The Last Financial Crisis

Seems that the last financial crisis characterized by the crash of the housing market had several causes. At the bottom of the food chain were the retail mortgage lenders that increased subprime lending to the point of offering no docs required, interest-only loans with ARMs. In the most extreme cases the borrower could choose to pay nothing for the length of the ARM and have the accrued interest added to the principal during the no-payment period. This kind of lending would allow a $14,000 per year subprime borrower to borrow the entire amount for the house with no down payment and no payments for the first 3 years. After 3 years the interest rate jumped significantly.

Mortgages were not kept by the loan originators. Instead they were sold to other financial entities who typically packaged groups of mortgage loans into bonds called mortgage-backed bonds. The bonds were rated based on the risk of the loans contained within the bond from AAA for no-risk non-subprime to BBB for very risky sub-prime loans. Another level of indirection was added when groups of mortgage-backed bonds were combined into instruments called CDOs (Collaterized Debt Obligation). This extra level of indirection made it difficult for ratings agencies to correctly rate the CDOs. In many cases, BBB or below loans were wrapped into CDOs that were given a AAA rating.

Next up were the big banks that greatly increased their exposure to mortgage-backed bonds throughout the early 2000s. In order to offset the riskier bets, they diversified by buying AAA-rated mortgage bonds or CDOs. But the ratings agencies inaccurate ratings on the CDOs created a situation where the banks could not accurately judge the level of risk contained in the CDOs being bought.

In all of this mayhem, a few astute individuals detected the patterns of destruction and placed short bets against the bubble. Some of these actors in the play are profiled and followed in the book The Big Short. It is an easy read for getting an overview of the sequence of events that lead to the crash of 2007-2008.