I was going to call this “Financial Crisis for Dummies” but on looking at the evidence the worst dummies in the current mess are all investors and financial “experts”, who know exactly how these things work and were STILL stupid enough to get into it.
This article is based primarily on a lecture from esteemed economics academic Alan Blinder, who pulls no punches and explains things in a detailed and surprisingly accessible way. His lecture, which is about 90 meg, can be downloaded here.
First things first: anyone who still says that this crisis was caused by people taking home loans (mortgages) that they couldn’t afford is wrong. The “sub-prime mortgage market” (“sub prime” meaning basically “people who might not pay us back”) made up 25% of the total mortgage market in the US. Now that’s a lot, but it is nowhere NEAR enough to explain the collapse of the entire global economy. This crisis only happened because a number of other aspects of the financial system were also in dangerous waters. And it is to them, the financial “experts”, to whom we can focus our blame.
Now, the following explanation has been massively simplified. It is all true, but a lot of the details and nuances have been left out. If you know enough about economics to spot something I got wrong or misunderstood then please POST IT, so that I may learn.
Thank you :)
In order to understand what happened we need to talk about clipper ships. Remember the Dutch East India Company? It’s ok if you don’t. Just understand that the way things worked back a few centuries ago was that if you could get a ship full of European “stuff” to China then it would come back full of Chinese “stuff”. And because Europe didn’t have any Chinese stuff you’d make a frikking fortune.
So naturally people wanted to send ships over there, but that takes money, so they borrowed money, lots of it and used that money to load up a ship and send it off. From then on things were basically up to luck. If your ship came back you paid off your loan and still made a fortune. But if your ship sank in a storm or was taken by pirates then you were screwed. Completely, fully, deeply and rhythmically, SCREWED.
Note: the act of taking out a loan you can’t pay back if things go bad is called “over leveraging”. This will come up later.
It was a dangerous business but the potential profits lured many people into it. And in a bizarre way kinda the same thing started happening again in the early 2000s.
(I know that the following explanation of the derivatives market leaves out how derivatives actually work, but given how hard that is for anyone to explain I feel my explanation deals with the central points without damaging people’s brains)
It starts with a “Mortgage Backed Security” or MBS. What an MBS is, in human language, is a collection of home loans (mortgages). Let’s call the guy who owns this MBS “Adam”. Now that Adam has bought himself a collection of loans he is looking pretty financially safe. Every month most of the people whose mortgages make up the MBS make their monthly loan payment to Adam so he gets all that money.
But Adam is clever, or at least thinks he is. He wants even more money. So he goes to someone else, let’s call them “Brian”, and he says:
“Brian! Why don’t you buy some of my MBS, it’s a collection of loans where mostly everyone pays me back. Then you too can get money every month.”
Brian says “Well Adam I’d love to. But I don’t have any money.”
Adam: “That’s ok Brian, just take out a loan.”
Brian: “Wait. So I will take out a loan, and then pay that loan back using money that I get from other people, who are ALSO paying back their loans?”
Adam: “Exactly. Everything will be fine, as long as everyone pays back their loans. It’s kinda like a clipper ship. As long as the ship arrives everyone you will be able to pay back your loan.”
Brian: “But what if the people whose loans make up the MBS don’t pay up?”
Adam: “Well then we’re FUCKED! :D
But don’t worry, over the last 5 years pretty much everyone has paid back their loans, on time.”
Brian: “And before 5 years ago?”
Brian: “Your shrewd argument has convinced me! I shall do it!”
Now, this is pretty risky investment practice for both Brian and Adam, but it was nothing compared to what happened next.