The housing crisis in the Netherlands has turned into a housing emergency, the head of the Dutch real estate agents’ association said on Thursday. New figures

What really happened in 2008 economic crisis? I need a simpler explanation.

Where to begin on a subject as important and complicated as the topic of the global financial crisis of 2008? A myriad of factors were in play and before giving you the punch line — let me begin by setting the table with some background info.

  • There is only one thing, and one thing only, that keeps banks in business — that’s having the confidence of their stakeholders, particularly the creditors of the bank (e.g., depositors, debt holders, trading counterparties).
  • Banks are highly leveraged — meaning that the banks are existentially dependent on debt funding to run their operations. The high wire act is intensified by the fact that much of their debt is short term in nature. If you can’t continually roll over your debt you’re dead.
  • Banks are also interconnected to each other in numerous ways — banks lend to each other, and take counterparty risk with other banking institutions through the capital markets as well.
  • Immediately following the tech bubble collapse in 2000 and 2001, the head of the Fed, then Alan Greenspan, felt it important to have loose monetary policy. That means flooding the capital markets and the economy with cheap money (we call it “liquidity”) — in an attempt to avert a recession.
  • The Fed does this by increasing the money supply and by lowering interest rates. They do this through open market purchases of government debt (price and yield of bonds are inversely related) and lowering the benchmark rate that the Fed controls — which is called the “Fed Funds Rate.” (The Fed, by the way, is supposed to be impervious to political influence … more on this later.)
  • Said loose monetary policy does work to a point — like a shot of adrenaline for the economy. This lowers the cost of borrowing for consumers and corporates alike. However, too much of it can have adverse consequences. Think of cheap credit being no different than heroin — it can be addictive and it can hurt a lot of people in the end.
  • It all started very slowly at first. With interest rates at historic lows and because consumers were feeling battered after the bursting of the tech bubble earlier in the decade, individuals started to move money into other asset classes, including real estate, to find returns.
  • With low borrowing costs, though, not everyone was happy. The profitability of banks is dependent on “spread” — that is how much banks charge on loans as compared their costs of funds. Just remember that low interest environments are generally bad for banks as “spreads” often get compressed.
  • Underwriting criteria and diligence standards for credit risk were weak to start with, but got even looser over time. Far too many loans were approved that probably never should have. But what to do with these loan assets once created? (More on that below.)
  • Unless you closely follow the markets, you’re probably are unaware that most banks don’t actually hold mortgages for very long. They ideally want to originate what are called “conforming mortgages.” This is because mortgages that are originated by the banks are sold on to other investors — most go to Fannie Mae and Freddie Mac — but need to be “confirming.” These are two quasi government entities (they are publicly traded) whose sole purpose is to promote a healthy housing market. By being able to sell the loans that they originate, banks are able to originate more loans. Freddie and Fannie want standardized loans so they set the criteria by which banks must follow if they are going to sell their mortgages to them.
  • Meanwhile, one of the adverse consequences of low a interest rate environment is that this actually hurts savers. Where do you park your cash if you need yield? If you’re the Chief Investment Officer of a large investor — think about pension funds, insurance companies, or endowments — you’re not looking for home runs. You want slow and steady and that means having a sizable allocation to fixed income products. However, there’s not much in the way of yield now thanks to the Fed.
  • The cash on hand from institutional investors (we refer to this as “liquidity” as well) thus went in search of yield — i.e., higher interest rates. (No different to how you might shop around among banks to get the best rates on your long term deposits.)
  • But — there is no free lunch in the capital markets or in investing. You can’t have better yields (or returns of any type) without taking on more risk. Very, very important. (More later on this.)
  • In case you’re wondering, the size of the debt capital markets vs. equity capital markets is many, many times larger. So, when the aforementioned class of investors has a change in attitude, the impact on real asset prices (like real estate) around the world can be enormous.
  • Some clever folks had an insight on how to create securities that would offer institutional investors higher yield without much added risk. So the investment banks invented a new class of fixed income securities: CDOs (collateralized debt obligations).
  • CDOs are — simply put — a lot of little assets pooled into a big one. Or more specifically, the cash flows of a lot of little assets — in this case individual mortgages — pooled into one big one. Once pooled together, the cash flows are combined, then divided into smaller pools based on expected payout profiles, and securities are created — the CDO. Depending on which part of the CDO offering you buy, the instrument will be tied to a designated pool of expected cash flows.
  • Once the CDO is created, the institutional investors could then pick and choose what cash flows they wanted. An investor could opt for a higher yielding security, for example, knowing that they were taking greater credit risk. Or vice versa. However, buyers of the securities all took comfort from the fact that assets were pooled together and that while some borrowers would default, most of that risk was diversified away by the pooling of risk in the first place.
  • I know that this will sound dumb to many, but many investors thought they really weren’t taking that much incremental risk because of the benefits of diversification — lots of little assets pooled into one big one. They also took comfort from the fact that were investors “beneath them” that took the first losses in the overall pool of cash flows.
  • Not surprisingly, fixed income investors loved CDOs backed by mortgages. In the early days, investors couldn’t get enough. The investment banks were happy to supply them with the product, but there was one problem. They needed to source more loans to pool into new CDOs.
  • Well you may now think that shouldn’t be a problem, as there surely must be plenty of people out there that have or want homes? And yes — there are. However, you’d be wrong about something really important. The number of credit worthy borrowers is actually relatively small.
  • So mortgage brokers and specialty banks then targeted a new class of borrowers — and this where the term “subprime” becomes en vogue. A huge swath of the American consumer heretofore had been shut out of home ownership now found themselves able to get mortgages.
  • Realizing that the banks were now loosening their underwritring standards, some “clever” people got together and created independent mortagage origination companies to help create supply for CDOs — subprime mortgages. Their sole purpose was to find borrowers. Sadly, there were a lot of bad actors that pushed mortgages through to the banks who then packaged their mortgage portfolios for sale via CDOs (e.g., Washington Mutual and Countrywide Financial).
  • With more buyers now in the market, real estate prices began to heat up around the US.
  • As real estate prices began to move, the asset class further attracted speculators. We all know of people in our network that had their own “real estate” portfolio. Consumers were leveraging themselves to the hilt in order to buy and flip real estate. Well the process spiraled and spiraled, and spread and spread, not unlike an aggressive cancer that had started to metastasize.

Now — I know that was a long winded preamble — here’s how things unfolded from there.

  • CDOs were now a massive part of the debt capital markets by 2007 and 2008. They were owned by nearly every institution on the planet. Lots of widows and orphans had exposure to the product (directly and indirectly) through their pensions, mutual funds, life insurance policies, etc.
  • Not satisfied in just making origination fees by putting CDOs together and selling them to institutional investors, many investment banks created derivatives around the CDOs.
  • A derivative is simply a contract between two parties where one is betting on the price of the underlying asset is going to behave one way, while the other is betting on the price doing the other or nothing. (The math and the nuances of derivatives are seriously complicated, but you get the idea.)
  • Given the fees to be had, others enter the fray. The biggest player was the insurance giant, AIG. You may say — “huh?” Yes, AIG, the big diversified and sleepy insurance company.
  • AIG was then looking for alternative ways to generate revenue, and over time they became a very large player in the capital markets. The team at AIG realized that they could sell “insurance” on CDOs. Their pitch was: “Hey Mr. Pension Manager, you have a lot of exposure to CDOs in your investments portfolio. You need to some protection. We will sell you insurance on the CDOs that you own in the event that they don’t pay at maturity.”
  • AIG, and a whole host of other financial institutions led by Goldman and Deutsche Bank, sold hundreds of billions of dollars worth of insurance on CDOs through a common form of derivative called CDS — a credit default swap.
  • The way a CDS works is that if the CDOs that were being insured payed out as expected at maturity then no insurance by AIG needed to be paid. AIG, or whomever that underwrote the insurance risk, gets to keep the insurance premium — which was substantial. If the CDO blows up, AIG pays out the insurance claim.
  • Because the market for CDS on CDOs was new, fees charged for this form of insurance were very attractive. More and more banks got into the act.
  • Remember what I said earlier. Like climbers on a mountain, each bank is connected to every other. They are directly or indirectly tied to the fates of others — often tied through counterparty exposure via derivatives.
  • Well the last few years before the crash, this cancer successfully reached the marrow of our financial system and would continue to spread pernicously, completely and without remorse until nearly every sector of the markets was infected.
  • Now at this point in the cycle (mid 2000s), real estate prices are on fire. Some institutions decide that it’s just not good enough being an agent — that is selling securities on behalf of others. Lehman Brothers — and they were not alone — said that “advisory and placement fees look like chump change. We want to invest our own capital [what we call being a “principal”] into real estate.” So, they take their own capital and start speculating in real estate. They go big into it and, among other things, buy mortgage originators to get an edge for their investment banking business unit that creates CDOs. They also speculate on billions of dollars worth of real estate around the world because they want to ride the wave of real estate price appreciation now unfolding. Of course, Lehman borrows money to do all of this.
  • With the demand for real estate assets and CDOs hitting a fever pitch, the ecosystem around mortgages starts to expand and mutate in unexpected and uncontrolled ways.
  • Entire hedge funds are formed with the sole purpose of investing in CDOs. This of course means you need more CDO products, which also means you need to find more borrowers. In order to feed the beast, underwriting standards become even more loose among mortgage brokers and providers.
  • Each of these hedge funds also need protection on their CDO holdings. AIG and others also sell them the insurance, too. More CDS contracts are sold and hundreds of millions in fees are generated.
  • So now the total notional amount of risk surrounding mortgages in the US is hundreds of times larger than the actual size of the real estate market. The distribution of what should have been a relatively small amount of risk has been massively enlarged through CDOs and CDSs, and was now in the hands of nearly every financial institution.
  • Then the daisy chain then starts to collapse. (No surprise.)
  • When a whole bunch of folks are given loans that they had little chance of being able to repay bad things will eventually happen.
  • Defaults start to appear — but it’s just a little bump at first. Institutional investors in the ecosystem are comforted by the fact that the US real estate market is actually just a collection of a lot of little markets — “risk has been pooled in CDOs so diversification will avoid anyone from getting hurt.”
  • Not so fast. Two hedge funds managed by Bear Stearns blow up. (“Ruh-roh, Shaggy.”) Smelling something amiss, creditors of Bear Stearns start to pull back. The anxiety feeds on itself and Bear nearly collapses. But the Fed pushes the company into the arms of JP Morgan for pennies on the dollar. Everyone is relieved thinking that the problem was isolated.
  • You’d think that’be the end of the story. Nope. Not by a long shot. This is where things start to really get interesting.
  • The Fed, now run by Ben Bernanke, along with the Secretary of the Treasury, Hank Paulson (the former CEO of Goldman), are roundly criticized for bailing out Bear Stearns’s shareholders. (The shareholders, including the CEO, actually got crushed from the “rescue.”)
  • Conservative pundits on CNBC and Fox are aghast because the government has just introduced “moral hazard.”
  • “These guys at Bear just just f*cked up, why should the government broker a deal, subsidize it and help push the company into JPM?”
  • “Ok. We get it,” say the overseers of finance in the US — “We are going to get tough.”
  • Now back to AIG. Remember they have been selling insurance on CDOs all throughout this run up in real estate prices. But as losses started to creep into these subprime mortgages, they are faced with the prospect that they just might have to deliver payouts on the insurance they sold.
  • You may remember the tsunami that was created by an asteroid that hit the Atlantic Ocean in the movie “Deep Impact” — a great film starting Tea Leoni and Robert Duval, BTW. Well by 2008, AIG now knows that they have a problem.
  • They thought they were selling flood insurance to homewowners in the Gobi Desert. (“Easy money, man.”) Guess what? They now see on the distant horizon a tsunami headed their way that makes that wave from “Deep Impact” look like a ripple in the kiddie pool.
  • AIG comes to the stark realization that they don’t have enough capital to cover the losses on the insurance contracts that they wrote, and the markets get wind of this.
  • Fast forwarding a bit, and after getting battered by the markets, AIG has a one way express ticket to a town called Oblivion, which is populated by companies like Worldcom and Enron, and the sherif is a guy named Eric Estrada. Well, sh*t. That’s the place where highfliers go to pasture, including TV idols from the 1980s.
  • What happens next? A government sponsored bailout of AIG is orchestrated. The US government takes a big stake in the company by injecting fresh capital into the company.
  • Now AIG is many, many times larger than Bear Stearns. If you thought that you saw market obvservers get upset with the rescue of Bear — well these same pundits take their displeasure to a whole new level: BSC. (They go “bat shit crazy.”)
  • Paulson, Bernanke, and W are pilloried in the press. The conservative pundits were just brutal. After a few “mea culpas” the lessons have been learned — “No. More. Bailouts. We get it!”
  • Yet another problem has been brewing — remember Lehman’s been buying real estate assets all over the world. The rub — these assets haven’t been performing as they hoped. They don’t know it just yet, but “they goin’ to die” — and in ignominious fashion.
  • Losses are mounting in Lehman’s highly leveraged real estate portfolio, and they don’t have enough capital to cover their losses. Creditors to Lehman are sensing a problem and they stop rolling over their lines of credit, starving the company of cash needed to fund their daily operations. (It’s a bad idea to have a mismatch in how you fund your liabilities — short dated, like Lehman, as compared to the speed at which your assets convert into cash which is long dated, like real estate assets.)
  • Lehman fires their CFO and promotes one of their top bankers to be the face of the company to the markets. Despite her wit, seasoning and telegenetic presence, the markets aren’t impressed. She gets decimated on her first earnings call.
  • Remember that scene at the end of the movie “Fargo” where the cop discovers that the kidnappers she’s been chasing across the state have turned on each other? Do you remember what she says the the surviving perpetrator? “I guess that would be your friend there in the wood chipper, eh?” Well, that’s what happened to the new CFO.
  • The run on Lehman begins again and accelerates. No stopping it this time.
  • The Fed tries to orchestrate a merger, first with BofA, and then others. They even ask Warren Buffet make an investment into Lehman. Buffet and BofA are too smart to bite. They walk away.
  • In a Hail Mary attempt, the CEO of Lehman, Dick Fuld, tries to get one of the Korean Banks to save Lehman.
  • You may know about the Hail Mary of all Hail Marys. In “The Play” — Doug Flutie was the quarterback for Boston College. He completed a last second TD pass 50 yards down field to beat a heavily favored University of Miami. That play also won him the Heisman Trophy. Now imagine Flutie trying to complete that pass paralyzed from the waist down. Well — the odds of Lehman pulling off the deal with the Koreans were actually lower.
  • With nowhere to go, the Board of Lehman turns to the government. But W, Paulson and Bernanke are like — NFW. “We can’t touch this. Are you kidding? We are the champions of the free market and — gosh, darn it — we must avoid moral hazard. I am the ‘decider.’ ”
  • Finance ministers around the world make calls to leaders in the US government to express their concerns over the fate of Lehman. (Remember — financial institutions are interconnected.) Markets everywhere are starting to go into panic mode. Some leaders even go so far as to say to W — “don’t let Lehman fail!”
  • Well. The Fed and others let Lehman fail.
  • One crisp fall morning we wake up the news that Lehman has filed for bankruptcy protection and the markets open up in a full blown panic not seen since October 1929.
  • Remember what I said that one thing and one thing only keeps financial institutions in business? Well, guess what. Confidence is now gone.
  • Visualize the passengers on the Titanic continuing to dance away in the ballroom after hitting the iceberg. “Buffy, dear, that was a wee bump was it not?” Once Lehman failed all bets were off. The collapse of Lehman was a wake up call to all who were continuing to dance thinking nothing really was amiss. Using my analogy above, those same patrons, once giddy with champagne, now realize they now have to head for the exits. One problem, there ain’t enough life boats or life preservers to go ‘round. Yep. Boss, we got some issues.
  • Now everyone is awake to the fact that our financial system — the very lifeblood of the global economy — might be a house of cards. Credit is officially frozen and the markets seize up. The reverberations are profound.
  • Like the Death Star from Star Wars training its sights on its next hapless planet that it must blow into smithereens like Alderaan (“Luke — I feel a a great disturbance in the Force”), Merrill Lynch finds itself in firing range.
  • With limited chance of surviving, the government forces Merrill into a merger of BofA. (The CEO of BofA had a gun pointed at his head by Bernanke and Paulson.)
  • Soon other banks find themselvers in cross hairs of the Death Star. On and on the daisy chain continues to collapse.
  • Banks, and their regulators, from around the world are starting to freak out. (Banks being interconnected and no one having any confidence left.)
  • Banks in the UK and Europe start to wobble. They have exposure to US banks and they too own CDOs or have sold CDS (insurance).
  • The entire banking system of Iceland collapses, and with it their economy. (Damn — we might have to back to being Vikings seeking to rape and plunder foreign lands, the the fair locals with unpronounceable names.) That chant you heard during Euro 2016 when Iceland upset England in Quarterstage play — well we heard it in NY across the Atlantic in 2008. (“Hooh!”) It was reminiscent of the sound of the nation being sucked into the Atlantic.
  • No joke — the thought of Armageddon is now top of mind on the smartest financial professionals and regulators around the world at this point. Some say we’re headed into a nuclear winter and a new species will emerge resembling the creatures from The Walking Dead.
  • In the end, the US government had to create TARP (and other laws) in order to inject hundreds of billions of $ into the the banks, and forcing a number of other mergers. (BTW, all of the taxpayer money that was invested was returned and at a gain.) TARP and other actions took many months to stablize the system and at first it didn’t look like it would help. But the actions of the Fed and Treasury did in the end stop us from going over the edge. (See the infographic below.)
  • Let’s hope we never have to go through anything like the Global Financial Crisis again. All kidding aside, we were very close to the precipice — with chaos being unloosed around the world.

Sorry for the long post. For those interested in an even simpler explanation. Here’s the infographic that explains it all below (start from the top of the column on the left and work your across and then repeat row by row):