banks and brokers could borrow tons of money with a very low interest rate.  There is always the potential to earn more money with borrowed money.  

So here’s the idea.

When a new homeowner takes out a mortgage to buy a house, the lender or bank gets that piece of paper that says the homeowner will pay back that loan plus interest, and that interest equals their income or profit.  The new homeowner is supposed to provide documentation to demonstrate how reliable they will be in paying their mortgage payment every month.  However, this mortgage still has risk.  The banks who handled this mortgage could just hold on to it, or, they could sell this mortgage to a third party.  

So this third party borrows millions of dollars and buys thousands of bundled mortgages, also known as collateralized debt obligation, or CDOs.  This is great for them, because now they are getting these mortgage payments with high interest.  Even if a homeowner does end up defaulting on their loan, no loss!  The real estate market has been climbing and is continuing to climb, and the house can be sold for a pretty penny, probably more than it was first purchased for.  

The Fatal Flaw

This was a genius plan.  However, there was one major issue.  Soon, demand for highly-rated, AAA mortgages outgrew the supply.  So what could be done?

Banks certainly didn’t want to lose out on this great money-making deal which was working so well for them.  They began giving anyone breathing a mortgage if they wanted one, even if they had no source of income and no way to actually pay off their mortgage.  Still, they didn't think this was a major problem, because if (or more likely, when) the homeowner lost their house from failing to pay back their mortgage, the house could be sold and profit could still be made.  

But still, investors probably wouldn’t be very interested in buying a stack of risky mortgages.  So instead, the credit rating agencies who were in charge of rating these mortgages started giving all of them AAA ratings, leading investors to believe they were as safe as can be.  

Sub-prime mortgages, a lack of honesty, and too much borrowed money set the stage for a massive chain reaction.

Housing Market Bubble Burst

Out of 75 million home-owners, 50 million of them had mortgages.  

So remember, this all started basically back in 2001, when annual interest rates on borrowed money from the federal reserve was at an all time low.  Money was being borrowed like crazy, and subprime mortgages were not only being given out, but also sold by U.S. mortgage companies to banks around the world.

Around 2005-2008, people began to default on their mortgages as interest rates reset and rose.  Many of these mortgages, regardless of if they were marked prime or subprime, had ARM, which is an adjustable rate mortgage.  This meant interest rates would go up on the mortgages after a certain number of years.  These adjusted rates were often hidden in the fine print and buyers were unaware of what they were actually getting themselves into.

While selling subprime mortgages was “okay” when people who bought the mortgages were aware they were buying into a risky situation and knew they could get a higher return at the end of the day, remember just about any mortgage was getting approved and rated as a AAA mortgage.  These people who likely would not have been able to get a mortgage in the first place in any other circumstances were unable to pay, so they defaulted.

Again, a few defaults here and there is really no big deal in the grand economic scheme.  Whoever holds the mortgage would then get the house and usually could sell it.  But when hundreds of thousands of homeowners are defaulting?  That’s a problem.  

The Economic Decline

“A total of 1,014,618 homes have been lost to foreclosure since the housing crisis hit back in August 2007.” - From a CNN article published December 11th, 2008

At this point, the Lehman Brothers, who had been around since their birth as a small general store in 1844 and had since grown to become one of the largest investment banks in the world, had already filed for bankruptcy.  Their stocks had plummeted a shocking 93%, and they became the largest corporate bankruptcy in the history of the United States.  Though they definitely weren’t the only major player filing for bankruptcy due to the crisis, they are considered the most notable.

Homeowners initially considered to be genuine prime mortgages also began to add to the crash.  When they saw the homes around them plummeting in value, and their own home being worth significantly less than what they owed, many began walking away and defaulting on their mortgages, even if they were still financially capable of paying.  

The whole world was suffering from this crash.  Home values had been increasing across the world, and they seem to have all plummeted at the same time.  Millions of people lost their jobs.  

Additional Factors

There are so many layers to this crisis.  Some organizations were placing bets on whether or not certain mortgages would be paid or defaulted on, known as credit default swaps, which acted like an insurance policy for CDOs.  This just added more debt and lost money to the whole mess.

There was a rise in oil prices in 2008, as well. Though usually in a recession oil prices fall, there was an increase in demand for oil from China and India, which pushed the prices up instead of down. Soon thereafter though, as the effects of the recession weighed on the global economy, oil experienced a dramatic crash, as global growth stunted demand for commodities.  

The stock market crashed and reduced wealth across the board.  People were suddenly without jobs and without extra money to spend.  Since spending and exchanging money is crucial to a sustainable economy, this only damaged the situation further.  

A single country experiencing a recession is problematic enough, but when the whole world suffers the same thing?  Recovery is difficult, and the United States government focused on bailing out large corporations.  However, out of all this, we’re still here.  Bitcoin was invented in the wake of this economic disaster, which opened the door to a whole new industry.  DeFi is yet another evolution spawned from the cryptocurrency movement that may very well prevent us from future recessions like 2008.  We’re lucky to live in a world where no matter how bad something can get, good can come out of it.  

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