A Crisis so Severe, the World Financial System Is Affected

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A Crisis So Severe, The World Financial System Is Affected
Following a period of economic boom, a financial bubble—global in scope—has now burst.

A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail.

John Bird, John Fortune, Subprime Crisis, February 14, 2008
While there are many technical explanations of how the sub-prime mortgage crisis came about, the mainstream British comedians, John Bird and John Fortune, describe the mind set of the investment banking community in this satirical interview, explaining it in a way that sometimes only comedians can.

Together with impressionist Rory Bremner, derivatives (securities derived from other securities) are also explained:

Bremner, Bird, and Fortune, Silly Money: Where did all the money go?, Part 3, November 10, 2008

Bremner, Bird, and Fortune, Silly Money: Where did all the money go?, Part 4, November 10, 2008 The betting of practically anything helped create enormous sums of money out of almost nothing. However, as former US Presidential speech writer, Mark Lange, notes, “because [derivatives are] entirely unregulated and trade on no public exchanges, their originators can deliberately hide their vulnerabilities.”

Jonathan Jarvis explains the causes of the credit crisis in a short, engaging video:

The Crisis of Credit Visualized, Jonathan Jarvis
If you are unable to see the video, or, for further details, the next two sections go into this further.

Securitization And The Subprime Crisis
The subprime crisis came about in large part because of financial instruments such as securitization where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer gets regular payments from all those mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.)

As BBC’s former economic editor and presenter, Evan Davies noted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up.

Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it went beyond their area of expertise. For example,

Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities. Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on. Some banks loaned even more to have an excuse to securitize those loans. Running out of who to loan to, banks turned to the poor; the subprime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Subprime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US. Some banks evens started to buy securities from others.

Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news. Side Note» High street banks got into a form of investment banking, buying, selling and trading risk....
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