Claire Conger

The easiest and most entertaining (alligators in swimming pools!) way to understand the financial crisis of 2008, is to watch the movie The Big Short.

It is a true story and covers the basics of how debt escalated into a financial explosion. It depicts our moral imperative to make money, to find the loopholes, to be the most wealthy–finance is a game!

The movie explains about the banks earning fees by putting together (aggregating) mortgage backed collateralized debt obligations (CDOs) and our getting into trouble when the banks wanted more mortgages so badly that underwriting standards were abandoned. (Aggregating methods were supposed to mitigate risk by combining mortgages from different parts of the country into one CDO, the thinking being that the housing market moves differently in different regions.) The crisis was compounded exponentially by the re-combining of the mortgages into synthetic CDOs–the same mortgage could be in more than one CDO.

As the market for CDOs saturated and the lack of underwriting standards began to be reflected in default rates, the CDO aggregators started having a hard time selling the CDOs and their repo desks had a hard time funding them (aggregating the mortgages was done buy buying the mortgages, often with loans from other financial institutions; the repo desk finds the loans; when aggregation is complete the CDOs are rated by the rating agencies and sold like bonds to investors). The movie touches on the structural trap of rating agencies being paid by the people who need ratings.

There is a lot the movie doesn’t cover, for example, it was deregulation that allows speculators (heroes in the movie) to buy credit default swaps on credit contracts of which they are not a party. In other words, deregulation allowed insurance to be bought on something the buyer doesn’t own and the the insurer to sell that insurance as he wishes.

Here’s the concept applied to normal life: When you buy a home, you usually have to pay a monthly premium for an insurance policy on your loan (PMI)–your lender makes you pay for it, and the lender is the one who gets paid by the insurance company if you default. Now imagine if I, your neighbor, looked at you and thought, this guy’s not going to be able to make his mortgage payments, I’ll buy insurance on his loan. Everybody in the neighborhood does the same thing. You default. We each collect from the insurance company the full value of your loan. Sounds crazy, our fictitious little credit default scheme. Who would sell insurance like that?

The credit default swap is an insurance product that was invented for protecting banks from default by their corporate customers. It was approved by our regulators because it purported to spread risk. It started with individual corporate loans with the swap having only one buyer, and it allowed the bank more space on its balance sheet for more loans. (Does this sound dangerous already?)

The crisis was compounded further by applying the credit default swap insurance product to the mortgage backed CDOs and selling them to anyone. It’s what brought down AGI. When speculators can buy insurance on something they do not own, the seller rakes in the premiums, but the payout can be (was!) ruinous. Who would sell insurance like that?